Sunday, June 20, 2021
We inflated away the debt once - but it's harder to do that now
Posted by David Smith at 09:00 AM

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

The inflation that we have all been worried about is here. Consumer price inflation, which jumped last month to 2.1 per cent from 1.5 per cent, is now above the official 2 per cent target. More spectacularly, industry’s raw material and fuel costs rose by 10.7 per cent in the 12 months to May, its highest for almost 10 years.

Prices charged by industry have risen in response and were up by a chunk 4.6 per cent over the past year. And, to add to the inflationary cocktail, average earnings in the three months to April were up by 5.6 per cent on a year earlier. In April alone they were up 8.4 per cent, boosted by 9.4 per cent pay growth in the private sector.

There are many caveats to be applied to these figures. Base effects – comparisons with very weak prices a year ago when the pandemic first hit – are boosting inflation rates now, though these are not all pulling in the same direction. Food prices, for example, fell by 1.2 per cent in the 12 months to May, because they were rising quite strongly during and after the first lockdown in spring 2020.

Another downward distortion arises from the VAT reduction from 20 to 5 per cent on hospitality, which took effect in mid-July last year. That will drop out of the annual inflation comparison in July or August, and at the end of September the rate is scheduled to go up to 12.5 per cent, en route to 20 per cent from the end of March last year.

As for average earnings, the two big distortions here are the furlough effect – more than twice as many workers were furloughed at the end of April 2020 compared with April this year – and the compositional effect. A drop in the proportion of low-paid workers, particularly because of the difficulties of sectors like hospitality, has the effect of pushing the average for earnings growth higher.

The rise in inflation clearly puts pressure on the Bank of England. A 0.1 per cent Bank rate looks very low in an economy bouncing back rapidly from last year’s slump. The Bank, meanwhile, has yet to complete all the additional quantitative easing (QE) announced since the start of the pandemic and there are strong arguments for not doing so. Andy Haldane, its departing chief economist, voted last month to reduce the total by £50 billion. The Bank’s monetary policy committee (MPC) meets again this week, but markets do not expect a policy shift.

Most, not all, economists responded to the latest inflation data by revising up their peak forecast for inflation this year, some to more than 3 per cent, but stuck with their view that the inflation rise will be temporary, or “transitory”. That is also the view of the majority on the MPC.

The rise in inflation has brought to surface another question, however, and it is one that I get asked quite a lot. Government debt has risen a lot as a result of the pandemic, and so has corporate debt. Would it not make sense to inflate some of this away?

The template for this was what happened after the end of the Second World War. In 1946-7 public sector net debt was 252 per cent of gross domestic product, compared with just under 100 per cent now. It is officially projected to be above 100 per cent for years to come.

From that 252 per cent, however, debt fell sharply, to less than 40 per cent of GDP by 1980 and under 22 per cent by 1990. When Gordon Brown set a limit of 40 per cent of GDP for debt under his fiscal rules in 1997, this was not an unrealistically low figure.

Some of that fall, certainly initially, reflected demobilisation and the shift from a wartime to a peacetime economy. Some of it was the result of austerity. Financial repression, when the cost of government borrowing is kept below the rate of inflation, also helped.

There was also, however, a more direct inflation impact. The consumer prices index, the current inflation measure, does not go back far enough, but retail price inflation shows the big picture. In the 1945-9 period inflation averaged 4.7 per cent, in the 1950s 4.3 per cent and in the 1960s 3.5 per cent. The big inflation, of course, was in the 1970s and 1980s, averaging 12.6 and 7.5 per cent respectively.

By this means, the real value of government debt was reduced. How did we deal with the legacy of post-war debt? Mainly by inflating it away. This should be distinguished from overseas debt, by the way, which was paid back over decades, mainly to America. US and Canadian WW2 debt was paid back in more than 50 instalments by the end of 2006.

Could history repeat itself for domestic public sector debt? The problem is less extreme than after the war, but we are a long way from debt of 40 per cent of GDP, let alone 22 per cent. Inflating the debt away is less painful than tax rises or public spending restraint.

There is though, or there should be, a problem. In 1946 the Bank was nationalised but it took more than 50 years, until 1997, before it was granted independence, with a requirement to keep inflation at target. Since then, consumer price inflation has averaged 1.9 per cent, a fraction below the 2 per cent target.

Inflating the debt away is thus not really an option, as long as the Bank sticks to its mandate. Any attempt to inflate the debt away would, in theory, meet with higher interest rates, which would be counter-productive. When you have a lot more debt, funding it at low interest rates is paramount, and the huge expansion of QE has created a direct link between Bank rate and the cost of funding government debt.

At one time it was common to hear talk in Westminster of taking back control, so to speak, of interest rates by reversing Bank independence. That would be disastrous for confidence, and I have heard much less of that talk recently.

The question then becomes one of how much inflation the Bank is prepared to tolerate. It is set to “look through” this year’s rise in inflation without responding with higher interest rates. The question then is how many more inflation overshoots it is prepared to look through. From the perspective of government debt, the more the better. But not, clearly, for the economy’s wider health.