That, by the way, is the idea that countries can inflate their way out of indebtedness.
Morgan’s Global Economics Team, headed up by Joachim Fels, Manoj Pradhan and Sypros Andreopoulos, has made the case for “soft default” of this sort for a while — that’s despite resistance from colleagues and clients, we might add.
They argued on Thursday that it was still a reasonable solution when high debt was deemed undesirable and political will for higher taxes and lower spending was, to say the least, lacking.
The added attraction comes from yields usually being slow to react to inflation anyway — something which would ease the debt-payment burden on governments rolling debt today.
Meanwhile, even if yields did rise instantaneously, the analysts said debt being rolled only intermittently in most cases would still see the effective nominal interest rate respond only partially. Voila! A debt erosion results. As they noted:
Historically, yields lag behind inflation. Throughout the 1970s, bond yields never meaningfully caught up with the inflation takeoff: real interest rates were mostly very low – indeed negative for sustained periods – a bad time for bonds. Exactly the opposite happened during the Great Moderation of the 1980s and 90s. The sustained decline in inflation meant real interest rates were high, giving rise to a long bull market for bonds (see Exhibit 2).
Statistical work suggests the same conclusion. The empirical academic literature suggests both that bond yields take a long time to incorporate inflation expectations, and that inflation expectations themselves are sticky (see the Box on the previous page for an extensive discussion). Put another way, the fact that nominal yields take time to catch up with inflation gives rise to the observed negative correlation between inflation and real yields.
In short, inflation lowers the real effective interest rate the government pays on the debt through reducing a) the nominal effective interest rate and b) real market yields. Moreover, the evidence suggests that these mechanisms work over a sustained period of time – allowing substantial debt erosion.
The Morgan Stanley analysts, of course, aren’t really alone in their debtflation view.
Another long-time advocate of intentional inflationary policy for resolving debt issues has been Kenneth Rogoff — Harvard economist and co-author of the definitive guide to sovereign defaults, This Time is Different.
And as the MOST analysts themselves noted, he’s flagged already up evidence of why additional reasons exist for making inflation relevant today:
The evidence strongly suggests that, for the US as well as internationally, high debt has historically come hand in hand with lower growth as well as higher inflation (see Carmen Reinhart and Kenneth Rogoff, Growth in Times of Debt, NBER Working Paper 15639). For the US, they show that debt to GDP ratios in excess of 90% have meant materially higher inflation and lower growth (see Exhibit 3).
Essentially, it’s a balance that supposedly makes sense:
Related links:
U.S. Needs More Inflation to Speed Recovery, Say Mankiw, Rogoff – Bloomberg
The debt-inflation myth, debunked by UBS – FT Alphaville
Sticky inflation, redux – FT Alphaville
Inflationistas, Deflationistas and Goldilockeans – FT Alphaville