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July 8, 2014

Historically, Piketty notes that inflation has been used by many countries as a tool to reduce debt, especially France and Germany. Some definitions: A government bond is a nominal asset (one whose price is set in advance and does not depend upon inflation) as distinguished from a real asset such as real estate and shares of stock (whose prices vary in response to the economic situation at any given time and usually increase as fast or faster than the rate of inflation), and so even a modest increase in the rate of inflation will, over time, substantially reduce the public debt. Thus if a nominal asset such as bonded debt is issued at a stated price that pays a certain rate of interest at certain intervals until the debt is retired (bonds redeemed) and the issuing country decides to induce, say, a ten per cent inflation rate over each of the next five years, everything else being equal, that will significantly reduce the real value of the underlying debt as well as interest due to fifty percent of its face value. Bondholders in such a case are said to have taken “a haircut,” but those who issued the debt, all other things being equal, just had a fifty percent reduction in their liability to pay both interest and principal. The tool of inflation could save us trillions, so what are we waiting on?
That seems easy, so perhaps the trillions of long term debt we have amassed could be substantially reduced if the Fed, instead of “watching inflation,” would “let her rip.” Wait a minute; what are the downsides to this rosy scenario? Well, we are not Greece or Argentina or Iceland where defaults and substantial “haircuts” are not that big a deal given the size of their economies and limited exposure of their bondholders who are likely to have diversified investment portfolios designed to take some risk and shock; we are (so far) number one in size of economy as well as the leader in the financial world with enormous investment tentacles out all around the globe in all kinds of deals both here and abroad, so I envision the results of such an American “inflation as policy” as follows: First there would be chaos in the international debt markets with bond traders and mutual fund managers jumping out of buildings a la the Great Depression; there would be trading firms and investment and even commercial banks (freed by the disastrous repeal of the Glass-Steagall Act to buy and sell funny paper around the globe and securitize anything that moves) by the ton in bankruptcy court, and, worst of all, millions of ordinary Americans would be wiped out, poverty would zoom, the middle and upper middle classes would take a big hit, investment would cease, credit markets would dry up etc. but other than that (and many other unnamed debacles) such as sudden increases in wage inequality due to lack of purchasing power, reduction in public services, escalating prices etc., everything would be normal, whatever “normal” in such chaos would be, and while many argue that debt size is no problem but rather that the ratio of debt to GDP should be our measuring stick, I don’t want to test that hypothesis now via experiments in induced inflation as policy, especially since we know that inflation has a way of getting out of hand with a life of its own (aka panic) beyond “government-set” limits. (See Germany’s experience in the 1920s.)
Considering such likely outcomes, one might ask who in their right minds would employ inflation to reduce debt? Answer: It is done all the time (see Greece and Argentina) and I view it as a partial repudiation of debt, i.e., while the issuing country does not call it that, it has the same effect. With inflated money, the issuing debt authority can hand out “haircuts” to all of its investors via induced inflation and currency devaluation. Result? The issuing country’s debt becomes junk and any future issues to raise new money or refinance old debt are likely to be very costly as investors (if any) hedge against repeat performances of repudiation or unattended inflation with outlandish demands for increased interest along with altered language in the debt instruments themselves designed to reduce their risk – with the further result that those countries which are broke must pay at a much higher rate on new or reconfigured debt than those which are not and which, in the absence of renewed inflationary policy, makes it ever tougher to get out of their financial hole(s).
Germany in the 1920s was involved in massive inflation and the old saying that came from such an experience was that “It takes a wagonload of marks to buy a wagonload of bread.” Thus the ordinary German of that day was rendered poor by government policy (or the lack of one) and the relatively few rich among them may have taken a “haircut” as well if they did not hold diversified portfolios (real as well as nominal assets). With that situation and widespread resentment of the terms of The Treaty of Versailles that ended World War I, the German people were sitting ducks in their misery for someone to come along and explain that they had been brutalized by French reparations demands, the unjust provisions of the Treaty of Versailles, and that they had really not lost World War I but rather that their efforts in that war had been undermined by “Jews and liberals, who had stabbed them in the back.”
We all know who was selling them such emotional poppycock with his hysterical speeches and Aryan prattle – Hitler. It is difficult to measure with precision just how much inflation per se had to do with the rise of fascist scum like Hitler, but I think the panic brought on by worthless currency and the resulting civil commotion in Germany after World War I had a lot to do with it. Panic can easily morph into outrage and anger as against those who are perceived to have brought such panic about, and so rose a corporal to chancellor and a war unlike any others in terms of millions and millions of dead and dismembered and devastation of property and infrastructure on a scale unknown to Caesars and Khans.
It is clear to me that deliberate adoption of inflation policy as a tool to reduce our long term deficit is not the way to go today. The rise of Hitler with the unimaginable death and destruction he brought to the world is, I think, a prime example of the “Law of Unintended Consequences.” Having learned many lessons, the Fed now has “set” inflation limits at one to two percent, and while I don’t agree with the items used to determine such rate (what with food and energy excluded via Reagan from such computation), I think we are generally on the right track in managing (if not reducing) our debt.
One of the less sensational ways to reduce our debt is simply to adopt policies that make our economy more productive and putting an end to wage inequality. That would bring in billions of dollars which could be applied, among other things, to debt reduction. That is a topic I will not discuss at length here, and speaking of topics, I promised in Part V that I would discuss three means of debt reduction in this part. I have fallen short, having only discussed inflation. I will get to the other two, I hope, in Part VII. Stay tuned. GERALD E


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