Increasing inflation rates could curtail the national debt, according to a Dec. 9 working paper by economics professor Nancy Marion and Joshua Aizenman, a former Dartmouth professor now working at the University of California, Santa Cruz. While it may be tempting to use inflation as a way to help the country recover from its debts, a drastic increase would have negative consequences for the American economy, the paper says.
Although the researchers do not necessarily advocate increasing inflation rates deliberately, the paper explores the possibility of increasing the inflation rate as one factor in changing the trajectory of the federal debt and its consequent effects.
The paper concludes that increasing the inflation rate from under 2 percent to 6 percent over four years could reduce the public-debt-to-GDP ratio by 20 percent. Currently, the United States' public debt is equivalent to about 54 percent of the annual U.S. GDP, according to the study. Foreign creditors control approximately half of the debt.
By increasing the inflation rate, the government could minimize the real cost of reimbursing bond-holders without necessarily raising taxes or cutting government spending. While the nominal value of the debt would remain the same, more revenue would be created by tax rates that are not indexed for inflation. The increased revenue would allow the government to pay for interest charges and cover the debt.
"We're not advocating using inflation to erode the value of the debt," Marion said in an interview with The Dartmouth. "We're looking at the costs and benefits and exploring why governments might be tempted to use inflation."
Marion noted that American inflation rates might already be increasing because of the Federal Reserve Bank's efforts to increase the money supply.
"Certainly there is a persuasive argument that one can make that we might see higher-than-anticipated inflation because the Fed has injected trillions into the economy," Marion said. "Over time, as we recover from the recent financial crisis, having all this money sloshing around will increase inflation unless the Fed can sop it up."
The Fed must control inflation caused by excess money lending by selling government bonds and removing the revenue gathered from the money supply, according Marion.
"This is as much an art as a science," Marion said. "If the money supply is reduced too quickly we will fall back into recession, and if it is reduced too slowly it will cause inflation."
A slight increase in the inflation rate may be beneficial to the economy, Marion said. The increase might help raise housing prices and reduce the number of foreclosures, while also aiding individuals and firms in debt, she said.
However, several factors would likely offset the success of an instituted rise in inflation, according to the paper. Although in 1946 the average period until outstanding government bonds matured was nine years, it is presently about 3.9 years, which would increase the turnover of inflation-protected bonds. This would mean that the government would have to pay back the real amount of bonds more quickly, and would therefore get fewer benefits from increasing inflation.
The unpredictable nature of an economy wracked by rising inflation could also discourage job-creating investment and cause foreign creditors to choose to invest in countries other than the United States, according to an article on the study in the Toronto Star.
Aizenman and Marion said that due to the increasingly globalized modern economy, increased inflation would have a more detrimental effect for the United States because outsourcing investment is easier.
"Another concern would be a reduced role for the dollar, and speculation that it might become less important relative to the Chinese yuan or the euro," Marion said.
Marion and Aizenman chose to explore potential solutions for remedying the national debt because of the recent financial crisis, Aizenman said. The researchers estimate that the U.S. federal government will owe over $6 trillion by the end of the 2010 fiscal year and predict that public debt could reach 70 to 100 percent of gross domestic product in the next 10 years.
"Macroeconomics is frequently lacking discipline in the sense that we need events like this crisis in order to focus on the issues." Aizenman said.
The increasing debt-to-GDP ratio that the U.S. is experiencing is unsustainable and will become a significant liability over time if it is not remedied by government intervention, according to Marion. Aizenman stressed that manipulating the inflation rate is only one small part of remedying the debt.
"I think that inflation is not the main issue at hand," Aizenman said. "Beyond the narrative of the short term, the ultimate future of the U. S. will be impacted more by the bigger concern of returning to the fast growth rates of '90s."
Aizenman and Marion based their thesis off of the period of high public debt in the United States following World War II. After the war, the combination of increased inflation and GDP effectively allowed the country to recover from the debt. In 1946, the public debt was 108.6 percent of GDP, but by 1975 the debt had fallen to 25.3 percent due to the expanding economy and inflation. Aizenman and Marion noted that postwar inflation reduced the 1946 debt-to-GDP ratio by about 40 percent in less than a decade.
