History suggests that primary budget surpluses and economic growth are the most dependable means countries have at their disposal to reduce debt, according to analysts at Deutsche Bank.
However, given political and economic constraints, these options "appear remote" in a contemporary context, they added.
Enter inflation. In theory, price gains can help with debt by reducing the real value of those borrowings over time, thereby making it easier to pay back obligations with future dollars. Fixed-rate debts, for example, can become manageable as inflation possibly raises a borrower’s income.
Yet this boost for those paying off debts can be tempered by an increase in nominal -- or unadjusted for inflation -- interest rates. Central banks can set these rates at higher levels to help put a lid on inflationary pressures, although at the cost of making debt more expensive.
In a note, the Deutsche Bank analysts said that, "across the full sample," any gains for indebted countries from inflation have been "largely offset by higher yields." However, they said, this experience varies widely by country.
"[S]ome nations benefited significantly from inflation, while others saw debt burdens worsen as rates climbed, with more heavy lifting required through primary surpluses or real growth," they wrote.
This dynamic underscores an argument that inflation can only be an effective tool to deal with elevated debt levels if "yields are contained," the analysts said.
"Financial repression," in the guise of policies that aim to weigh down interest rates to help manage national debt loads, becomes one option lawmakers can explore, they said. But they warned that such a strategy is only more feasible when "you have high domestic debt holdings, a degree of capital controls, a cooperative central bank and a degree of policy credibility." Instead, inflation -- albeit with a mixed track record -- may emerge as "the most practical tool" for helping reduce national debt piles "provided policymakers can successfully implement measures to keep yields in check," the analysts said.
