Economist Magazine recently had a fantastic article on the history of how government could use 'financial repression' to pay down their debt. Here below are my summary and some highlights. You certainly will see some of the same gimmicks will be repeated during this debt liquidation process.
To pay down government debt, essentially, there are 3+1 ways:
1) Grow out of it, with income from economic growth being subtracted by interest rate payments. As long as the income is greater than interest payment, this will work out;
2) Tax out of it – this requires some real sacrifice of the country and its countrymen. Ironically, higher tax often inhibits faster economic growth, especially when the economy is already quite weak, so most economists will probably advise against it. Higher tax is also not very helpful in controlling government spending;
3) Inflate out of it – the easiest way, and a no-brainer, and governments have been using it all along human history. But it comes with long-term dire consequences. For one, the government may ruin its reputation as a debtor. People, both domestic and foreign, will be less willing to lend in the future, if ever again at all.
In the case of the United States, since a lot of government debts are held by foreigners, it's even easier to let foreigners foot the bill by printing money, as long as the whole international financial system, based on the US dollar, won't collapse (the bet is Chinese and Japanese are stuck into 'dollar trap' – they have no choices, so inflate while you still can). The long-term consequence is US dollar loses its status as international reserve currency. Some sort of new international monetary system will eventually emerge.
4) Lastly, the 4th way – rolling over into new debt with lower interest rate. This is often combined with an inflation rate that is higher than the nominal interest rate. With real interest rate being negative, government essentially solves its liquidity problem by financing its borrowing through lower interest and reduces its debt load through inflation.
Now, the excerpts from Economist:
Following the second world war many countries reduced debt quickly without messy defaults or painful austerity. British debt declined from 216% of GDP in 1945 to 138% ten years later, for example. In the five years to 2016, by contrast, British debt as a proportion of GDP is expected to drop by just three percentage points despite a harsh austerity programme. Why was it so much easier to cut debt in the immediate aftermath of the war?
Inflation helped. Between 1945 and 1980 negative real interest rates ate away at government debt. Savers deposited money in banks which lent to governments at interest rates below the level of inflation. The government then repaid savers with money that bought less than the amount originally lent. Savers took a real, inflation-adjusted loss, which corresponded to an improvement in the government’s balance-sheet. The mystery is why savers accepted crummy returns over long periods.
The key ingredient in the mix, according to research by Carmen Reinhart of the Peterson Institute for International Economics and Belen Sbrancia of the University of Maryland, was “financial repression”. The term was first coined in the 1970s to disparage growth-inhibiting policies in emerging markets but the two economists apply it to rules that were common across the post-war rich world and that created captive domestic markets for government debt.
Repression delivered impressive returns. In the average “liquidation year” in which real rates were negative, Britain and America reduced their debt by between 3% and 4% of GDP. Other countries, like Italy and Australia, enjoyed annual liquidation rates above 5%. The effect over a decade was large. From 1945 to 1955, the authors estimate that repression reduced America’s debt load by 50 percentage points, from 116% to 66% of GDP. Negative real interest rates were worth tax revenues equivalent to 6.3% of GDP per year. That would be enough to move America’s budget to surplus by 2013 without any new austerity programme.