The first sign of the economy’s turnaround is the Federal Reserve’s decision to scale back interest rate hikes. As inflation eases, economists sound a cautionary note for how long this will last before rates get too low and bring about high inflation again.
The “debt, inflation” is the amount of money that a country owes. When there is an increase in debt, it can lead to higher inflation. Economists are warning about this issue as the US economy starts to recover from high levels of debt.
Inflation is lowering the weight of the world’s public debt in relation to its economic production, a benefit for governments that experts warn may potentially backfire if inflation continues to rise.
According to data from the International Monetary Fund, some highly indebted European countries, such as Greece, Portugal, and the United Kingdom, are on track to erase the additional debt raised to combat the Covid-19 pandemic as a share of gross domestic product over the next year or two, bringing their debt-to-GDP ratios below 2019 levels.
The reason for this is that rising inflation, along with rapid economic development, is boosting economic output measured in dollars, euros, or pounds. While government borrowing costs are increasing, they are still low, implying that public debt as a percentage of GDP—the key metric used by economists to assess a country’s financial sustainability—is declining in many areas.
According to figures from the Federal Reserve Bank of St. Louis, public debt in the United States fell to roughly 123 percent of GDP at the end of last year from 136 percent in the middle of 2020, despite the government running deficits of around one-quarter of GDP over the last two years.
According to IMF figures, inflation lowered the US public debt to GDP ratio by around 5 percentage points last year. According to the figures, US government debt will be about 12 percentage points lower as a fraction of GDP next year than the IMF predicted in October 2020.
“Unexpected inflation paired with low nominal rates works wonders for debt dynamics,” said Olivier Blanchard, a former IMF chief economist who is now a senior fellow at Washington’s Peterson Institute for International Economics. “However, the lesson for policymakers should not be to depend on that system.” Before the epidemic, Mr. Blanchard was one of the leading economists advocating that countries could absorb larger debt levels.
Higher inflation has a long history of assisting in the reduction of public debt relative to production. Bondholders who support government borrowing often demand higher interest rates to offset growing prices, which adds to the debt load. After WWII and until the 1970s, the United States inflates its national debt. Other administrations have failed to do so, resulting in interest rate spikes and hyperinflation.
Ricardo Reis, a professor at the London School of Economics, and other economists discovered in a 2014 article that investors were pricing in a less than 1 in 2,000 probability that an unanticipated surge of inflation would reduce US public debt by 5.5 percentage points.
In an interview, Mr. Reis stated, “The improbable event occurred.” He warned that the breakthrough was a one-time gift to governments that may backfire by jeopardizing their capacity to cheaply grow debt, as they have previously done.
“We’ve never had to conduct that much austerity in the previous 20 years,” Mr. Reis added. To prevent interest rates from rising, governments should reiterate their goals to keep inflation low, he said. “Last year was a fluke,” he said, “and we need to come back rather soon.”
Interest rates throughout the world are increasing rapidly, and central banks are expected to cut their holdings of government debt, raising public borrowing costs even more. If inflation continues to rise, investors may begin to demand much higher interest rates. As a result of the higher service costs, governments’ debt load may grow.
“It is true that inflation surprises help to lower debt ratios,” Vitor Gaspar, director of the IMF’s fiscal affairs department, wrote recently in the fiscal monitor. “However, in a regime of permanently high and volatile inflation, the attractiveness of sovereign bonds is undermined, making it harder to sustain elevated levels of debt.”
“‘Inflating away the debt is never a wise idea,’” says the author.
Professor Ricardo Reis of the London School of Economics
Meanwhile, following a series of geopolitical shocks, such as Russia’s conflict in Ukraine, and as governments spend extensively in the transition to cleaner energy and digital technologies, the demands on the public purse are increasing. According to the IMF, advanced countries are likely to raise yearly public investment by 0.5 percentage point of GDP in the medium term, compared to pre-pandemic predictions.
Governments, on the other hand, are enjoying the advantages of high inflation for the time being.
Fertilizer prices have risen to all-time highs, with far-reaching implications for farmers, agricultural production, and food costs. Patrick Thomas of the Wall Street Journal outlines the reasons behind the increase and what it may mean for your pocketbook. Ryan Trefes/Getty Images
According to the IMF, higher-than-expected inflation decreased public debt-to-GDP ratios in advanced countries by 1.8 percentage points of GDP and by 4.1 percentage points of GDP in emerging markets, excluding China, last year. The major effect on Europe is likely this year, as inflation rises.
According to IMF figures, public debt in Greece will fall to 185 percent of GDP this year, down from 212 percent in 2020, when the country’s huge public debt created a crisis that threatened to break apart the eurozone.
According to Yannis Stournaras, a European Central Bank policy maker and the governor of Greece’s central bank, the decline reflects the gap between Greece’s strong nominal growth rate and low borrowing rates as a consequence of its bailout during the eurozone financial crisis.
Portugal’s government debt is predicted to decrease far below its current level as a percentage of GDP in 2020.
AFP/Getty Images/Patricia de Melo Moreira
The scenario is similar for Cyprus and Portugal, which also received foreign bailouts during Europe’s financial crisis.
According to IMF estimates, Portugal’s government debt is predicted to decrease comfortably below its 2019 level as a percentage of GDP by 2024. The public debt of Cyprus is predicted to fall to 87 percent of GDP in 2024, the lowest level since 2012, the year before the country’s international bailout.
The results “underline the reversal in how public finances have been handled in the previous few years, compared to the disastrous pre-2013 era,” according to Michalis Persianis, head of Cyprus’ Fiscal Council.
Mr. Persianis stated that throughout the epidemic, Cyprus’ government focused on funding to encourage firms to keep employees and a freeze on private debt payments. Incomes and demand were bolstered by both measures. The government’s income increased as a result of the strong economy, easing the burden of public debt.
According to the IMF, government debt in the United Kingdom is forecast to fall to about 83 percent of GDP next year, down from a high of 103 percent in 2020.
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According to a spokeswoman, the UK government is dedicated to decreasing public debt in the face of increasing interest rates, and has recently announced tougher spending regulations.
Bondholders are the losers in such instances. Regulations enacted during the 2008-09 financial crisis mandate investors and banks to purchase safe assets such as government bonds, even if they lose money. The goal is to make the financial system safer.
Mr. Blanchard described it as a “hidden kind of expropriation.”
Following WWII, the United States government exploited a similar circumstance to cut its debt-to-GDP ratio from 120 percent to 40 percent over two decades, much to the chagrin of bondholders. In the 1970s, the United States re-inflated part of its debt. However, in the 1980s, bondholders enjoyed a period of record high profits. As a percentage of GDP, public debt fell in the 1970s but rose dramatically in the 1980s. “In the early part of the 1980s, the advantages of the 1970s were reversed,” Mr. Reis remarked.
Because debt maturities are shorter, more bonds are tied to inflation rates, and there are more alternative investment alternatives now, greater inflation is more likely to push up public borrowing costs, according to the IMF.
Governments in South America produced money in the 1980s to pay bills and inflate away debts, but the measures backfired, resulting in increased interest rates and hyperinflation.
Mr. Reis said, “I would not agree that inflating away the debt is ever a smart idea.” “Historically, it has gone wrong more frequently than it has gone well.”
The government of the United Kingdom has announced new guidelines for public expenditure.
Agence France-Presse/Getty Images/Daniel Leal
Tom Fairless can be reached at [email protected]
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