Debt-Liquidation Inflation

Debt problems are not new.  The United States is not the first nation to rack up debts that cannot possibly be paid back through taxation.   This is an ancient dilemma, with ancient “solutions”.   A government can deal with a debt problems in one of two ways:  1) Bankruptcy.  2) Inflation.  As you will see, the latter is the most common resolution, historically, and quite likely the future of the United States of America. 

The history of debt-liquidation inflation starts before Christ, long before the invention of paper money, in fact.  Back in the days of silver coins, governments with debt problems resorted to “coin-clipping”, an ancient form of inflation.  The government would receive silver coins in taxes, and then shave off small amounts of silver to create new coins, and use the old ones to finance the budget and pay down debt as if nothing had happened.  What did happen was debt-liquidation inflation in its most primitive form. 

Another ancient example is more blatant, comical, and a good example of future debt-liquidation inflation in the era of paper money.  From the classic book This Time Is Different:

“Dionysius, who had borrowed from his subjects in the form of promissory notes, issued a decree that all money in circulation was to be turned over to the government, with those refusing subject to the pain of death.  After he collected all the coins, he stamped each one-drachma coin with a two-drachma mark and used the proceeds to pay off his debts.” (pg. 174)

Now that’s what I call inflation!   Brilliant.   Instead of default, this Greek tyrant from the 3rd century B.C. chose the more politically expedient option, to inflate his way out of the debt problem.   It wasn’t so easy back then, prior to the printing press, but he got the job done nevertheless. 

Since the invention of fiat currency (i.e., paper money), debt-liquidation inflation has gotten far easier.  No longer do governments have to collect coins and shave or re-stamp them.  In the modern era, governments simply print more money.  Yet it works the same: inflate the money supply to pay off debt.   Clip and pay; re-stamp and pay; print and pay; it is all the same thing: debt-liquidation inflation. 

Now that we have the proper historical context, let us look at the current US debt dilemma:

Clearly, the United States has a debt problem… a big debt problem.   It is a debt problem with many facets.  There is a private sector debt bubble with credit card debt, auto loans, student loans, mortgages etc.    There is a financial sector debt bubble revolving around the gargantuan derivatives exposure at major banks.    And of course, most importantly, there is the US government debt bubble, which, when using fiscal gap accounting, comes out to $210 trillion.    These are debts that simply can’t be paid in full without inflation. 

So where is this US debt problem going?   To review, there are essentially two possible outcomes:  1) Bankruptcy.  2) Inflation.   Either the debt is reduced the old-fashioned way through defaults, bankruptcies, restructurings, deleveraging, or possibly even a debt Jubilee.   Or the debt is inflated away, which is a default in another form.  

The common denominator in both options—default or inflation—is that debt-wealth (that is, wealth held in the form of IOUs from others, like bonds, money markets, bank deposits, annuities, and the like) will be wiped out to a large degree.   Either you don’t get paid back, or you get paid back in currency that is worth far less.   And both options will involve a similar level of debt-wealth destruction.   (For example, Dionysus could have restructured his debt and only paid back 50%, or re-stamped one drachma coins as two drachma coins, as he did, both of which would have had essentially the same impact on debt holders). 

So which one is it?  Will the US default on its debt or choose debt-liquidation inflation?   You don’t have to read very far in my book or my blog to know which path I think the United States is headed down.    In fact, you know the answer from the title of this post.   The “solution” to this debt problem will be debt-liquidation inflation. 

To be fair, I can’t go very far in talking about inflation without recognizing the other possible outcome, deflation.   Deflation is the base-case scenario.   If left to the free-market, the outcome of this enormous debt bubble would be debt deflation, and another deflationary depression. 

Unfortunately, we don’t live in a free-market system any longer.   With government control of our currency through the central bank and US Treasury, there is another method of dealing with excess debt: the printing press! 

Inflation will be chosen for a variety of reasons, not the least of which is that it is the far more politically expedient option.   The government doesn’t have to take your money through taxes; they take your wealth through the printing press.  It’s a stealth tax, and it hits the smallest group the hardest.  Inflation has a much more sizable impact on the wealthy (the wealthy who hold the wrong form of wealth, debt-wealth).   If you are living paycheck-to-paycheck, which is unfortunately the majority of our population, then what do you care?   Your paycheck will presumably go up with inflation, and there will be serious price controls on the necessities of life, so not all that much will change for you (in the short-term).  If you are wealthy, however, it is a much different story.  If you hold wealth in bonds, or in the bank, or in annuities, you will be the one taking the biggest hit. 

Debt-liquidation inflation looks like this: print money and pay off debts.  For example, the Fed could print $20 trillion dollars tomorrow, buy every US Treasury bond outstanding, and the debt would vanish.   Problem solved!   Well, kind of.   

Of course, that course of action is not going to happen.  It will be an insidious inflation over the course of years or even decades. 

However, there is an even bigger problem.   While the $19 trillion debt can be inflated away, most of the $210 trillion fiscal gap cannot.  Social Security is an open-ended promise; the government has promised the necessities of life: food, water, shelter, utilities, ect.   Medicare is the same, a promise of health care.  Those promises are inflation-adjusted, so by definition, cannot be inflated away.

While debt-liquidation inflation is the most likely path for the US government, it is not a cure-all.  Because much of the debt is inflation-adjusted, much more will have to be done:  financial repression, capital controls, price controls, wealth confiscation, and the like.  But those are topics for another day….