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Inflation is not the solution.
It's tempting to think that the US can inflate its way out of fiscal problems. A faster, sustained increase in prices would erode the real value of past debt, and higher future inflation would reduce the real resources needed to service and pay back the promises we are making today.
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Adding fuel to the fire, a growing chorus of household-name economists from both sides of the political aisle are advocating higher inflation as the remedy for our fiscal maladies.
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Flawed strategy: Three hurdles.
Indeed, we think three hurdles preclude eroding the real value of our debt with inflation.
1) Investors would recognize even a stealth inflation policy and would quickly push up yields. 2) Nearly half of Federal outlays are either officially or unofficially indexed, meaning that increments to debt would rise with inflation. 3) And the Fed is unlikely to acquiese.
The lessons from history may not apply.
On the surface, it appears that history contradicts our view.
(...) rapid nominal growth brought debt held by the public from 108.6% of GDP in 1946 to just 36% of GDP in 2003. Th calculations futher show that inflation accounted for 56% of that decline, while real growth accounted for the remainder.
(...) during the period from 1945 to 1974, inflation accounted for only 23% of the decline in debt/GDP.
Thoses assumptions are critical in evaluating history, because it turns out that the US postwar experience was anomalous for three reasons. First, a rapid decline in defense spending yielded a significant "peace dividend".
Second, nearly half of Federal outlays are linked to inflation, meaning that increments to debt would rise with inflation. Social Security, which accounts for one-quarter of Federal outlays, is officially indexed, and Medicare and medicaid are "unofficially" indexed. Over the period 2009-2020, CBO estimates that these three programs will account for 72% of the growth in total federal outlays and about that share of the growth in debt."
(...) Finally, while many viwe the Fed as politically constrained, we ahve doubt that Fed officials will not tolerate a significant rise in inflation, much less encourage it."
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