Reducing The Debt Through Inflation: A Wrong Path

Alleviating public debt through a dose of inflation is a widely shared and defended idea, it even seems obvious. But what is it really? A note from the Fipeco website (a French non-profit association) takes stock of the fallacy of this belief.

Already, many people don't know this, but part of the government debt (11%) is indexed to inflation (the OATi, see my 2018 article). The inflation of the eurozone, not even that of France. In the event that it increases, the interest charges on these bonds would skyrocket, negating the expected gains on the rest of the debt.

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Image Source: Pexels

Secondly, it must be understood that an increase in inflation will obviously push investors to demand higher interest rates, otherwise they will no longer buy bonds. According to the scenario used by Fipeco, which is quite credible, with inflation at 5.0% from year one, the interest rate gradually increases from 1.0% in year one to 5.0% in year ten. Under these conditions, the debt initially falls somewhat (from 120 to 103% of GDP) and then rises gradually. As can be seen, the gain is in fact, very limited.

In effect, the first condition for taking advantage of a return to inflation is to stop all deficits so as not to need to borrow any more, and even to generate a surplus to pay off past loans coming due. In this way, the past debt burden is effectively reduced. But this is an illusion, as deficits have become the morphine of most countries on the planet! On the contrary, this increase in the rate of inflation, which leads to a slight decrease in public debt, will rather encourage governments to further increase their deficits.

On the other hand, the costs of high inflation are numerous. For central banks, keeping inflation under control for a long time is part of the core of their credibility; if it were to rise, they would lose it, and it would be very difficult to rebuild. It is not easy to get inflation going again, but once it has gone, it can accelerate and become very difficult to control. Without even considering hyperinflation, with a rate of only 10%, it is difficult to return to inflation of around 3%. Remember that it took France several years in the 1980s to achieve this.

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