Is Debt Inflationary?
© Martin A. Armstrong
One of the ideas being kicked around in Germany is that of issuing debt to cover the costs of unification. The German government argues, as most other nations, that inflation will not emerge if the costs of unification are covered by new debt rather than the outright of printing money. The problem stems from the antiquated definition of inflation. Many still believe that a rise in money supply leads directly to inflation. Therefore, if a nation borrows to cover expansion, rather than printing money, the money supply will not increase. Since the money supply does not increase, it is believed that inflation will not emerge.
This type of thinking has dominated the postwar era. It is this very aspect that has also led to our escalating national debts worldwide (Britain & Australia excepted of late). In reality, inflation will emerge in Germany regardless whether or not the funding is borrowed or the money supply is increased.
Studying the short-term effects, one could argue that borrowing to cover a deficit of any kind is deflationary within a closed economy (free from international influences). Indeed, history is littered with famous politicians who have argued that a “national debt” will be a “national blessing”. Abraham Lincoln once said … “The great advantage of citizens being creditors as well as debtors with relation to the public debt is obvious. Men readily perceive that they cannot be much oppressed by a debt which they owe to themselves.”
Lincoln’s thoughts on the subject are still echoed by politicians more than a century later. Anyone in favor of government spending will take this side of the argument every time. However, there are two major problems with this statement. The first problem, from a domestic viewpoint, rises from the impression that the people owe themselves and therefore they cannot be oppressed by themselves. On a collective national basis, this leads to the false assumption that a nation could therefore wipe out its debt since it owes it to itself. On the surface, this is a reasonable accounting practice that forms the basis of a “net worth” statement. If I had $1 million dollars in cash, I could lend that money to myself and sign a note back to myself in return. My assets would therefore double because I could argue that I have $1 million in cash plus a note personally guaranteed for another $1 million. If I default on my own note to myself, what is the harm. I still have the original $1 million and nobody gets hurt. This is the line of thinking most politicians will argue in favor of a national debt.
However, in the above example I am only one person and no one else is involved in this somewhat flawed logic. As a nation, there are millions of other individuals involved. Some will be lenders and others borrowers. The population is eventually oppressed because a nation cannot so easily default on its debt. That segment of the population who lent the funds to government will be wiped out. Others who were the recipients of government cash could care less because they did not lend a dime to the government and stand to loose nothing by default directly. Because the reality of this situation is that there will be winners and losers within the population is why government does not follow their own arguments to the final conclusion and simply wipe out all debt.
Ultimately, the people are oppressed by the debt because government must meet its obligations to the lenders (interest payments). Currently, interest expenditures in the United States have exceeded Social Security in 1989. Because interest expenditures become the fastest rising cost of government, new taxation is introduced in an effort to increase revenues. Therein lies the oppression.
Secondly, our line of discussion has been limited to the domestic economy ignoring all external or international influences. Whenever the debt of one nation ends up in the hands of another, all interest expenditures end up in the hands of the foreign nation. This robs the domestic economy of any long-term benefits because at 8%, an equal amount of original borrowings will be extracted from the economy in less than 10 years. This results in a transfer of one nation’s wealth into the hands of another at a pace far greater than transactions in world trade alone.
Increasing a nation’s debt does not produce deflation but inflation over decades. In the domestic situation, let us assume that a nation borrows $1 billion. It issued bonds and sold $1 billion thereby extracting that amount of capital from within the domestic economy. That action in isolation would be deflationary. However, the $1 billion is then spent and placed in the hands of another segment within society. It is true, that this inflationary aspect cancels out the deflationary tendencies yielding, on the surface, a non-inflationary appearance. Nevertheless, this can be just an illusion. The “real” effect will depend greatly upon how the money is spent within the system.
Let us consider the German Unification situation. If the borrowed capital is placed in the hands of the East German citizens by swapping the East German currency for that of the West at or near par, purchasing power of the East will rise dramatically. Much of those funds will end up in consumer hands resulting in higher demand and shortages of goods. This will create inflation domestically regardless whether the funds were borrowed or printed. A less inflationary aspect would be for government borrowings being used in projects that directly increase productivity. An increase in productivity increases the supply of goods thereby diminishing the inflationary pressures.
If the initial borrowings are funded, NOT by domestic lenders but by international, then we are still looking at a net infusion of capital that will be inflationary. Because the capital is international in origin, no domestic deflationary tendency is created. All that remains is that of domestic inflation. When the borrowed capital is injected into the system, the net effect will be to increase the domestic money supply. There is no immediate difference between this transaction and simply increasing the money supply through printing other than the fact that interest payments will be transferred offshore.
For years governments have battled over the issue of trade. They recognize the fact that trade deficits mean the net transfer of domestic capital to offshore manufacturers. What government fails to understand is that borrowings that also end up in the hands of offshore investor also result in large sums of capital being exported.
Australia is a classic case. The government, fearing inflation and trade deficits, maintains high interest rates far above world base rates in an effort to curb domestic purchases of foreign goods. But an examination of the current account deficit of Australia reveals that the majority of the deficit is actually transfer payments involving offshore loans. This is draining Australia of vitally needed capital. The payments to lenders offshore yield no taxation to the government. If interest rates were lowered, domestic borrowers would return to onshore funding and the interest expenditures would then become domestic income subject to local taxation.
The entire issue of debt, inflation and government spending is quite complicated. One cannot simply make a blanket statement that a national debt is a blessing or a curse. There are times when government spending funded by debt can be beneficial to the domestic economy. Such instances are limited to areas in which the collective interests of society are at stake such as is the case concerning the national defense. It is a government’s obligation to defend its people. This is a collective effort and not one that a private group will undertake. Whatever the collective effort, government borrowing to improve the infrastructure in a manner that will increase the productivity of a nation is a worthwhile project. Borrowing for entitlement programs or anything that does not directly create employment or increase the productivity of the nation is wrong. Such social expenditures for moral obligations are a gift to such groups as the homeless. Funds of this nature should not be borrowed. They should come from taxation or surplus revenue.
The debate whether or not borrowing is less inflationary than outright expansion of the money supply will continue until man exists no more. Anyone who attempts to argue that borrowing is not inflationary is simply ignoring the true facts. Society cannot be lumped together as a whole. Borrowing of any kind results in the transfer of wealth. In a domestic society, indeed the rich will become richer and the debtor will move deeper into debt. In an international arena, precious domestic capital will be transfer offshore. Unless productivity increases at a rate far in excess of the interest costs, inflation will emerge and the nation’s wealth will eventually disappear.
History has proven time and again that every fall of an empire or civilization has come at the hand of excessive debt and/or collapse of the economy and infrastructure. Governments should be barred from borrowing funds except in time of war, natural disaster or for specific collective projects that increase productivity and/or build the infrastructure. If government is not bridled, debt will merely become and abused habit that eventually oppresses and ultimately destroys its own people.