Reader’s Question: Why Does Inflation Make it Easier for Governments to pay back the debt?
The big fall in national debt as % of GDP occurred during relatively high inflation periods of 50s, 60s, and 70s. The 1920s and 30s were a period of deflation and high debt.
There are a few reasons inflation makes it easier for a government to pay its debt, especially when inflation is higher than expected. In summary:
- Higher inflation increases nominal tax revenues (if prices are higher, the government will collect more VAT, workers pay more income tax)
- Higher inflation reduces the real value of debt, bondholders on fixed interest rates will see a fall in the real value of their bonds and it becomes easier for the government to pay back these bonds.
- Higher inflation can enable the government to freeze income tax thresholds so more workers pay higher tax rates – it becomes a way to increase tax revenues without increasing tax rates.
Why inflation can benefit the government at the expense of bondholders
- Let’s assume an economy has 0% inflation, and people expect inflation to remain at 0%.
- Then let us assume the government needs to borrow £2bn by selling 30-year bonds worth £1,000 to the private sector. To attract people to buy bonds, the government may offer an interest rate of 2% a year.
- The government will then have to pay back the full amount of the bonds £1,000, plus the annual interest payments on these bonds (£20 a year at 2%).
- The investors who buy the bonds will make a profit. The bond yield (2%) is above the inflation rate. They get back their bonds plus the interest.
- However, suppose, unexpectedly there was inflation of 10%. This reduces the value of money. As prices go up because of inflation, £1,000 would buy a lower quantity of goods and services.
- Because of inflation, the government would get more tax revenue as wages and prices increase (e.g. if prices go up 10%, the government’s VAT receipts will increase 10%)Therefore, inflation helps government automatically get more tax revenue.
- However, bondholders lose out. The government still only have to pay back £1,000. But, inflation has reduced the value of that £1,000 bond (real value is now £900.) The inflation rate (10%) is higher than the interest rate (2%) on the bond, so they are losing the real value of their savings.
- Inflation means that repaying bondholders requires a smaller % of the government’s total tax revenue – so it is easier for government to pay back the original debt they borrowed.
The Government (borrower) is better off, bondholders (savers) are worse off as a result of inflation.
Evaluation (index-linked bonds)
Because of this risk, some bondholders will buy index-linked bonds. This means that if inflation increases, the maturity value and interest rate on the bond automatically increases in line with inflation – to protect the real value of the bond. In this case, the government doesn’t benefit from inflation because it ends up paying higher interest payments and it can’t devalue the debt through inflation.
Inflation and benefits
In 2022, the UK has forecast inflation to peak at 6.2%, which will lead to a sharp rise in nominal tax receipts. However, the government has increased benefits and public sector pay at a lower rate of inflation. In April 2022 inflation-linked benefits and tax credits will rise by 3.1 per cent – this 3.1% was decided from the (CPI) inflation rate back in September 2021.
Therefore, public sector workers and benefit recipients will see a real fall in income – their benefits will rise 3.1%, but inflation could be as high as 6.2%. In this case, the government budget position will improve by raising benefits at a slower rate than inflation.
Debt is only improved by the conscious decision to raise benefits and wages at a lower rate than inflation.
Inflation and bracket creep
Another way government finances can benefit from inflation is to keep the income tax threshold fixed. For example, the basic rate of income tax (20%) starts at £12,501. There is a 40% tax rate at £50,000 and 50% tax rate at £150,000. Inflation will mean nominal wages increase and more workers will start to pay income tax at higher rates. Therefore, the government effectively increase average tax rates – even though it appears the tax rate stays the same.
Long Term Implications of inflation on bonds
If people buy bonds expecting low inflation, but then lose their real value of savings because of high inflation, they will become reluctant to buy bonds because they know inflation can reduce the value of bondholders’ savings.
If bondholders fear the government may cause inflation, then they will want higher bond yields to compensate for the risk of losing money through inflation. Therefore the prospect of high inflation can make it more difficult for the government to borrow.
Note: bondholders may not expect zero inflation, what damages bondholders is unexpected inflation.
Example Post War Britain
In the 1930s, inflation was very low. This is one reason why people were willing to buy UK government bonds at low-interest rates (in the 1950s, the national debt increased to over 230% of GDP). In the post-war period, the debt burden was to some extent reduced by the effects of inflation which made it easier for government to meet its repayments.
In the 1970s, unexpected inflation (from oil price shock) helped to reduce the government’s debt burden in various countries such as US.
The fall in UK national debt as a % of GDP in the post-war period was partly accelerated by inflation – reducing the real burden of debt. Though debt also fell due to a prolonged period of economic growth and rising tax revenues.
Economic Growth and Government Debt
Another issue is that if the government reflate the economy (e.g. pursue quantitative easing) this may also stimulate economic activity as well as inflation. Higher GDP is a key factor in helping government gain more tax revenues to pay back debt.
Bondholders may be nervous of an economy that is predicted to have deflation and negative economic growth. Although the real value bonds can increase with deflation, they may fear the economy is stagnating too much and so the government will struggle to meet its debt.