Debt and Inflation (2): Background

I want to look at the "productivity" of debt, and at eroding the real value of debt by inflation during the Great Inflation. But first I want to evaluate the notion of the real value of debt and the inflation-adjustment of debt.

I looked at inflation-adjusted debt a while back, in Iffy, Piffy:

Graph #1: Inflation-Adjusted Gross Federal Debt

At the time, I said this:

This graph shows that before about 1981 the growth of the Federal debt kept pace with inflation, and since that time the growth of the Federal debt has far exceeded inflation. The change is surprisingly distinct.

Okay. However, in that post I also expressed this conclusion:

If the Federal debt only keeps up with inflation, then the debt is not excessive. By this measure, until 1981 the Federal debt was certainly not excessive.

Today, I am not certain of that.


I went looking for other examples of inflation-adjusted debt graphs.

Mark Wieczorek looks at the national debt, adjusted for inflation, and writes:

In 1950's dollars, our debt is currently $887,445,036,515.72 or 887 billion dollars, which is 3.45 times the size of the debt in 1950. Here's just the inflation-adjusted debt from 1950 - 2003. This graph paints a very interesting picture about the past few administrations.

At Technorati, Steve Kosoris provided graphs of the U.S. National Debt, also adjusted for inflation. And at Bearwatch, Sackerson looked at US public debt since 1945 - inflation-adjusted. Sackerson writes:

For a long time, US public debt increased no faster than consumer price inflation, then under Reagan it appears to have started its steep rise. The causes are presumably complex...

And the Supporting Evidence site looks at the Federal debt, showing both current and inflation-adjusted values:

Source: Supporting Evidence

Oddly, all of the inflation-adjusted debt graphs I found were for the government debt. None showing total debt. Not even mine.

I still wonder what can and cannot fairly be said about these graphs and about the inflation-adjustment of debt. My first thought was: Wow, Reagan really increased government spending! But that's not right -- or, at least, it isn't what the graphs show.

If increased government spending was the cause of the change in trend, it would show up in current spending. It would show up in the deficits immediately. But it would appear in accumulated debt only after a lag. Cumulative numbers change slowly.

So if increased government spending caused that distinct change in the debt graph, we should look for the increase not in the years after 1981, but in the years before. And we should look not at the accumulated debt, but in the annual deficits, the additions to accumulated debt. Mark Wieczorek, quoted above, shows the additions to debt:

Additions to the National Debt, Adjusted for Inflation

The increase appears to begin in the mid-1960s, concurrent with the increase of inflation. Not concurrent with Reagan in the 1980s.

Note that the increase in deficits is not explained by inflation, for the graph shows inflation-adjusted deficits.

Productive Argument, with a Touch of Irony

In their 2007 article The Real Economic Crisis, Dean Baker and John Schmitt attempted to shift attention from "the bursting of the US housing bubble" to "the sharp deceleration in productivity growth since the middle of 2004."

From the article:

Between 1947 and 1973, the golden age of postwar capitalism, productivity growth averaged about 2.8% per year in the United States.

From 1973 through 1995, however, productivity growth took a nosedive, with the average rate dropping to just 1.4%.

From the mid-1990s on, however, official productivity growth again accelerated rapidly, returning to a 2.9% rate reminiscent of the golden age. Quite suddenly, though, in the second half of 2004, productivity growth dropped sharply.

Again, summarizing those dates, we observe:

1947-1973	1973-1995	1995-2004	2004-2007
GOOD	NO GOOD	GOOD	NO GOOD

Andolfatto links to The Productivity Slowdown Reaffirmed by James Kahn and Robert Rich, and offers a snippet from their opening paragraph:

Economists generally agree that productivity is the primary ingredient for sustainable growth in GDP and wages. The August productivity data release provided some clarification regarding trend--or long-run--GDP growth, but the news was not good: Following a resurgence of strong productivity growth in the late 1990s and early 2000s after nearly a quarter-century of slow growth beginning in 1973, the latest reading from a trend tracking model now indicates that slow productivity growth returned in 2004.

Kahn and Rich do indeed reaffirm the termination dates 1973 and 2004 noted by Baker and Schmitt -- and reaffirm the "goldenness" of the 1947-73 period.


David Andolfatto's post is a follow-up to his What output gap? on James Bullard's "wealth shock" theory.

Thus in the new post Andolfatto expands on the consequences of overestimating Potential GDP or trend growth. He refers again to Kahn and Rich:

It is widely believed that the difficulty of detecting a change in trend growth contributed significantly to the economic instability of the 1970’s, as policymakers were unaware of the slowdown in productivity growth for many years, and only much later were able to date the slowdown at approximately 1973. This resulted in overestimating potential GDP (at least so the conventional wisdom goes) and setting interest rates too low, and double-digit inflation followed not long after.

If the Fed permits money-growth commensurate with an over-estimate of Potential Output, the result will be inflation. The argument for slower money growth today gains strength by comparison with the 1970s (because we know what happened then). But this does not mean the argument is correct.

We don't know that the circumstances are similar. We cannot measure Potential Output. It is all a guess. Dismiss the analogy to the 1970s, then do what you will with the rest of their argument.


At the Fed, they attribute changes in productivity trends to "events such as wars, changes in government policies, or structural change in the economy" (Kahn and Rich). Elsewhere, that is. Anywhere but at the Fed.

I on the other hand attribute changes in productivity trends to changes in the debt-per-dollar ratio, the reliance on credit and the factor cost of money. Nowhere but at the Fed.

