It is fashionable amongst the more cynical forecasters to say that of course the US, the UK and even Euroland will turn to inflation. When heavily in debt, they argue, governments love a bit of inflation. It erodes the value of their debt.
It is certainly true that the main Central Banks of the US, UK, Euroland and Japan are much more concerned today about the poor rate of gr0wth than about inflation. Japan has so little inflation that they want to get the rate up. The UK still has too much inflation, but the Bank has long been ignoring that. I do not doubt that the authorities now are much more tolerant of inflation. None think it is about to become a major problem.
The issue though, is does inflation help an over indebted state? Is it the easy way of getting out of debt? I do not think so.
A relatively high rate of inflation in a given country is likely to cause devaluation of the currency. Where a state has borrowed from abroad in foreign currencies, the debts can get bigger as the domestic currency falls. The UK state has borrowed some money abroad – as with the borrowings of Network Rail – so would be vulnerable to lower sterling on these.
The UK state has also borrowed substantial sums in the form of Index linked gilts and National Savings. Here the state expressly cannot inflate away from the debt, as the debt goes up in line with the rise in prices.
It is true that the bulk of the UK state debt is in sterling and borrowed at a fixed rate of interest. It is therefore true that this debt should get easier to repay as the state inflates. This debt does reduce in real terms. It only gets easier, however, if the state revenues rise in line with inflation or better, outpacing spending.
As the state is still spending well in excess of its income, we have to think about the impact of inflation on both its spending and its income. The danger for the state is that the gap between income and spending could get bigger, enlarging the deficit, if inflation gets too high.
The state guarantees real gains for many recipients of state pensions, and nominal gains for other benefit recipients. Inflation may make getting the deficit down according to plan more difficult. The government has traditionally offered real rises to state employees each year. Expenditure in expensive areas like health tend to have higher rates of inflation than the average rate, and have budgets guaranteed to rise in real terms. Much spending is likely to remain more buoyant than price rises, or to keep up with price rises.
Meanwhile, incomes are likely to be damaged by more inflation. Price rises can damage business profits and reduce the number of high incomes earned here in the UK available to tax. We have seen how Income Tax and wealth tax receipts have fallen in cash terms in the last couple of years, at a time of considerable inflation. The danger is that higher inflation could accelerate the gap between spending and revenue.
It is not guaranteed that a state can inflate its way out of debt. The danger is all too real that more inflation hits the costs and the revenues of the state in a way which widens the gap or deficit. The only ways out of excessive debt are to remove the deficit and grow the economy.