We have a lot of debt, and it is increasing. At some point this has to stop.
There are three ways of doing this:
1) Increase revenue as proportion of GDP + reduce spending (fiscal austerity).
2) uptick in business cycle, resulting in higher tax receipts and less benefits spending (grow your way out)
3) inflation, which erodes nominal debt.
Traditionally, inflation is a political impossibility, since it punishes savers, anyone working for a salary that isn’t inflation-linked and reduces investment (due to lower price certainty).
However, governments are finally realising that inflation might actually be the least politically painful instrument of debt erosion:
Abe’s incoming government in Japan is taking about unlimited central bank intervention to achieve a 2% inflation target; Bernanke recently announced Fed rates would remain zero-bound until unemployment fell to 6.5%; Nick Carney, the soon-to-be Governor of the Bank of England is being pushed by Osborne to explore a change in the Bank’s mandate – something he will be comfortable with considering the multiple-objective format of the Bank of Canada (on who’s board he currently sits); Mario Draghi pushed through the LTRO this summer and more recently managed to coax Germany into accepting a radical Outright Monetary Transactions scheme under which the ECB can step in to buy unlimited quantities of short term bonds in any country with a distressed debt market ( and this at a time when the ECB balance sheet is already the largest in the world).
By the end of the year, every major central bank in the world will be testing the boundaries of loose monetary policy. All of them have been pushed there by their respective governments. Mid single digit inflation target is the new norm, even if it isn’t yet official.
So far loose money hasn’t caused inflation because velocity has been so low, but as the economies of the US, China and the other EMs start to pick up then it will start to be felt in the price indexes. It is difficult to imagine Europe in a sufficient state of deflation to counter it.
At that point we will have higher inflation and unprecedented government debt – either we can tighten money and reduce the inflation but increase (double? triple?) the cost of servicing debt; or we can let the inflation run a little, erode our debt and keep servicing costs low. The latter is clearly the easier, but more precarious, option. What i dont know is if it the right or wrong one.