What are the downsides of the policy to using inflation to solve the debt crisis?

Many observers comment that inflation is a way to achieve this. With quantitative easing boosting liquidity and raised levels of inflation in the West it may seem odd but it is not obvious that governments are actually using inflation or that if they were it would be a good idea.

In the West governments and the personal sector are looking to reduce their indebtedness. Many observers comment that inflation is a way to achieve this. With quantitative easing boosting liquidity and raised levels of inflation in the West it may seem odd but it is not obvious that governments are actually using inflation or that if they were it would be a good idea.

The main cause of global inflation comes from emerging markets. Emerging markets tend to fix against the dollar and so as a result have effectively adopted US monetary policy. Without a financial crisis to contend with and convergence pushing growth strongly the result has been inappropriate monetary policy and rapid inflation. This is particularly evident in food and energy prices which have pushed up global consumer prices. In emerging markets, where food and energy are a large part of the consumer basket, this has also pushed up wages whilst in the West a weak economy has limited this effect. Unless wages rise in response to higher commodity prices it is not clear that we have genuine inflation – that is a sustained increase in general prices. In the meantime the higher levels of measured inflation have been helpful in avoiding the deflation that caused such problems for Japan in escaping from its debt trap. Right now though it is hard to see how inflation can increase much further for longer in the West – although liquidity growth is high credit growth is extremely weak, unlike in emerging markets.

The other issue is whether high inflation can actually help reduce the debt crisis. If interest rates rise with inflation then there is no benefit. So only if debt is long term and fixed rate is there a significant benefit. With the majority of Western governments having average debt maturity of four years and heavy borrowing at the short end, inflation can play only a limited role, the exception perhaps being the UK where average government debt maturity is 14 years.

So raised levels of inflation have been very helpful in avoiding the Japanese problem of zero nominal rates and positive real rates. However Western governments would need to do a lot more to create levels of inflation that would significantly ease the debt crisis – several rounds of Quantitative easing and competitive devaluations by many countries. Currently they seem more focused on using fiscal austerity to solve indebtedness than inflation.