ANZ Finance blog | Sometimes, Inflation is the Only Way Out

Sometimes, Inflation is the Only Way Out

Published 20 May 2022

By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland

Sometimes, Inflation is the Only Way Out -- McGraw Hill ANZ Finance Blog

The Australian government gross (and net) debt is approaching $1 trillion and will, in all likelihood, top the trill. Gross national debt is around 50% of national income (GDP). Like most things, it’s the relative not the absolute that matters most. If you owe $100,000 on your mortgage and your income is $100,000 per year, that is a debt-to-income ratio of 100%. Australia’s position is like someone with a $100,000 per year income and a mortgage of $50,000. Not an overly dramatic situation but one that could still turn sour if we are not careful. What if our income falls? What if we need to borrow more? How soon do we have to pay it back? Falling GDP (national income) is the definition of a recession and that is something that is never entirely off the cards, especially now.

Comparing yourself with someone in an even worse position might make you feel better for a while. If we look at the figures, we find that most other countries are in the same position as Australia, and some are in a far worse position. Seemingly. We say seemingly because, after all, you might owe $25,000 on your mortgage and someone else might owe $200,000. And, at the moment, you might both have the same income. But if your chances of maintaining or growing your income are weak while the other person’s is strong, they will recover from what looks to be a more dire situation faster than you. Some of these economies have a demonstrated track record of innovation that might just get them out of trouble.

"Comparing yourself with someone in an even worse position might make you feel better for a while. If we look at the figures, we find that most other countries are in the same position as Australia, and some are in a far worse position."

For now, though, the comparison of Australia with other countries is favourable. The United States’ net debt is more than $25 trillion (USD). Germany’s is around $3 trillion (USD). So is Italy’s. Japan’s is around $12 trillion (USD). Relative to GDP, Japan is in the worst situation. Its debt levels are more than 200% of GDP. Again, not an absolutely precarious situation. We wouldn’t feel overly alarmed by someone with an income of $100,000 having a mortgage of $200,000. Italy’s debt-to-income ratio is approaching 200%. The United States has topped 150%, and Germany sits around equal with Australia at approximately 50%. Interestingly, Germany’s gross national debt only increased by 10% during the pandemic. Australia’s increased by 20%.

To see whether these levels are likely to cause big trouble, we can look at some of the numbers leading up to the Global Financial Crisis (GFC) and the sovereign debt crisis that followed on its heels. Greece was the prominent story at the time. In 1980, Greece’s debt-to-income ratio was just 26%, but it rose steeply from 1980 onwards. By 1990, it was 100%, where it remained, more or less, until the early 2000s. Following another steep climb, by 2010 it was 146%. [See the International Monetary Fund’s data mapper for debt]. What happened here is instructive and should serve as a warning. Greece did not have an exceptionally high debt-to-GDP ratio but when the GFC hit and the economy went into recession, the income side of the ratio fell away, causing Greece to lose a handle on the situation. There were other factors specific to Greece’s situation but, broadly, it demonstrates how quickly things can turn south.

This leads us to the question of how, now that all these countries are in this situation, they are going to get out of it. If it becomes too much, they could just default on their debts. But that’s not an option for any country that wants to continue to be a part of the global financial community. And the odds that any of the countries we have mentioned will be forced to declare bankruptcy are not very high. Another option is to do the hard yards and pay back what is owed. This will take years, even with low interest rates. Eventually, most countries will get there but it’s a long road. And interest rates won’t be this low forever. So, default or pay it back. Is there another option? Yes, there is.

"Even if you don’t cause inflation on purpose, you can still benefit from it. The reason lies in the fact that people are not really interested in money but in the goods that money can buy."

A third way, not immediately obvious, is to inflate your way out. Even if you don’t cause inflation on purpose, you can still benefit from it. The reason lies in the fact that people are not really interested in money but in the goods that money can buy. If I lend someone $100, I will charge a higher amount of interest if I expect inflation to eat into the purchasing power of that $100 between now and when I get paid back. It’s the goods I’m interest in, not the $100 bill. This works both ways. If purchasing power does decrease after I take out a loan (at a fixed amount of interest), then I am paying back fewer goods than I otherwise would. Since governments have issued large amounts of bonds at fixed coupon rates, they benefit considerably from inflation.

Think of it like this. Let’s say that $1 buys 1 thing. $1,000 buys 1,000 things. The government issues a $1,000 bond. The government has borrowed 1,000 things (or enough to buy 1,000 things). The bond is a promise to pay regular (fixed) coupons of, say, $30 every year for 20 years + the $1,000 in year 20. If there’s no inflation, the government is effectively paying back 30 things every year plus 1,000 things at the end. But… If inflation goes to 5% and stays there, by year 5 the government is only paying back 23 things instead of 30 things. And if inflation keeps up, at the end, the government will only repay 350 things, instead of 1,000 things.

One might ask whether the same benefit can be experienced by a mortgage holder. Probably not. For one, the mortgage holder’s mortgage interest rate will generally increase with inflation, ensuring the bank continues to collect the same number of things, not just the same number of dollars. Even if the mortgage is fixed long term, the mortgage holder will usually find that wages don’t keep pace with inflation. What might be gained by paying back “less things” to the bank is lost by having one’s income buy less things at the store.

One thing is clear. Inflation is not necessarily a bad thing if you’re a government in debt. It could be the only way out.

Discussion Question

Use the IMF’s data mapper to explore trends in debt levels across four different countries in which you are interested.

Further Reading

Government debt is treated in Part 4 of the text.