Inflation: Good for Governments, Bad for You

When public debt starts hitting the tens of trillions, governments only have one option: inflate it away. Sorry citizens!

Key Takeaways:

For governments drowning in debt, a depreciating currency can be a lifesaver. Future dollars are worth less, making the debt easier to pay off.
However, rising inflation also means borrowers demand higher interest rates – something the U.S. can’t really afford.
When investors lose faith in the central banking system, they turn to gold. Are we approaching that monumental turning point?

Drowning in Debt

Let’s say your annual salary is $40,000. You have a big spending habit, so your expenses total $60,000 per year. To cover your lavish spending, you borrow $300,000 from your friend and promise to pay him back in 10 years.

Clearly, your spending habits are unsustainable. How can you ever expect to pay back your debt?

The craziest part of this illustration is the numbers are real. Add seven zeros to the end, and you get the actual financial position of the United States government.

U.S. national debt: $30,500,000,000,000 (30.5 trillion)
U.S. federal spending: $6,200,000,000,000 (6.2 trillion)
U.S. federal tax revenue: $4,200,000,000,000 (4.2 trillion)

The Power of Inflation

Governments accept these numbers because they have a little trick up their sleeve: inflation. When governments borrow money in an inflationary environment, their future debt becomes easier to pay off.

Let’s say you borrow $1,000 from your friend and agree to pay him back in 10 years. If the inflation rate stays at 10% for the next ten years, those 1,000 dollars will have lost 65% of their purchasing power. You still give your friend $1,000, but the money he receives will be worthless compared to the money he originally loaned you.

Inflation helps the debtor and hurts the creditor. Today’s biggest debtors are not college grads or gambling addicts, but governments.

Debt to GDP

The debt-to-GDP ratio measures a nation’s public debt relative to economic output. A high debt-to-GDP ratio is a major warning sign for economists. It means the government has exchanged long-term economic strength for short-term gain.

The chart below shows the United States’ debt to GDP since 1968. During the onset of COVID-19, the ratio hit an all-time high of 136%. Today, it sits at 123%.

From April 2020 until now, inflation has helped bring down the debt-to-GDP ratio. Inflation has increased economic output in nominal terms, because consumers have to spend more to get the same goods and services. Debt has been growing, but not as fast as inflation.

Because inflation is currently a global phenomenon, this pattern can be observed in other highly indebted nations. Greece’s debt-to-GDP ratio has dropped from 206% in 2020 to 193% today. Portugal’s has come down from 135% to 127%. France’s has dropped from 118% to 112%.

So inflation is good, right? It is reducing federal debt relative to output. Of course, consumers are paying $5/gallon for gas and watching their savings account and salary deteriorate, but at least governments can rest easy.

The Impact of Interest

At least they can for a while. Unfortunately, the benefits of inflation are short-lived. There is another key factor in the debt equation: interest.

Governments have to pay interest on their debt. When inflation rises, creditors demand higher interest payments from the debtor. This takes away any free lunch the debtor thought they could get via their depreciating currency.

Back to the example with your friend: if he thinks the inflation rate will be 10% for the next ten years, he might charge you an interest rate of 10% on your $1,000 loan. That means you will have to pay your friend $100 every year for ten years, PLUS the original loan of $1,000 a decade later. Otherwise, why would he lend you the money?

In the case of the U.S. government, “treasury yields” are the interest rate. The U.S. takes on debt by selling treasury bonds. People buy treasuries in hopes that they will receive their money back plus interest. When investors think inflation will outpace their interest rate, they demand a higher annual yield. Thus, bond yields rise.

The chart below shows the 30-year, 10-year, 5-year, and 2-year treasury yields this year. They are rising as fast as they ever have in U.S. history, and they are still far behind the inflation rate.

Going for Broke

Interest costs are a big deal. Right now, the U.S. government’s interest costs are only $433 billion annually, about 1.4% of the total debt and 10% of federal revenues. But, as interest rates continue to rise, those percentages will climb.

If interest rates tripled or quadrupled from their current levels (not an unreasonable expectation, considering how high inflation is), the government could end up paying $1.7 trillion in interest costs every year. That means interest costs would suddenly eat up 40% of federal revenues.

Inflating away debt may work when a nation’s debt-to-GDP ratio is around 50%. The U.S. successfully inflated away a considerable amount of debt during the 1970s. Consumers had to endure a decade of awful stock market returns and three recessions, but we came out alright on the other side.

With a debt-to-GDP ratio of 127%, this is no longer an option.

Finding a Hedge

Our inflationary economic system reinforces irresponsible government spending and debt accumulation. It works until it doesn’t, and unfortunately, we are approaching that very moment.

That’s where gold comes in. Not only does gold serve as an inflation hedge, but also as a hedge against federal debauchery. Historically, gold has performed extremely well during economic turning points and secular periods of stock market underperformance. Both of these situations will likely characterize the next few years as the Federal Reserve and the U.S. government attempt to dig themselves out of an economic crater of their own creation.

Most investors will go down with the ship. This year’s carnage is proof. Gold investors can watch the situation unfold from the safety of a financial lifeboat.

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