Only one way out of debt: inflation

When talking about debt levels, it is important to distinguish between private and public debt. While the ratio of public debt to GDP has in the past been higher than it is now, the ratio of private debt to GDP is at levels far higher than at any time in history. It is private sector debt more than public debt that is weighing down the global economy and which is going to make a return to normality so difficult.

There really is only one politically acceptable and economically feasible route out of this crisis: inflation.

John Kemp laid out the arguments quite clearly several months ago: ¹

“Despite acres of newsprint devoted to the federal budget deficit over the last thirty years, public debt at all levels has risen only 11.5 times since 1975. This is slightly faster than the eight-fold increase in nominal GDP over the same period, but government debt has still only risen from 37 percent of GDP to 52 percent.

“Instead, the real debt explosion has come from the private sector. Private debt outstanding has risen an enormous 22 times, three times faster than the economy as a whole, and fast enough to take the ratio of private debt to GDP from 117 percent to 303 percent in a little over thirty years…

“The resulting debt was only sustainable so long as economic conditions remained extremely favorable. The sheer volume of private-sector obligations the economy was carrying implied an increasing vulnerability to any shock that changed the terms on which financing was available, or altered the underlying GDP cash flows…

“From this perspective, it is clear many of the existing policies being pursued in the United States and the United Kingdom will not resolve the crisis because they do not lower the debt ratio…

“Trying to cut debt by reducing consumption and investment, lowering wages, boosting saving and paying down debt out of current income is unlikely to be effective either. The resulting retrenchment would lead to sharp falls in both real output and the price level, depressing nominal GDP. Government retrenchment simply intensified the depression during the early 1930s. Private sector retrenchment and wage cuts will do the same in the 2000s…

“The need to work down real debt and boost cash flow provides the motive, while the massive liquidity injections into the financial system provide the means. The stage is set for a long period of slow growth as debts are worked down and a rise in inflation in the medium term.”

¹ U.S. and UK on brink of debt disaster, John Kemp, 20 January 2009