Will the US inflate away its public debt?, by Ricardo Reis, Vox EU: Should the US Federal Reserve raise the inflation target from its current level of 2%? And will it? One benefit would be to make hitting the zero lower bound less likely, which would lead to less severe recessions, as Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro (2010), Daniel Leigh (2010), and Laurence Ball (2013) have argued on this website. Other benefits of higher inflation that Kenneth Rogoff has been emphasising for a while might include accelerating the fall in real wages during the recession, and deflating away debt overhang (Rogoff 2014).1
One of the most indebted economic agents is the government. The federal debt limit has had to be raised repeatedly in the past few years, and at the end of the 2013 fiscal year the gross federal debt outstanding was 101% of GDP – the highest ratio since 1948. It is therefore natural to imagine – like Aizenman and Marion (2009) –that inflating away the public debt is possible, perhaps effective, and maybe even desirable. Using a simple rule of thumb to estimate the effect of higher inflation on the real value of debt, they venture that US inflation of 6% for four years could reduce the debt-GDP ratio by roughly 20%.
However, in our recent work we show that the probability that US inflation lowers the real value of the debt by even as little as 4.2% of GDP is less than 1% (Hilscher, Raviv and Reis, 2014). Why is this estimate so small? We show that there are two reasons: first, the private sector holds shorter maturity debt; second, high levels of inflation in the next few years are extremely unlikely. ...
One way or another, budget constraints will always hold. This is true as much for a household or a firm as it is for the central bank or the government as a whole. If the US government is to pay its debt, then it must either raise fiscal surpluses or hope for higher economic growth; the former is painful and the latter is hard to depend on. It is therefore tempting to yield to the mystique of central banking and believe in a seemingly feasible and reliable alternative: expansionary monetary policy and higher inflation.3 Crunching through the numbers we find that this alternative is not really there.