Using inflation to reduce US debt - Trump’s ‘soft default’ option

In a recent interview with Time Trump said something that pricked the ears of economists: “You know, inflation, certain levels of inflation, will also pay off that debt very rapidly. Very rapidly.” Not only did this add to concerns in the bond market but it also pointed to a possible option to reduce debt for a government running out of options. This raises the question of ‘Just how easy is it for any government to use inflation to reduce debt levels?’ Such a question is not irrelevant given the potential implications for bonds and the accepted mantra of the past 20 plus years that lower inflation is good.

How can inflation reduce government debt levels?

For any government aiming to use higher inflation to reduce debt levels the initial issue becomes identifying the dynamics via which this could occur. Here it is useful to distinguish between inflation reducing the level of debt via the deficit versus reducing the debt level directly. At a very high level inflation can impact on government debt levels through two main channels :

Deficit Reduction - Tax System

One of the initial channels via which inflation can impact upon the level of government debt is via the tax system and a reduction in the budget deficit. The most common channel by which inflation can increase tax revenue is via ‘bracket creep”, the process by which taxes are levied on nominally specified values in the tax code whose real value then falls when the price level rises. Bracket creep often occurs when inflation, or real income growth, pushes taxpayers into higher income tax brackets. When this happens income tax receipts increase without an increase in real income. Unfortunately the ability of ‘bracket creep’ to increase tax receipts in the US has been reduced as tax indexing was enacted in the Economic Recovery Tax Act of 1981, and took effect for tax years 1985 and beyond. That said there are still some areas where inflation can interact with US tax system via capital gains liability calculations and depreciation of capital goods. Yet overall, with the indexing of many major tax brackets from 1985, the scope for inflation to reduce the government budget deficit via ‘bracket creep’ is more limited in the US.

Direct Debt Reduction - “Soft Default”

Now inevitably the focus shifts to the second major channel via which inflation can have an impact on the level of government debt, that is more directly through the value of the existing supply of liabilities. Higher inflation reduces the real value of the stock of existing non indexed government debt. By increasing inflation the wealth of people who hold dollars and other fixed nominal return assets such as non-indexed U.S. Treasury debt is reduced. The real value of the debt asset declines with higher inflation since the income received by the debt-holders is fixed in nominal terms and so has lost real purchasing power. Unexpected inflation, therefore, effectively transfers wealth from debt-holders to the government and, as such, functions as a tax whose size is proportional to the amount of outstanding debt. Accordingly, unexpectedly high inflation works as a “soft default” on current government debt since the real value of the debt asset is repriced under new inflation expectations.

The extent of the gain from debt debasement of existing debt arising from higher inflation is driven by :

• who holds which debt : the more government debt held by the private sector the larger the wealth transfer to the government.
• its maturity structure : the longer the duration of outstanding debt the larger the reduction in the value of the existing liabilities.
• the future volatility and persistence of inflation : the more persistent the increase in inflation the greater the longevity of the ‘one off’ wealth transfer.

The downside of pursuing such a policy is that in well-functioning financial markets, if price inflation is expected, then the price of these types of assets accounts for inflation so that the real return of the asset is maintained. For a government needing to fund ongoing deficits the pricing of new debt will reflect the higher level of inflation. Unless savers and investors can be repeatedly “tricked” with higher inflation each year, as a policy tool it is not a viable long-term option. As a result in well functioning, frictionless markets, all prices instantly adjust to unexpected inflation, so there are no real effects other than a one-time wealth transfer from the debasement, or devaluation, of the existing stock of government debt. Under normal circumstances benefits to the government from such debt debasement is best viewed as a ‘one off’ impact.

For inflation to act as a long term policy tool requires not just the debasement of existing government debt but also newly issued debt on an ongoing basis. The ability of the government to debase newly issued debt is determined by :

• the efficiency of bond markets : the slower bond markets are to adjust pricing to reflect the higher levels of inflation the greater the scope for a ‘soft default’ to reduce debt beyond the initial ‘one off’ wealth transfer.

Effectively the use of inflation to debase government debt as an ongoing policy tool requires the yields on government debt to be contained so that nominal yields do not fully reflect the higher level of inflation. Enter financial repression which refers to a collection of government laws, regulations, and monetary policies used to channel domestic private savings directly to the public sector at artificially low interest rates. Specifically financial repression seeks to use regulations etc to prevent bond yields from adequately pricing in market and inflation risks. Financial repression can become an active policy tool that can substantially increase the likelihood of large ongoing inflationary debasement of government debt. This highlights that often it is not higher inflation per sae that debases the government debt but rather the other government policies that come with it.

