In principle, inflation can reduce the size of a government’s debt relative to its economy.
In principle, increasing interest rates tends to slow inflation.
Governments/Central Banks may allow – intentionally or, more likely, unintentionally – inflation to persist for a number of years, only ratcheting up interest rates when public dissent absolutely requires it owing to persistent high inflation.
Disclaimers: To be clear I don’t think this is necessarily a good idea. I also don’t envy the position of central bankers and governments. Broadly, the US and many countries in Europe have high levels of debt and now high levels of inflation. I don’t see an easy solution. As I understand, people who know a lot more on this than me (including central bankers) don’t see an easy solution either.
Also, thanks to friends who helped me think through and develop concepts in this piece.
Debt and Inflation Problems:
Two current issues in the US, and much of Europe, are i) high inflation and ii) high levels of debt. I’ll focus first on the US with a graph from Olivier Blanchard and his team that I’ll come back to a few times in this blog.
Figure 1, below, has a lot on it, so start by just looking at the right hand side. Today, core inflation in the US has reached 6%. At the same time, the real interest rate (which is roughly what you get on savings after subtracting inflation) is negative 6%!
The next graph is the US government debt, divided by US Gross Domestic Product (GDP – which is the annual value of what the US economy produces). It’s common to consider this ratio (rather than the absolute amount of debt in dollars) because, if the US economy expands, then there is more money available (via taxes) to pay for the debt. So, it’s the debt relative to the size of the country’s economy that matters (not just the dollar amount of debt):
Looking at Fig. 2, obviously government debt has gone up significantly in recent years in the US – above WWII levels (in terms of this ratio).
Importantly, if there is strong inflation, then it’s common for the output of a country to increase (in dollars or Euros) just because prices are going up (as opposed to more work being done or products being made). Since government debt is mostly fixed in dollars (or Euro), this reduces the ratio of government debt to output (GDP) and is known as “inflating away the debt”.
Just a note on the EU
There are similar trends for inflation and debt in many EU countries. Additionally, it’s worth noting that – unlike states in the US, which are required to balance their annual budgets), countries in the EU can run a deficit. Since EU countries run different deficits they have different levels of debt-to-GDP and, broadly speaking, the interest rate that each EU country’s government pays is also different as a consequence. Since Germany is the biggest economy, it’s common to compare the interest rate an EU country pays to what Germany pays for its debt. This is referred to as the spread over German bonds. Italy is a common spread to look at because it’s a big economy with a lot of debt. (Probably it also makes sense to keep an eye on the spreads of countries nearer Russia right now that are under pressure owing to the war in Ukraine.)
Anyway, here’s the Italian spread, clipped from a Financial Times article on my phone earlier today:
I’ll come back to Fig. 3 later, but the point is that Italy has quite a high amount of government debt (relative to the size of it’s economy) compared to Germany, so it pays a higher interest rate. As European Central Bank interest rates move higher (to combat inflation), this can disproportionately increase borrowing costs for Italy relative to Germany (because Italy has more debt). So, the European Central Bank increasing interest rates has the further complication to consider of disproportionately increasing the amount governments like Italy (and other high debt countries) pay out on interest every year, which could then create a systemic risk for the Euro.
Phase 1: An opportunity to tackle debt
Central banks (at least the US and European central bank) have a mandate to keep inflation under control and around 2% (which clearly isn’t happening now). In principle, if central banks are independent from government, this is their goal (coupled with a goal of aiming to keep unemployment low).
From a government standpoint, there are competing interests:
On the one hand, inflation is highly unpopular and can get politicians voted out.
On the other hand, if government debt is high and there is a sense that interest rates may be higher in the future, governments feel pressure to limit or reduce their debt.
In the Eurozone, there is little that smaller countries can do to affect interest rates (which are controlled by the European Central Bank). However, the European Central bank must keep an eye on the risk that, in increasing interest rates to combat inflation, it disproportionately increases the interest paid by countries with higher debt. This is probably the leading explanation of why the interest rates paid by Italy versus Germany are trending upwards now in Fig. 3.
Now, what I say above about increasing interest rates is only loosely accurate. Increasing interest rates only makes government debt a bigger problem if inflation is constant. If inflation is high and interest rates remain below inflation, the cost of having debt (i.e. interest payments) gets worse, but the Euro value of what the economy produces (and what is collected in taxes) goes up even faster – due to inflation.
To state the idea (of how to reduce government debt) more clearly: If Central Banks raise interest rates slowly, such that inflation remains high, it is theoreticall possible for governments to reduce their debt.
A lot (probably most) of voters really dislike inflation and wouldn’t like this approach if it was present in advance. However, if it just plays out slowly, it seems somewhat reasonable for governments and central banks to state – after the fact – that they were just too slow and not aggressive enough increasing interest rates to combat inflation.
As I said in the intro, I don’t like or recommend this strategy, but I think it’s valuable to think through the possibility.
Technical Note: The strategy of inflating debt away only works if real economic output stays constant (or increases) while prices (and nominal GDP) are being driven up by inflation. If there is high inflation, but the economy is shrinking in real terms, these effects work against each other and nominal GDP doesn’t increase as much as inflation. Real GDP in 2022 is a bit shaky because there are real supply chain issues owing to both the aftermath of COVID and to the war in Ukraine. So, I’m unsure that allowing inflation to persist would actually help to reduce the debt much, although that wouldn’t rule it out being accidentally run as a strategy.
