With G7 public debt stocks at record highs, inflation has become a key fiscal concern. A new IMF paper estimates that a fall of inflation to zero would raise debt ratios by another 5-6%-points. A rise of inflation to 6% would lower debt ratios by 11-18%-points of GDP through real debt erosion. Inflation would offer additional fiscal benefits, such as higher revenues through “seigniorage” and progressive income tax tariffs.
IMF Working Paper 14/96, June 2014
The below are excerpts from the IMF paper. Cursive text and underscores have been added.
The inflation temptation
“The global financial crisis has led to unprecedented public debt buildups in peacetime, thereby raising serious concerns about debt sustainability in advanced economies. If history is any guide, the current environment of low growth and falling inflation will compound the scale of the problem.”
“Higher inflation could help reduce public debt through three main channels.
- First, governments can capture real resources through base money creation (seigniorage)… Seigniorage represents the real revenues a government acquires by using newly issued money to buy goods and non-money assets…
- Second, inflation can erode the real value of the debt. The impact of this channel will depend on the maturity structure and currency denomination of the debt, as well as on the interest rate response to higher inflation, with inflation having the largest impact on long-term, fixed-rate, and local-currency-denominated debt…
- Third, inflation can affect the primary balance, including if [tax] brackets are not indexed under a progressive income tax.”
The impact of inflation on seigniorage revenues
“Given the relatively low levels of base money in most advanced economies, seigniorage from higher inflation would play only a limited role in lowering debt ratios. Simulations suggest that one additional point of inflation would raise seigniorage for the sample by about 0.12% of GDP annually. So, raising inflation from…[IMF] baseline projections [of an average of 1.6%] to 6% for five years…would generate cumulative seigniorage revenue of about 2.5%-points of GDP…”
The impact of inflation on the real debt stock
“The medium- and long-term, non-indexed, domestic- currency-denominated debt should be the easiest to inflate away…[Indeed] medium- and long-term, non-indexed, domestic- currency- denominated debt are the most common type of debt in G-7 countries … However, in countries with substantial liquid assets, the inflation impact on net debt could be significantly different from that on gross debt. We therefore analyze the impact of inflation on both gross and net debt ratios [with the latter subtracting liquid financial assets].”
“Simulations suggest that if inflation were to fall to zero for five years…this would increase the average gross debt-to-GDP ratio in 2017 by about 6%-points…the average net debt-to-GDP ratio would increase by about 5%age points over the next five years… [Gross] debt increase varies from 2%-points for Canada to 4—5%-points for France, Germany, the U.K., and the U.S. Italy’s debt increase is 8%-points, and Japan’s is 12.5%-points.”
“In contrast, raising inflation from [IMF] baseline projections to 6% for five years would erode the debt-to GDP ratio…Assuming that the G- 7 countries have constant debt maturity structures, experience no impact of inflation on economic growth, and experience a one-for-one adjustment to inflation of nominal interest rates on newly-issued debt (full Fisher effect)… the average gross debt-to-GDP ratio [is estimated to decrease]…about 14.5%-points…the average net debt-to-GDP ratio would be reduced by about 11%age points over the next five years. ”
“The partial Fisher effect would increase the inflation impact on debt reduction. The Fisher hypothesis postulates that anticipated inflation and nominal interest rates move together. However, most empirical studies have not confirmed a one-to-one relationship…Indeed, fully anticipated inflation has been found to have an effect of less than one unit on nominal interest rates, and thus reduces real interest rates… [our] simulation results suggest that raising the average inflation rate to 6% annually with a partial increase in nominal rates [50%], would reduce the 2017 gross debt-to-GDP ratio for the sample by about 18%age points…the net debt-to-GDP ratio reduction would be about 14%-points.”
“Suppose now we would like to target a large level of decrease in debt- to- ratio, for example, by 30%-points. How much inflation would be needed to achieve this level of debt reduction? This sizable debt ‘liquidation’ would require double-digit inflation. Simulations find that raising the inflation rate to about 11% between 2013 and 2017 or raising it to about 18% for two years, and then maintaining it at 6% for the remaining three years, would reduce the 2017 gross debt-to-GDP ratio for the sample by 30%-points.”
The issue with inflationary policies
“Allowing inflation to drop to very low levels for an extended period would make the task of tackling high levels of public debt even more difficult. The occasional “surprise inflation” that leaves inflation expectations unaffected could help to a degree.”
“Reliance on inflation to erode debt could lead to fiscal dominance with inflation rates drifting even higher as confidence in the future value of money is lost. As a result, inflation expectations could be un-anchored, undermining framework’s credibility to control inflation. The un-anchoring of inflation expectations might also have significant implications for the future structure of the government debt portfolio, making it more crisis-prone by raising liquidity, currency, and the interest rate risk.”
“The un-anchoring of inflation expectations could increase long-term real interest rates, distort resource allocation, reduce economic growth, and hurt the lower-income households. This would likely make it difficult for governments to finance their budgets, leading to even higher debt-to-GDP ratios. Introducing some form of financial repression could keep interest rates low, but such policies may be difficult to enforce in a complex financial environment, and could cause additional collateral damage to the economy.”