Why the U.S. cannot inflate its way out of debt

Summary:  As we slowly become aware of our government’s debt load, we seek easy solutions.  How sad that there are no easy solutions. 

America was born in a decision about debt.  Treasury Secretary Hamilton proposed that the United States assume the war debts of the states incurred during the Revolutionary, paid for by tariffs on imported goods, and a tax on liquor.  Carried with Washington’s support, this formed a key plank of the Federalist Party‘s platform.  Opposition by Jefferson and Madison led to the formation of the Republican Party (mark one).  We took the road less traveled that led to greatness.  Will we have the strength of will to continue on that path?

Contents

1. Yearning for the easy solution; slow realization that door has closed
2. About inflation
3. Alternatives to inflation
4. The road less traveled
5. Posts on the FM website about inflation

(1)  Yearning for the easy solution; slow realization that door has closed

One reason for the widespread complacency about the inexorable rise of government debt since 1982 is our confidence in the power of inflation.  Some examples:

• “Inflation is Now the Lesser Evil“, Kenneth Rogoff, 2 December 2008
• “Is inflation our friend?“, Ezra Klein, blog of the Washington Post, 17 February 2010
• “A healthy dose of inflation“, The Economist, 15 March 2010

Many posts on the FM website have debunked this delusional belief (listed below).  Slowly the realization spreads that we might have to deal with our debt the hard way.

1. “The debt-inflation myth debunked“, blog of the Financial Times, 4 August 2009
2. Why Inflation Won’t Solve Our Debt Problems, blog of the New York Times, 18 February 2010
3. “Why the U.S. can’t inflate its way out of debt“, CNN Money, 11 March 2010 — “It’s dawning on people that getting a handle on burgeoning U.S. debt will be a long and hard process.”

(2)  About inflation

Unexpected inflation provides the magic sauce for profligate governments, diminishing the burden of their debts.  But expected inflation makes things worse, not better.  When the government’s creditors anticipate inflation, they take protective action. 

• Shorten the maturity of their loans (inflation has less effect on short loans)
• Shift investment preferences from government bonds to inflation-protected bonds (e.g., TIPS) and hard assets.
• Move money into harder currencies, or even physically move funds out of the country.

Consider America’s situation in 2 years (to pick an arbitrary number, when we’re well into the recovery).  Everybody (including elderly widows in Smallville) will own nothing but hard assets, inflation protected securities, and short-term debt.  The average maturity of the Federal debt will be 2 weeks. Under these circumstances the government must avoid inflation at any cost, as the resulting increase in its interest cost would be lethal.  Japan is in a similar situation today.

Note that these actions by themselves push up interest rates, worsening the government’s financial position. 

(3)  Alternatives to inflation

There are only 3 ways to resolve excessive debt loads, excessive meaning debts that cannot be paid — or that the debtor will not pay off.

(a)  Growth:  given time and rapid wage growth, the debt burden becomes manageable.  We pay it off ever more easily as incomes grow.  That was the dream solution to America’s high levels of household debt and large long-term government obligations.  It burst in 2000, and will not return in time to help us.

(b)  Inflation, reducing the real weight of our debt.  This requires two things.  First, real growth in wages (no signs of this).  Second, either the cooperation or blindness of bond investors — they must either accept negative real after-tax yields, or remain oblivious to rising inflation.  The consequences are severe if our creditors (domestic and foreign) rebel.

(c)   Default, the hard way to burn off debt.  This can take many forms, not just refusal to pay.  Governments can change in the maturity, terms, or interest rate of loans.

(4) “The Road Not Taken”, By Robert Frost

TWO roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;

Then took the other, as juSt as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,

And both that morning equally lay
In leaves no step had trodden black.
Oh, I kept the first for another day!
Yet knowing how way leads on to way,
I doubted if I should ever come back.

I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.

(5)  Posts on the FM website about inflation

1. Is the US Government deliberately underestimating inflation?, 8 November 2007
2. Death of the post-WWII geopolitical regime, III – death by debt, 8 January 2008 – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
3. A giant breaks his chains and again walks the earth: inflation, 10 June 2008
4. The geopolitics of inflation, an introduction, 17 June 2008
5. Consequences of a long, deep recession – part I, 18 June 2008
6. Debt – the core problem of this financial crisis, which also explains how we got in this mess, 22 October 2008
7. Inflation or Deflation? Nobody knows what path will we take., 21 July 2009
8. Beginning of the end of the Republic’s solvency. Soon come the first steps to a reformed regime – or a new regime., 14 August 2009
9. The falling US dollar – bane or boon?, 14 October 2009
10. A lesson from the Weimar Republic about balancing the budget, 10 February 2010
11. Would a default by the US government help America?, 21 February 2010
12. Can Obama turn America into something like Zimbabwe?, 22 February 2010
13. The Fed is not wildly printing money, as yet no hyperinflation, we’re not becoming Zimbabwe, 2 March 2010
14. We might default on our governments’ debt in the future. Do you know how often we’ve done so in the past?, 5 March 2010
15. Can Obama turn America into something like Zimbabwe?, 22 March 2010

Afterword

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