Got Debt? Inflate Your Way Out!

In The Beginning:

According to the original constitution, "the legistature of the United States shall have the power to borrow money and emit bills of credit." However, there were opponents to the movement allowing the government to take on liabilities and issue a fiat currency. Alexander Hamilton voiced the majority of the delegates who won the removal of that phrase from the constitution. Hamilton stated, "to emit an unfunded paper as the sign of value ought not to continue a formal part of the constitution, nor ever hereafter to be employed; being in its nature, repugnant with abuses and liable to be made the engine of imposition and fraud." He correctly believed that allowing the government to create a currency that was backed by nothing more than a government promise is prone to corruption.

The Creation of a Fiat Currency:

In 1972, Nixon took US currency off the gold standard. The currency then suffered terrible inflation and Nixon found himself in jail on other charges.

The Bubble:

Famed investor Warren Buffet said February 28, 2009: "When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s, but the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."

Where We Are Today:

CBO report states, “That debt stood at 41 percent of GDP at the end of fiscal year 2008, a little above the 40-year average of 36 percent. CBO projects that in the next few years, deficits will be extraordinarily high by historical standards— almost 12 percent of GDP in fiscal year 2009 and almost 8 percent in fiscal year 2010. As a result, debt will grow to 60 percent of GDP by the end of fiscal year 2010.” Some analysts feel that the CBO is understating the problem by overestimating future economic growth.

[See chart at top of post]

As of September 2008, the U.S. government’s current and unfunded liabilities are estimated at $56.5 trillion, which equates to more than 4x the GDP. These include promises to repay investors holding U.S. Treasury debt, primarily China and Japan, along with promises made in the form of VA benefits, Social Security, Medicare, etc.

The Payoff:

It would be reasonable to question how this burgeoning debt will be paid off -- if at all. I suppose there are two real options available, three if we assume another technology bull market rally.

1. The government defaults on its obligations to investors and/or the citizenry of this country. This means that the government cannot and will not fulfill its obligations as promised. Although this may seem farfetched, the S&P credit rating for Britain is teetering on the edge of a downgrade to AA.

More likely the government will resend the marvelously extravagant promises made by politicians past in an effort to ease ongoing liabilities. The politicians who advocate this will likely spend little time in office, regardless of their common sense approach to the wasteful spending occurring now.

That leaves tax increases. Since any politician that advocates tax increases on the poor low-income class, who pays NO income taxes currently, will surely never be elected, the common sense answer is soak the rich. As discussed previously in “A Policy Vacuum,” I hopefully made clear that tax increases will only increase revenue to the federal piggy bank to a certain point, followed by decreases in revenue for each additional increase in the tax rate. This theory has also been explored in a wonderful, but long, book called Atlas Shrugged. (If you haven’t read it yet, it is a great book with a strikingly similar government philosophy that we see before ourselves today.)

2. The government deflates their debt obligation through monetization. See Monetizing the Debt here for an explanation.

Effectively this means that the Federal Reserve will create and flood the market with trillions of dollars of the greenback. According to the FOMC, “Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.” This equates to an injection of cash in the tune of $1.75 trillion.

So why does it make sense to increase inflation to pay off debt? Imagine you are the purchaser of a widget that cost $100,000 payable in 1 year. Let’s assume that we have zero inflation. When you pay back the loan in 1 year’s time it will be worth $100,000 in purchasing power, the same as today.

Let’s now assume that inflation is 10%. When you pay back the loan you will give the loaner $100,000 but it will only purchase $90,000 of goods or services.

The primary debt holders have already voiced their concern of a devaluation of their investment through hyper-inflationary policies. Although Timmy “Tax-cheat” Geithner has reassured our investors not to worry, paying back the immense amount of debt will take some action besides Hope and spare Change!