Looking back and looking forward.
By Daniel at 25 December, 2009, 1:33 pm
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As the US debt-to-GDP ratio rises towards 100%, policymakers will be tempted to inflate away the debt. For example, US inflation of 6% for four years would reduce the debt-to-GDP ratio by 20%, as it happened following WWII.
The debt-to-GDP ratios projected over the next ten years are unsustainable and can be reduced in only four ways:
1. GDP can grow rapidly enough to reduce the ratio. This scenario requires a robust economic recovery from the financial crisis. (Probality: Low )
2. Inflation rises, eroding the real value of the debt held by creditors and the effective debt ratio. Foreign creditors (46%) will share the burden of any higher US inflation along with domestic creditors. (Probability: High)
3. Government uses tax revenue to redeem some of the debt. (Probability: Low)
4. The government can default on some of its debt obligations/promises. (P: High)
Looking back, the US has used each of these ways to reduce its debt/GDP ratio.
In 1946, gross federal debt held by the public was 108.6%. Over the next 30 years, debt as a percentage of GDP decreased almost every year, due primarily to an expanding economy as well as inflation. By 1975, gross federal debt held by the public had fallen to 25.3%.
The immediate post-World War II period is especially revealing. Between 1946 and 1955, the debt/GDP ratio was cut almost in half. Average debt maturity was 9 years; the average inflation rate was 4.2%. Hence, inflation reduced the 1946 debt/GDP ratio by almost 40% within a decade.
Today, the debt/GDP ratio has increased dramatically, exacerbated by the financial crisis. In 2009, it reached a level not seen since 1955.
The US, with high nominal debt denominated in its own currency, has an incentive to try to inflate it away to decrease the debt burden. With foreign creditors holding a about half of the debt, foreign soverigns will bear about half of the inflation tax.
Looking back, the foreign share of US debt was essentially zero up until the early 1960s. It has risen to 47% of publicly held debt in 2009. Thus foreign creditors would bear about half of any inflation tax should inflation be used to reduce the debt burden, with China and Japan hit hardest.
Looking forward, the dollar will continue to fall and inflation will rise to 6% plus rates. Gold will continue to rise as China and Japan will hedge their US debt with gold and commodities to protect their investment.
- DandyDon
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