Rising Sovereign Debt Pushing Fear of Domestic Inflation Ahead of Jobs Data

It is unlikely real economic growth and the resulting growth of tax revenues will be strong enough to generate a surplus of the US budget for many years, according to economic analysis by Capital Economics. Initial unemployment insurance claims are on the rise again this week as private-sector employment is expected to remain weak in official data to be released Friday by the Department of Labor. Even with slightly more disposable income in June, households saved even more, indicating weak demand for goods and services could continue to dampen economic recovery. The US,  like some European countries, is showing a high ratio of debt to gross domestic product (GDP). And, unlike some EU countries linked to the euro, the US could potentially “inflate away the real value of that debt,” the firm’s senior US economist, Paul Ashworth, said in commentary today. Based on the firm’s calculations, the Federal debt burden could climb to 80% of GDP by 2014 and almost 100% by 2019: “With the Federal debt headed seemingly inexorably towards 100% of GDP and beyond, the temptation for policymakers to try and inflate away the real value of that debt is understandable,” Ashworth said. “Generating the inflation rates needed to restrain the growth of the debt to GDP ratio, however, would require radically changing the Federal Reserve‘s existing price stability mandate.” The Fed would essentially have to implement policies that encourage inflation. Based on Capital Economics calculations, keeping the US debt-to-GDP ratio below 100% would require an inflation rate of at least 13%. “With interest rates already at the zero bound and the banking system still in a fragile state, it is questionable whether the Fed could even generate double-digit price inflation,” Ashworth said. “We suspect it would require the use of quantitative easing on a massive scale, which would include a program to monetize the Federal budget deficit by buying large amounts of Treasury securities.” Although any policy to inflate away debt would be troublesome, such a policy might be attempted at some point in the future. The US is not the only major economy to be experiencing high national debt. According to commentary from the Federal Reserve Bank of St. Louis, government debt is typically indicated as a percentage of GDP. The recent global recession increased deficits and debt-to-GDP ratios in many countries. Additionally, while interest rates are favorably low right now, a likely increase as the global economy strengthens will further increase deficits. This has revived fears of some advanced economies defaulting on sovereign debt “and unleash a global financial tsunami,” economist Silvio Contessi said. The below chart, provided by the International Monetary Fund (IMF), shows debt-to-GDP and deficit-to-GDP ratios for selected economies for 2007 and 2009. The average GDP growth rate over 2003-2007 is listed in parenthesis: Contessi noted these debt-laden EU countries almost uniformly have a high share of government expenditure as a percentage of GDP, low fertility rates and a large informal economy. Additionally, most currently spend or are projected to spend in the future a larger share of their GDP to pay for public pensions. Another common element is membership in the euro area, which Contessi said “presumably prevents the members of this group from inflating away their debt.” Write to Diana Golobay.

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