Phase 2: Time to stop inflation
At some point, allowing inflation to go on (even if it is reducing the impact of government debt) becomes too expensive politically and there is a need to take more drastic action by increasing interest rates a lot. The theory behind why increasing interest rates works is that it give people an incentive to save and makes it expensive to borrow. If interest rates are jacked up a lot, then businesses and individuals stop applying for as many loans (so they have less money to spend), and they also have more incentive to save. The theory is that this reduces spending and stops prices from spiralling upwards. Unfortunately it often has the significant side-effect of putting the economy into a recession.
Now, go back to Figure 1 and look at February 1975. At that time (like 2022), inflation went up a lot and real interest rates (actual interest paid minus inflation) went heavily negative. The federal reserve did start to increase interest rates slowly, but inflation remained very high until the early 80s (above 6%). It took some very sharp increases to interest rates by Paul Volcker (head of the Fed) to finally get inflation back down to low single digits.
Basically, Paul Volcker had to increase interest rates up into the high teens (roughly twice the rate of inflation at the time) in order to to convince people to change their expectations of constantly increasing prices. That’s not to say the same parameters apply here today, but it is a worthwhile case to consider because of the high inflation and negative real interest rates that emerged then. It may well take more aggressive interest rate increases than what central banks are doing today in May 2022.
Clarifying Remarks on this Outcome/Approach
I certainly don’t think what I outlined above is an approach that we will hear overtly talked about by governments or central banks. It may even be unlikely that it’s an implicit strategy (although I see government-debt reduction as an implicit motivator). More likely, the risk of setting off a recession results in Central Banks leaning towards a slow increase of interest rates – unintentionally allowing inflation to remain high for some time – but eventually bringing about the realisation that stronger interest rate increases are needed to tame inflation.
It’s possible of course that supply chains normalise and prices start to stabilise. However:
Unemployment is low and job openings are high, which may put upward pressure on wages
Warren Buffett feels stock market prices are very high and have been high in recent years. One reason they may be high – particularly through COVID – is that central banks pumped a lot of money into markets (by buying their own government debt, and even private company debt). If there’s a lot more money in the economy, but nothing has changed fundamentally about what the economy is producing (or its potential), then inflation is a natural way the system tries to rebalance.
This is macro-economics though, so there’s a high chance my reasoning here is just wrong.
My dialogue with inflation (the part after May 2022 is obviously made up):
Inflation towards the end of 2021: You think you have more euros?
Me towards end of 2021: Yeah, my stocks have been going up lovely, and governments supports for companies and people during COVID were decent. Now I have more euros.
Inflation at in April 2022: Ok, you can have your euros but I’m going to make each euro worth less.
Central banks in May 2022: We’re going to catch you inflation with some moderate interest rate increases.
Stock market in the meantime: Ouch.
Inflation some time later 2022: You haven’t caught me just yet.
Central banks some time later 2022 (and hopefully not even later): Ok, you’re right, inflation, we really need to ramp interest rates.
Job market in the meantime: Ouch.
Inflation some time 6 months to 3 years later: Yeah, you finally got me.
P.S. Hedging against inflation (kind of technical)
I did quite a bit of digging, and it’s quite hard to financially hedge against inflation. “Hedging against inflation” is the same thing mathematically as saying “making a bet that inflation will be higher than expected”, although it just sounds better to say “I’m hedging/protecting against inflation” 😂.
One can try to buy commodities or gold, but their prices are unpredictable and it’s hard to time the market.
Stocks and real estate are probably good hedges in the very long run, but in the short run inflation (and increasing interest) rates could hurt both stock and real estate prices a lot (worth reading about Weimar Germany after WWI by Jens Parsson).
This brings me to… A theoretical way to hedge inflation…
…is to buy Treasury Protected Inflation Securities (TIPS, or their European equivalents), which are government bonds that pay out a base interest rate (fixed for the life of the bond), but also pay out an additional amount of interest that adjusts to the prevailing rate of inflation. This alone doesn’t protect against inflation because markets likely assume that any increase in inflation will (eventually) be met by increasing interest rates from central banks. The price of TIPS goes up if inflation goes up, but the price of TIPS goes down if base interest rates go up (because now your old bonds are competing with new bonds that are paying a higher base rate). So, it’s not enough to buy TIPS, you would have to buy TIPS and also sell short a roughly equal amount of normal government bonds (which offer a higher base interest rate but no additional inflation adjusted interest).
Buying TIPS and also borrowing and then selling (known as selling short) normal bonds is starting to get complicated. Professional traders can do it, but there are costs (borrowing government bonds to sell will require you to pay interest just for the borrowing).
Actually, there are complex electronically traded products like RINF (US) and a LYXOR (European) product that wrap this into one single offering that traders can buy or sell. However, the liquidity (amount that one can buy without oneself affecting the price) of each product is very low. So, this isn’t a good way to hedge against inflation. I bought a small amount of each, but mostly for learning the process because I didn’t buy enough to have much of a benefit for my portfolio mostly because i) I’m worried these products are not liquid (even for a tiny player like me) and ii) the next reason.
If indeed there is persistent high inflation, it’s possible that governments may outright cancel inflation-protected products (or, more likely, find ways to adjust how the inflation rate is calculated for the purpose of interest payments). This might sound conspiracy-like, but if inflation got to 10%+ (and that is hopefully unlikely right now) then it becomes important to slow the flow of money out of the country and currency. This has happened many times before, e.g. when the US government banned ownership of gold in the 20th century.
So, just buying inflation protected bonds may not work when you need it most (which is when there is really bad inflation).
All of this said, there are order of magnitude better traders than me on this topic, so perhaps there are big inflation hedge bets being placed. If you know of examples, I’d love to learn more.