The Inflation Option

inflation (1)

I found this at the Economist’s Free Exchange really interesting.

[B]etween 1946 and 1955, the debt/GDP ratio was cut almost in half. The average maturity of the debt in 1946 was 9 years, and the average inflation rate over this period was 4.2%. Hence, inflation reduced the 1946 debt/GDP ratio by almost 40% within a decade.

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.

Two thoughts.

One, the Treasury has been financing the debt on a short-term basis. Makes sense given the yield curve but it might be a decision that we come to rue.

Two, the authors of the study say this implies slightly higher inflation rates for a shorter period of time in order to accomplish the same thing. One wishes that it was that easy to turn the inflation switch on and off and, as economists are wont to do, they neglect to factor in the likely behavior of politicians.

When the bill comes due, count on the politically easy inflation road, expect it to be significant and don’t be surprised if it roars out of control thus bringing us to the next recession.


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