SOVEREIGN debt has replaced the bank crisis as the biggest worry for investors. The problems in Greece have served to focus attention on the budget deficits of the entire southern Eurozone.
And last week the head of sovereign risk at Moody’s, talking about the situation in the US and UK, said: “We expect the situation to further deteriorate in terms of the key ratings metrics before they start stabilising”. In other words, these countries may face a downgrade of their AAA status. As a warning, this statement is even less than a shot across the bows, more simply a reiteration of the obvious: that given the current state of the economy, it will be some time before public finances are back at “healthy” levels.
Resumption of sustained economic growth would help immensely, because that would generate higher tax revenues. Bear in mind that the debt-to-GDP ratio, a number so beloved of the media, is not the metric that ratings agencies care about most. What they consider first and foremost is the level of annual debt servicing costs as a percentage of government revenue. Rising tax receipts will, everything else being equal, assuage the rating agencies’ worries.
There is however another way to address the problem, and that is to inflate it away. High inflation erodes the value of debt (for both governments as well as individuals) so over time would reduce its real amount. There is also evidence that higher inflation enables economies to regain competitiveness, as it acts in a similar way to a currency devaluation.
Might governments be tempted to adjust policy and allow for a “little” inflation? Now could be the time, because the concept of inflation targeting has come under attack in some quarters and the consensus behind it may be breaking down. A recent high-profile paper from IMF economists Olivier Blanchard, Giovanni Dell’Ariccia and Paulo Mauro has concluded that low inflation does more harm to an economy than good.
Some level of inflation, let us say 4 per cent instead of the targeted 2 per cent, would enable central banks to respond more proactively to economic crises (read: reduce rates quicker and by more). It would also result in more room to make cuts because interest rates end up higher if there’s a higher target inflation rate.
Also higher inflation means wage growth can take place without impacting productivity; workers are happier accepting a 4 per cent salary rise when inflation is 5 per cent than a 1 per cent rise when inflation is 1 per cent.
Again, it looks an easy win: the southern Eurozone could raise productivity and competitiveness without budget and wage cuts if inflation was running at 5 per cent instead of at 1 per cent. The upside looks great, especially as it gets governments out of a bind. And governments ultimately set inflation targets for their central banks, so it would be easy to set the target higher.
However if they did that, it would be a mistake. One can never quote professor Milton Friedman often enough, and inflation isn’t a free lunch. There are costs as well as benefits associated with it.
In the first place there is no tap that can be turned on to start inflation rolling. It isn’t something that can be engineered with any precision, and there is no guarantee that a tolerable 4 per cent level won’t turn into a painful 8 per cent shortly after.
Secondly, to have any real benefit for government deficits, the public debt needs to be long-dated, thus enabling inflation to erode its value over time. A quick look at the chart shows that only the UK’s debt is sufficiently long to benefit from this.
There’s more. Public sector liabilities, including salaries and pensions, are invariably index-linked. Higher inflation will be a shot in the foot as it will result in higher public spending. In the private sector, there is the genuine hardship of long-term savers (such as the retired) who would see the value of their savings eroded, while younger people, who are more likely to be borrowers, will see their interest costs rise.
And finally there is possibly the biggest danger of all: credibility risk. Central banks build reputations over time, and a reputation for credibility is the hardest-earned. Moving from a 2 per cent target to a higher one is, at least in the medium-term, bound to have a negative impact on the reputation of the central bank. Consequently investors will demand a higher risk premium for holding that country’s debt. Again, the end result is higher interest costs.
Investors, and the market as a whole, need to keep governments on their toes and insist that inflation targeting remains in place and stays at a low level. By all means add productivity and employment targets, and add asset prices to the consumer prices index’s (CPI) basket of “goods”.
But to start allowing for higher inflation would be to open Pandora’s box: we simply don’t know where it will end. And in the meantime investors everywhere would get unfairly punished. It is vital that a low inflation target is maintained. Central banks of the world unite: you have nothing to lose except your credibility.
Professor Moorad Choudhry is a visiting professor at London Metropolitan Business School.