Inflation’s Impact on Government Debt

I can’t believe that I have found it necessary to write this article. In recent days I have seen a large number of economists in the media claim that in order for the USA and European countries to reduce their public debts, more inflation is needed. I now find it necessary to explain how inflation with the aim of reducing debt will not help the economy, but instead hinder it.

There is no doubt that inflation can erode the value of existing debt. The USA, which currently faces a $16.8 trillion public debt (Compared with a $16.5 trillion economy) has an obvious incentive to inflate to help reduce this debt, the logic being that if there were an inflation rate of 5% per year, and growth of 2%, then the economy would be expanding in nominal terms by 7% per year, which would allow the government to run a budget deficit of say 6%, which is roughly what the USA will run this year, and reduce its debt to GDP ratio. The inflators (Often Keynesian economists – but not always) claim that this is good as it allows the government to continue to run deficits sustainably and even lowering the overall debt load as a percentage of GDP. However there are two problems with this view.

 

The First Problem

The first problem is that as soon as the public catches on that the Federal Reserve is now targeting a 5% inflation rate, which will happen very quickly, assuming that they don’t come straight out and say it, is that interest rates on government bonds will rise. Suppose a current treasury bond is yielding 1% and the inflation rate is 2% – that is the real (inflation adjusted) yield is -1%. If inflation were to rise to 5%, assuming the market were to remain in equilibrium, the bond’s yield would increase to 4%, allowing investors their -1% real return that they had before. Accordingly, if the USA or EU countries were to attempt to use inflation to reduce the value of the debts that their countries rack up, they would very quickly find that they needed ever higher inflation rates, to keep ahead of the market raising the rate it demands. Needless to say, this would be devastating for any developed economy. However, many inflationists are aware of this, and claim that the inflation is not designed to help the government sustainably run deficits, but instead to reduce the value of the debt it has already racked up, which leads to the second problem.

 

The Second Problem

The second problem is with this idea that inflation will reduce the value of the debt already incurred. This claim that inflation is only designed to reduce the value of the existing debt load is by far the most common reason that many economists say we need inflation. However they fail to see that inflation is essentially a zero sum game. Printing pieces of paper with $100 dollars written on it does not increase the amount of wealth in an economy. Instead, it transfers it from one party to another (And does damage to the market distribution of resources, which does even more damage further down the road). In the case of an indebted government, the Keynesian economists are quite correct inflation will reduce the value of the debt load. However what they miss is the cost of reducing the debt in this way. Again it must be stressed, as the amount of production in the economy has not increased as a result of the inflation, the governments reduced debt load must come at the expense of another party – that party is the bond holders, who get paid back with dollars that are worth less than they were expecting.

As an example, let’s assume that a government owed bond holders $100 in a years’ time. The bond holder may be assuming an inflation rate of 2% plus or minus .5%. That is after a year he is expecting the real value of that hundred dollars to be worth between $97.50 and $98.50. The bond holder will have made other investments, loans and deals assuming that he will receive this money in the future. However, if the inflation rate over that next year turns out to be 10%, then instead of getting the purchasing power of $98 after a year as expected, he instead gets the purchasing power of $90 instead. Thus the inflation has essentially taken $8 from the bondholder and transferred it to the government. While this is of course good for the government, it is bad for the bondholder.

Today, the majority of bonds are held by private banks and financial institutions (After the Federal Reserve). Many, if not most of these banks and institutions remain extremely weak in the fallout of the Global Financial Crisis, and it is from these banks that the government’s proposed inflation would expropriate money from – causing further damage to these institutions. The value of treasury bonds sold to the public in the USA is now nearing $12 trillion. This would mean that an increase in inflation rate from 2% to 4% – the very minimum suggested increase in inflation according to many Keynesians, would cost bond holders $240 billion – a figure roughly equivalent to the entire annual GDP of Israel or Greece. To put a loss of this size into perspective, in 2012 the profits of all US banks combined was $141 billion – the potential loss due to an increase in inflation of just a bare 2% would be enough to wipe out all this profit and a huge amount more.  It would almost certainly cause another credit market freeze of the kind seen during the Financial Crisis, causing problems to cascade into another global financial crisis.

The irony of this of course is that much of this government debt was incurred trying to protect the very companies which an increase in inflation will push out of business – requiring the firms to either need to be bailed out again, or go out of business, exactly what the original bailout attempted to avoid.

 

 

Inflation is not the answer to the government’s debt problems. People who advocate such a solution look only at inflation’s impact in reducing the debt burden on the government, but forget that inflation is just a zero-sum redistribution of resources. What they fail to see is the impact of inflation on companies and individuals who have purchased debt, assuming that the Federal Reserve will stick to its word and keep inflation low. The impact of inflation on those people will be catastrophic.

