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Post Covid-19 Inflation: Should Governments Care About National Debt?

“Blessed are the young for they shall inherit the national debt.” — Herbert Hoover

At the time of publication, U.S. debt was estimated to be $28,239,008,350,646 (28 trillion U.S. dollars). U.K. national debt was £2,505,290,850,892 (2.5 trillion pounds). France’s national debt was €2,560,624,067,827 (2.5 trillion euros). It is hardly useful to compare absolute debt numbers (a $2 million debt for Jeff Bezoes would probably be more affordable to him than a $2,000 debt for a university student, for example), so let’s convert those numbers to Debt over GDP ratios: 129.09% (U.S.), 85.4% (U.K.), 98.1% (France). In per capita terms, every French citizen owes €38,189. Every Brit owes £37,588. Every American citizen owes U$86,094.

This amount is unlikely to arrive at your house as an invoice to be paid within 30 business days – but it is still an amount that the national government owes on its citizen’s behalf. Much of this national government debt is owned by its own citizens, therefore only representing a transfer of wealth from one (usually older and wealthier) individual to all (on average younger and poorer) residents, at a fee known as the yield to maturity of the government bond (for the French, for example, that’s currently valued at 0.191% for a 10-year debt commitment).

How can this affect you? Well, all that money has to come from somewhere. In the post COVID-19 world, the repayment of this debt is likely to come in one (or a combination) of these three fiscal/monetary tools: (1) increased taxes in the future, (2) decreased government spending in the future, such as cutting welfare programs, or (3) inflation. Increasing taxes or cutting popular programs can be suicidal for politicians, but in theory these are the only tools available to a government that wishes to balance its fiscal budget. In fact, (our favorite crisis economist) Keynes advocated that the national government had a moral obligation to encourage spending in dire times. It does not matter how the government does it – Keynes famously suggested paying workers to dig up holes and fill them up again – as long as it stimulates consumption. His theory, however, assumed saving would come before investment – an assumption that any debt to GDP ratio of over 100% (such as the U.S.) would inevitably break.

However, there is a third option that is primarily controlled by the central banks: inflation. If a government issues debt in its own currency, which is the case for most high-income countries, and if it can interfere with its central bank (in a practice we call fiscal dominance, i.e. when the government does not fully respect a central bank’s independence), it can simply print more money to pay for its national debt. The value of money would deteriorate, but so would the government’s debt responsibility. These inflationary pressures would act as a tax on the country’s residents: wealth, pensions and even current income would deteriorate. Pre-existing debt with fixed rates would also lose some of its value, as for example, 3% of $100 might not be able to buy as many goods as when the loan was agreed upon. In this manner, inflation can end up bankrupting financial institutions and businesses. In 1940s Hungary, you could repay your entire mortgage loan with the same amount of money it took to buy marbles (if you had entered into a fixed-rate mortgage a few months before inflation started becoming a problem) and effectively get a house for free.

The most commonly known source of inflation is uncontrolled money-printing, but there are other factors that influence high inflation: Increase in money supply + decrease in unemployment + rapid increase of money velocity + aggregate supply shortages.

The Covid-19 pandemic has certainly caused an aggregate supply shock as companies have decreased production, but it has also decreased money velocity and aggregate demand (increasing savings) as people have lost or are afraid to lose their jobs, and may not be very optimistic for the near-future. However, when the Covid-19 pandemic is behind us (probably when 60-70% of the western population is vaccinated), it is expected that people will want to travel, go out, buy new clothes, and just generally spend. This would increase money velocity extremely fast. Businesses would respond to this demand by creating service jobs, lowering the unemployment rate, and thus further increasing total income. However, the global supply chain might not be able to respond as quickly, as factories have been closed permanently and workers laid off in 2020, creating a shortage of supply. All of these elements, combined with money-printing and government injections, can become just the perfect recipe for an uncontrollable high-inflation period in the western world.

But not everyone agrees with this view: according to a new monetary theory called Modern Monetary Theory (very creative, I know), or MMT for short, governments never have to worry about their national debt. As long as they issue debt in their own currency, they don’t have to pay for their debt with taxes nor bonds. The solution is then simple: the government can just print more money. In a still obscure flow of systems, MMTers argue that this would not necessarily cause inflation (as only fiscal policy can cause inflation), and thus the government has a moral duty to encourage aggregate demand not only during times of crisis, as per Keynes, but at any time in the business cycle. This theory is often defended by left-wing politicians, who would like to expand the role of the government in the social sphere, but often encounter budgetary challenges in their defense. One of the most important pieces of historical evidence for this theory is the post-WWII period where debt had exploded due to military spending, but most countries involved did not see hyperinflation. Modern economists may argue that this is not enough evidence – too many confounding variables were interacting to be able to properly isolate the effect of national debt. If this is the argument, MMTers could potentially be able to make a case with whatever happens in the post-pandemic period.

Although nothing is clear for now, in the words of famous economist John Cochrane, inflation usually happens when nobody is expecting it – and neither households nor the bond markets are able to fully predict it fast enough. The greater question then relies on whether the Fed, the ECB and other central banks are ready and willing to correctly respond to these inflation signs when they happen, and what consequences these responses will have on the economy. As almost every country expanded their balance sheets in 2020/2021, the global economic context might even become an international game of chess (or for the economists, a classic case of game theory): if the Fed decides to commit to controlling inflation and hints about raising rates, the ECB will find itself in a risky position if it continues to allow for monetary easing. In conclusion, governments should care about their national debt, but appearing to care about national debt needs to come at the right time – and now is clearly not that time just yet.


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