Spending cuts of any type are almost as unattractive to lawmakers. Taking away what the electorate considers a “right” or a “entitlement” is the equivalent of ending your political career.
Raising taxes is more palatable, especially in countries where the majority of people do not pay taxes or where the increases only affect “the rich,” as the populace perceives them. The danger is that if taxes are raised too high, the motivation to labor is reduced, and the economy as a whole collapses. As a result, gross tax collections fall, causing the country’s debt crisis to worsen as the government is forced to borrow more to avoid making any spending cuts.
Then there’s inflation. The most politically acceptable method of lowering the debt in a way that is mostly unnoticed by the people is to use sluggish, chronic inflation.
How Does Inflation Reduce Debt?
Because the currency loses value as a result of inflation, the people and institutions who own the debt are the losers. Assume you borrow money from the government by purchasing a $1000 US government bond with a ten-year maturity. You could get a fully loaded laptop or a round trip ticket to London for $1000 at the moment you buy it.
Let’s imagine the United States inflates its currency at a pace of 7% for the next ten years, which is roughly double the “average” inflation rate of 3.3 percent for the previous 80 years. The bond matures at the end of that period, and you receive your $1000 back. You go out to buy a laptop, which now costs $2000. The journey to London was also $2000. Many people in this situation will believe that laptop and airline ticket prices have increased.
In fact, the cost of these things hasn’t increased by a penny in real dollars (dollars adjusted for inflation). In this scenario, the value of the dollar has fallen by 50 percent over ten years. The United States government is the great winner here, as its multitrillion-dollar debt has been cut in half (in real terms) in just ten years. They were able to do so without raising taxes or slashing spending, which politicians find irresistible.
If the country experiences persistent deflation, similar to Japan, where consumer prices have fallen by up to 2% per year over the past 15 years, government revenues will fall while the real value of the country’s large debt will rise, further stalling future growth. It becomes a vicious cycle with few, if any, instruments available to politicians to break it.
As a result, the ideal treatment is progressive inflation. Citizens become like the proverbial frog that is slowly cooked in a pan of water with the temperature gradually increasing, rather than being frozen to death by deflation, when it is done well. Of course, neither outcome is good for the frog in the end.
Is government debt reduced by inflation?
Because there is no inflation indexing, higher inflation diminishes the real value of the government’s existing debt while raising the tax burden on capital investment. By increasing the present annual inflation target regime from 2% to 3%, debt is reduced while GDP is reduced.
How does inflation help to reduce the national debt burden?
Question from a reader: Why does inflation make it easier for governments to repay their debts?
During the 1950s, 1960s, and 1970s, when inflation was quite high, the national debt as a percentage of GDP dropped dramatically. Deflation and massive debt characterized the 1920s and 1930s.
Inflation makes it easier for a government to pay its debt for a variety of reasons, especially when inflation is larger than planned. In conclusion:
- Nominal tax collections rise as inflation rises (if prices are higher, the government will collect more VAT, workers pay more income tax)
- Higher inflation lowers the actual worth of debt; bondholders with fixed interest rates will see their bonds’ real value diminish, making it easier for the government to repay them.
- Higher inflation allows the government to lock income tax levels, allowing more workers to pay higher tax rates thereby increasing tax revenue without raising rates.
Why inflation can benefit the government at the expense of bondholders
- Let’s pretend that an economy has 0% inflation and that people anticipate it to stay that way.
- Let’s say the government needs to borrow 2 billion and sells 1,000 30-year bonds to the private sector. The government may give a 2% annual interest rate to entice individuals to acquire bonds.
- The government will thereafter be required to repay the full amount of the bonds (1,000) as well as the annual interest payments (20 per year at 2%).
- Investors who purchase the bonds will profit. The bond yield (2%) is higher than the inflation rate. They get their bonds back, plus interest.
- Assume, however, that inflation of 10% occurred unexpectedly. Money loses its worth as a result of this. As prices rise as a result of inflation, 1,000 will buy fewer products and services.
- As salaries and prices rise, the government will receive more tax money as a result of inflation (for example, if prices rise 10%, the government’s VAT receipts will rise 10%).
- As a result, inflation aids the government in collecting more tax income.
- Bondholders, on the other hand, lose out. The government still owes only 1,000 in repayment. However, inflation has lowered the value of that 1,000 bond (it now has a real value of 900). Because the inflation rate (ten percent) is higher than the bond’s interest rate (two percent), their funds are losing actual value.
- Because of inflation, repaying bondholders needs a lesser percentage of the government’s overall tax collection, making it easier for the government to repay the original loan.
As a result of inflation, the government (borrower) is better off, whereas bondholders (savers) are worse off.
Evaluation (index-linked bonds)
Some bondholders will purchase index-linked bonds as a result of this risk. This means that if inflation rises, the maturity value and interest rate on the bond will rise in lockstep with inflation, protecting the bond’s real value. The government does not benefit from inflation in this instance since it pays greater interest payments and is unable to discount the debt through inflation.
Inflation and benefits
Inflation is expected to peak at 6.2 percent in 2022 in the United Kingdom, resulting in a significant increase in nominal tax receipts. The government, on the other hand, has expanded benefits and public sector salaries at a lower inflation rate. In April 2022, inflation-linked benefits and tax credits will increase by 3.1%, as determined by the Consumer Price Index (CPI) inflation rate in September 2021.
