Inflation won't just erode our national debt

When it comes to government debt, it’s all relative. There was consternation when UK national debt hit a then-record high £1tn in 2012 – and then only eight years later it had doubled to £2tn.

The level of debt in an economy is not necessarily a good measure of its indebtedness: as a country’s output increases, so does its ability to pay back its debts. For this reason, some economists use debt-to-GDP ratios as their measure of choice. 

The IMF’s latest fiscal monitor reports that global debt stood at 92 per cent of GDP at the end of 2022, about 8 percentage points above the level at the end of 2019. In the UK, it sits at just more than 100 per cent of GDP. So, even by this measure, the global public finance position looks precarious.

There are three options when it comes to reducing debt-to-GDP ratios. One is to foster economic growth, so that GDP grows faster than debt. The second is fiscal austerity through spending cuts, tax increases, or both.

Governments can also benefit from a negative real return on bonds: if nominal interest rates are lower than the rate of inflation, government debt can be ‘inflated away’ – as long as the economy grows by at least the same rate as inflation. So, counterintuitively, debt levels does not need to drop for the debt-to-GDP ratio to decrease: as long as debt grows more slowly than GDP, the ratio will automatically start to fall.

Governments can also benefit from a negative real return on bonds: if nominal interest rates are lower than the rate of inflation, the 'real value' of debt falls. So, counterintuitively, debt levels does not need to drop for the debt-to-GDP ratio to decrease: as long as debt grows more slowly than GDP, the ratio will automatically start to fall.

After WWII, UK debt peaked at 270 per cent of GDP but fell to 50 per cent over the subsequent three decades. This was not driven by austerity: according to the OBR, debt increased by 137 per cent over the period in nominal terms. Instead, favourable growth and inflation dynamics kicked in. Nominal GDP increased by more than 1,200 per cent over the period, and the interest rate on government debt was lower than the inflation rate for 24 of the 30 years in question. The debt-to-GDP ratio plummeted as a result. 

IMF economists noted last month that unexpected inflation is eroding the real value of government debt again today. Their analysis found that for countries with a debt-to-GDP ratio of more than 50 per cent, each percentage point of unexpected inflation reduces public debt by 0.6 per cent of GDP – with the effect lasting for several years. As the chart shows, this exerted a downward force on government debt in both advanced and developing economies last year. 

But governments cannot rely on inflation alone to improve their fiscal positions. IMF economists note that once inflation becomes persistent and better anticipated, it stops contributing to declining debt ratios. While ‘surprise’ inflation reduces the debt-to-GDP ratio of heavily indebted countries, an increase in ‘expected’ inflation does nothing of the sort. Projections from the body suggest that public debt levels will return to their pandemic-era highs by 2028 as a result. 

Agustin Carstens, general manager of central bank umbrella body, the Bank of International Settlements, said last week that “we should take no comfort in the fact that higher inflation has helped lower public debt-to-GDP ratios”, adding that “these drops do not provide exploitable fiscal space”. The impact of higher interest rates are also expected to drag on economic growth in the year ahead, worsening debt-to-GDP ratios. According to Carstens, “interest rates may need to stay higher and for longer than previously thought. And if they do, governments will feel the pinch”.

Domestically, there is the added complication of index-linked gilts. Here, the UK stands out: 24 per cent of total government debt is inflation linked, compared to 7.5 per cent in the US. This means that rising inflation leads to eye-watering debt service costs. Last week’s public finance figures showed that interest payable on debt increased to £107 bn (47 per cent more than in the financial year ending 2022), as rises in the Retail Prices Index increased the interest payable on index-linked gilts. When it comes to public finances, inflation is no easy fix.