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Deflating National Debt Through Inflation

devaling moneyThe Federal Reserve is back in the inflation business. The Fed, with the blessing of the U.S. Treasury and the Obama administration, recently announced they will again start inflating the money supply in hopes of staving off a sustained deflation. Why are they so fearful of deflation?

Put simply, most government officials know how to deal with inflation. Actually, inflation is the political savior of an overspending country that finds itself deep in debt, as the U.S. is today. A country has four tools to retire its debt: raise taxes, cut spending, declare bankruptcy, or debase the currency through inflation (learn more here).

Of these options, bankruptcy is the most unpalatable. It would most likely mean the country goes through a gut-wrenching depression and is unable to borrow for the foreseeable future.

Almost as unpalatable to politicians are spending cuts of any kind. Taking away something the electorate views as a “right” or an “entitlement” is akin to ending your political career.

Raising taxes is somewhat more appealing, especially in countries where the majority of the voters don’t pay taxes or the increases apply primarily to those the electorate perceives as “the rich.” The risk here is that if taxes increase too much it reduces the incentive to work and the whole economy raising taxes to fight inflationcrashes. This means gross tax revenues fall, which in the end actually increases the country’s debt problem as the government must increase borrowing to keep from making any spending cuts.

That leaves inflation. A slow, chronic inflation is the most politically palatable way of reducing the debt in a manner that is somewhat unnoticeable to the electorate.

How Does Inflation Reduce Debt?

With inflation, the losers are the people and institutions that own the debt, because the currency shrinks in value. For example, say you loan the government money by buying a $1000 U.S. government bond that matures in ten years. At the time you buy it, you could buy a fully loaded laptop or a round trip ticket to London for $1000.

Now, let’s say the U.S. inflates its currency at a 7% rate for the next ten years, which would be about twice the “normal” inflation rate of 3.3% for the past 80 years. At the end of that time the bond matures and you get your $1000 back. You go to buy a laptop; they now sell for $2000. That trip to London costs $2000, too. Many people in this situation will think that the prices of laptops and airline tickets have gone up.

Actually, in real dollars (which are dollars adjusted for inflation), the cost of these items hasn’t gone up a dime. It’s the value of the dollar that’s gone down, in this case, by 50% over ten years. The big winner here is the U.S. government, because its multi trillion-dollar debt has been chopped in half (again in real dollar terms) in ten short years. They accomplished this without raising taxes or cutting spending, which is intoxicatingly appealing to politicians.

If the country slides into chronic deflation, similar to Japan which has seen consumer prices fall up to 2% a year for 15 years, government revenues will fall while the real value of its massive debt will grow, further stagnating future growth. It becomes a vicious cycle which politicians have few, if any tools, to combat.

That is why gradual inflation is the preferred medicine. When it’s done well, citizens become like the proverbial frog that is cooked slowly in a pan of water where the temperature is gradually increased, rather than being frozen to death by deflation. In the end, of course, neither outcome is good for the frog.

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13 Responses to Deflating National Debt Through Inflation

  1. Dan Schweihs November 1, 2010 at 5:21 am #

    The government has many other choices in addition to the four you mention.
    Dan

  2. Rick Kahler November 1, 2010 at 7:47 am #

    Dan, On a retail level, what other broad option that I did not mention do you see that government has to pay down debt?

  3. jerry and carol November 1, 2010 at 8:39 am #

    Dan, I too wonder what other options government has than the 4 Kahler mentioned. Curious minds want to know.

    Please explain, Dear Watson…er, Rick, about the dollar value in inflationary times. Does not the stock market and cash, not bonds, increase similarly to the inflationary rate?

    Thanks, Jerry and Carol

  4. Greg November 1, 2010 at 9:04 am #

    In my opinion, inflation also hides or masks consumer debt as it does the same thing as government debt, it looks smaller over time. It takes a mortgage on a home and makes the debt appear smaller relative to the value of the collateral (home). Maybe that is what the government is hoping for to also alleviate some of the issues relative to the current foreclosure crisis. Just inflate your way out of it instead of addressing more fundamental issues such as should the US government continue to subsidize the housing market whether it be via Fannie and Freddie or tax credits for mortgage interest.

