When “Inflate Away the Debt” Stops Working

Key Concepts

• Sovereign Debt Crisis: A situation where a government cannot repay its debts.
• Debt-to-GDP Ratio: The total debt of a government as a percentage of its Gross Domestic Product (GDP).
• Inflation: A general increase in prices and fall in the purchasing value of money.
• Yield Curve Control: A monetary policy where a central bank targets a specific interest rate for government bonds of a certain maturity.
• Financial Repression: Government policies that artificially lower borrowing costs for the state, often at the expense of savers and investors.
• Net Federal Outlays as a Percent of GDP: The total amount of money the US government spends compared to the size of the economy.
• Deficit/Surplus as a Percent of GDP: The difference between government spending and tax revenue, expressed as a percentage of GDP.
• Total Federal Revenue as a Percentage of GDP: The total amount of taxes collected by the government as a percentage of GDP.
• Debt Spiral: A situation where a government's debt grows so rapidly that it becomes impossible to pay off without further borrowing or printing money.
• Debt Monetization: The process by which a central bank buys government debt, effectively printing money to finance government spending.
• Quantitative Easing (QE): A monetary policy where a central bank purchases longer-term securities from the open market to increase the money supply and encourage lending and investment.
• Quantitative Tightening (QT): The opposite of QE, where a central bank reduces its balance sheet by selling or letting government securities mature.
• Productivity Boom: A period of significant increase in the efficiency of labor and capital.
• Debasement: The reduction in the intrinsic value of a currency.

The Unraveling of the "Inflate Away the Debt" Playbook

The Current Sovereign Debt Landscape

The United States is currently facing a significant sovereign debt challenge, with the debt-to-GDP ratio exceeding 120% and remaining at this level for approximately five years. This situation is comparable to the post-World War II era when the debt-to-GDP ratio also reached high levels (around 120% in 1946) due to wartime spending. While a high debt-to-GDP ratio is not the sole definition of a sovereign debt crisis, it is widely considered a critical threshold.

A commonly accepted definition of a sovereign debt crisis is when interest payments on the debt exceed total tax revenue. In such a scenario, a nation is forced to borrow to cover all its expenses, as tax dollars are entirely consumed by interest payments. Currently, the US has not reached this point. In the last fiscal year, the US collected approximately $5 trillion in taxes, while net interest costs on the debt were just under $1 trillion. However, if current trends continue, the US is projected to reach a point where interest payments surpass total tax revenue.

The Historical "Inflate Away the Debt" Strategy and Its Limitations

Historically, governments facing sovereign debt crises have attempted to resolve them by inflating away the debt. This strategy was employed successfully by the United States after World War II. Through a combination of yield curve control and financial repression, the US government was able to issue bonds at interest rates below the rate of inflation. This effectively transferred purchasing power from the public to the government, as the value of savings eroded.

This period was also characterized by a significant productivity boom, fueled by the return of soldiers from war and increased female participation in the workforce. This economic growth, coupled with borrowing below inflation, allowed the debt-to-GDP ratio to shrink for the subsequent 40 years.

However, the success of this strategy was heavily reliant on a crucial factor: drastic reduction in government spending. The chart of net federal outlays as a percent of GDP reveals an "insane spike" during World War II, reaching over 40% of GDP. Post-war, this spending crashed back down to just under 11% of GDP. This sharp decrease in spending, not just the inflation strategy, was instrumental in escaping the debt crisis.

The Divergence: Current Spending vs. Post-WWII Era

The current situation starkly contrasts with the post-WWII period. Since 1975, average US government spending as a percentage of GDP has been around 20%. While spending spiked to about 30% of GDP in 2020 and 2021, it has not returned to pre-pandemic levels and is now trending upwards again. Unlike the post-WWII era, there is no indication of significant spending cuts.

This sustained high level of government spending, coupled with chronic deficits, has led to a slow but steady increase in the debt-to-GDP ratio over the past 40 years, reaching the current 120%.

The Problem of Chronic Deficits

The issue is exacerbated by chronically increasing deficits, which have been the norm for approximately 50 years. While World War II saw a significant deficit spike (26% of GDP) followed by a rapid rebound to a surplus, the US has been running deficits consistently. Last year, the deficit exceeded 6% of GDP, a level unprecedented before the Great Financial Crisis and World War II. This continuous borrowing to cover spending in excess of taxes is rapidly growing the national debt, pushing towards a point where inflation may be the only perceived solution.

The Limits of Tax Increases

A common suggestion to address rising debt is to increase taxes. However, data suggests that the US economy has a limit to how much it can be taxed. The total federal revenue as a percentage of GDP has historically peaked around 18%. When taxes approach or exceed 17.5% of GDP, the economy tends to shrink, leading to recessions. This has been observed multiple times. Conversely, when taxes fall to around 15%, they tend to rebound. This suggests a "sweet spot" of approximately 15-17.5% of GDP for taxation, which allows the economy to grow and the government to extract revenue. Therefore, significant tax increases to close the deficit are unlikely to be sustainable without harming economic growth.

The Debt Spiral and the Ineffectiveness of Inflation This Time

The current scenario presents a debt spiral: rising expenses, increasing interest costs, and continuous borrowing to cover these expenses, which in turn increases future expenses. The government's intended solution is to inflate away the debt by printing money.

However, this strategy is unlikely to work this time due to the fundamental difference in spending patterns. Unlike the post-WWII era where spending plummeted, current US federal spending is dominated by mandatory expenses such as Social Security ($1.6 trillion and growing), Medicare ($1 trillion and growing), healthcare ($1 trillion and growing), interest on debt ($1 trillion and growing), national defense ($1 trillion and growing), and income security ($0.75 trillion and growing). Two-thirds of federal spending is mandatory, meaning it is legally required. Even eliminating the entire discretionary budget would not result in a surplus.

Furthermore, the Social Security trust fund is projected to be empty in seven years, necessitating a potential 25% increase in expenses borne by inflation, borrowing, or taxpayers.

The Mechanics of Debt Monetization and Its Consequences

The process of "printing money" to cover expenses involves the Federal Reserve switching from Quantitative Tightening (QT) to Quantitative Easing (QE). This is known as debt monetization, where the Fed buys US Treasuries from the open market, exchanging them for newly created dollars. While the exact mechanics are complex, an increasing Fed balance sheet signifies an attempt to inflate away the debt. The Fed has indicated a potential shift towards QE, which would facilitate this process.

The critical flaw in this strategy is that inflation increases government expenses. When new money is injected into the economy, it chases the same amount of goods and services, leading to price increases. This rise in the cost of living directly impacts mandatory government expenses like Medicare, Medicaid, and Social Security, causing them to "go through the roof." The purchasing power of the printed dollars declines, making it more expensive to cover these obligations.

The Need for Productivity or Asset Ownership

The post-WWII era benefited from a significant productivity boom. While a similar boom is possible, it is not guaranteed. Without increased productivity, there is insufficient wealth to cover the government's "stupid and reckless spending." In the absence of such a boom, individuals are advised to become asset owners to hedge against the debasement of the currency. This is reflected in the current high valuations of gold, real estate, and stocks, which are seen as hedges against a falling dollar.

The video concludes by reiterating the importance of understanding the Federal Reserve's actions regarding QT and QE, with a reference to a previous video on the topic.