“Controlled Inflation“ as Exit Strategy?

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In 2010, a key issue of the political agenda in Euro-Atlantic space will be the costs of the financial crisis. Governmental debt has exploded because of bank bailouts and support measures for the real economy driven into deep recession by the financial crisis. How should the immense state indebtedness – often at ratios of 100% of GDP or even higher – be brought down to manageable levels? Progressive public debt reduction by the growth of the real economy? Or by “controlled” inflation, which “devalues” national debt and state expenses – in particular social expenses?
By Michael Liebig


At present, the central political question in Europe is: What exit strategy out of the debt morass generated by the financial crisis? Before we proceed in dealing with this question, a clarification is necessary. The absolute size of public debt is not really important, what counts is the ratio of government debt to the overall capacity of the economy, usually measured in GDP and GDP growth. Qualitative factors like technological productivity or innovation capacity are inadequately represented by the GDP parameter. The same caveat applies to government debt, namely its purposes: Is it spent for productive investments, education for example, or for other, “consumptive” purposes which however may be socially or otherwise necessary. Nevertheless, the ratio of public debt to GDP is a reasonable indicator for determining whether public debt can be “carried” by the economy or is unsustainable. And this question will loom over two important elections in Western Europe in the first half of 2010:

  • On May 9, 2010 there will be state elections in the German federal state of North Rhine-Westphalia (NRW). 18 million people are living in NRW, roughly a quarter of the German population. Seven months after the Sept. 2009 Bundestag vote, the election result in North Rhine-Westphalia will significantly impact the Christian-liberal coalition government in Berlin. Will it strengthen or weaken Chancellor Merkel? And this will greatly influence what the Merkel government will do on the politically all-important budgetary front.
  • The latest by June 3, 2010 general elections must be held in Britain. It seems almost certain that Labour Prime Minister Gordon Brown will be voted out of office, being replaced by the Conservative Party’s David Cameron. However, the Tories must win a landslide victory to get a safe majority in the House of Commons which will be very difficult. The voter turnout is uncertain, and so are the chances of the “other parties“ – Liberal Democrats, Scottish National Party, Green Party, the UK Independence Party, and British National Party.

The British Economy and State Finances

Let’s look first at the situation in Britain. Even if available statistical data differ somewhat, during the past 15 months, the British state has laid out close to one trillion euro (or roughly 70% of Britain’s GDP) for the bailout of banks. That is the biggest bank rescue package (as ratio of GDP) in the world. Major British banks like RBS and Lloyds have been nationalised – and with them their vast liabilities. Precise figures on Britain’s government debt are difficult to calculate, but they have literally exploded as a consequence of the financial crisis. A indicator of the gravity of the situation is the Bank of England’s “Quantitative Easing” policy. The BoE has bought roughly 230 billion euro of British state bonds (gilts) – paying by printing money.

During the past 15 months, the exchange rate of the British Pound sterling has dropped by 25% vis-à-vis the euro – however without improving noticeably British exports. Besides, one should keep in mind that manufacturing sector contributes only 11% to the British GDP.

Britain is the country with the third largest current account deficit in the world, along with the USA and Spain, while China, Germany and Japan have the largest current account surplus.

Under Thatcher/Major and Blair/Brown, the British economy seemed to thrive due to a largely deregulated, but highly profitable finance sector, debt-driven consumption of private households, and grand-style property speculation. All three economic vectors have been shattered by the financial crisis, which they helped to unleash in the first place. At the same time, industry and infrastructure have atrophied. In addition, the economic balancing factor of North Sea oil production is progressively disappearing because the reserves are getting exhausted.

The net result is that Britain’s economic weight is shrinking and its ranking in the G20 is declining. The next British government will not be able to go past to these realities.

“Jellyfish” Cameron and What He will likely Do

Leaving political values aside, the likely next Prime Minister does not measure up to either Thatcher or Blair. David Cameron lacks any charisma or even character contour – be it good or bad. Steve Bell, the cartoonist of the London Guardian presents Cameron as „Jellyfish“: glassy, gelatinous, no firm contours, but capable of spitting out poison.

It can be taken for granted that a Cameron government – like its predecessors – will focus on promoting the London „finance industry“. Brown’s loudly announced „radical boni tax“ for investment bankers is to last only for a few months in any case – so Cameron will have no problem with this one. The “City” depends on ultra-light regulation for its financial services, notably proprietary trading. So the Cameron government will make sure that this will go on. The Cameron government will do all it can to obstruct, circumvent and water down serious regulation measures for the British finance sector, including measures agreed to by the G20. The financial profits made by the “City” is an irreplaceable source of revenues for the British government. An up and running “City” is the government’s only hope for recovering some of the funds spent for bailing out banks.

On the other side, the likelihood that the next British government will seriously try to turn around the deindustrialization trend and reactivate the manufacturing sector is close to zero. And the same goes for bigger infrastructure investments, not much will happen here.

Property speculation – the past decades’ great „wealth creator“ – cannot be reanimated in the foreseeable future. Equally, credit-financed consumption – the other great “economic driver” – cannot be revived any time soon because the indebtedness of British households – credit card debt, consumer loans and mortgages – is simply too high.

