1 September 2021

‘Inflating away the debt’ sounds attractive, but there’s a good reason it won’t work

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Something, at some time, is going to have to be done about the national debt. The question is, as ever, what?

Running a budget surplus which then pays down that debt doesn’t appeal politically – it’s always more fun to spend tax money than it is to collect taxes, and voting patterns show that the electorate share that view. There is the possibility of simply holding things constant and allowing economic growth to reduce the debt as a portion of GDP. Making it, in terms of systemic problems, an irrelevance in a decade or four. This does require, however, that we don’t run up even more debt in the meantime.

Or, of course, we could return to the tried-and-tested tactic of inflating our way out of it. That is what we did last time – anyone who invested in government stock, in gilts, to help pay our World War II debt lost near all of their capital value. Expropriating the people helping you pay off your debt isn’t all that kind, but it is expedient.

The morality of the idea aside, trying to inflate away debt simply won’t work this time around. As this recent report in the Telegraph sets out:

Surging inflation is set to cost Rishi Sunak an extra £12bn this year, potentially squeezing his ability to offer more giveaways in the Budget. About a quarter of the £2.2 trillion in national debt is tied to the retail price index (RPI), so the unexpected jump in inflation forces the Treasury to pay more to investors who own gilts.

The fact that a significant part of the UK’s debt is already linked to inflation means that inflation won’t, in fact, reduce that part of the debt. Yes, it’s only 25% of the total pile, but a rise in the interest on that part of the debt – and the RPI-linked gilts are all in the section not held by the Bank of England – does impact upon the budget and negate some of the benefits of inflation in eroding the debt. For the usual manner of paying – without a balanced budget – such increased interest costs is to issue more gilts.

However, the headline figure for government debt isn’t actually the indebtedness of the government. The future costs of healthcare, old age pensions and the rest of the welfare state dwarf any number that is clearly apparent in the financial markets. And all of those  expenses are linked to the inflation rate. To a large enough extent those promises are made upon things which are the inflation rate. That means that induced inflation will simply increase the cost to the Government of its own future payments for pensions, the NHS and so on.

It is, of course, just and righteous that government should keep its promises to us for the taxes we’ve already paid – we are paying tax now to provide those things to the old of today and it’s our children who will be coughing up for our own turn at the trough. These are bills that cannot be inflated away.

The really crucial point though is that we have sophisticated financial markets now. Those who wish to avoid such an inflation tax can, and almost certainly will.

One description of this is the ‘fool me once, fool me twice’ principle. We’ve already seen what happened last time we built up an enormous debt, those who lent to the government ended up losing their money thanks to inflation. Investors are unlikely to let the same thing happen to them again.

Bear in mind, too, the huge impact that great inflation had on financial markets. Before that great inflation, equities weren’t a significant part of the standard investment portfolio, because gilts were financially rewarding – inflation was, over time, below interest rates, so investors got a real return on their money. That all changed for several decades after the war, which led to the explosion of equities, which were – to some degree at least – protected from inflation because their profits and dividends tend to rise along with it.

Another important factor is that we can now invest abroad, avoiding British inflation. Many already do so and doubtless more would in a world of higher inflation in the UK.

Of course, this is not an even process and some do lose out. On the other hand great inflation-protected sectors are fast-moving consumer goods, utilities where they’re not subject to price caps, and so on. The over-arching point here is that thanks to the post-war experience and financial innovation since then, we now have a much better idea of how to preserve capital in a time of inflation.

The most obvious lesson is not to lend to government by buying fixed-rate bonds, and few investors will want to do so if inflation reappears. The very fact they won’t will itself push up the rates must offer and kibosh the attempt to inflate the debt itself away. Nor can the Bank of England just buy all those gilts – that just increases the money supply and so leading to more inflation.

Given that we’re not going to gain budget surpluses any time soon, that leaves only one viable way out of this corner – growth. That may be slow, possibly arduous and even boring. It also requires a modicum of fiscal rectitude in politics, which, given the enthusiasm of our politicians for spending money, is probably a forlorn hope.

Ultimately, however, that really is our only option. The world has long moved on from governments being able to rook savers to pay for their past spending.

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Tim Worstall works for the Continental Telegraph and the Adam Smith Institute.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.