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Inflating Away Debt


Few see the benefits of deflation.


Common wisdom is that the Fed will "inflate debt away". I hear it over and over. When pressed for details as to exactly how this would transpire, no one ever has any. Is it possible to inflate debt away? Let's take a look at both consumer debt and government debt to see what we can find out.

Why The Fed Cannot Inflate Consumer Debt Away

  • The Fed cannot put dollars in everyone's pocket.
  • The Fed cannot create jobs.
  • The Fed cannot force consumers with no money to buy houses to drive prices back up.
  • The Fed cannot change consumer attitudes towards debt and spending.
  • The Fed cannot force businesses to go on hiring sprees.
  • The Fed cannot force wages to rise.
  • The Fed cannot do anything about global wage arbitrage.

In the grand scheme of things the Fed is pretty powerless when it comes to all of the above. Congress, on the other hand can do some of those. In fact, we are already seeing action with a $150 billion stimulus program. However, the fiscal stimulus program is already dead on arrival. At best it will cause a 0.5% short term one time rise in GDP. Then what?

Yes, there will be various job programs and other schemes, but the housing bubble followed by a commercial real estate bubble created far more jobs than any government programs are ever going to create. Housing is in contraction, and commercial real estate is headed there.

Consumer debt is the big issue and the Fed can't do much about defaults that are are going to rise for the rest of the year if not longer. Expect to see rising defaults on auto loans, residential housing, and credit card debt. If that was not bad enough, add in rising defaults on commercial real estate, commercial and industrial loans and corporate bonds. Increasing consumer and commercial defaults will impair bank's willingness and ability to lend. The Fed is powerless to stop this.

Some propose alternative energy bubbles, infrastructure bubbles, or sovereign wealth funds, but none of those can create enough jobs to inflate away debt or create a larger bubble.

Can The Fed Inflate Government Debt Away?

Inflationists make two mistakes when it comes to government debt. The first is in assuming government debt is more important than consumer debt. (It will be after consumer debt is defaulted away, but it's not right now.) The second is that it's not so easy to inflate government debt away either. Those who think it's easy, need to answer a few questions:

  • What would a "successful" inflation campaign do to future costs on unfunded medical liabilities?
  • What would a "successful" inflation campaign do to future social security payments?
  • What would a "successful" inflation campaign do to mortgage rates and cash strapped consumers already struggling to make mortgage payments?
  • What would a "successful" inflation campaign do to energy costs?
  • And most of all, what would increased inflation do to interest on the national debt?

By "successful" I mean produce a meaningful rise in inflation. Inflationists act as if unfunded liability costs and interest on the national debt stay constant. Also ignored is the loss of jobs and rising defaults that will occur while this "inflating away" takes place. Tax receipts will not rise enough to cover rising interest given a state of rampant overcapacity and global wage arbitrage.

Yet in spite of these obvious difficulties, the mantra is repeated day in and day out.

Inflating debt away only stands a chance in an environment where there is a sustainable ability and willingness of consumers and businesses to take on debt, asset prices rise, government spending is controlled, and interest on accumulated debt is not onerous. Those conditions are now severely lacking on every front.

Who Benefits From Deflation?

  • Those with no debt, few assets, and enough current income to get by nicely.
  • Those with no debt and lots of cash to get by nicely.
  • Those with a ton of debt and enough credit to be able to refinance that debt at much lower rates.

The government fits in that latter category.

Ironically, with massive interest payments on the national debt, about half of which goes to foreigners, the US government would be one of the biggest beneficiaries of deflation if it could drive long term interest rates down to 2% or lower then refinance the entire national debt at those rates.

The National Debt is $9.2 Trillion

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Chart courtesy of

"Budget Deficit" vs. "National Debt"

Suppose you want to spend more money this month than your income. This situation is called a "budget deficit". So you borrow. The amount you borrowed (and now owe) is called your debt. You have to pay interest on your debt. If next month you don't have enough money to cover your spending (another deficit), you must borrow some more, and you'll still have to pay the interest on the loan. If you have a deficit every month, you keep borrowing and your debt grows. Soon the interest payment on your loan is bigger than any other item in your budget. Eventually, all you can do is pay the interest payment, and you don't have any money left over for anything else. This situation is known as bankruptcy.

Interest Expense on the Debt Outstanding

The interest expense paid on the national debt is the third largest expense in the federal budget.

The Interest Expense on the Debt Outstanding includes the monthly interest for:

  • U.S. Treasury notes and bonds
  • Foreign and domestic series certificates of indebtedness, notes and bonds
  • Savings bonds
  • Government Account Series (GAS)
  • State and Local Government series (SLGs) and other special purpose securities

Historical Totals Of Interest On National Debt

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Average Interest Rate December 2007

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Interest on the national debt for fiscal year 2007 was $430 billion dollars! About half of that went to foreigners. So far in FY 2008 (October 2007-January 2008) interest paid was $178 billion. Now think about what would happen if interest rates fell to 2% and the government could refinance all that debt long term at 2% or less. Short term deficit spending would likely soar in a steep deflationary recession, but the long term benefits on interest payments would be enormous.

Couple a sharp reduction in interest on the national debt with a sharp reduction in military and entitlement spending and the dollar would go soaring while oil prices would plunge. Yes, a huge reduction in military spending may be a pipe dream (short term anyway), but long term interest rates at 2%-2.5% is not. I expect the latter will happen.

Thus contrary to popular wisdom, it's far easier to deflate debt away (even government debt), than it is to inflate it away. The irony is that deflation is a huge long term benefit, but virtually no one sees it that way.

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