This is the setting in which a Cameron government will face the issue of Britain’s state indebtedness. Will it raise taxes for the majority of the population? Will public spending – in particular social expenses – be cut down drastically? I would guess that state expenses will reduced for social and educational programs and infrastructure, while consumption taxes will be raised. How deep the cuts will be, is difficult to judge.

I think even military expenses, which are very high in post-imperial Britain, will be downsized. This would be quite relevant for Germany: Cameron’s shadow defence minister, Liam Fox, has announced that the British Forces in Germany will be withdrawn. Indeed, there is no plausible reason why – 15 years after the last Russian soldier left Eastern Germany – 23,000 British troops should still be stationed in the north of Germany? But I fear that the British pull out from Germany will not occur as fast and complete as Fox has announced. At first, a pull out means higher costs – savings come only later. The Royal Navy will be downsized: Instead of 4 there will be only 3 strategic ballistic missile submarines, and whether two big aircraft carriers will really be built, is also doubtful. The Royal Air Force too will be cut down in size. The Army will probably not suffer in funding because Britain needs a face-saving departure from Afghanistan.

But all the mentioned cuts in the state expenses – and also rising taxes – will not solve the problem of the British government debt. Moreover, a robust recovery of the British economy – like in the USA – can almost certainly be ruled out: The debt-financed domestic growth dynamic of the past decades has played out. And there is no industrial base strong enough to participate – by exporting – in the growth dynamic in Asia and Latin America. Much more likely is a longer-term stagnation phase with zero or minuscule growth of the British economy.

Controlled Inflation

State bankruptcy or a debt moratorium are out of question for the British. This option is reserved for Ambrose Evans-Pritchard’s columns on Greece, Hungary and other “failed states” on the Continent. I suppose that the British establishment and the next government are envisaging a „solution“ which comes down to “controlled inflation“. And here lies a convergence of interest with the United States which will likely further cement the Anglo-American “special relationship”. After all, leading American economists like Kenneth Rogoff and Paul Krugman are already advocating controlled inflation.

What would controlled inflation mean? A gradual “debt relief” for the state at the expense of the majority of the population – and foreigners, if a significant portion of the national debt is held by them. Inflation means the “devaluation” of state loans at the rate of the general prize increase. After 5 years of 5% inflation, the value of state loans has declined by 27% (if no inflation indexation exists). Moreover, the same is also valid for all other state expenses, in particular social expenses. For the recipients of social security programs, the purchasing power of their pensions, unemployment benefits or family allowances decreases corresponding to the inflation rate. Concretely, their standard of living will decline. And the same is valid for the private savings of the majority of the population. Savings‘ value/purchasing power will shrink.

On December 21, 2009, the Neue Zuricher Zeitung carried an editorial which featured the not-so-discreet debate in “financial market circles” on “controlled inflation“ as the means to resolve the problem of unsustainable state indebtedness in the aftermath of the financial crisis. NZZ commentator Andreas Uhlig referred to a study by the US economists Joshua Aizenman and Nancy Marion, titled „Using Inflation to Erode the U.S. Public Debt.“ (LINK). In it, Aizenman/Marion write:

„In this paper, we examine the role of inflation in reducing the federal government’s debt burden…[W]e develop a model that shows the impact of a nominal debt overhang on the temptation to inflate… Model simulations suggest when economic growth is stalled, the U.S. debt overhang may trigger an increase in inflation of about 5% for several years. This additional inflation would significantly reduce the [government] debt ratio [of GDP]… [I]nflation reduced the 1946 debt/GDP ratio [122%] by almost 40% within a decade.”

The current size of the US federal debt, standing at 90% of GDP, is unsustainable, write Aizenman/Marion. Besides state bankruptcy, austerity, and robust growth, there is the option “inflating away” public debt. Inflation means “eroding the real value of debt held by creditors and the effective debt ratio. With foreign creditors holding a significant share of dollar-denominated U.S. Federal debt [currently 44%], they will share the burden of any higher U.S. inflation along with domestic creditors”. The conclusion of Aizenman und Marion is: “The model predicts that a moderate inflation of 6% percent could reduce the debt/GDP ratio by 20% within 4 years”.

The the historical example cited by Aizenman and Marion, the reduction of US public debt through inflation between 1946 and 1955, seems far fetched because at that time America’s real economy was growing robustly. At present, the US economy is – at best – stagnating. If Britain and the USA were to pursue a policy controlled inflation, the likely result would be a variation of 1970s-style “stagflation”.

I do think however the the American and British governments will indeed go for controlled inflation. Aizenman and Marion don’t pick up the issue of the impact of inflation on social security expenditures. But already on October 26, 2009, the NZZ’s Andreas Uhlig had written that “some financial market observers” are saying that particularly the pension obligations of Western states cannot be financed in the long run. “A way out is cutting entitlements, notably via controlled inflation. That is another reason for choosing inflation as exit strategy”.

However, in Germany, and continental Europe generally, one knows – not only from the experience of the Weimar Republic – that “controlled” inflation can easily turn into uncontrolled inflation. Therefore, I would expect that continental European governments and the European Central Bank (ECB) will not endorse the Anglo-American „exit strategy“ of controlled inflation. I guess, they will quite „conventionally“ freeze and cut state expenses and raise taxes, while focussing on innovations in the real economy and promoting exports, particularly strengthening trade and investment ties to Asia and Latin America.

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