Hyperinflation As A Debt Repudiation Device? No According To UBS, Yes According To Recently Declassified IMF Paper

Some time ago UBS economist Paul Donovan claimed that hyperinflation as a policy tool to inflate away a staggering debt load (for those of you who have missed all the recent musings by SocGen's Edwards and Grice, this is precisely the situation the developed world countries, not to mention the STUPIDs, find themselves in right now) is unworkable due to the impacts this type of concerted action would have on broader markets. "The idea that governments can readily inflate their way out of their debt problems is a misnomer — arising, perhaps, from confusion between the fate of the individual bondholder and the response of the collective market... [M]odern governments can not rely on markets to remain collectively indifferent to inflation. Inflation will raise the nominal cost of borrowing (of course) but through the inflation uncertainty risk premium it will also add to the real cost of borrowing." Yet a recently declassified paper by the IMF's Guillermo Calvo "Is Inflation Effective for Liquidating Short-Term Nominal Debt?" (a document which was previously not for public use) comes to a frighteningly different conclusion, one which could imply that the last weapon in the Fed's, and the administration's arsenal, could very well be just this heretofore unthinkable "bazooka approach" previously thought only possible in such developing countries as Korea and Venezuela.

The crux of Donovan's thesis focuses on the average duration of a portfolio of government securities, which in a normal world would have a predisposition to longer-dated securities. "The fundamental obstacle to governments eroding their debt through inflation is the duration of the government debt portfolio. If all outstanding debt had ten years before it matured, then governments could inflate their way out of the debt burden. Inflation would ravage bond holders, and governments (with no need to roll over existing debt for a decade) could create inflation with impunity, secure in the knowledge that existing bond holders could do nothing to punish them." Setting aside for a second the fact that over the past year the government's Treasury holdings have focused on the short-dated side of the curve (with Bills hitting 40% of all marketable debt recently), which would make Donovan's case much harder to prove as it indicates that the Treasury may well be anticipating the need for a (hyper)inflation event, the core issue remains unresolved: when all else fails, the only optionality is precisely inflating. The various administration offices would not think twice if indeed the country, and the private sector, were to reach a point where half or more of their revenue was going to cover just interest expenses - a ratio suicidal for any economic activity (the fact that no banks are lending any money for now is beside the point).

A declassified paper by the IMF, which has recently gained prominence as the last backstop in a Greek bailout, should the EU balk at providing assistance to the country, authored by Guillermo A. Calvo, titled "Is Inflation Effective for Liquidating Short-Term Nominal Debt?" provides a dramatically different perspective than that of the presumably idealistic Donovan. In essence, the paper claims, should a country impose a dramatic surprise devaluation that is big enough "not expected to be followed by further devaluation can reduce the real value of the debt through both inflation and lower nominal interest rates (because no future devaluation is expected)." Ah, the power of the crowd's (flawed) assumptions, so well utilized by the administration currently, which hopes that the consumer class will "expect" things to get back to normal and the old Ponzi regime can resume. 

Paradoxically, Calvo's claim is that should there be a preponderance of short-maturity debt, the expectation matrix would be one that makes devaluation less favorable as market actors would expect a devaluation, thereby reducing the impact of any such action. This basically takes Donovan's thesis and puts in practical terms:

Short-maturity nominal debt may not necessarily remove the temptation to devalue in order to lessen the debt-service tax burden. Thus, to the extent that the private sector is aware of the temptation to provoke a surprise devaluation, the temptation will be taken into account by a rise in nominal interest rates. This will increase the fiscal deficit and may actually be a primary force behind a currency devaluation. Therefore, the existence of nominal debt obligations may give rise to a devaluation inflation cycle fueled by expectations.

More observations on the role of expectations:

The mere fact that people expects a devaluation to occur increases the rate of accumulation of government debt, thus giving incentives to devalue in order to get rid of the debt (at least, partially), except possibly in the extreme case discussed at the end of previous paragraph. It is, therefore, conceivable that expectations play a crucial role in the determination of the final devaluation/inflation outcome.

To be sure, debt inflation is not the only outcome. Even the IMF hints at the existence of "more sociall painful types of debt repudiation."

It is important to note that the inflation/devaluation bomb could be largely defused if all debt was indexed to the price level. This type of indexation, incidentally, should not be confused with floating rate nominal debt, since the latter is formally equivalent to the debt instruments that we have been discussing (and which, as shown above, could be partially liquidated through inflation). Price indexation removes by definition all incentives to inflate in order to get rid of the debt (unless, of course, the government plays tricks with the price index). From this point of view, thus, debt indexation to the price level may provide an additional, and maybe even powerful, medicine to fighting the credibility gap. It goes without saying, however, that inflation is just one many debt-liquidation instruments. Hence, removing its tentacles does not ensure that the government will not resort to other, perhaps more socially painful, types of debt repudiation.

Calvo's very troubling conclusion to those who still don't see what the possible endgame for the Fed may be:

The main message coming out of this paper is that inflation may be an effective instrument to get rid of an unduly high level of outstanding public debt. This was shown to be the case even when the monetary authorities are unable to provoke unexpected inflation, and bonds are of instant maturity... A once-and-for-all devaluation will give rise to inflation but will not necessarily lead to an increase in the nominal interest rate. This decoupling of interest rates and inflation restores the debt-liquidation power of the latter.

The bad news of the paper is that short maturities, although a possible reaction to inflationary expectations and imperfect policy credibility (see Spaventa (1987)), are not a sure way to discourage inflation as a debt repudiation device. Therefore, the existence of a relatively large stock of nominal public debt may very well give rise to the suspicion that the government might try to use inflation to reduce the social cost of servicing the debt.  Consequently, the public is likely to try to cover itself against partial repudiation by requiring an interest rate larger than under full credibility.

An easy solution to multiple expectations-led equilibria is to index debt instruments to the price level. But for that to really work, all the other mechanisms of debt repudiation must also be disabled. Otherwise, debt indexation, like the removal of a safety valve, may generate even more serious cracks in the system.

Is the IMF paper a harbinger of policy to come? While Donovan is correct in principle, the opportunity cost, should debt levels become insurmountable, of a devaluation will likely be actively considered by all financial "experts" in the administration. Coupled with a prevalent expectation that this kind of action, especially in light of Donovan's analysis, and coupled with a short-maturity focused debt curve, means that the likelihood of just such a policy is becoming increasingly likely.

Full declassified IMF paper link (and Scribd below).