The Effects Of Inflation Upon Debt, And How Our Government Is Using It Against Us

My slightly younger but much more articulate brother posted a short, pithy tweet today, stating simply that “Debt is dumb.” I responded with a somewhat sarcastic, somewhat conspiratorial but ultimately factual tweet (in all of its limited capability) as to how in many cases, being in debt is far from dumb. My brother responded and asked me to elaborate, which of course was what I was hoping for, as this is a topic that really gets my blood boiling, aside from being a topic that I’d be willing to wager a majority of this country has no concept of, despite the seemingly high willingness of a large portion of the individuals living within the country to plummet themselves into debt while simultaneously being ignorant of the benefits of such a situation and/ or decision. This defeats the point.

Of course, it wasn’t something I could elaborate upon within the 120-word minimum required by Twitter, unless I wanted to release hundreds of successive tweets with little revisional editorial ability. So, I took the time to write out my message, which is admittedly about half educational and half far-fetched conspiracy theory. However, what I am getting at here is that the real value of one’s debt is highly dependent upon the movements of inflation (and deflation) in the economy, and that is not something that is based upon theory. It is a fundamental fact that few Americans take the time to rationalize in their heads, and do not immediately realize without a strong background in economics.

For example, let’s say that you bought a home for $400,000 that is now worth $200,000. For simplicity’s sake, let’s also say that you made no down payment and have no equity in the home- you are $200,000 in debt on the home because you owe the bank $400k and can only sell the home for $200k. Do you stand to benefit in one direction or the other from that debt based on whether there is inflation or deflation in the economy?

First, let’s clarify some definitions in the most simple terms. Inflation is the rate at which the costs of goods, services and commodities are rising, and thusly, purchasing power is falling. Deflation occurs when the costs of these things fall, and, all else equal, purchasing power rises.

It may not be immediately apparent on the surface, but you stand to vastly benefit from your $200,000 debt in the case of an inflationary scenario. There are many reasons why this is the case. Most simply, in an inflationary environment, by definition, the price of your house will rise. If it were to suddenly be valued at $400,000 again solely due to the inflation in the economy, you could simply sell the house at that price, pay the bank back the $400,000 that you owe, and your debt would disappear. It DISAPPEARS just because of the inflation! Also, all else equal, in an inflationary economy you would expect to have higher nominal wages, adjusted for the changing value of the currency although the same in real terms (buying power). However, since the original nominal $200,000 debt stays constant as the real value of the dollar changes, that debt amount becomes less and less significant as inflation rises and by definition, the value of every $1 becomes less.

The main negative in an ordinary debt scenario in this example is of course that as inflation ramps up, so do interest rates increase, and money becomes more expensive to borrow. However, your mortgage is not effected by increases in interest rates, since you’ve locked in a (presumably low) rate at a point in the past, and you’ve already borrowed the money at that previous juncture. (This is not to say that the value of a mortgage held by the bank is not impacted by a change in interest rates- quite the opposite, or my profession would not exist! But that’s a topic for another, quite a bit more complicated post).

In contrast, a deflationary scenario in this example would be a disaster- the value of the house will fall, hence increasing your debt. Also, you are likely to see a fall in wages, or even be laid off, as a result of lower prices and productivity in the economy at large. Your debt is rising at the same time that your income is falling. Interest rates would fall towards zero as they are now, leaving you with little potential return on any money you have saved.

You may be wondering how these forces take hold of the economy to begin with. First, let me differentiate between “good” inflation and “bad” inflation.

Good inflation happens when value is added to the economy by way of innovations, developments in technology, introductions of efficiencies in goods and services, etc. Prices rise, but productivity rises in lock step, at a rate between 2-3% ideally, and since GDP is rising at the same rate that the currency is declining in value, there is no real effect on buying power from the inflation. This is, allegedly, what the Fed is trying to accomplish, but I have my doubts that this is really their endgame as I will demonstrate further below.

What has happened instead now sets the stage for “bad” inflation- inflation that is created by the government without an increase in GDP to accompany it and justify it. This, of course, is the result of printing money out of thin air, as opposed to having a hard asset behind it to justify it. Deflation is much easier to grasp, as it results simply from a lack of aggregate demand, which, despite what elaborate formula you may have learned in school, is almost completely a function of what is called the consumption effect. This, essentially, is nothing more than the amount of discretionary income available within an economy (and to some extent, the amount of personal borrowing within a bubble, read: DEBT. But this, again, is a topic for a different blog.)

