Why the USA can’t inflate its way out of debt.

Mar 11, 2010. Why the U.S. can’t inflate its way out of debt. Financial Times.

It’s dawning on people that getting a handle on burgeoning U.S. debt will be a long and hard process. So if lawmakers can’t agree on a credible plan, some have suggested that the country could just “inflate its way” out of its fiscal ditch by boosting prices and wages and eroding the value of the currency. The United States would owe the same amount of actual dollars to its creditors — but the debt becomes easier to pay off because the dollar becomes cheaper.

It’s true that inflation could reduce a small portion of U.S. debt. The International Monetary Fund (IMF) estimates that in advanced economies less than a quarter of the anticipated growth in the debt-to-GDP ratio would be reduced by inflation. But the mother lode of the country’s looming debt burden would remain and the negative effects of inflation could create a whole new set of problems.

  1. A lot of government spending is tied to inflation. If inflation rises, so do government obligations, like Social Security, Medicare, and other are indexed.
  2. Inflation would also make future U.S. debt more expensive, because inflation tends to push up interest rates. And the Treasury will have to refinance $5 trillion worth of short-term debt between now and 2015. [The debt’s value could go down for a couple of years because of surprise inflation. But then … the market’s going to charge you a premium interest rate and say ‘you fooled us once but this time we’re going to charge you a much higher rate on your three-year bonds’.
  3. Another potential concern: Treasury inflation-protected securities (TIPS), which have maturities of 5, 10 and 20 years. They make up less than 10% of U.S. debt outstanding currently, but the Government Accountability Office has recommended Treasury offer more TIPS as part of its strategy to lengthen the average maturity on U.S. debt. The higher inflation goes, of course, the more the Treasury will owe on its TIPS.
  4. What’s more, the knock-on effects of inflation are not pretty. A recent report from the IMF outlined some of them: reduced economic growth, increased social and political stress and added strain on the poor — whose incomes aren’t likely to keep pace with the increase in food prices and other basics. That, in turn, could increase pressure on the government to provide aid — aid which would need to keep pace with inflation.

So where does that leave lawmakers? Facing tough choices. Deficit hawks and market experts have been calling on lawmakers to come up with a strategy to stabilize the growth in U.S. debt, which would be implemented only after the economy recovers more fully. The idea is to signal to the markets that the country is serious about getting its longer term debt under control so that the burden of paying it back doesn’t consume an ever-increasing share of the federal budget.

The recommended exit strategies are pretty basic, if unpopular: tax increases and spending cuts. Economic growth will play a key role as well — since a strong economy produces more tax revenue. But the country cannot grow its way out of its problems. To do that, the economy would have to expand at Herculean rates annually from here on out. And even the most optimistic economist doesn’t see that on the horizon.

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