We can bring down the debt ratio without resorting to higher inflation

Just as after the Second World War, the best route forward is economic growth and a tight budget

Three weeks ago I floated the idea that the recent change in the American inflation target may herald the deliberate adoption of higher inflation as a policy objective.

Moreover, I pointed out that what starts in America has a way of coming over here before too long.

Now some people in the UK are beginning to see higher inflation as both inevitable and desirable. Inevitable, I don’t buy. But would higher inflation be a good thing?

The answer partly depends upon whether it would be possible to maintain inflation at a slightly higher rate than 2pc – say 3pc or 4pc – without it taking off. Some people argue that maintaining moderate inflation is impossible. They compare it to the objective of trying to remain a little 
bit pregnant.

Yet in the 20 years after the end of the Second World War inflation remained fairly low.

It wasn’t until the late Sixties that it took off, culminating in the inflationary explosion of the Seventies.

We certainly shouldn’t want to go there again. But the situation then was very different. Today, trade unions are much weaker and the international business environment is much more competitive. I doubt that oil prices are about to surge.

Moreover, inflationary expectations should be anchored by the recent experience of very low inflation.

However, you shouldn’t imagine that even moderate inflation would come without costs. Inflation redistributes income and wealth. Higher inflation would help to reduce the ratio of government debt to GDP, but only by simultaneously reducing the real value of such debt held by individual savers, and also pension funds, insurance companies and banks, thereby bringing losses to pensioners, the holders of various insurance policies and shareholders.

As we learnt from our experience in the Seventies, different groups are more adept than others at ensuring that their incomes keep pace with the onward march of prices. The worst placed are those who have retired on a fixed pension. Their real income falls remorselessly as prices rise. Incidentally, the same is true of commercial rents – until the time for uprating arrives.

Furthermore, inflation lowers the efficiency of the economy by confusing price signals and worsening the allocation of resources. And once the expectation of future inflation has become embedded and central banks are no longer able to hold interest rates down, nominal interest rates and bond yields rise, causing all sorts of problems for businesses and households.

If and when these various costs are deemed too high to accept, then bringing inflation back down again itself incurs heavy costs. In essence, this involves running the economy below full capacity, with the attendant consequence of higher unemployment.

But what is the alternative way to bring the debt ratio down? Suppose that the only alternative is a period of swingeing tax rises and expenditure cuts?

I would regard this as not only unpalatable but also likely to be self-defeating. Even if it had the effect of reducing the Government’s deficit (which it is not bound to do) it would reduce GDP.

Moreover, because of the adverse effect on incentives and efficiency, it would reduce GDP growth in the future. So this is most certainly not a good way of going about reducing the ratio of government debt to GDP.

The way to deal with our high debt ratio is to live with it, allowing sustained economic growth to bring it down gradually over time – if you can. Fortunately, we in the UK are well placed to do this. Interest rates are low, the average maturity of the debt is very long, default risk is zero and, after the virus, sustained economic growth should resume. But not all countries are so well placed.

Admittedly, even such a policy needs to be accompanied by some fiscal restraint. Economic growth will not bring the debt ratio down if every year new borrowing keeps adding substantially to the stock of debt.

So, at some point, the deficit will need to be brought down, preferably to about zero.

The time to do this, though, is when the economy can absorb this fiscal tightening while sustaining full employment. This may be because private sector demand is buoyant or because extra private spending can be successfully encouraged through looser monetary policy.

Neither of these conditions holds today. But before too long demand 
may be sufficiently strong to absorb a fiscal tightening.

Some analysts have suggested that there is a completely painless alternative: have the central bank buy all government debt and then cancel it. This sounds too good to be true but it isn’t daft.

We owe debt to ourselves anyway, so why torture our economy in an attempt to bring the debt ratio down? We have already gone partially down this route since the Bank of England now holds almost 40pc of all UK government debt. This has not been cancelled but the debt has in effect been suspended. So why not go the whole hog?

The problem is inflation. Already the Bank has pumped up the monetary base massively. If it bought all the remaining government debt it would probably cause a huge expansion of the money supply. Then we really would risk an inflationary upsurge of Seventies proportions.

The combination of economic growth and a tight budget is how we brought the debt ratio down during the 19th century, after the Napoleonic Wars drove it above 200pc of GDP. And that was without the “benefit” of inflation.

After the Second World War, we brought the debt ratio down from over 250pc of GDP, again through this same route, helped by a dose of inflation, kept moderate until the Seventies.

I believe that we can manage to pull off something like this again, without resorting to higher inflation. But if the choice is between a higher inflation rate and a raft of massive tax rises and spending cuts, I think I know which way most of the policy establishment would incline.


Roger Bootle is chairman of Capital Economics

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