Why inflation won’t work…..

Problem with high national debt? Easy - inflate that debt away and negative real interest rates will rapidly reduce that debt to manageable levels.

From a certain economic perspective, this theory has some validity however as the economy serves society which is made up of people, then people’s reaction to the inflation reality would dictate how the story evolves.

Inflation will need to be controlled

High levels of inflation, without even considering hyperinflation, always become a political issue. There is always a significant proportion of society, including some with power, that lose from inflation. As a political issue, the result will be pressure to combat inflation and utilise the usual mechanisms, such as price freezes and increase of interest rates…..making the original debt issue worse until defaults spread

Delayed effects of inflation control mechanisms

Inflation measures reflect the past and the effects of interest rates changes take a long time. A sequence of “inflation is high so let’s raise rates” is actually inflation a few months ago was high and increasing interest rates will take effect in in 6-12 months’ time. This is continual lag between inflation and the interest rate affects will reduce real debt however this also means there will be an overshoot at some point when interest rates will be higher than necessary when inflation is already reduced.

The delayed effects mean interest rate overshoot and economic contraction

At that point, the logic of “inflation is high so let’s raise rates” would actually mean, the last time inflation was measured it was high but it has actually fallen and will continue to fall due to previous interest rate increases so let’s hammer the economy more and raise interest rates again.

The scale and timing for interest rate change is critical however the economy is a large, changing, complex and chaotic system so trying to do subtle control via a small number of variables (such as interest rates) with a delay is impossible.

Inflation can contract the economy, increasing interest rates almost guarantee it

Along with government intervention to adjust interest rates, investors will adjust required returns to account for inflation. As inflation measurements inform the market, investors will consider the interest rates, current inflation and future expectations of inflation in their pricing for new loans. Higher prices for new debt will reduce demand; less new debt is contractionary in of itself. Renewed debt will at higher prices leading to higher defaults – failed firms and entities contract the economy.

More government intervention required to ‘help’ the declining economy

Increasing interest rates increase default rates. Pessimistically, this could lead to a cascade of defaults throughout the economy however this would not occur as government would intervene in a similar way to the GFC. Depending on the amount of money in the economy and its momentum, Interest rates rises would be slowed or reversed to balance inflation issues with economic contraction; leading to a potential for stagflation. Interventions such as specific government loans to companies will take place again to socialise private debts to the population.

Social and economic problems will be addressed by more debt

While inflation is high, increasing wage claims combined with increasing interest rates will result in yet more distortions throughout the economy:

• Viable firms slow or challenged to adjust (e.g. low margin commodity producers) may risk insolvency,

• The prices of human and financial capital will increase reducing investment,

• Individuals without sufficient pricing power in their wages will become increasingly impoverished and their cash savings will erode.

All of this will reduce aggregate demand and consequently Government deficits will increase to fund social expenses, debt support and national projects conceived to replace aggregate demand. These deficits will add to national debt….. luck and happenstance will determine if this new government debt will be less than reduction of national debt by inflation.

So inflation may reduce the real national debt however the cycle of responses by individuals, firms and the government will result in negative economic and social outcomes that may actually require in an increase in debt.