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from Jeremy Warner in the telegraph…

One of the effects of relatively high inflation is to ease the burden of debt by reducing its real value. For a highly indebted nation such as Britain, inflation therefore seems to make sense as an economic strategy.

With no control over their own monetary policy, the Portuguese and other fiscally-challenged eurozone nations don’t have that luxury. Without inflation to do the work for them, the austerity required to get public debt under control becomes that much greater, which is one of the reasons why Portugal will soon be following Greece and Ireland into seeking a bail-out. Britain, by contrast, gets a relatively pain-free way out of the mire.

That’s the conventional wisdom, anyway, but it is also largely rubbish. Wednesday’s analysis of the public finances by the Office for Budget Responsibility provides further evidence of why elevated inflation can never be economically benign.

Three powerfully negative effects are identified by the OBR. As a result of higher than expected inflation, living standards will fall for longer than previously anticipated, public borrowing will end up higher, and real terms cuts in public spending will have to be deeper.

So adverse are the consequences that the Government may have to abandon its commitment to real increases in health spending over the Parliament.
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Using the OBR numbers, the Institute for Fiscal Studies calculates that in fact real spending on the National Health Service will fall by 0.9pc unless the Government tops it up from somewhere else. In the round, the public spending cuts will have to be £4bn deeper, while borrowing will end up £46bn higher. So much for inflating away the nation’s debts.

The cause of this phenomenon is obvious when you think about it. Large elements of spending, including benefits and the costs of servicing index linked gilts, will continue to rise in line with inflation, but because earnings are lagging prices, there will be a shortfall on the revenue side of the ledger, thereby increasing the amount the Government has to borrow.

Similarly, higher inflation – but no change to the cash size of departmental spending limits means that the real size of the cuts will be bigger.

One of the biggest shockers from the detail of Thursday’s OBR assessment is the escalating amount of money going straight down the drain of debt servicing costs. As public debt rises, these payments rise from £30.9bn last year to £66.8bn in 2015/16, or from 4.6pc to 8.8pc of all government spending.

Worse, these numbers are an understatement of the true position. According to data aired at a Taxpayers’ Alliance seminar on Thursday, once private finance initiative payments, public sector pensions and other off-balance sheet liabilities are taken into account, the true size of the interest bill will be more like £200bn by the end of the Parliament. I won’t trouble you with the projected costs of social security and tax credits, but they are little less alarming.

Against this backdrop of rising expenditure, Ed Balls, the shadow chancellor, accuses the Government of putting the economy “back in the danger zone” by seeking to apply at least a degree of restraint. Mr Balls is much more highly qualified in economics than I am, but he obviously understands nothing about the basic principles of finance.

The miracle is that the bond markets remain as compliant as they are given this toxic mix of inflation and continued public indebtedness. Moody’s reaffirmed the UK’s triple A rating on Thursday, but it warned inflation posed a significant risk. They can say that again. There must come a point when the gilts market turns. What higher interest rates would do to that £200bn debt servicing bill scarcely bears thinking about.

The growth forecasts are precarious enough as it is without the hammer blow to the public finances and the wider economy that higher borrowing costs would deliver.