Is inflation the solution?

In my previous commentary (“The BIG fiscal challenge” of 5 May 2010) I outlined the huge challenge some countries are facing in getting their fiscal affairs in order. In the meantime Greece and other European countries such as Portugal, Spain, Italy, France and Britain have announced steps varying from cuts in government spending to higher taxes to reduce their budget deficits and reverse the rising government debt.

Prior to the latest crisis Germany had already passed a bill that for all practical purposes will impose a balanced budget from 2016, and it is now trying to persuade other European countries to do the same. It is commendable that governments have taken decisions, which could have negative political consequences, on such a wide front. Nonetheless, they are still facing major political and social unrest – it is a fact that no society will easily reach agreement on the equitable distribution of a burden generally regarded by everyone as unfair.

Consequently there is still a school of thought that contends that higher inflation is unavoidable as it is the easy way out. Higher inflation obviously reduces the real value of the existing government debt (even though it makes the new debt more expensive) and accelerates the drop in the debt-GDP ratio as nominal GDP rises more quickly. Tax revenue will also benefit from higher inflation and make it easier to fund the government’s interest burden (provided the rise in non-interest expenditure is held in check.)

Even if governments were not to actively encourage higher inflation, the thinking go, they will not resist an increase in inflation with the same enthusiasm and determination as in the past. The inevitable resultant rise in long-term interest rates (which will exceed the rise in inflation as markets price in higher inflation risk) is a problem for another day. So too is the pressure on their currencies.

The final link in the chain is to accept that the accommodative policy followed by most central banks at present, especially the policy of so-called “quantitative easing” in terms of which central banks are buying large quantities of government bonds without offsetting the accompanying increase in the money supply, will inevitably result in higher inflation.

I must say I do not share the view of the school of thought that advocates higher inflation.

In other words, 4% p.a. additional inflation would reduce the debt burden by 8 percentage points over a period of five years. Reducing the debt burden within a reasonable period of time to say, 60% of GDP would therefore required even higher inflation or a much longer period of sustained higher inflation, or both. Nothing is said about how inflation will subsequently be brought under control again.

Research by George Hall and Thomas Sargent shows that less than a quarter of the reduction in America’s debt-to-GDP ratio in the period from 1946 to 1974 came from negative real returns on bonds, viz. higher inflation, with bonds with a maturity of more than five years bearing the brunt.

Thirdly, international financial integration has resulted in a large part of government debt being held by foreign creditors (for the US it is approximately 50%, mostly Chinese and Japanese). While this makes the inflation option more tempting from a domestic political perspective, its international political and currency ramifications could be severe, especially for a reserve currency such as the dollar.

Unemployment is at its highest level in years and is expected to recover very slowly, with resultant downward pressure on wages. The maelstrom of the Great Recession companies have experienced during the past two years has compelled them to become extremely cost-efficient and stretch their profit margins. And last but not least, the events in Europe will give new momentum to the deflationary trends.

The downward pressure on inflation will continue for at least the next two to three years and give central banks room to reduce their balance sheets systematically, In any case, it is a fact that a large amount of the liquidity created in the past two years was not converted into higher loans by the bank system, but ended up in deposits at the central banks. As Ben Bernanke of the Federal Reserve has repeatedly stated, these deposits could easily be offset by raising the interest rate applicable to them.

In any case, it appears as if neither the policy makers nor the general public has any appetite for the inflation solution. When three months ago Olivier Blanchard, chief economist of the IMF, proposed that the developed countries should aim for 4% inflation instead of the traditional 2%, he was truly maligned. There is no sign of the traditional European aversion to inflation diminishing – just look at how vehemently the European Central Bank was criticised for its decision to buy the government bonds of countries with debt problems.

So what is the alternative? 

The research by Hall and Sergeant mentioned above concluded that strong GDP growth and large primary budget surpluses played a decisive role in reducing the US’s post-WWII debt burden. A paper by Chryssi Giannitsarou and Andrew Scott likewise found that between 80-100% of fiscal imbalances between 1960 and 2005 in six major developed countries were corrected by shifts in the primary budget surplus. They also makes the interesting observation that the cause of the increase in government debt will have an influence on the way in which the debt burden is reduced, with non-war induced debt being less likely to be monetised.

An analysis by the IMF shows that in the ten major fiscal consolidation plans in developed countries during the past 25 years, government debt was reduced on average by 41% of GDP over an average period of 12 years, with around 90% of the correction brought about by an improvement in the fiscal position. The average increase in the cumulative primary surplus was approximately 38%. The adjustment was achieved without a rise in inflation – on the contrary, inflation trended downward during this period.

Also, the countries concerned did not forfeit economic growth (in most cases economic growth accelerated during the period of consolidation), but one has to concede that it was during a period in which the global economic performed relatively well. It was the period generally known as the “Great Moderation”, with higher growth and lower inflation plus greater macro-economic stability.

The general economic environment will obviously not be as supportive in the next few years. This implies that the countries that have to undergo major fiscal consolidations will have to find other means of stimulating economic growth and employment in order to alleviate the political and social tension.

An important reason why the above-mentioned fiscal consolidations did not hamper growth is because they were accompanied by the realisation that the private sector is the power plant of the economy, and resultant policies, such as deregulation, which underlie it. In the current political climate it is almost unthinkable that such a view will meet with approval. In fact, the current leaning is rather towards greater regulation and government intervention, and not only in the financial sector.

But it is precisely that view that is required.

In an article in the Financial Times of 25 May 2010 Robert Zoelick, president of the World Bank, advises the developed countries to take a leaf out of the developing and emerging- market countries’ book. While the developed countries are focusing on stricter regulation, the others are focusing on continued deregulation and the strengthening of the private sector’s role in the economy. They know that this is the deciding factor that has put them on their current path of higher growth.

Advocates of a bigger role for the government in the economy like to refer, for example, to China to support their argument. However, by statically looking at the issue instead of asking what has changed, they are missing the point. The acceleration in China’s economic growth during the past 30 years was accompanied by a diminishing of the government’s role and a bigger role for the private sector and the market system. Should one analyse the respective contributions by the private and public sectors to China’s growth performance, one would find that it is thanks to the former.

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