We can't inflate our way out of debt

Why the U.S. can't inflate its way out of debt
Published on 03-13-2010
CNNMoney.com

It's dawning on people that getting a handle on burgeoning U.S. debt will be a long and hard process.

So if lawmakers can't agree on a credible plan, some have suggested that the country could just "inflate its way" out of its fiscal ditch.The idea:

Pursue policies that boost prices and wages and erode the value of the currency

The United States would owe the same amount of actual dollars to its creditors -- but the debt becomes easier to pay off because the dollar becomes less valuable.

That's hardly a good plan, say a bevy of debt experts and economists.

"Many countries have tried this and they've all failed," said Mark Zandi, chief economist at Moody's Economy.com.

It's true that inflation could reduce a small portion of U.S. debt. The International Monetary Fund (IMF) estimates that in advanced economies less than a quarter of the anticipated growth in the debt-to-GDP ratio would be reduced by inflation.

But the mother lode of the country's looming debt burden would remain and the negative effects of inflation could create a whole new set of problems.

For starters, a lot of government spending is tied to inflation. So when inflation rises, so do government obligations, said Donald Marron, a former acting director of the Congressional Budget Office (CBO), in testimony before the Senate Budget Committee.

"[W]e have an enormous number of spending programs, Social Security being the most obvious, that are indexed. If inflation goes up, there's a one-for-one increase in our spending. And that's also true in many of the payment rates in Medicare and other programs," he said.

Inflation would also make future U.S. debt more expensive, because inflation tends to push up interest rates. And the Treasury will have to refinance $5 trillion worth of short-term debt between now and 2015.

"[The debt's] value could go down for a couple of years because of surprise inflation. But then ... the market's going to charge you a premium interest rate and say 'you fooled us once but this time we're going to charge you a much higher rate on your three-year bonds,'" Marron said.

The Treasury is increasing the average term of its debt issuance so it can lock in rates for a longer time and reduce the risk of a sudden spike in borrowing costs. But moving that average higher won't happen overnight. And, in any case, short-term debt will always be part of the mix.

Another potential concern: Treasury inflation-protected securities (TIPS), which have maturities of 5, 10 and 20 years. They make up less than 10% of U.S. debt outstanding currently, but the Government Accountability Office has recommended Treasury offer more TIPS as part of its strategy to lengthen the average maturity on U.S. debt.

The higher inflation goes, of course, the more the Treasury will owe on its TIPS.

Just last week, the CBO noted that interest paid on U.S. debt had risen 39% during the first five months of this fiscal year relative to the same period a year ago. "That increase is largely a result of adjustments for inflation to indexed securities, which were negative early last year," according to the agency's monthly budget review.

What's more, the knock-on effects of inflation are not pretty. A recent report from the IMF outlined some of them: reduced economic growth, increased social and political stress and added strain on the poor -- whose incomes aren't likely to keep pace with the increase in food prices and other basics. That, in turn, could increase pressure on the government to provide aid -- aid which would need to keep pace with inflation.

More viable alternatives

So where does that leave lawmakers? Facing tough choices.

Deficit hawks and market experts have been calling on lawmakers to come up with a strategy to stabilize the growth in U.S. debt, which would be implemented only after the economy recovers more fully.

The idea is to signal to the markets that the country is serious about getting its longer term debt under control so that the burden of paying it back doesn't consume an ever-increasing share of the federal budget.

The recommended exit strategies are pretty basic, if unpopular: tax increases and spending cuts.

Economic growth will play a key role as well -- since a strong economy produces more tax revenue. But the country cannot grow its way out of its problems.

To do that, the economy would have to expand at Herculean rates annually from here on out. And even the most optimistic economist doesn't see that on the horizon.