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Projections indicate the US Federal debt held by the public may exceed 70–100% of GDP within 10 years. In many respects, the temptation to inflate away some of this debt burden is similar to that at the end of World War II. In 1946, the debt ratio was 108.6%. Inflation reduced this ratio by more than a third within a decade. Yet there are some important differences – shorter debt maturities today reduce the temptation to inflate, while the larger share of debt held by foreigners increases it. This paper lays out an analytical framework for determining the impact of a large nominal debt overhang on the temptation to inflate. It suggests that when economic growth is stalled, the US debt overhang may induce an increase in inflation of about 5% for several years that could significantly reduce the debt ratio.

Since the start of 2007, the financial crisis has triggered over $1.62 trillion of write-downs and credit losses at US financial institutions, sending the American economy into its deepest recession since the Great Depression and the global economy into its first recession since World War II. The Federal Reserve has responded aggressively. In an effort to hold down borrowing costs and boost lending, it has kept the target rate for overnight loans between banks at 0–0.25% since December, 2008, and it has pursued unconventional monetary easing.1 Fiscal policy became expansionary as well. The $700 billion Troubled Asset Relief Program and the $787 billion Economic Recovery and Reinvestment Act were signed into law. In all, Federal spending increased 18% in FY2009, to 25% of GDP, the highest level in over 50 years. Revenues fell almost 17% below receipts in 2008, to about 15% of GDP, the lowest level in over 50 years.2 The United States is now facing large Federal deficits and growing public debt. In FY2009, the Federal deficit was $1.4 trillion, or 10% of GDP, the highest deficit-to-GDP ratio since 1945.3 In FY2010, the deficit was 8.9% of GDP. The Federal debt held by the public grew to $7.5 trillion, or 53% of GDP, at the end of FY2009, the highest debt-to-GDP ratio since 1955.4 The estimated debt ratio for FY2010 is an even higher 63.6%. The total outstanding Federal debt for FY2009 was $11.9 trillion, or 83.4% of GDP.5 The gross Federal debt is estimated to be $13.8 trillion in FY2010, nearly 95% of GDP. If economic recovery is slow to take hold, large deficits and growing debt are likely to extend into future years. Not surprisingly, concerns about government deficits and public debt now dominate the policy debate. Many observers worry that the debt/GDP ratios projected over the next ten years are unsustainable.6 Given that concern, and assuming that deficits can be reined in, how might the debt/GDP ratio be reduced? There are four basic mechanisms. First, GDP can grow rapidly enough to reduce the ratio. This scenario requires a robust economic recovery from the financial crisis. Second, inflation can rise, eroding the real value of the debt held by creditors and the effective debt ratio. With foreign creditors holding a significant share of the dollar-denominated US Federal debt, they will share the burden of any higher US inflation along with domestic creditors.7 Third, the government can use tax revenue to redeem some of the debt. Fourth, the government can default on some of its debt obligations. Over its history, the United States has relied on each of these mechanisms to reduce its debt/GDP ratio.8 In this paper, we examine the role of inflation in reducing the Federal government’s debt burden. We start in Section 2 by laying out some stylized facts. We examine Federal debt held by the public since World War II and show how publicly-held debt as a percentage of GDP has evolved. We also provide time-series evidence on average maturity length of the public debt. We observe that very little of the debt is indexed to inflation, despite the introduction of Treasury inflation-protected securities (TIPS) in 1997, and all debt is denominated in dollars. The distributional impact of inflation depends on the allocation of debt between domestic and foreign creditors, so we next show how the share held by foreigners has grown over time. We end this section by estimating the impact of various inflation scenarios on the debt/GDP ratio, and we calculate how the inflation burden would be shared between domestic and foreign creditors. In Section 3, we develop a model that shows the impact of a nominal debt overhang on the temptation to inflate. The model illustrates that the optimal inflation rate is also positively related to the share of the debt held by foreign creditors, the cost of tax collection, and the share of non-indexed debt. For sensible parameter values, the model indicates that when economic growth is stalled, the US debt overhang may trigger inflation about 5% higher than expected for several years. This additional inflation would significantly reduce the debt overhang. In Section 4, we conclude by comparing the current period with a past period in US history when the debt overhang was high. We argue that today’s temptation to inflate away some of the debt burden is similar in some respects to that in the immediate post-World War II era, when inflation eroded part of the debt burden. Yet there are important differences – shorter debt maturities today reduce the temptation to inflate, while the larger share of debt held by foreign creditors increases it.

A lesson to take from the model and the sensitivity analysis is that eroding the debt through inflation is not farfetched. The model predicts that a surprise arrival of a moderate inflation episode on the order of 6% could reduce the debt/GDP ratio by up to 20% within 4 years. That inflation rate is only slightly higher than the average observed after World War II. Of course, inflation projections would be much higher than 6% if the share of publicly-held debt in the US were to approach the 100% range observed at the end of World War II. Hence, while moderate inflation may help reduce today’s debt burden, much less powerful tool for addressing long-term fiscal challenges. The current period shares two features with the immediate post-war period. It starts with a large debt overhang and low inflation. Both factors increase the temptation to erode the debt burden through inflation. Even so, there are two important differences between the periods. Today, a much greater share of the public debt is held by foreign creditors—48% instead of zero. This large foreign share increases the temptation to inflate away some of the debt.41 This temptation may be reduced, however, should the implicit repudiation of debt obligations through inflation come at the cost of higher risk premia on newly-issued debt. Another important difference is that today’s debt maturity is less than half what it was in 1946–3.9 years instead of 9. Shorter maturities reduce the temptation to inflate. These two competing factors appear to offset each other, and the net result in a simple optimizing model is a projected inflation rate slightly higher than that experienced after World War II, but for a shorter duration. In the sensitivity analysis, we raised a concern about the stability of some parameters across periods, particularly the parameters that capture the cost of inflation. It may be that the cost of inflation is higher today because globalization and the greater ease of foreign direct investment provide new options for producers to move activities away from countries with greater uncertainty. Inflation above some threshold could generate this uncertainty, reducing further the attractiveness of using inflation to erode the debt. Moreover, history suggests that a modest inflation may increase the risk of an unintended inflation acceleration to double digit levels, as happened in 1947, and in 1979–1981. Such an outcome often results in an abrupt and costly adjustment down the road.42 Accelerating inflation had limited global implications at a time when the public debt was held domestically and the US was the undisputed global economic leader. In contrast, unintended acceleration of inflation to double digit levels in the future may have unintended adverse effects, including growing tensions with global creditors and less reliance on the dollar.43