It is commonly said that « inflation reduces debt. » This is one of the reasons why some argue that higher inflation in Europe would have a positive impact on the economy in a context of excessive government debt. What is the mechanism underlying this assertion?
Let’s assume that a country has a debt of €1.9 trillion (the French government’s debt at the end ofthe third quarter of 2013). Let’s also assume that cars have an average cost of €10,000, a baguette costs €1 on average, and gasoline costs €1.70 per liter at the pump. Let’s assume that, in one year, all prices double in France. Cars now cost an average of €20,000, a baguette costs €2, and gasoline costs €3.40 per liter. If prices double, the government’s tax revenue from consumption taxes also doubles! If the 20% VAT on cars brought in an average of €200 per car sale to the government, it will now bring in an average of €400; if gasoline taxes brought in an average of, say, €0.95 to the government, they will now bring in €1.90, and so on for all products subject to taxes. The link is therefore simple: if all prices double, tax revenues double [1]!
But what about spending, you might say… The government’s real income will therefore remain unchanged. But its nominal income will change. And in a context where debts are not indexed to inflation (the vast majority of French government debt), it is this nominal income that matters. Indeed, if my debts have a fixed interest rate of 3%, this means that I will have to repay (out of a total amount of €1.9 trillion) €57 billion in interest each year and €1.9 trillion when the debt matures. Whether inflation is 2% or 4%, these figures will remain the same. My expenses therefore do not change with inflation in terms of debt. Only my income increases: if prices double, tax revenues double. A budget surplus of 1% of GDP will have twice the impact in terms of debt reduction when inflation is twice as high. It is therefore as if the debt incurred to date were worth half as much [2]. Inflation therefore has the power to reduce debt.
Similarly, it is easy to see that the « weight of debt » (debt relative to GDP) decreases with inflation. Nominal GDP increases simply because of inflation, which automatically lowers the debt-to-GDP ratio. It is for these reasons that it is commonly said that inflation reduces the weight of debt.
Julien Pinter
Notes:
[1] One could argue that if prices rise, demand falls. This objection is not really relevant to the reasoning proposed here. Inflation generally leads to wage increases in the medium/long term, so that if prices double, it seems reasonable to assume that wages will also almost double in the long run. Demand therefore does not need to be modified in the timeframe we are considering here, at least not to the extent that it would invalidate our reasoning. Similarly, it should be noted that our argument, as it stands, only concerns tax revenues from consumption taxes (nearly 50% of the French government’s tax revenues). It is easy to generalize this to all tax revenues, as we have just shown: in the long term, if wage increases are such that real incomes remain unchanged, then tax revenues from income taxes will also double (a similar argument could apply to corporate taxes).
[2] This theoretical reasoning applies to debts that are not indexed to inflation and are denominated in national currency. In the case of debts denominated in foreign currency (a large proportion of the debts of many emerging countries), the link is more complex. If inflation is caused by a fall in key interest rates, it is generally accompanied by a depreciation of the national currency, which increases the weight of the debt in nominal terms and therefore ultimately does not have the same effects as in a country where the debt is almost entirely denominated in the national currency.
