As Inflation Eases Public Debt Burden, Economists Warn


Creeping inflation is helping to reduce the burden of global public debt relative to its economic output, a boon for governments that economists say could easily backfire if inflation remains unchecked.

Some highly indebted European countries, including Greece, Portugal and the United Kingdom, are on track to wipe out additional debt incurred to fight the Covid-19 pandemic as a share of gross domestic product over the past year. next year or two, taking their debt to GDP ratios below 2019 levels, according to data from the International Monetary Fund.

The reason is that inflation, coupled with rapid economic growth, boosts economic output measured in dollars, euros or pounds. While government borrowing costs are also rising, they remain relatively low, which means that public debt as a percentage of GDP – the main yardstick by which economists measure a country‘s public debt sustainability – is falling in many places.

In the United States, public debt fell to around 123% of GDP at the end of last year, from 136% in mid-2020, even as the government ran up deficits of around a quarter of US GDP over the past two years, according to data from the Federal Reserve Bank of St. Louis.

Inflation reduced the US public debt-to-GDP ratio by about 5 percentage points last year alone, according to IMF data. U.S. public debt will be nearly 12 percentage points lower as a percentage of GDP next year than the IMF projected in October 2020, the data showed.

“Unexpected inflation, combined with low nominal rates, does wonders for debt dynamics,” said Olivier Blanchard, former chief economist at the IMF and now a senior fellow at the Peterson Institute for International Economics in Washington. “But the political lesson should not be to rely on this mechanism.” Mr. Blanchard was a prominent economist who argued before the pandemic that governments could manage higher indebtedness.

It is historically rare for episodes of rising inflation to help reduce public debt relative to output. Bondholders who fund government borrowing normally demand higher interest rates to compensate for rising prices, adding to the debt burden. The United States ballooned public debt after World War II and into the 1970s. Other governments failed to do so, often setting off spirals of rising interest rates and hyperinflation.

In a 2014 paper, Ricardo Reis, a professor at the London School of Economics, and other economists found that investors valued less than a 1 in 2,000 chance that an unexpected surge in inflation would reduce U.S. government debt by 5.5 percentage points.

“The unlikely thing happened,” Mr. Reis said in an interview. He warned that development was a one-time gift to governments that could backfire by jeopardizing their ability to raise debt cheaply, as they have done recently.

“In the past 20 years, we have never had to do so much austerity,” Mr. Reis said. Governments should reaffirm their intentions to keep inflation low to prevent interest rates from skyrocketing, he added. “Last year was a fluke, we have to come back pretty quickly,” he said.

Global interest rates are rising significantly and central banks are considering reducing their holdings of government debt, which is expected to further increase government borrowing costs. If inflation remains high, investors could start demanding much higher interest rates. Such an increase in service charges could in turn increase the debt burden of governments.

“It is true that inflationary surprises help to reduce debt ratios, but in a regime of permanently high and volatile inflation, the attractiveness of sovereign bonds is undermined, which makes it more difficult to maintain levels of high indebtedness,” said Vitor Gaspar, IMF director. department of fiscal affairs, wrote recently in his fiscal monitor.

“I wouldn’t say that inflating debt is always good policy.”

— Ricardo Reis, professor at the London School of Economics

Meanwhile, pressures on the public purse are mounting after a succession of geopolitical shocks, including Russia’s war in Ukraine, and as governments invest heavily in the shift to cleaner energy and digital technology. Advanced economies are expected to increase annual public investment by 0.5 percentage point of GDP over the medium term compared to pre-pandemic forecasts, the IMF said in April.

For now, however, governments are reaping the rewards of high inflation.

Last year, higher-than-expected inflation reduced public debt-to-GDP ratios by 1.8 percentage points of GDP in advanced economies and by 4.1 percentage points of GDP in emerging markets excluding China. according to the IMF. For Europe, the main impact should occur this year with the surge in inflation.

In Greece, where high public debt sparked a crisis that nearly erupted the euro zone, public debt is expected to return this year to its 2019 level of 185% of GDP, from 212% of GDP in 2020, data shows. of the IMF.

The drop reflects the difference between Greece’s high nominal growth rate and low borrowing costs resulting from its bailout during the eurozone debt crisis, said central bank policymaker Yannis Stournaras. European Union and Governor of the Greek Central Bank.

Portugal’s public debt is expected to fall comfortably below its 2019 level as a percentage of GDP.


Patricia de Melo Moreira/AFP/Getty Images

For Cyprus and Portugal, which also received international bailouts during the European debt crisis, the story is similar.

In Portugal, public debt is expected to fall comfortably below its 2019 level as a percentage of GDP by 2024, according to IMF data. Cyprus’ public debt is expected to fall to 87% of GDP in 2024, which would be the lowest level since 2012, the year before the country’s international bailout.

Michalis Persianis, chairman of the Cyprus Tax Council, said the data “underlines the turnaround in public financial management in recent years, compared to the dismal period before 2013”.

During the pandemic, the Cypriot government chose to focus on spending to encourage businesses to retain staff and a moratorium on private debt payments, Persianis said. Both measures supported incomes and demand. Strong economic growth then boosted government revenues, easing the public debt burden.

In the UK, public debt is expected to fall to around 83% of GDP next year, below 2019 levels and down from a peak of 103% of GDP in 2020, according to the IMF.

A spokesman said the UK government has pledged to reduce public debt amid rising interest rates and recently unveiled tougher rules on public spending.

In such situations, the losers are the bondholders. Investors and banks are required to buy safe assets such as government bonds, even if they lose money, under regulations introduced after the 2008-09 financial crisis that aim to make the system financially safer.

“It’s a hidden form of expropriation,” Mr. Blanchard said.

After World War II, the US government took advantage of a similar situation to reduce its debt-to-GDP ratio from 120% to 40% in two decades, to the detriment of bondholders. In the 1970s, the United States once again inflated some of its debt. But this was followed in the 1980s by a period of historically high returns for bondholders. Public debt fell during the 1970s as a percentage of GDP, but rose sharply in the 1980s. “The benefits of the 1970s reversed in the first half of the 1980s,” Reis said.

Today, higher inflation is more likely to drive up public borrowing costs because debt maturities are shorter, more bonds are pegged to inflation rates, and there are more opportunities for investment alternatives, according to the IMF.

In South America in the 1980s, governments printed money to pay the bills and inflate their debts, but the policies backfired, leading to rising interest rates and hyperinflation.

“I wouldn’t say inflating debt is always good policy,” Reis said. “Historically, it went wrong more often than it worked right.”

In the UK, the government unveiled tougher rules on public spending.


Daniel Leal/Agence France-Presse/Getty Images

Write to Tom Fairless at [email protected]

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