Here's the thing. At the Fed, they're wearing blindfolds and swinging sticks, trying to hit Potential GDP. Meanwhile, I am saying that what they think are changes in Potential Output are simple results of changes that you can see in the debt-per-dollar curve.

[ Part 1 ]	[ Part 2 ]	This is Part Three

Adam Smith Explains the Demise of Aristocracy

(Just a bit more from Book One, Chapter VI of The Wealth of Nations)

As any particular commodity comes to be more manufactured, that part of the price which resolves itself into wages and profit comes to be greater in proportion to that which resolves itself into rent.

Arthur Shipman Explains the Demise of America

As any particular economy comes to rely more on the use of credit, that part of price which which resolves itself into interest comes to be greater in proportion to that which resolves itself into wages and profit.

The Thrill Is Gone

From A special report on debt: Repent at leisure, The Economist, 24 Jun 2010

Hyman Minsky, an American economist who has become more fashionable since his death in 1996, argued that these debt crises were both inherent in the capitalist system and cyclical.

Inherent, and cyclical. Agreed. At The Economist, they know an impressive statement when they see it, at least if the speaker is fashionable.

Debt increased at every level, from consumers to companies to banks to whole countries. The effect varied from country to country, but a survey by the McKinsey Global Institute found that average total debt (private and public sector combined) in ten mature economies rose from 200% of GDP in 1995 to 300% in 2008... There were even more startling rises in Iceland and Ireland, where debt-to-GDP ratios reached 1,200% and 700% respectively.

"Debt increased," the Special Report says, but "the effect varied." The excerpt suggests the "effect" was that debt increased, and the variation was that it increased to various levels. This is not an impressive analysis.

At The Economist, they are unable to identify the effect of increasing debt. They are also insensitive to warning signs from the economy:

From early 2007 onwards there were signs that economies were reaching the limit of their ability to absorb more borrowing. The growth-boosting potential of debt seemed to peter out.

"The growth-boosting potential of debt seemed to peter out." All they can muster is that the beneficial effect of debt "seemed to" peter out. Are they not sure of it?

The growth-boosting potential of debt has been bending the support beams of our economy in obvious ways since the early 1970s. Not "from early 2007 onwards." At The Economist, they are grossly insensitive to the signals our economy sends to us. As their own graph shows, debt is a depressant and it is getting worse.

Oh, and I think the word is "onward," not "onwards."

To understand why debt may have become a burden rather than a boon, it is necessary to go back to first principles. Why do people, companies and countries borrow? One obvious answer is that it is the only way they can maintain their desired level of spending. Another reason is optimism; they believe the return on the borrowed money will be greater than the cost of servicing the debt.

They are still unwilling to commit to the notion that debt has become a problem: "...why debt may have become a burden..." Unbelievable.

And the "first principles" story only shows they don't know why debt has become such a burden. Why is debt a burden? Because of the cost of it, plain and simple.

Remember when "buy now, pay later" was a sales pitch and a way of life? Well, the economy today is in the "pay later" phase. "Buy now" stimulates the economy, but "pay later" is the counterbalancing depressant. It's a yin-yang thing.

Or we can do cost-benefit analysis: The benefit of credit use is clear to the user, and stimulative to the economy. But credit-use creates debt. And the cost of debt is the counterbalancing depressant.

It is not debt that boosts growth. The use of credit boosts growth. Debt -- the evidence of credit use -- is the burden we're left with, after the thrill is gone.

The problem with debt, though, is the need to repay it.

No. Debt must always be repaid. Every act of lending is supported by the assumption that the debt will be repaid. And though it may sometimes happen that a debt goes unpaid, borrowers also recognize the obligation they assume. The "need to repay" is not the problem with debt. The problem is the excessiveness of debt.

To use numbers from the Special Report, debt at 200% of GDP is not such a problem, but it becomes a problem at 300% or 700% or 1200% of GDP. It becomes a problem when it becomes excessive. It's not rocket science.

Another reason why debt matters is to do with the role of banks in the economy. By their nature, banks borrow short (from depositors or the wholesale markets) and lend long. The business depends on confidence; no bank can survive if its depositors (or its wholesale lenders) all want their money back at once.

Is the problem confidence, or is the problem debt? And if the problem is confidence, is it not a problem because of the excessive level of debt?

This excerpt, if it says anything at all, says it would be wise to prevent debt from reaching excessively high levels. Only, The Economist doesn't say that.

CONCLUSION

The beneficial effect of debt, as the Special Report points out, is its "growth-boosting potential." But at The Economist, they cannot identify the effect of increasing debt on that potential. They do not understand the economy's response to excessive debt.

They are vague and unsure of the problem. They say the benefit of debt "seemed to peter out." But they are confused as to whether the trouble is with debt or with "confidence." They say debt "may have" become a burden, but they are not certain. They are unwilling to commit even to the view that debt has become a problem.

They present us with an awkward phrase: "economies were reaching the limit of their ability to absorb more borrowing." And they observe this limit arising in 2007. But in 2007 the recession was beginning, and our financial crisis was in the works. Surely the problem was glaring by then, at least in hindsight.

They ignore the long-term difficulty we've had, since the early 1970s, achieving an acceptable level of growth. They fail to relate that difficulty to levels of debt that were already high in the 1970s. They fail to observe that everything we've done to boost growth, everything we've done since the 1970s has fallen short, and that only debt itself has continued to grow with any vigor.

They cannot even identify the problem with debt: Excessiveness.