As a result, public employees and benefit recipients will suffer a genuine drop in income their benefits will increase by 3.1 percent, but inflation might reach 6.2 percent. The government’s financial condition will improve in this case by increasing benefits at a slower rate than inflation.
Only by making the purposeful decision to raise benefits and wages at a slower rate than inflation can debt be reduced.
Inflation and bracket creep
Another approach for the government to benefit from inflation is to maintain a constant income tax level. The basic rate of income tax (20%), for example, begins at 12,501. At 50,000, the tax rate is 40%, and at 150,000, the tax rate is 50%. As a result of inflation, nominal earnings will rise, and more workers will begin to pay higher rates of income tax. As a result, even though the tax rate appears to be unchanged, the government has effectively raised average tax rates.
Long Term Implications of inflation on bonds
People will be hesitant to buy bonds if they expect low inflation and subsequently lose the real worth of their savings due to high inflation. They know that inflation might lower the value of bondholders’ money.
If bondholders are concerned that the government will generate inflation, greater bond rates will be desired to compensate for the risk of losing money due to inflation. As a result, the likelihood of high inflation may make borrowing more onerous for the government.
Bondholders may not expect zero inflation; yet, bondholders are harmed by unexpected inflation.
Example Post War Britain
Inflation was fairly low throughout the 1930s. This is one of the reasons why individuals were willing to pay low interest rates for UK government bonds (in the 1950s, the national debt increased to over 230 percent of GDP). Inflationary effects lowered the debt burden in the postwar period, making it simpler for the government to satisfy its repayment obligations.
In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.
Inflation helped to expedite the decline of UK national debt as a percentage of GDP in the postwar period, lowering the real burden of debt. However, debt declined as a result of a sustained period of economic development and increased tax collections.
Economic Growth and Government Debt
Another concern is that if the government reflates the economy (for example, by pursuing quantitative easing), it may increase both economic activity and inflation. A higher GDP is a crucial component in the government’s ability to raise more tax money to pay off its debt.
Bondholders may be concerned about an economy that is expected to experience deflation and negative growth. Although deflation might increase the real value of bonds, they may be concerned that the economy is stagnating too much and that the government would struggle to satisfy its debt obligations.
What options does the government have for debt reduction?
Interest rates are another means for governments to stimulate the economy, create tax revenue, and, ultimately, reduce the national debt by keeping them low. Individuals and corporations can borrow money more easily with lower interest rates.
What is the impact of inflation on government spending?
The Federal Reserve can use a variety of monetary policy measures to try to keep inflation under control. To avoid the detrimental consequences of rapidly shifting prices on the economy, the central bank seeks to manage inflation (as measured by the PCE Price Index) at roughly 2% per year. To attain the target inflation rate, the Federal Reserve might use a variety of policy tools. They can, for example, influence how much money banks lend to consumers and businesses by modifying the discount rate, which is the interest rate banks pay on Federal Reserve loans; they can also change the amount of money banks must maintain on hand (known as reserve requirements).
The federal funds rate the interest rate that banks charge one another for overnight borrowing is the most popular approach for the central bank to control inflation. The federal funds rate has an impact on other interest rates that affect corporate and consumer borrowing costs. When inflation becomes too high, the Federal Reserve can raise the federal funds rate, making borrowing more expensive and thereby reducing the money supply. If inflation is too low, on the other hand, the central bank can cut it to encourage the economy and raise inflation. Interest rate fluctuations, on the other hand, can have significant economic effects, such as affecting financial markets, indebted organizations, and national debt interest expenses.
Why does the government use inflation to borrow?
The economy will benefit if the RBI purchases some of the government’s bonds since interest rates will not rise. However, if the economy does not expand, the extra money floating around in the system might lead to inflation.
What causes inflation is government debt.
Second, when the yield on treasury securities rises, firms operating in the United States will be perceived as riskier, necessitating a rise in the yield on freshly issued bonds. As a result, firms will have to raise the price of their products and services to cover the rising cost of debt payment. People will pay more for products and services as a result of this, leading in inflation.
Debtors or creditors benefit from inflation.
- Inflation redistributes wealth from creditors to debtors, so lenders lose out while borrowers gain.
- We can’t assert that inflation favors bondholders because Statement 2 doesn’t utilize the term “inflation-indexed bonds.”
What happens to debt in a hyperinflationary environment?
For new debtors, hyperinflation makes debt more expensive. As the economy worsens, fewer lenders will be ready to lend money, thus borrowers may expect to pay higher interest rates. If someone takes on debt before hyperinflation occurs, on the other hand, the borrower gains since the currency’s value declines. In theory, repaying a given sum of money should be easier because the borrower can make more for their goods and services.
Who is responsible for the national debt?
Debt of the State Over $22 trillion of the national debt is held by the general populace. 3 A substantial amount of the public debt is held by foreign governments, while the balance is held by banks and investors in the United States, the Federal Reserve, state and local governments, mutual funds, pension funds, insurance companies, and holders of savings bonds.
Which country owes the most money?
Venezuela has the highest debt-to-GDP ratio in the world as of December 2020, by a wide margin. Venezuela may have the world’s greatest oil reserves, but the state-owned oil corporation is thought to be poorly managed, and the country’s GDP has fallen in recent years. Simultaneously, Venezuela has taken out large loans, increasing its debt burden, and President Nicolas Maduro has tried dubious measures to curb the country’s spiraling inflation.