Inflation: Our Cure for Debt

As the Greek government slides closer to default because of its crushing deficits and level of debt, more than one American has asked, in light of our huge projected budget deficits, whether the U.S. government could be in that position someday.  Paul Krugman says that the responsible policy for the U.S. to follow is to inflate away our debt, an option not open to the Greeks who are part of the euro zone.  So no, we can avoid a repeat of the Greek tragedy.

We’ve done it before, Krugman says.  After World War II our debt as a share of GDP was larger than Greece’s is now, but a decade later we lowered the debt to GDP ratio thanks to economic growth and, especially, inflation.

The parallel doesn’t exactly hold because the era Krugman refers to in American history was an era of balanced government budgets, whereas Greece is hoping, through austerity measures, to get its deficit below 9% of GDP.

But, there is some truth to Krugman’s story.  The Greeks are stuck with European monetary policy as long as they stay in the euro zone, which prevents them from using inflation to reduce their debt burden.  Meanwhile, there is nothing to stop us from inflating our debt away.

With the national debt in excess of $12 trillion and deficits projected to fall to under $1 trillion (Wow, it’s hard to write such big numbers!), 10 percent inflation would keep the real value of the debt about the same, or maybe even reduce it a bit.

We’ve done it before, and nobody seemed to complain much.  During the 1970s the value of the dollar fell by about half because of inflation, and while people did complain about the inflation, nobody said much about the fact that in effect, by 1980 we defaulted on half the debt we had in 1970.

So, don’t worry about the national debt, or the budget deficit.  But do watch out for inflation.