Morgan Stanley argues against this view:
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 acquiesce.
While history has shown the debt-flation strategy to work, MS argues that today is different:
My colleague Spyros Andreopoulos explores this issue in depth in a provocative recent piece (see The Return of Debtflation? February 10, 2010). His calculations show that rapid nominal growth brought debt held by the public from 108.6% of GDP in 1946 to just 36% of GDP in 2003. The calculations further show that inflation accounted for 56% of that decline, while real growth accounted for the remainder.
Spyros acknowledges that his calculations implicitly assume that debt service is a constant share of GDP. In reality, debt service varies with changes in interest rates, in the debt, and in the maturity structure of the debt. So, if debt is growing relative to GDP and rates are rising with inflation, debt service/GDP will also rise, boosting the overall deficit and debt/GDP. That limits the ability of policymakers to inflate the debt away. Indeed, using an alternative framework, George Hall and Thomas Sargent calculate that during the period from 1945 to 1974, inflation accounted for only about 23% of the decline in debt/GDP.
With clear limits to this strategy, it appears that the best way to cut debt is to cut spending.
Source: Morgan Stanley
