Is Inflation the Answer?

Everyone is concerned about debt.  The national debt.  The European debt.  Their own personal debt—credit cards, underwater mortgages, college loans.  What to do about debt will be one of the major issues of the November elections at all levels of government; what we decide to do about debt will affect not only the elections and government policies but also the lives of individuals.  Will my taxes go up?  Will my home be foreclosed?  Will I be able to afford basic living expenses after I graduate?  Will the future be better or worse?

The positions of the two major political parties are predictable.  The Democrats will blame Wall Street and call for more government stimulus spending.  The Republicans will blame big government and call for lower taxes and big cuts, at least in so-called “discretionary” spending (i.e., no cuts to defense).  Both sides will wave the unemployment statistics as support for their positions.

Meanwhile, some economists, those of a Keynesian persuasion, will support the Democrats’ position and also call for more inflation.  Inflation, they argue, will reduce the value of all debt, thus making it easier to pay down over time.  Paul Krugman, the Nobel laureate and New York Times columnist, has called for an inflation rate of 4%.  (The current inflation rate is about 1.7%.)  Looked at from the “big picture” angle, more inflation certainly would reduce the real value of all debt.  If one borrows $100 today, and the inflation rate is 4%, a year from now your debt is worth $96 (in current dollars, adjusted for that 4% inflation).   Which is to say that what is worth $100 today will be worth $104 in one year.  But your debt document will still read “$100.”  A steady 4% inflation rate over several years will indeed reduce the value of your original debt amount considerably, thus making it easier to pay off.

Provided:  That your income has at least kept pace with inflation, but preferably has pulled ahead of it (say 5 or 6%).   In other words, for the inflation-reduces-debt game to work, income also has to inflate, i.e., increase.  So that next year your income needs to be at least 4% higher than it is today, but again preferably more like 5 or 6% higher.  There was a time back in the day when incomes did in fact keep pace with or exceed the rate of inflation.  Good times, those.

But it has been some time since that was the case.  As everyone knows, incomes have remained stagnant for at least two decades, well since before the 2008 financial meltdown.  In fact, a root cause of the financial crisis was the decrease, relative to costs, of all forms of income:  people were trying, very unrealistically, to maintain their spending levels, even as their purchasing power declined, by getting deeper into debt.  Notice that as housing prices escalated, banks were offering and people were accepting bigger and bigger mortgages with lower and lower down payments and trickier and trickier payment schemes (e.g., low teaser rates followed by whopping balloon payments), and everyone was counting on continued inflation to cover those escalating debts.  Why else would people refinance their homes in order to use the equity to buy stuff or finance college educations for their children?  Because, whether explicitly or not, they were counting on inflation to reduce the value of their debt.  Same for the various levels of government.  Projecting today’s costs (entitlements, wars, building projects, salaries and benefits) into the future when those costs, in the form of debt, would be worth less was simply a massive way of imitating what individuals were doing with their mortgages and credit cards.

But the problem for both governments and individuals was that, while debt was increasing, incomes were not.  The very people who had to pay for that debt, individual American debtors and taxpayers, were not benefitting from inflation; that is, while their debts were increasing, their incomes were stagnating, and in many cases (adjusted for inflation) were in fact declining.  Something had to give, and it gave.  The circle of debt and spending turned vicious indeed.

At the present time, there is no reason to believe that, should a 4% inflation rate actually occur, incomes will be affected.  With an employment rate consistently hovering in the vicinity of 9%, with many people working at less than their peak (underpaid, part-time work, etc.), with still others dropping out of the labor market in despair (and therefore no longer counted as “unemployed”), and with older unemployed workers resorting to taking Social Security early, there is little incentive to increase wages and salaries at all, let alone to keep pace with inflation.  So a 4% inflation rate will not help, but in fact hurt, the college graduate with $40,000 in student loans to pay off on the wages of a waiter or barista; it will not help the retirees on fixed incomes and with savings held in savings accounts and CDs; it will not help the middle-class family with an outsized mortgage and only one wage-earner, who in any case may have taken a big salary cut when he/she was laid off and finally found another job after months of looking.  And it will not help any level of government when income and property taxes are down because of lower wages and devalued real estate.  Taxing the rich, however the rich are defined, will not help much.  It’s the middle class that finances both the economy and governments, so if the middle class is shrinking (rapidly), both the economy and government are in permanent trouble.

In big picture terms, in computer modeling and theoretical terms, inflation might look like the answer to our debt problems; but in personal terms, in terms of individuals trying to live in a world both of debt and inflation, it looks like no answer at all.

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