Wednesday, August 05, 2009

UBS Kills The Debt-Inflation Myth

Inflation bears argue that high debt levels in private sector and the rapid increase in fiscal deficits will force governments to generate rising prices, in order to "inflate" their way out of debt burden.

Economists at UBS decided to line up data, so the myth is killed. FT Alphaville has an extensive feature on the research note. However, I quote here the key take-aways:
The problem with the idea of governments inflating their way out of a debt burden is that it does not work. Absent episodes of hyper-inflation, it is a strategy that has never worked.

The fundamental obstacle to governments eroding their debt through inflation is the duration of the government debt portfolio. If all outstanding debt had ten years before it matured, then governments could inflate their way out of the debt burden. Inflation would ravage bond holders, and governments (with no need to roll over existing debt for a decade) could create inflation with impunity, secure in the knowledge that existing bond holders could do nothing to punish them.

The idea that governments can readily inflate their way out of their debt problems is a misnomer — arising, perhaps, from confusion between the fate of the individual bondholder and the response of the collective market.

The higher debt service cost becomes a problem for a government that is pursuing an inflation strategy because government debt does have to be rolled over. Unless a government is willing to pursue hyper-inflation as a strategy, raising inflation will not reduce the government debt burden. Indeed, history indicates that the reverse result will be achieved.
And some charts with maturity profiles of major governments, click to enlarge, courtesy of UBS Investment Research.

But, of course, there are such short-term governments around that do not see further than till the end of current day ...

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