It's time for me to commit heresy again by pointing out the dirty little secret of the developed world's policymakers.

They are trying to engineer a modest burst of inflation to devalue the debt crushing the life out of their economies. This strategy rewards borrowers and punishes savers.

Behind closed doors this tactic is being discussed as "financial repression".

It's a pretty sneaky trick: the least disruptive way to get rid of debt is to reduce its real value, by ensuring interest rates paid to term-depositers and bond-holders are lower than inflation. This reduces the purchasing power of the savings by the time they are withdrawn and means borrowers can service the debt as their incomes rise in line with inflation.


This strategy was used in the 1950s and 60s by American and British governments to erode the real value of debts they incurred during World War II. At one end of the interest-rate spectrum, central banks cut official cash rates to about zero. That's what has happened since 2008 in Britain and the United States, despite consumer price inflation running at anything from 1-5 per cent.

At the other end, governments can force down bond yields. Central banks can print money and use it to buy government bonds, which forces down bond yields. This is known as quantitative easing, and is something the US Federal Reserve and the Bank of England have done to the tune of about US$2 trillion since 2008.

For politicians, this strategy is much more attractive than an almightly day of reckoning whereby debt is restructured, bank shareholders are wiped out and bond-holders are forced to turn their bonds into shares. The drama convulsing bond markets in Europe is an example of this.

The debate about whether to use financial repression or to allow a debt restructure often pits richer and more powerful special interests against the poorer public. This also pits an older generation of rich savers against a younger generation of borrowers.

The two sides have to agree on how much debt needs to be written off. That is the predicament facing Europe and the US. How do they make the debt go away without crashing the system?

The simplest way is financial repression, and this is the solution the grown-ups of the economics world have chosen. Ultimately though, a timid period of inflation above interest rates may not be enough to wipe away debts ranging from 300-900 per cent of GDP in the US and Europe.

The way to reset the global economy is a huge and immediate dose of inflation. It would wipe out a lot of older people's savings, but in a way that doesn't wipe out the economy. It may be the only way out the young will accept - if only they could vote for it.