Few topics are less conducive to rational debate than the national debt. One of the most divisive questions is whether a country can get into trouble issuing debt in a currency it controls. Surely, a nation would face bigger problems if it borrows in foreign currencies or gold than if it only promises to repay in script it can print itself. But how much of an advantage is it to control the borrowing currency?
The issue is gaining in importance as the U.S. is poised to more than double to $1 trillion the amount of debt it issues this year to pay for a ballooning budget deficit.
In the extreme, some people imagine that the U.S. could simply print lots of $1,000 bills to pay Treasury debt as it comes due. That's not realistic. Investors would treat such an action as a default, and that's what it would be. There would be the same financial and diplomatic repercussions and the same downstream bankruptcies as if the government simply refused to pay. Moreover, the economy would lose its currency. Private debts and nominal contract revenues denominated in dollars would become worthless. The U.S. would be much wiser to negotiate a restructuring.
A more reasonable scenario would be if the U.S. allowed mild inflation to reduce the purchasing power of the dollars needed to repay the debt. The difficulty here is that while inflation reduces the value of the existing debt, it causes investors to demand higher interest on future debt. If the U.S. had the fiscal discipline to pay off debt out of income as it came due, this would not be a problem. But if America had that kind of fiscal discipline, it wouldn't have any debt problems in the first place.
Look at the experience from high inflation in the 1970s and early 1980s. Since 1970, the U.S. has issued $134 trillion of Treasuries to the public and repaid $119 trillion, leaving $15 trillion outstanding. Converting to 2017 dollars, the U.S. issued $184 trillion, repaid $163 trillion and so has net borrowings of $21 trillion 2017 dollars. Since it only owes $15 trillion of 2017 dollars, it saved $6 trillion due to inflation.
On the interest side, the U.S. paid $7 trillion in interest, which translates to $12 trillion in 2017 dollars. Inflation accounted for $7 trillion and $5 trillion was real return to investors. So while inflation since 1970 saved the U.S. $6 trillion on debt repayments, it cost it $7 trillion in additional interest.
The chart below shows the yearly effect of inflation. The yellow line is the annual inflation rate on the right scale. The blue line is the gain each year from inflation eroding the value of the existing stock of public Treasury debt, in billions of dollars on the left scale. The red line, also in billions of dollars on the left scale, shows my estimate of how much extra interest the U.S. paid because of that year's inflation. You can see that the red line is consistently above the blue line. Inflation has added to the real cost of the debt, not reduced it.
Of course, the U.S. has not been running inflation as a calculated effort to minimize the cost of the debt, so the fact that inflation has hurt in the past doesn't mean it might not help in the future. It comes down to whether the Treasury can fool investors. My personal guess is that the Treasury might be able to take in individual investors and less sophisticated institutions, but there's no virtue is transferring national debt problems to them.
I doubt that the Treasury can make a lot of money consistently fooling smart money investors, including foreign central banks. So I don't think inflation is a magic bullet for debt problems. It may buy time for negotiating restructuring, but I think the U.S. will either have to pay back back the purchasing power of what it borrowed, default or keep rolling the debt over forever.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of "The Poker Face of Wall Street."
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