Bastille Day - Laramie Hirsch first posted this on his own site, but has agreed to post here at MOTW, as well. This week’s Bastille Day in Paris featured a man flying...
9 hours ago
In contrast, inflation would have had little impact on reducing the debt burden in the mid-1970s. That period was characterised by a lower debt overhang, inflation was higher, and debt maturities were shorter (under 3 years). As a result, in 1975 a five-point increase in inflation would have reduced the debt/GDP ratio from 25.3% to 21.9%. The estimated impact of inflation on today’s debt/GDP ratio is larger than in the mid-1970s but not as large as in the mid-1940s. If inflation were 5% higher, the debt/GDP ratio would be about 20% lower, a debt ratio of 43.4% instead of 53.8%. Our computations of the impact of inflation on the debt overhang assume that all debt is denominated in domestic currency, none is indexed, and the maturity is invariant to inflation. Regression analysis confirms that US debt maturities over the period 1946-2008 are not responsive to inflation.Here's the variable I'm concerned about: the reserves of nations with large U.S. dollar positions. What happens to their currencies if the U.S. dollar is devalued?
We develop a stylistic model that illustrates both the costs and benefits associated with inflating away some of the debt burden. The model, inspired by Barro (1979), shows that the foreign share of the nominal debt is an important determinant of the optimal inflation rate. So is the size of the debt/GDP ratio, the share of debt indexed to inflation, and the cost of collecting taxes. A lesson to take from the model and the simulations is that eroding the debt through inflation is not farfetched. The model predicts that inflation of 6% could reduce the debt/GDP ratio by 20% within four years. That inflation rate is only slightly higher than the average observed after World War II. Of course, inflation projections would be much higher than 6% if the share of publicly-held debt in the US were to approach the 100% range observed at the end of World War II.
The current period shares two features with the immediate post-World War II period. It starts with a large debt overhang and low inflation. Both factors increase the temptation to erode the debt burden through inflation. Even so, there are two important differences between the periods. Today, a much greater share of the public debt is held by foreign creditors – 48% instead of zero. This large foreign share increases the temptation to inflate away some of the debt. Another important difference is that today’s debt maturity is less than half what it was in 1946 –3.9 years instead of 9. Shorter maturities reduce the temptation to inflate. These two competing factors appear to offset each other, and the net result in a simple optimising model is a projected inflation rate slightly higher than that experienced after World War II, but for a shorter duration.