Debt sustainability and the inflation debate

Article published by AGEFI Hebdo on 28 April 2022
By Michala MARCUSSEN, Group Chief Economist

The IMF’s newly released Fiscal Monitor warned governments that recent improvements in public debt ratios stemming from higher inflation cannot be relied upon in a regime of permanently higher and volatile inflation. Core to this concern is the differential between the interest rate paid by on government debt and economic growth; as this gap narrows, fiscal room is reduced and debt sustainability concerns may emerge. It is thus worth considering how the arguments framing the inflation debate shape real economic growth and real interest rates.

Top of the list arguments behind a permanently higher inflation regime is the climate transition, with the idea that investment in renewable energies and energy efficiencies will not keep sufficient pace to offset the underinvestment in fossil fuels, thus keeping energy prices high at least over the foreseeable future. Decarbonisation technologies, moreover, increase demand for metals and minerals. And then there is the impact of climate change itself, with shifts in weather systems causing disruption to key supply chains and not least food production, further fuelling inflation. Combined, these factors would significantly lower trend growth and likely further compress the real equilibrium interest rate. 

Public finances could in such a scenario come under further pressure to protect notably low-income households from high energy costs. An additional issue for economic growth stems from the premature retirement of the existing capital shock, no longer viable under the pressures of the climate transition. Question is, moreover, whether investors would demand higher risk premia on sovereign debt.

Faster rollout of new investment, be it public or private, arguably lowers the risk of a painful cocktail of higher inflation expenditures and lower growth. The same holds true also for new technologies and new consumer spending patterns in a more circular economy. Real equilibrium interest rates should increase in such a scenario, but risk premia on government debt should ease.

Ageing populations also rank high on the list of arguments weighing in for a permanently higher inflation regime, caused notably by a shrinking labour force and sharply increased demand for care services. Public finances would come under pressure from increased age-related expenditures, lower economic growth and the related decline in revenues. Real interest rates would see opposing forces, with lower productivity pushing them down and running down of private savings in old age pushing them up.

Social pressures for greater equality have also entered the inflation debate. Social welfare systems are, however, not an obvious cause of inflation and well-designed policies fostering education and active labour market polices have been shown to lower inequality without sparking inflation.

The final broad group of arguments in the inflation debate is protectionism and deglobalisation; here the real impact is to weigh on economic growth, but while the impact on real equilibrium interest rates is likely downward from the productivity channel, it could well be upward from reduced accumulation of excess savings in key emerging economies.

Balancing these numerous arguments, its not hard to see why the IMF is urging that governments are mindful of the real impacts that come with the various dimensions of the inflation debate. That both the Fed and the ECB are signalling removal of past policy easing at the current juncture is, moreover, no surprise but not yet an issue for debt sustainability with still negative real rates and positive real growth. Question is how central banks would react to a situation of still high inflation and much weaker growth; a return to target credit supply rather than the credit price may be a more palatable solution to lean against inflation without exacerbating public debt sustainability risks.