Sunday, August 10, 2014

10/8/2014: Inflating Away the Public Debt? Not so fast...

There is a lot of talk amongst Irish and european policymakers about the big great hope for deflating public debts across euro area periphery: the prospect of inflation taking chunks out of the real debt burdens. This hope is based on a major misunderstanding of history. In many a cases, in the presence of debt overhang, higher inflation does help erode the real value of debt. Alas, "While across centuries and countries, a common way that sovereigns have paid for high public debt is by having higher, and sometimes even hyper, inflation, this rarely came without some or all of fiscal consolidation, financial repression, and partial default (Reinhart and Rogoff, 2009)." This quote starts the new NBER paper, titled "Inflating Away the Public Debt? An Empirical Assessment" by Jens Hilscher, Alon Raviv, and Ricardo Reis )NBER Working Paper No. 20339, July 2014)

In other words, it remains to not entirely clear just how effective inflation can be in current environment, given there are no defaults and there are no direct and aggressive financial repression measures implemented in the majority of the advanced economies, yet.

The NBER paper takes on the issue from the U.S. debt perspective. Per authors, "…with U.S. total public debt at its highest ratio of GDP since 1947, would higher inflation be an effective way to pay for it?"

"Providing an answer requires tackling two separate issues:

  1. "The first is to calculate by how much would 1% unanticipated and permanently higher inflation lower the debt burden. If all of the U.S. public debt outstanding in 2012 (101% of GDP) were held in private hands, if it were all nominal, and if it all had a maturity equal to the average (5.4 years), then a quick back-of-the-envelope answer is 5.5%.1 However, we will show that this approximation is misleading. In fact, we estimate that the probability that the reduction in U.S. debt is as large as 5.5% of GDP is below 0.05%. The approximation is inaccurate since the underlying assumptions are inaccurate. The debt number is exaggerated because large shares of the debt are either held by other branches of the government or have payments indexed to inflation and the maturity number is inaccurate because it does not take into account the maturity composition of privately-held nominal debt."
  2. "The second issue is that assuming a sudden and permanent increase in inflation by an arbitrary amount (1% in the above example) is empirically not helpful. After all, if the price level could suddenly jump to infinity, the entire nominal debt burden would be trivially eliminated. It is important first to recognize that …if investors anticipated sudden infinite inflation, they would not be willing to hold government debt at a positive price. Second, the central bank does not perfectly control inflation, so that even if it wanted to raise inflation by 1% it might not be able to. Moreover, there are many possible paths to achieving higher inflation, either doing so gradually or suddenly, permanently or transitorily, in an expected or unexpected way, and we would like to know how they vary in effectiveness. Therefore, it is important to consider counterfactual experiments that economic agents believe are possible."

The authors "calculate novel value-at-risk measures of the debt debasement due to inflation, and ...consider a rich set of counterfactual inflation distributions to investigate what drives the results. Using all these inputs, [authors] calculate the probability that the present value of debt debasement due to inflation is larger than any given threshold. The 5th percentile of this value at risk calculation is a mere 3.1% of GDP, and any loss above 4.2% has less than 1% probability. Interestingly, much of the effect of inflation would fall on foreign holders of the government debt, who hold the longer maturities. The Federal Reserve, which also holds longer maturities, would also suffer larger capital losses."

The paper also "…explores the role of an active policy tool that interacts with inflation and is often used in developing countries: financial repression. It drives a wedge between market interest rates and the interest rate on government bonds, and acts as a tax on the existing holders of the government debt. We show that extreme financial repression, where bondholders are paid with reserves at the central bank which they must hold for a fixed number of periods, is equivalent to ex post extending the maturity of the debt. Under such circumstances inflation has a much larger impact, such that if repression lasts for a decade, permanently higher inflation that previously lowered the real value of debt by 3.7% now lowers it by 23% of GDP."

In short, there is no miracle inflationary resolution of the U.S. debt conundrum. And similarly, there is probably none for the euro area sovereigns stuck with debts in excess of 90-100% of GDP. The pain of inflation alone is simply not enough to magic away debts. Instead, the pain of inflation will have to be coupled with the added pain of financial repression, and in the euro area case, this pain will befall more domestic investors and savers, than in the U.S. case simply due to differences in debt holdings. While no one expects the financial repression in the euro area to match that deployed in Greece and Cyprus, one can expect the financial repression measures (higher taxation in general, higher taxation of savings and overseas investments, higher rates of cash extraction from consumers via public sector pricing and higher concentrations in the financial services sector to increase rates of cash extraction by the banks) are here to stay and to most likely get worse before things can improve a decade later.

The myth of higher inflation as a (relatively) painless salvation to our debt ills is getting thinner and thinner...

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