A handy thing about inflation is that it improves government finances, though not reliably. Deflating public debt with higher prices only works when it’s the right type of inflation, and that’s not what Europe has got.
The UK’s post-WWII rebuild is example of how reflation can work. Wartime spending loaded Britain with public debt equivalent 270 per cent of GDP and a recession lasted from 1943 to 1947. But by letting inflation run high for a few decades (4.6 per cent annually on average) the ratio had deflated to about 50 per cent by the start of the 1970s.
It didn’t happen in isolation though. Post-war stimulus including a 30 per cent devaluation of sterling vs gold meant nominal growth easily outstripped nominal interest rates, resulting in rising incomes and governments that consistently ran in surplus. Real growth through the golden era (~2.8 per cent pa on average) plus a tame interest rate on the mostly foreign-held sovereign debt (~3.6 per cent pa) became a fiscal snowball — as illustrated by this chart from Bridgewater’s Principles for Navigating Big Debt Crises:
As per above, economies are manifold. Barclays’ economist Philippe Gudin de Vallerin et al explain the evolution of public debt as . . .
… the sum of the primary balance as a percentage of GDP and the debt-to-GDP ratio for the previous period, multiplied by the difference between the average nominal interest rate on the stock of debt and nominal growth:
Bt = -Dt + Bt-1 (rt-gt)
where B is the debt ratio, D the primary balance ratio and r the average nominal interest rate on the stock of debt and g nominal growth.
The big problem now is with g, the nominal growth rate. It’s tricky to measure because consumer price indexes include imported goods such as Norwegian gas and Indonesian coal, whereas GDP is exclusively domestic value-add.
And since Europe is a net importer of commodities, nominal growth is being squeezed. These two charts from Barclays show how the Harmonised Index of Consumer Prices is running 3 percentage points hotter than the GDP deflator, which has a drag from import prices of about 8 percentage points versus zero a year ago:
A weakening ratio between import and export prices (known as the terms of trade) also means European households suffer disproportionately. Barclays guesses that the supply-side shock has knocked 4 percentage points off Euro area growth, which against tepid wage inflation leaves the nominal rate deep in negative territory:
What about windfall taxes? Ok, but recent measures taken by Spain, Italy and Germany have been earmarked to stuff like social security and renewable energy investment, with no corresponding reduction in deficit targets. Also, stagflation almost never translates into higher tax receipts. Here’s Barclays again:
Another thing to note there is r, the average nominal interest rate, which is very slow to move. Market interest rates can rise but only new bond issuance will price off the higher yield. Even that might not even matter much, given a percentage of new issuance will be to flip expensive debt issued during the 2010-12 crisis. And since the crisis, Euro area states have been issuing debt with ever-lengthening maturities. Absent a default threat or a serious political meltdown, the pass-through of market rates should happen gradually.
That’s not true of inflation-linked debt, which for France and Italy make up 10 per cent of the total. Italy, unlike its neighbours, also has floating-rate securities that account for another 6.6 per cent of tradeable debt.
Under Barclays’ base case of inflation peaking in September, Italy will be paying about €10bn more in inflation compensation next year, or double the 2021 level. If inflation stays elevated through 2023 the bill will rise to €16bn, which is that’s on top of about €3bn in variable rate coupons:
Based on current market rates this burden isn’t big enough to raise serious concerns about sustainability, “assuming [Italy’s] fiscal position returns to a conservative stance”, says Barclays. The bigger worry is a repeat of May and June’s mini panic, because any threat that policies tighten further and growth forecasts deteriorate would raise the real possibility of a doom loop:
