One cheer for inflation — but only one
Some 94% of Americans are either “upset” or “concerned” about inflation, according to a recent Post-ABC News poll. In a Tuesday Wall Street Journal op-ed, President Joe Biden declared fighting it his “top economic priority.”
Time for somebody to say something nice about inflation. Specifically, it’s a sneakily effective way to cut federal debt in real terms: The government pays bondholders back in dollars that have less purchasing power than the dollars it borrowed. Also, the capital gains tax is not indexed to inflation, which increases the government’s revenue from this source.
On May 25, the nonpartisan Congressional Budget Office reported the impact of inflation was one reason it is projecting that the ratio of federal debt held by the public to gross domestic product will decline from 100% at the end of 2021 to 96% in 2023.
All of the above is intended as only one cheer for inflation — and a faint one at that. When taxes rise, it should be openly, by a vote in Congress. Still, to acknowledge this particular, limited upside can help us understand our fiscal and economic predicaments — and how we muddle through them.
As Carmen Reinhart and M. Belen Sbrancia explained in a 2015 International Monetary Fund working paper, “a surprise burst in inflation” is one of the five means by which countries, including this one, have reduced debt in real terms since World War II.
The best parallel to our post-pandemic time might be the moment right after 1945. Then, military spending had driven the debt-to-GDP ratio to about 110% while rationing, like more recent covidrelated lockdowns, restrained consumer demand. When the war was over, price controls ended. Demand surged. Annual inflation averaged 6.5% from 1946 to 1951, according to a 2012 study by economist Nathan Sheets.
Inflation surprises can’t last forever, by definition; eventually, investors demand a higher rate of interest and the government faces pressure to impose painful austerity.
The temptation can thus be strong to hold interest rates down artificially. And in the post-World War II United States, that is just what government did, through a 2.5% cap on long-term government bond yields that lasted until 1951.
Reinhart and Sbrancia call this policy “financial repression.” No such expedient is in the offing today, however. Federal Reserve Chair Jerome Powell has announced the central bank will raise interest rates until inflation abates — just as his predecessor Paul Volcker did to end the United States’ last outbreak of unexpected inflation, in the early 1980s. Biden, as President Ronald Reagan did back then, is signaling support for the Fed, despite recession risks.
The good news is the CBO’s forecast assumes that Powell succeeds, with inflation reverting to the Fed’s 2% target by 2024. However, by then real federal debt will be growing again, en route to 110% of GDP by 2032 and 185% by 2052. These are unprecedented levels, carrying unknown risks; hedging against them would be prudent.
Of the three remaining debt-to-GDP reduction methods in Reinhart and Sbrancia’s paper, one — default — is not an option. That leaves two: rapid real GDP growth and fiscal discipline. The United States achieved both in the 1950s after inflation and financial repression ended.
By the end of that decade, inflation, financial repression, growth and balanced budgets had combined to lower publicly held debt to less than 50% of GDP.
In addition to inflation’s impact, the CBO’s new report attributed the recent decline in the debt-toGDP ratio to a post-COVID surge in real growth. However, a key reason the budget office expects the ratio to head up again is that growth will be an anemic 1.6% from 2023 to 2026. As for tax and spending discipline — the U.S. political system’s recent record is not encouraging, to say the least.
For fiscal sustainability, the United States finds itself reliant on a unique asset: Investors all over the world still consider U.S. government debt a haven. They accept comparatively low real returns to hold it, as continued strong recent demand for Treasury bonds shows. Some $7.6 trillion of the total $22.3 trillion in U.S. debt held by the public is owned abroad, including by central banks that hold their reserves in Treasury bonds.
An unfriendly government — China — owns $1 trillion, or 13%, of this amount. Yet nations that are not only friendly to the United States but have mutual-defense treaties, or equivalent relationships, with it hold $3.8 trillion, or 50%, according to Treasury Department data.
These partners, which include the likes of Japan, Canada and Taiwan, have powerful incentives not to dump their chief military protector’s bonds, especially amid the worst geopolitical tensions since 1945.
You might even say U.S. allies are a bit like homefront Americans in World War II, who bought and held low-interest war bonds partly for lack of any better alternative — but mainly to participate in a common cause.