Monday, February 22, 2010

Inflation Won’t Solve Our Debt Problems – By Catherine Rampell

Thanks to Ian for passing this along.

Lately I have seen a few suggestions, here and there, that the United States should consider inflating its way out of its rising debt burden.

The country essentially inflated its way out of much of its debt during the Great Depression, and again in the 1970s, according to Harvard’s Kenneth S. Rogoff. But as anyone who remembers the 1970s can attest, inflation can be painful. It’s no fun to get your paycheck and then find out that you cannot buy as many groceries or as much gasoline as you did the week before because prices have gone up so much.

The more powerful argument against inflating away debt is that it will not work, says Alan Auerbach, an economics professor at the University of California, Berkeley.

Why? Because so much of our long-term spending obligations are indexed to inflation. In other words, the debts will rise along with inflation, so they won’t “feel” any smaller. Here is how Professor Auerbach explained it in an e-mail message (links added are mine):

Sudden inflation can only inflate away the debt that is (1) not indexed, the way TIPS are; and (2) not very short term (i.e., not T-bills), so that the interest rates cannot be reset to much higher rates that would compensate for inflation. Also, there is no net gain to inflating away debt held within the government (e.g., the Social Security trust fund, etc.). So, as of the end of November (data from the Treasury Web site; probably can be updated through December now), that left about $5.4 trillion worth of debt that could be made to disappear with a sudden, rapid inflation.

But most of our long-term imbalance, which Bill Gale and I have estimated at $53-$126 trillion (in our paper published in Tax Notes in October), depending on how far out one looks, comes from exploding entitlement programs, which are either explicitly indexed to inflation — Social Security — or implicitly indexed (Medicare and Medicaid) because they provide services that will also grow in cost with inflation. So the best we could do, using the lower estimate of the long-term gap (a 75-year number) would be to eliminate 5.4 of 53 trillion, or about 10 percent.

In other words, even if the government printed a lot more money and lowered the purchasing power of the dollar, 90 percent of the country’s debt problem would survive.

So what are the other strategies for bringing down the country’s long-term deficits?

The one countries always hope for is growth.

If the economy grows quickly enough, tax revenues can rise faster than spending. This helps explain why the country had budget surpluses in the late 1990s and early 2000s. A booming economy — greased by the stock bubble, of course — helped push tax revenues even higher than the government had expected they would be.

But the grow-your-way-out-of-debt option is usually too rosy, especially during a recession.

A country loaded with debt can try to simply tighten its belt, by raising tax revenues and/or slashing spending. But there are major political obstacles for these policy initiatives because they are so painful, at least in the short-run.

Finally, a country can restructure its debt or default, which is generally considered the worst-case. Just as a person defaulting on a loan can mar his ability to borrow in the future or even get a job, a country defaulting on its debt obligations will have trouble getting other nations and investors to trust it in the future, too.