Think of it in the simplest terms. You and I are shipwrecked on a desert island. We agree that in order to survive, I will spend my time gathering water from a waterfall for us to drink, and you will spend your time growing and harvesting potatoes for us to eat. We agree that I will trade 1 bucket of water for every 2 potatoes you grow. This is our simple economy. Then, one day, another ship wrecks on our island. The captain is an expert at making rum from the island’s natural resources. We want rum so we can enjoy ourselves in this awful situation. So I agree to deliver 1 bucket of water for every bottle of rum, and you agree to trade 2 potatoes for every bottle of rum.

In this example, we use commodities as our currency. If our island became more sophisticated, we might print paper money, and might be able to trade in our potatoes, water and rum to the central bank who could hold those commodities as reserves, and give us paper money in exchange for those assets. The point is that we would have the paper money, but the central bank would have hard assets to justify the creation of said money (this used to be gold in the USA). The money is merely a symbol of the assets’ value to make trade less cumbersome as the economy grows and new goods and services are added (another guy wrecks and starts growing coconuts, another guy wrecks with a jet ski in tact and starts giving jet ski rides for a charge, etc).

If we were to have done this before the rum producer arrived on the island, and decided that our 2 for 1 trade had a value of $1, and traded say, 200 potatoes and 100 buckets of water  as reserves for cash to the central bank, we’d each have $100 paper money now, right? Then after establishing the trade value for 1 bottle of rum as being equal to that $1, our new companion could trade in 100 bottles of rum to the central bank as well, and he would also have $100 of paper money. Take a deep breath and make sure that all makes sense.

So, what we have here is a situation where the money supply has increased (there is now $300 circulating in the economy instead of $200), but you and I did not lose buying power as a result of the paper money injection into the economy. You still get a bucket of water for two potatoes just as you did before, and can even get a bottle of rum now. This is an example of good inflation. Dollar values of goods may increase now that there is more money circulating within the economy, but the money is there for a reason- a valuable good/ service has been added to the economy- and, most importantly, buying power does not change.

Compare that to what the U.S. economy has set itself up for in the event that any of the money that the Fed has printed (which is currently sitting on the sidelines in the form of treasuries and mortgage backed securities) finds its way back into the economy as a result of a sudden improvement in economic conditions. You’re looking at trillions of dollars of fake money that will serve only one purpose upon entrance into the actual marketplace- the complete and utter decimation of the dollar, as the sudden influx of fake money will drive prices exponentially higher. This is the dreaded hyperinflation scenario.

Thankfully, this is a long way from actually happening. The economy continues to struggle and banks are hesitant to loan; all the while people are equally hesitant to seek loans, even at historically low mortgage rates. And, we do have to trust that the Fed could anticipate changes in the economic environment quickly enough to unwind QE before it caused dangerous repercussions in the economy, don’t we?

This brings me to the quasi-conspiracy theory  that I was getting at via my tweet. Governments LOVE inflation. It gives them an excuse, and a solution, to spend money that they don’t have. Going back to my earlier example, what’s the easiest way to make a $16 trillion deficit disappear? By inflating it away to the point that $16 trillion isn’t even a lot of money anymore. In the end, inflation really just becomes a sneakier, more conniving way for the government to tax its citizens. Who gets hurt the most if hyperinflation happens? People like me, who have all their assets in cash, who incidentally see deflation as a positive thing– I can buy more stuff with the same amount of money. But deflation terrifies the Fed above all else, and not for the reasons they say it does. They fear it because it makes current government debt even more substantial than it already is, and it renders all future government deficit spending more damaging than it already is.

Inflation is the cruelest power that a government has upon its citizens because it devastates their savings and decreases their buying power. It’s akin to a sudden tax on all of your current possessions, aside from being outright thievery. Meanwhile, the government makes out huge because they can spend dollars they don’t actually have while simultaneously decreasing the cost of replacing those overspent dollars by printing more of them and essentially stealing from its citizens’ savings accounts and daily discretionary spending.

Is it a coincidence that the Fed’s strategy for getting the economy back on track happens to perfectly coincide with the current administration’s agenda to spend beyond its means? Romney has already said that Bernanke is out if he is elected. It seems awfully coincidental that Bernanke’s supposed solution to our economic woes gives Obama the excuse he needs to spend money that the nation doesn’t have while saving his own job as Fed Chairman in the process. You can decide for yourself though.

The moral of the story is that if you feel like hyperinflation is about to take hold, get yourself in as much debt as you possibly can, because you’ll have the assets, and the paper money you will owe in exchange for them will essentially be peanuts eventually. This was my initial point, and our government is well aware of this reality. Heck, they’re doing it already.

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