Limits to inflating away debt and political commitments to future public spending

In response to my previous blog, “The fiscal black hole in  the US”, ‘Peter’ makes the comment that much of the unfunded ‘liabilities’ under social security and Medicare are index-linked and cannot be inflated away.  This is an important point.  Inflation reduces the real value of nominal liabilities. If these nominal liabilities are interest-bearing, and have fixed market-determined interest rates that mas or menos reflect the rate of inflation expected at the date of issuance of these liabilities over the maturity of the liability, then only actual inflation higher than the inflation expected at the time of issuance actually reduces the real value servicing that liability.  If longer-maturity nominal debt instruments are floating rate securities, whose variable interest rate is linked to some short-term nominal rate benchmark, it becomes very difficult to inflate the real burden of that liability away.  

If the liability is index-linked, it is impossible to inflate its real value away.  The same holds if the liability or the commitment is denominated in foreign currency, something that is uncommon in the US, but common elsewhere.  Only a change in the real exchange rate can affect the real burden of foreign-currency-denominated liabilities.

Formally, some of the unfunded liabilities, including current social security commitments to future benefits, have indexation clauses attached to them – sometimes to CPI inflation, sometimes to the inflation rate of average earnings.  Political commitments to health care provision are no doubt, in the minds of the public, commitments to a given standard of care, which amounts to index-linking to earnings growth and the growth in the cost of other health care inputs.  But the legislation and rules covering these future commitments do not, as far as I know, contain any explicit indexation rules and formulae.  If the political determination to renege on these commitments is there, it can therefore be achieved quite easily through actual inflation – it would not even require unexpected inflation.  This is what was done in the UK with the real value of the state pension – the UK’s social security retirement benefit.  As a result, the UK now has the least generous state-funded basic pension of any western country. 

Of course, the true savings for the budget achieved by eroding the real value of the state pension in the UK is smaller than the reduction in the value of the state pension.  The poverty in old age created by the very low state retirement pension leads to higher public expenditure in other budgetary categories.  Examples of this are the Winter Fuel Payment in the UK (which amounts to throwing a discretionary payment at the elderly around Christmas, to stop them from freezing to death), or the free TV license for the over 75s, which stops the elderly from going out, rioting and blockading Parliament to demand a less stingy basic state pension.  Such examples of the Haile Selassie welfare state ( named after my father’s description of watching the late Emperor of Ethiopia drive through Addis Abeba throwing bank notes from the window of his limousine) taking over when a systematic approach to welfare threatens to become unaffordable can be found all over the world. 

So yes, to the extent that any liabilities, whether they are formal contractual obligations or political promises or commitments are de-facto index-linked, they cannot be inflated away.  This does not mean that governments will not attempt to inflate them away.  The history of hyperinflations tells us what happens if neither the anticipated inflation tax nor the unanticipated inflation tax can fill the budgetary hole.  Hyperinflation is not in the US future, however, as any conceivable US government would default on its formal obligations and renege on its political commitments before letting that happen.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website