Unicredit thinks it is highly unlikely that real interest rates can be negative enough, for long enough, to solve the problem

REGULAR readers will know the mantra "inflate, stagnate, default" that this writer has perceived to be the three likely outcomes of the debt crisis. Now Marco Valli, the euro zone economist of Unicredit, the Italian bank, has produced a very interesting 27-page note on the issue. To give the game away, the title is "Inflating away the debt overhang? Not an option". Mr Valli argues that a central bank trying to achieve this aim would face three challenges

1. to create inflation in the current context of large economic slack and private/public sector deleveraging. 2 to do so in a way that faster inflation leads to negative real interest rates, thus generating a transfer from investors to the government and 3 to deliver negative real rates that are sufficiently large and/or last sufficiently long to allow for a significant reduction of the debt/GDP ratio

Mr Valli argues that

it is virtually impossible to satisfy these three conditions in a low-growth, high-public-deficit environment

Of course, in a strong growth, low deficit (better still, a primary surplus) environment, there would be no need for a central bank to take the risk of attempting to inflate the debt away.

The problem of creating inflation in economies where unemployment is high, and wages are not growing, should be obvious. Where there has been above-target inflation in recent years, notably in the UK, it has been the wrong kind; imported commodity prices which act as a tax and make it more difficult to pay down debt. There has been a lot of celebration about the success of Abenomics but while it has driven the stockmarket up, and the yen down, we have yet to see the effect in the consumer price numbers.

Mr Valli goes on to make a second point that, even if the central bank were able to drive inflation up, the markets might react by pushing up interest rates and keeping rates from being negative. Much debt is short-term, so would have to be refinanced at higher rates, and some is linked to inflation so is useless for this purpose. Here is an abbreviated version of his table, looking at the G7

Avg debt T-bills Variable or

maturity (% total) linked

(yrs) (% total)

Canada 5.9 30.1 5.3

France 7.0 15.4 11.8

Germany 6.4 7.9 2.8

Italy 6.6 8.5 17.1

Japan 7.9 18.8 5.8

UK 15.2 4.7 22.0

US 5.4 21.1 7.0

So while the UK is well-placed in having a long average maturity, it has a lot of inflation-linked debt, Canada has a lot of short-term debt, the US debt rolls over quickly and so on. The best placed country to inflate its debt away is Germany, which is least likely to do so.

This problem could be got round with capital controls (financial repression) and of course, we have seen mildly negative real interest rates. The problem is that such rates (leaving aside the collateral damage they do to savers, such as pension funds) are not negative enough to make a big dent in the ratios. Mr Valli proposes four options - a series of increasingly large inflation surprises with accelerating inflation; steady negative real rates with a stable inflation rate; a one-off surprise inflation jump; and higher inflation that is more than offset by a rising inflation risk premium.

For Option 1, he suggests a rel rate that starts at zero and falls by 1 point a year (-1%, -2% etc). This would reduce the debt-to-GDP ratio from 100% to 60% within 12-13 years but at the cost of very negative real rates (-12%) by the end, which look implausible. For Option 2, a steady negative real rate of -5% would take 25-30 years to cut the ratio from 100% to 60%, but at -4%, it would take 100 years. For Option 3, a one-off inflation shock would have to be 40% plus in a single year to get the needed effect, which would have other consequences.

And if all this went wrong, higher inflation but rising real rates would cause the debt-to-GDP ratio to soar, probably doubling over 10 years.

It is a very interesting and detailed paper. My only quibble is that we know indebted governments have generated high inflation in the past, and none of that context appears; if the central bank were willing to buy all government debt, then the problem of refinancing at higher rates would not occur. You might say that no central bank would do such a thing, but central banks are doing things today that most people would not have thought likely in the 1990s. Is it really such a big step from buying bonds in the secondary market to buying them directly?

After all, the UK government announced today that it borrowed only £6.3 billion in April but that was thanks to £3.9 billion transfer from the Bank of England, in the form of interest payments on gilts bought under the QE programme. When a government claims credit for interest it should be paying out (and may have to pay back to the central bank later), it is already nipping at the gin; can the days of guzzling lighter fluid be far away?