Thursday, April 2, 2015

But the minimum loss to inflation is like 30%. Isn't that high?

Think this through with me.

Graph #1: The third graph from mine of 30 March
Graph #1 takes the ratio of two versions of "Federal debt as a percent of GDP". It shows nominal (current dollar) debt as a percent of nominal GDP, relative to real (2009 dollar) debt as a percent of real GDP.

I don't know what "Federal debt as a percent of GDP" shows us. I think it shows that we're ignoring private debt. But anyway, inflation (when we have inflation) makes GDP bigger and eats away at the value of existing debt. Inflation affects both debt and GDP. But it affects them differently, because debt is a "stock" and GDP is a "flow". So I have been looking at graphs comparing these things.

Graph #1 is one such comparison. It shows current-dollar values as a percent of 2009-dollar values. The nominal values vary from a low of 40% to a high around 70% of the inflation-adjusted values. Basically, it shows that creditors lost out to inflation until around 1980, and then things turned more in their favor.

Still with me?

Graph #1 only shows the value of the principal on loan. It shows some loss to creditors due to inflation, even when inflation is minimal. I think that's because, well, a 10-year Treasury note has to cope with ten years of inflation, not just one year.

Graph #2: Percent Change in the GDP Deflator from year ago (blue) and 10 years ago (red)

Two percent inflation per year is more than 20% inflation in ten years. That much inflation would knock more than 20% off the value of principle on loan. So the value of money lent would fall to maybe 75% of its initial value after a decade of 2% inflation. Graph #1 is in that ballpark.

Next: Working interest into the mix

1 comment:

The Arthurian said...

The loss due to inflation in any one year is 2% or whatever the inflation rate was, or close. (Before coffee, I think the loss would be
(1 - 100/102)
for 2% inflation. So, close to 2%)

So if 'nominal' on the graph is, say, 30% less than the 'real', I think it means that there is a substantial backlog of debt from prior years, for which the loss due to inflation has already accumulated to maybe 28%. Then the current year's 2% increases the loss to 30%.
I'm never comfortable when I have to try to "talk through" some arithmetic; it means the arithmetic isn't obvious. But I think this explanation makes sense.