The Wall Street Journal today has an interesting look at the troubles associated with red ink. Among the resources cited is new research from Morgan Stanley with a clever title that asks: The Return of Debtflation?
It’s a revealing look into the history and the implications of sovereign debt and the related risk. You can read the full report, complete with graphs, here. Meanwhile, here’s the summary, which packs a punch on its own:
US public debt as a share of GDP is now higher than at any other time in history except after World War 2 – and rising: our US colleagues expect public debt to GDP to increase to 87% by 2020. How policymakers will deal with this fact will likely be one of the main drivers across markets going forward. So what are the implications of high public sector debt for fiscal sustainability and inflation? To answer this question, we look at how the US economy escaped high debt following World War 2. We then quantify the inflation risks inherent in today’s US fiscal position by asking what would happen if policymakers were to deal with the current debt overhang in the same way.
Stabilisation of public debt to GDP at current levels would require average inflation rates between 4-6% over the coming decade – even under much lower budget deficits than currently in place. On our numbers, even with budget deficits that are much lower than the current (and projected) levels, average inflation over the next ten years would have to be substantially above 2% to keep debt in check. Even a balanced budget would require 3% average inflation over the next decade. With an average deficit as low as 3% of GDP, debt stabilisation would require average inflation above 6%. Note that in the current fiscal year (FY) we expect a deficit of 9% of GDP, projected to decline to 5.2% of GDP by 2020. Suppose the government were to reduce the deficit to 5.2% from 2011 onwards – rather than by 2020. Stabilising the debt at current levels would then require an inflation rate of 9% on average over the next 10 years. What level of deficit would be consistent with achieving a 2% inflation target, on average, over the next 10 years? A 1% of GDP budget surplus.
It is clear that inflation risks of this magnitude are not in the price: currently, markets are anticipating inflation to be below 2.5% over the next 10 years, on average. Should we be worried about ‘debtflation’ – the Fed engineering inflation to keep the debt in check? A forward-looking central bank may prefer to create a little controlled inflation now to the pressure of inflating a lot later on. And the idea of controlled inflation has influential advocates in policy circles. Former IMF Chief Economist Kenneth Rogoff has suggested the Fed announce a 4-6% inflation target for a limited period. Coincidence?