Why the Debt Ceiling must be Raised

There is no doubt that the Unites States needs get its budget under control. That is beyond dispute. However, it should also be beyond dispute that Congress must pay for debts it has already incurred. If any private company were to default on its debts in the way that congress is threatening to default on its obligations, that company would be out of business.

If the Obama administration refuses to talk about cutting the deficit as Republicans allege, then threatening a default is certainly a good way to bring the political conversation to cutting spending. However, it comes at a cost. The US government currently spends about 20% of its revenue paying off interest on debt already issued. In threatening a default, Republicans risk spooking the buyers of this debt, which would do one of two things: The first is that bond buyers would demand a higher interest rate, meaning that it would become harder for the USA to cut its deficit, as more and more money was required just to pay off debt interest. The second is that the economy will see the situation for the government as dire enough to cause a slump in the recovery. This second situation will likely cause the Federal Reserve to further “stimulate the economy” by increasing its bond buying programme to keep up the demand for government bonds. Indeed if it did not do so, the US government would likely become insolvent. However in increasing quantitative easing, the Fed would issue (more) new money, and thus increase inflation, with all its negative consequences.

Republicans need to work out if the reward justifies the risk.

Most likely, the answer is no. There are other ways to get spending under control. A Republican dominated House of Representatives has the power to block proposals for additional spending, and a sufficiently obstructionist House of Representatives should be able to generate enough public discussion about dealing with the debt that the Democrats will be forced to listen to what the people are saying, and likely have to cut existing spending, to pursue goals which require additional spending which they prefer to some existing spending arrangements. While the cuts may take a little longer to attain this way than by threatening an outright default on US government obligations, this course of action may actually be more beneficial for two reasons. The first is that it helps to prevent an increase on the government’s interest rates (Which would act as a spending increase). The second is that in raising the debt ceiling, the Republicans prove that they are willing to act in a responsible manner.  This should appeal to swing voters and should lead to an increase in pressure on the Democrats to also act responsibly, cutting spending to more sustainable levels.

This would mean raising the debt ceiling.

How much should the debt ceiling be increased?
This is where the Republicans really do have a lot of power. Republican leaders should come out immediately and say that this is the last time that they will agree to increase the debt ceiling – for a certain amount of time, and therefore Democrats should request an amount which they believe they will increase the national debt over a certain timeframe – perhaps until the next election.

Republicans would then be free to force the Democrats to make adjustments if they asked for too much, and also, in keeping their promise to force Washington to behave responsibly, promise not to raise the debt ceiling again.

The message would be clear – It would also be popular with the public. This is how much extra money we will give Obama to pay off current liabilities, and future promises. There will be no further increases in the debt ceiling. There will be no further increase in taxes. You spend the money as you wish. You will not be bailed out again.

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Thomas Savery

The Trillion Dollar Question

Recently in the United States there were proposals to mint a trillion dollar platinum coin so the government could avoid having to raise the debt ceiling and avoid defaulting on its payments as it ran into its debt limit.

Thankfully the proposal is now dead. But what actually made this a bad idea? Listening to conservative media, you would assume the only reason why this was a bad idea would be because it was either illegal or just too absurd to possibly be used. On the other hand, liberals proposing the idea suggested that it would be a legal way to avoid default, and that such a move would not be inflationary because the government would have spent the money if the debt ceiling was raised anyway, so there was no inflation. Assuming that it was legal, and the government really did try to mint the coin, what would make it a bad idea?

The reality is that the coin is inflationary. There is a hole in the logic that the money the coin generates the government would have been generated by borrowing, and thus the coin is not inflationary.

There is an important difference between borrowing money and creating it. When money is borrowed, a business will lend the government money, which enables the government to deficit spend in the short term. However the business that the government borrowed from will then no longer be able to spend that money. If the government were to mint the coin, the government would gain an extra trillion dollars of newly created money to spend from the Federal Reserve (Where the coin would have been deposited) to spend. However, the businesses which are currently lending the government money would not lend more money as government stopped issuing debt, and thus the businesses would spend the money that would otherwise have been spend purchasing government debt on the next best thing available to them. Thus the coin can clearly be seen as inflationary, as normal government deficit spending comes from borrowing money from businesses, which then obviously cannot spend money they no longer have. Yet if the coin was to be minted, the government would be able to spend the same amount of money as it did previously, but at the same time businesses would also be able to spend, thus driving up prices in the economy, with all the negative results that follow.

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Thomas Savery