Thinking About Money

What do inflation rates, interest rates, currency exchange rates and the national debt have in common?

A great deal, yet much of it seems often unspoken.

Given that billions of dollars change hands daily as traders speculate on these values, it is only fair that I do so as well – though my speculation will be intellectual rather than financial.

Let’s start with inflation.

Inflation is bad, right? Everybody knows that. It reduces the value of your paycheck. It makes everything more expensive. Politicians hate inflation.

Or do they?

Let’s say the U.S. government borrows 8.4 trillion dollars (which happens to be today’s public debt).

The U.S. Gross national Product (estimated value of all goods and services produces this year) is about $13 trillion. That makes the debt about 65% of GDP – very high by historical standards (you have to go back to World War II to beat it).

Given that we continue to run a huge deficit (both a government budget deficit and a trade deficit) this value will continue to rise. Obviously, it can’t rise without limit (but what that limit is, we don’t know).

What we do know is that there are two ways to reduce the debt as a percentage of GDP – end the deficit or raise the GDP. Expecting the government to have the discipline necessary to reduce the debt is… well, optimistic would be to put it kindly. But you can increase the GDP easily (at least as expressed in numbers) through inflation.

Think about it – at the current inflation rate of 3%, even if there is no economic growth at all, the GDP will go up to about 13.4 trillion. The current dollar value of the debt would remain the same so the debt would now be 63% of GDP. And if you had an inflation rate of 10% you’d bring it down to 59% of GDP.

Inflation is a hidden tax on all of us, and on those outside of the U.S. who hold an increasingly large part of our debt.

Of course, they aren’t stupid.

If they see the value of the dollar dropping, what happens?

Well, for one thing they might be more reluctant to loan us money (buy dollars). To convince them to do so (as we must to finance the budget deficit) we’ll have to raise interest rates (or rather, the markets at which debt securities are offered will raise them for us).

Or, they might decide to trade in some of their dollars for another currency – say, Euros.

Either way the value of the dollar drops. Almost everything costs more (the one big exception is tech, where decreases in price due to Moore’s law and manufacturing efficiencies can mask inflationary effects). And while there is some pressure to raise wages, this is limited because higher wages will tend to drive even more jobs overseas (hello outsourcing). A weaker dollar does make exports more competitive on the global market, so the trade deficit might shrink a bit, but it’s not clear how significant that will be.

We’re already seeing the process happen. Inflation isn’t just a matter of statistics – I see it every day at the gas pump and at the mall. And interest rates are definitely rising. And the dollar has been gradually dropping against other currencies.

How far this will go is impossible to guess (at least for me). But if you factor in spending commitments by the government (like social security and Medicare), the problem seems monumental – one that would require extraordinary discipline and leadership (of the bipartisan kind) from our elected officials.

Of course, if we don’t have elected officials with extraordinary discipline and leadership, inflation becomes more likely. It allows politicians to claim to have reduced the national debt (as a percentage of GDP) while reducing taxes – very popular slogans, assuming we ignore the hidden tax of inflation. And if we don’t ignore it, they can always pull out the politician’s trump card and call it part of the fight against terrorism following 9/11. We’ll buy that, won’t we?

This entry was posted on Thursday, July 6th, 2006 at 11:34 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.