PAPER PROBES FED NIGHTMARE - INFLATING AWAY U.S. DEBT / THE WALL STREET JOURNAL ( RECOMMENDED READING )

December 10, 2009, 8:00 AM ET.

Paper Probes Fed Nightmare — Inflating Away U.S. Debt.

While it may be the stuff of nightmares for central bankers and dollar defenders, a new paper describes how the U.S. could use inflation to reduce the burden of record-high and rising government debt.

The research, published by the National Bureau of Economic Research, is based on a historical look at the interplay between rising prices and government debt burdens. It’s an issue sure to strike a few nerves, as the U.S. government’s debt moves to 50% of the nation’s gross domestic product, amid fears it could rise to 100% within the next decade.

What may lie ahead evokes the experience of the years right after World War II, when the U.S. debt burden did breach 100% of GDP. Much of that weight was taken off the nation by way of inflation. If back then, the U.S. could ride rising price pressures to make its problem go away, then why not now?

To be sure, the paper, which was written by economists Joshua Aizenman and Nancy Marion, isn’t advocating that the U.S. pursue a particular policy path. Federal Reserve officials, for their part, have been worrying in public about what they see as an unsustainable path of long-term government deficits. They believe those deficits could end a multi-year stretch of decidedly low inflation levels.

Others worry for different reasons. Some fear that inflating the nation’s debt away is the path of least resistance for political leaders who can’t make the hard choices on taxation and spending. The paper notes that “inflation reduced the 1946 debt/GDP ratio by almost 40% within a decade” as a sign of the temptation the strategy represents. In any case, there is widespread agreement that the current fiscal outlook is a grim one, even as short-term economic realities make increased government spending logical and welcome.

For those who detest inflation–and that’s most economists and policy makers–the bad news comes first. The paper says a review of the U.S. experience since World War II shows “eroding the debt through inflation is not farfetched.” If the U.S. now had inflation levels of 6%, it could grind the U.S. debt-to-GDP burden down by a meaty 20% in a mere four years. The paper notes that this level of inflation isn’t that far off the average level of price pressures seen since 1945.

It’s even possible that a stillborn recovery could do some of the work. “When economic growth is stalled, the U.S. debt overhang may trigger an increase in inflation of about 5% for several years,” and that “would significantly reduce the debt ratio,” the paper says.

There are notable differences between now and the immediate post-war period. Whereas the average maturity of U.S. debt is now shorter and much more of it is held overseas, in the wake of the war the debt maturity was longer and nearly all was in domestic hands, the paper notes. That said, the two periods both feature “a large debt overhang and low inflation” and that together increases “the temptation to erode the debt burden through inflation.”

But there are also reasons why trying to inflate the debt away might not be viable now. The research says the balance between who holds the debt and its maturity is important. Whereas the fact that more foreigners hold government debt can make it more attractive to inflate your way to a lower debt burden, the shorter maturity of the debt makes it a more expensive proposition over the longer run to do it.

Ultimately, it’s a risky strategy, the paper warns. It notes that there is a decent chance that “modest” inflation can give way to the double-digit percentage inflation that is painful to contain. In the current environment, the U.S. would also run the chance of making foreign creditors angry, and it could also exacerbate the move away from the dollar as the world’s chief reserve currency.

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