  5. Rick Kahler November 1, 2010 at 10:37 am #

    Jerry,

    Inflation is often a negative for stocks in the short run but share prices will eventually catch up. The same is true for REITS, as rising interest rates are a short term negative for real estate, but inflation will catch up with prices. Inflation is death for cash, unless the cash is represented by foreign currency holding.

  6. Joe Leandri April 6, 2011 at 11:27 am #

    Thank you for clarifying the process of how inflation can reduce debt. I am currently reading a book, ENDGAME, which posits that raising inflation to decrease debt is the path most countries will take. Your explanation of the effect inflation has on debt was extremely instructive since I do not have the educational or professional background in finance. Thanks again for your much needed help.

  7. Dennis Dawson May 30, 2011 at 10:00 am #

    Rick: I agree completely with your analysis of the effect of inflation on the National Debt(ND). I personally believe the structuring if the prime interest rate is a primary tool to accomplish this and is used by the Fed to control the inflation as a percentage of the ND , thereby making the appearances of a substantial reduction of the National Debt.

  8. Michael Schneider January 9, 2012 at 6:18 pm #

    I still don’t completely get it. Even if gradual inflation is used as a means of reducing the ND, the total dollar amount of the debt does not actually decrease. In other words, if the total debt is $15.2 trillion dollars today and that number continues to rise, what does it really matter what the rate of inflation does to the value of the dollar? $15 trillion or $20 trillion or $100 trillion dollars is still just that. Am I missing something?

  9. Rick Kahler January 10, 2012 at 4:22 pm #

    Michael,

    What you are missing is the errosion of the purchasing power of the dollar. $15 trillion today does not buy what $15 trillion buys in 10 years with a 7% inflation rate. In fact, it buys 50% less. This is the little hook that is so hard to understand. A dollar today is not the same as a dollar yesterday in an inflationary economy. Think about what $20 or an ounce of gold (they were one in the same) bought in 1930….a $20 gold piece bought the best suit in town. That same $20 in gold today still buys the best suit in town. The $20 bill? It doesn’t even buy a tie. I hope this helps.

  10. robert bryce September 5, 2012 at 9:12 am #

    Rick,

    2 questions.

    1. Is it correct to say that the government is stealing the value of my money to pay their debt, due to overspending?

    2.What would the inflation rate need to be to pay off the national debt in , say , 20 years, with no net changes in spending or taxes?

  11. ReaganLives! October 15, 2012 at 10:40 pm #

    There is no evidence that demonstrates that tax increases reduce the incentive to work, which I think you mean economic growth. In fact, Reagan raised Taxes 11 times. Clinton also raised taxes. And the economy during Reagan’s, and Clinton’s, presidencies grew. And consistent with this economic growth, employment increased, start-ups increased, and more money was being infused into the economy by the private sector investments. Conversely, the economy slowed during GW Bush’s years, which saw the biggest tax cuts in modern history. In Bush’s presidency, you could argue that the economy slowed because it was found that corporate profits could be increased despite a pruning of the GDP. Bain Capital, hate them or love them, demonstrated that leaner, smarter, more efficient businesses, are more profitable… the cost in loss of jobs notwithstanding. (But in their defense, they were doing their job, and looking out for investors.) Either way, one can make a good argument that the corollary between taxes and economic growth, if any, is confounded by other variables that is too complex for the electorate to grasp.

    That said, thank you for addressing my curiosity about how inflation affects our national debt. It’s odd to think that we can deal the debt by a proportional loss in the value of our currency… I’ve suspected that this could be the case. But, I think as you alluded to, it can’t be a good strategy.

  12. Freewill October 1, 2013 at 8:07 pm #

    Going back to Michael Schneider’s question above:

    “In other words, if the total debt is $15.2 trillion dollars today and that number continues to rise, what does it really matter what the rate of inflation does to the value of the dollar? $15 trillion or $20 trillion or $100 trillion dollars is still just that. Am I missing something?”

    I also fail to see how creating inflation can reduce the debt over the long haul, if none of the other measures for reducing debt and its rate of increase are put into practice. Certainly our national debt is currently increasing at a rate much faster than the inflation rate. So using your example of the Fed/treasury creating a 7% inflation rate for 10 years, what happens during that time as we continue to add to that debt? I would think that the rate of additional debt during that time would also increase as it now takes that many more dollars to provide the same and often increasing quantity of goods and services via the government (think health care, food, housing, etc. for example). Sound like a viscous spiral of certain death to me.

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