DEBT EROSION AND THE MARKET PROCESS

This paper explores the effects of debt erosion on the market process. Debt erosion is the attempt by government to lower the real value of its debt through the creation of unexpected inflation. In addition to the costs recognised by most economists, debt erosion through unexpected inflation can impair the price system's ability to coordinate exchange activity and can result in costly capital misallocations. This is because the creation of unexpected inflation implies disequilibrium in the money market. To avoid the harm from such monetary shocks, this paper suggests a separation between money and state, enshrined in an explicit rule at the constitutional level.