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Living with high debt

How is the government going to reduce the debt it incurred in partially protecting the economy from the pandemic? There’s one answer that won’t do – that it could erode the debt by high inflation.

This won’t work partly because almost a quarter of debt is now index-linked and so will rise as inflation rises. It will also fail because if investors anticipate permanently higher inflation they will sell gilts thereby pushing up their yields and raising the cost of servicing the debt. It is only unexpected inflation that erodes debt, but this is difficult to achieve even if it were desirable (which it’s not).

Which is not to say that government debt cannot fall quickly. It can. After World War II, government debt was equivalent to 259 per cent of GDP (it’s now 99.2 per cent). But in the following 20 years it dropped to just 80.7 per cent. This wasn’t – for the most part – because it was eroded by inflation. That averaged only 4.3 per cent in this period: it was only in the 1970s that inflation cut the debt significantly.

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