The Historical Evidence

So in theory it is possible, albeit difficult, for a government to use inflation to reduce the level of government debt. At this point it is useful to take a closer look at the history of debt consolidation to see the role that inflation has played. Eichengreen and Esteves (‘Up and away? Inflation and debt consolidation in historical perspective’ 2022) consider the largest debt consolidations across economies; defined as periods of at least ten years where debt-to-GDP falls by at least 15 percentage points. Eichengreen and Esteves identify thirty episodes since 1859. The authors then utilize their own methodology to decompose the reduction in debt into the primary forces of fiscal policy changes, real economic growth, nominal interest rates and inflation. The summation of the nominal interest rate and inflation impacts provide the impact from real interest rates or the impact from the inflationary debasement of government debt (‘debt debasement’). Their analysis found that :

• On average across these economies, debt consolidation is explained roughly equally by improvements in the primary budget balance and stronger real economic growth. These two factors account for nearly 100% of the debt reduction on average across economies in this sample.
• In isolation inflation has contributed to deleveraging, but its impact has often been neutralised by rising nominal interest rates. The result is that across the full sample, any gains from inflation were largely offset by higher yields; i.e. the impact from debt debasement was not significant.

The one issue with assessing overall results is that the analysis includes debt consolidations from the mid 19th century to now across both Developed and Developing nations. Obviously over that time frame and across countries the level of regulation within the financial markets will vary materially. To assess the impact of regulation it is interesting to initially separate the Eichengreen and Esteves data into pre 1985 and post 1985 periods. From a historical perspective 1985 is an important marker as the point at which the political focus shifted from the more ‘hands on’ Keynesian framework of economic management to the free market deregulated environment espoused by neo liberalism. Consequently it would be expected that the level of deregulation and associated capital mobility should be materially higher in the post 1985 period especially in Developed countries.

As Figure 1 highlights there are material differences in the average outcome depending on whether one is considering a pre or post 1985 timeframe. In the pre 1985 period the inflation impact was higher than the offsetting change in nominal yields. The result was a net reduction in government debt associated with higher inflation; i.e. a positive contribution from debt debasement. In the post 1985 period this positive impact had been eliminated most likely as a result of deregulation within the financial markets.

But how do we know that the impact is deregulation and not simply differences in inflation? The giveaway is the contribution from nominal interest rates. The impact from nominal interest rates is largely the same irrespective of the differing inflation environments. Yet in the pre 1985 period the impact from inflation was materially higher. This suggests that in the higher inflation pre 1985 period the impact on interest rates was more muted due to financial repression.

To take the comparison one step further it is useful to separate the post 1985 period into Developed and Developing countries. The rationale for this is that Developed Countries were more likely to have pursued the neoliberal agenda of deregulation of financial markets. Conversely Developing countries are more likely to still be imposing capital controls of some form.

Figure 2 shows that in the post 1985 period Developed Countries experienced a material negative impact from real interest rates. This points to the negative impact of higher nominal interest rates resulting from higher inflation more than offsetting the positive impact of higher inflation. Only those countries which likely exhibited ongoing capital controls in the post 1985 period, namely Developing countries, experienced a modest reduction in government debt from debt debasement.

Overall the data points to a quite mixed outcome from using inflation to reduce government debt levels especially in the post 1985 environment of deregulated financial markets. This raises an interesting question as to why there is still a belief that inflation can be used to reduce government debt levels? One reason is that it is quite appealing politically as it imposes a tax without the political stigma of explicitly raising taxes. The other is ‘historical nostalgia’ as a specific period in history demonstrated that inflation could be used to materially reduce government debt levels.

Figure 3 separates the pre 1985 period into the Post WWII phase of debt consolidation (1947 to late 1950s) and the Rest. The contrast is dramatic with the ability to use debt debasement to reduce government debt largely restricted to the Post WWII consolidation period. Further though there is often variability in outcomes, in the post WWII period nearly every country (Australia, France, New Zealand, USA & UK) experienced material positive impacts from debt debasement. The exception was Switzerland but this may be driven by the materially larger increase in nominal yields associated with normalisation of capital flows with the end of WWII. The success in debt debasement is largely due to Developed countries having established high levels of capital controls and financial regulation during WWII which carried over into the immediate post war period. It is only in the presence of such highly regulated markets that inflation was able to be used as a policy tool to materially reduce the level of government debt. The implication is that history points to the ability to use inflation to consistently debase government debt on an ongoing basis existing only for a very specific period of time.

Analysis of the Eichengreen and Esteves dataset highlights that though inflation as an independent variable can reduce debt this tends to be completely offset by the impact of higher nominal interest rates meaning that overall higher inflation had little impact on the ability of a country to reduce debt levels. When inflation was able to debase debt this was more the result of the existence of capital controls and financial regulations rather than the inflation itself. Those that look at history and say “Well the US did it once why not again?” are unfortunately referencing the very specific post WWII period where conditions were far from those which exist today. Overall, the ability of the US to use inflation to reduce govt debt levels either through deficit reduction or debt debasement would appear limited in today’s era of deregulated capital and financial markets. The sad reality which governments can’t escape is that debt reduction over a sustained period comes down to addressing the deficit itself while at the same time encouraging real economic growth.