princeton economics archive is-debt-inflationary

7/29/2019 Princeton Economics Archive is-Debt-Inflationary

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Is Debt Inflationary?by Martin A. Armstrong1990 Princeton Economic Institute

One of the ideas being kicked around in Germany is that of issuing debt to cover the

costs of unification. The German government argues, as most other nations, that

inflation will not emerge if the costs of unification are covered by new debt rather thanthe outright printing of money. The problem stems from the antiquated definition of

inflation. Many still believe that a rise in money supply leads directly to inflation.

Therefore, if a nation borrows to cover expansion, rather than printing money, the

money supply will not increase. Since the money supply does not increase, it is the

belief that inflation will not emerge.

This type of thinking has dominated the postwar era. It is this very aspect that has led toour escalating national debts worldwide (Britain & Australia excepted of late). In reality,inflation will emerge in Germany regardless of whether the funds are borrowed or themoney supply is increased.

Studying the short-term effects, one could argue that borrowing to cover a deficit of anykind is deflationary within a closed economy (free from international influences). Indeed,history is littered with famous politicians who have argued that a "national debt" wouldbe a "national blessing." Abraham Lincoln once said..."The great advantage of citizensbeing creditors as well as debtors with relation to the public debt is obvious. Men readily

perceive that they cannot be much oppressed by a debt which they owe to themselves."

Lincoln's thoughts on this subject are still echoed by politicians more than a centurylater. Anyone in favor of government spending will take this side of the argument everytime. However, there are two major problems with this statement. The first problem,from a domestic viewpoint, rises from the impression that the people owe themselvesand therefore they cannot be oppressed by themselves. On a collective national basis,this leads to the false assumption that a nation could therefore wipe out its debt since itowes it to itself. On the surface, this is a reasonable accounting practice that forms thebasis of a "net worth" statement. If I had $1 million dollars in cash, I could lend thatmoney to myself and sign a note back to myself in return. My assets would thereforedouble because I could argue that I have $1 million in cash and a note personally


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guaranteed for another $1 million. If I default on my own note to myself, what is theharm. I still have the original $1 million and no one gets hurt. This is the line of thinkingmost politicians will argue in favor of a national debt.

However, in the above example, I am only one person and no one else is involved in

this somewhat flawed logic. As a nation, there are millions of other individuals involved.Some will be lenders and others borrowers. The population is eventually oppressedbecause a nation cannot easily default on its debt. That segment of the population wholent the funds to government would be wiped out. Others who were the recipients ofgovernment cash could care less because they did not lend a dime to the governmentand stand to lose nothing by default. Because the reality of this situation is that there willbe winners and losers within the population and this is why government does not followtheir own arguments to the final conclusion and simply wipe out all debt.

Ultimately, the people are oppressed by the debt because government must meet itsobligations to the lenders (interest payments). Currently, interest expenditures in the

United States have exceeded Social Security in 1989. Because interest expenditureshave become the fastest rising cost of government, new taxation is introduced in aneffort to increase revenues. Therein lays the oppression.

Secondly, our line of discussion has been limited to the domestic economy ignoring allexternal or international influences. Whenever the debt of one nation ends up in thehands of another, all interest expenditures end up in the hands of the foreign nation.This robs the domestic economy of any long-term benefits because at 8%, an equalamount of original borrowings will be extracted from the economy in less than 10 years.This results in a transfer of one nation's wealth into the hands of another at a pace fargreater than transactions in world trade alone.

Increasing a nation's debt does not produce deflation but inflation over decades. In thedomestic situation, let us assume that a nation borrows $1 billion. It issued bonds andsold $1 billion thereby extracting that amount of capital from within the domesticeconomy. That action in isolation would be deflationary. However, the $1 billion is thenspent and placed in the hands of another segment within society. It is true that thisinflationary aspect cancels out the deflationary tendencies yielding, on the surface, anon-inflationary appearance. Nevertheless, this can be just an illusion. The "real" effectwill depend greatly upon how the money is spent within the system.

Let us consider the German Unification situation. If the borrowed capital is placed in thehands of the East German citizens by swapping the East German currency for that ofthe West at or near par, purchasing power of the East will rise dramatically. Much ofthose funds will end up in consumer hands resulting in higher demand and shortages ofgoods. This will create inflation domestically regardless of whether the funds wereborrowed or printed. A less inflationary aspect would be for government borrowings tobe used in projects that directly increase productivity. An increase in productivityincreases the supply of goods, thereby diminishing the inflationary pressures.


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If the initial borrowings are funded, NOT by domestic lenders but by internationallenders, then we are still looking at a net infusion of capital that will be inflationary.Because the capital is international in origin, no domestic deflationary tendency iscreated. All that remains is that of domestic inflation. When the borrowed capital isinjected into the system, the net effect will be to increase the domestic money supply.

There is no immediate difference between this transaction and simply increasing themoney supply through printing other than the fact that interest payments will betransferred offshore.

For years, governments have battled over the issue of trade. They recognize the factthat trade deficits mean the net transfer of domestic capital to offshore manufacturers.What government fails to understand is that borrowings that end up in the hands of anoffshore investor also result in large sums of capital being exported.

Australia is a classic case. The government, fearing inflation and trade deficits,maintains high interest rates far above world base rates in an effort to curb domestic

purchases of foreign goods. However, an examination of the current account deficit ofAustralia reveals that the majority of the deficit is actually transfer payments involvingoffshore loans. This is draining Australia of vitally needed capital. The payments tolenders offshore yield no taxation to the government. If interest rates were lowered,domestic borrowers would return to onshore funding and the interest expenditureswould then become domestic income subject to local taxation.

The entire issue of debt, inflation and government spending is quite complicated. Onecannot simply make a blanket statement that national debt is a blessing or a curse.There are times when government spending funded by debt can be beneficial to thedomestic economy. Such instances are limited to areas in which the collective interests

of society are at stake such is the case concerning the national defense. It is agovernment's obligation to defend its people. This is a collective effort and not one thata private group would undertake. Whatever the collective effort, government borrowingto improve the infrastructure in a manner that will increase the productivity of a nation isa worthwhile project. Borrowing for entitlement programs or anything that does notdirectly create employment or increase the productivity of the nation is wrong. Suchsocial expenditures for moral obligations are a gift to such groups as the homeless.Funds of this nature should not be borrowed. They should come from taxation orsurplus revenue.

The debate as to whether or not borrowing is less inflationary than the outrightexpansion of the money supply will continue until man exists no more. Anyone whoattempts to argue that borrowing is not inflationary is simply ignoring the facts. Societycannot be lumped together as a whole. Borrowing of any kind results in the transfer ofwealth. In a domestic society, indeed the rich will become richer and the debtor willmove deeper into debt. In an international arena, precious domestic capital will betransferred offshore. Unless productivity increases at a rate in excess of the interestcosts, inflation will emerge and the nation's wealth will eventually disappear.


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History has proven time and again that every fall of an empire or civilization has come atthe hand of excessive debt and/or collapse of the economy and infrastructure.Governments should be barred from borrowing funds except in times of war, naturaldisasters or for specific collective projects that increase productivity and/or build theinfrastructure. If government is not bridled, debt will merely become an abused habit

that eventually oppresses and ultimately destroys its own people.

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