Is inflation the solution?

Is inflation the solution? This is often the argument put forward to deal with the debt and return to stronger, more sustainable growth. The debt, which is widely seen as excessive, raises some doubt as to the sustainability and magnitude of the recovery. By constraining behavior, private and public debt leads to inertia, thereby limiting everyone’s ability to react.

A prolonged period of price acceleration could be the solution. By reducing the real value of the debt, a higher inflation rate would again give each economic agent additional room for manoeuvre.

The underlying idea is to imagine that the acceleration in inflation would iron out all the root causes of the crisis or even make them disappear, the economy then suddenly regaining its lost virtues. This approach raises, however, a number of questions. .

 Debt and income distribution

The first question is the following: were the debt to rapidly disappear, would western economies regain the qualities that underpinned the strong and sustainable growth of the past? This question can be reformulated by asking ourselves whether the increase in debt is not the consequence of an inability to renew the sources of revenue and growth. The causality is then not exactly the same.

On this point, the United States is illuminating. We can’t rule out the possibility that the rise in private household debt may have been the result of another economic transformation. In other words, the failure of income distribution since the mid-1980s. Since that period, there has been a profound change in income distribution that has favored the highest incomes. By way of illustration, Emmanuel Saez [1] of the University of Berkeley shows that, between 2002 and 2007, 65% of income growth was appropriated by 1% of the households with the highest revenues. This had not been the case during the postwar period when income distribution had been stable.

We note that the increase in private household debt has been accelerating since the mid-1980s, coinciding with the emergence of a greater disparity in income distribution. Consumption growth is then only explained by an increase in resources resulting in a higher level of debt.

In France, work arguing along the lines of a distortion in income distribution has recently been produced, supporting the idea that it may also be a factor behind the rise in private debt. In modifying the resources of the middle classes, the change in income distribution resulted in an increase in private debt. Could eroding this debt with inflation enable a return to more balanced income distribution?

 Reduce debt with inflation?

Generally speaking, inflation brings about income redistribution that particularly impacts those on fixed incomes. Those living on unearned income are thus penalized while employees benefit provided their salaries are, at least partially, inflation indexed. This impact on redistribution is, however, not the same as in the past since the highest incomes are no longer systematically fixed. In the United States, earned income is now a very significant proportion of the highest revenues. Emmanuel Saez has calculated that, in 2004, 60% of the revenues of the 1% of households with the highest incomes came from work. In 1916, this proportion was only 20%.

Inflation would thus not have the desired redistribution effect. Even were it to enable the debt to be gradually wiped out, income distribution would not return to the previous situation given, notably, the distortions that emerged during the mid-1980s. It would thus not have the desired qualities for a rapid, healthy and sustainable return to growth.

 Inflation for sure but for what growth?

This raises a third question: we need to establish whether the acceleration in inflation would enable the return of strong growth via investment. The experience of the 2000s raises some doubt. In a low-inflation environment with limited uncertainty, the Lisbon agenda, signed in 2000, was effectively inadequately applied within Europe. This strategy should have enabled Europe to enjoy strong and sustainable growth but it was not embraced with sufficient commitment.

Analysis of the inflation during the 1970s clearly shows that too much inflation leads to uncertainty and is reflected, for the economic agents, in a reduction in their time horizons. A more uncertain world, such as that of the 2000s, would not necessarily encourage the massive investment required to underpin renewed growth.

 Inflation and commodities

Which brings us to our fourth and last observation: the recent acceleration in inflation comes from rising commodity prices. This reflects a tax or a transfer of wealth and purchasing power from the consumer countries to the producer countries. In the 1974-76 period, fearing the cornering of this purchasing power by the oil producers, France introduced an offsetting strategy aimed at supporting demand. This was reflected in a rapid acceleration in inflation above 10% through to the early 1980s without, however, creating the conditions for renewed growth.

This so-called "second round" effect is not desirable. In the light of this experience, central bankers therefore do not want to create the conditions for an extended period of high and inflation.

 Conclusion

Inflation is sometimes seen as the magic solution that will suddenly "erase" past excesses and enable a return to a more positive trend. The arguments explored above do not validate this assertion. A sustained acceleration in inflation remains bad for employees with debt due to inadequate salary indexation and the constraints coming from the past on income distribution.

Experience since the early 1960s suggests that there are two levels of equilibrium for inflation in developed countries: a low level close to that seen over the past two decades and another of above 10%. Between these two clearly-identified levels, the inflation rate does not seem stable. This being so, to which level of equilibrium should we converge knowing that a low inflation rate does not rapidly erode debt? Furthermore, the level of long-term interest rates is governed by that of inflation. If the latter were to accelerate, interest rates would be higher and so would the cost of growth.

In a highly competitive global environment, the risk associated with rapidly-increasing consumer prices is to trigger renewed uncertainty for indebted countries and modest long-term growth that would then benefit their emerging counterparts.