What -- It only works with Federal Debt?

 

"In 1946, the debt ratio was 108.6 percent. Inflation reduced this ratio about 40 percent within a decade." 

"The model predicts that a moderate inflation of 6 percent could reduce the debt/GDP ratio by 20 percent within 4 years."

 - Joshua Aizenman and Nancy Marion

 

In the above quotes, Aizenman and Marion refer to the ratio of Federal debt to GDP.

The excerpt below begins on page 8. I have shortened the quote by omitting their parenthetical data; and again, they refer exclusively to the Federal debt:

A few observations are worth noting.  Inflation yielded the most dramatic reduction in the debt/GDP ratio—and the real value of the debt—in the immediate post-World War II period.  A five-percent inflation increase starting in 1946, for example, would have reduced the debt/GDP ratio from 108.6 percent to 59.3 percent, a decline in the debt ratio of 45 percent.  The sizeable inflation impact is not that surprising.  Not only was there a large debt overhang when the war ended, but inflation was low and debt maturity was high.  Thus there was room to let inflation rise... 

In contrast, inflation would have had little impact on reducing the debt burden in the mid-1970s after the initial oil price shocks.  That period was characterized by a lower debt overhang, inflation was higher, and debt maturities were shorter.  As a result, in 1975 a 5 percent inflation increase would have reduced the debt/GDP ratio from 25.3 percent to 21.9 percent, less than 15 percent.  

The factors they mention do seem important. Note in particular that in 1946 "inflation was low (2.3%)" and that in the mid-1970s "inflation was higher (11 percent in 1974)". So the crux of the matter is not entirely that "inflation would have had little impact on reducing the debt burden in the mid-1970s". In good part, it is that inflation actually did reduce the debt-to-GDP ratio in the 1970s. Not so much the Federal debt, which was then low, but private sector debt, and so that of the whole nonfinancial sector.

Note that the title of Aizenman and Marion's paper is "Using Inflation to Erode the U.S. Public Debt". Their focus is on the use of higher inflation as a tool for the reduction of the debt-to-GDP ratio in our time. This is one reason they point out that it works better when inflation is low than when it is high: because then there is "room to let inflation rise".

As for myself, I wouldn't be caught dead thinking of inflation as a potential tool to reduce the burden of debt. I see inflation not as a tool but as a problem. My focus is not on the use of increased inflation as a tool for the reduction of the debt-to-GDP ratio, but on the actual result of the actual inflation during the years of the Great Inflation, when inflation was high. 

The debt-to-GDP ratio remained low in those years, because of the inflation.

It must be true -- I saw it on Wikipedia

https://en.wikipedia.org/wiki/Debt-to-GDP_ratio#Changes

The Debt-to-GDP Ratio

The ratio of nominals is the better measure of the cost of debt.

The ratio of reals is the better measure of the growth of debt.

Note that the calculation of real debt is not the same as the calculation of real GDP, because debt is a stock and GDP is a flow.

Quick check

What I said on the 17th, #1:

Nonfinancial Debt increased from $2895.4B to $3290.0B during 1978. The inflation of 1978 inflated the difference, the $394.6B that was added to the accumulation during 1978. The 7.0% inflation makes the $394.6B 107% of what the increase would have been if there had been no inflation. With no inflation that year, the increase in debt would have been $368.8B. Add this to the starting value ($2895.4B) to get a number for what domestic nonfinancial debt would have been if there was no inflation in 1978. The number I get: $3264.2B.

Using FRED's source data as a place to start, I get debt-to-GDP ratios of 1.391 for 1977 and 1.399 for 1978. We could round them both to 1.4.

Using my numbers, figuring zero inflation in 1978, I get 1.391 for 1977 (same as above) and I get a ratio of 1.485 for 1978.

With seven percent inflation in 1978, FRED's number, we got a debt-to-GDP ratio of 1.399. With zero inflation in 1978, we would have got a debt-to-GDP ratio of 1.485.

Rounded to two decimal places, 1.40 versus 1.49. Rounded to one decimal place, 1.4 versus 1.5. The difference: one tenth of a percentage point.

 

What I said on the 17th, #2:

But putting it down in words, and being specific about the start-of-year accumulation and the during-the-year increase, I realized: At no point do I allow for debt that is being paid down!

 

What I have to say now: Let's suppose that during 1978, people paid off 10% of the $2895.4 billion starting balance of debt. So then the "low-point" of that balance would have been $2605.86 billion.

But the end-of-year balance was unchanged, at $3290.0 billion. To bring debt up to that number, during 1978 people must have borrowed (3290.0 - 2605.86) or $684.14 billion -- much more than the $394.6 billion I said on the 17th.

I assume all of this new borrowing was done so that the money could be spent: a fair assumption, I think. And I say that all of this spending would have occurred during 1978, at 1978 prices. So the amount of debt that was affected by the inflation of 1978 was $684.14 billion.

Because of the 7.0% inflation in 1978, this $684.14 billion was 107.0% of the debt that would have been required to make the same purchases if there was no inflation during 1978.

$684.14 billion is 107% of $639.38 billion.

If there was no inflation during 1978, and our low-point balance that year was 2605.86 billion, we would have ended the year with a debt accumulation of (2605.86 + 639.38) or $3245.24 billion dollars.

For GDP, as figured in the previous post, the number would have been not $2351.6 billion, but $2197.8 billion.

My corrected real-to-real debt-to-GDP ratio is (3245.24 / 2197.8) or 1.477 rather than the erroneous 1.485 reported in mine of the 17th.

This new debt-to-GDP ratio of reals stands in comparison to the 1.399 ratio of nominals arising from the FRED data for 1978. 

The ratio of reals remains higher than the ratio of nominals.

I don't know how much existing debt was actually paid down during 1978. I said 10%, but I think that's on the high side. I'll be looking into this again.

Simple stock-flow consistency and the debt-to-GDP ratio

 

 

Ideally, we would prefer to measure either a stock relative to a stock or a flow divided by a flow.

- Cecchetti, Mohanty and Zampolli, 2011

 

 

Going by this annual GDP Deflator, the inflation rate for 1978 was 7.0%, a nice round number. I want to look at that year.

The GDP for 1977 was 2,081.826 billion dollars. The debt, domestic nonfinancial debt for 1977, was 2,895.413 billion. For 1978 GDP was 2,351.599 and debt was 3,290.005.

For debt, I can subtract the 1977 number from the 1978 number to find the amount of debt that was added to the debt accumulation during 1978. For GDP I don't have to do that, because GDP starts every year at zero. Why are they different? It's a "stock vs flow" thing. Debt is a "stock". GDP is a "flow".

In terms of annual data, inflation is a "current-year" phenomenon. It affects current-year transactions, not transactions of prior years. Inflation changes stocks and flows in different ways because flows measure only "current-year" transactions, while stocks measure both current-year and prior-year transactions.

The GDP for 1978 was entirely sold (and mostly produced) in 1978, so the inflation of 1978 inflated all of GDP. But it is different for debt. Only the 1978 increase in debt was inflated by the inflation of 1978. The debt that was existing before the start of 1978 was already existing when the ball dropped at midnight, and the 1978 inflation could not change it. But the inflation of 1977 did inflate the 1977 addition to accumulated debt, and the inflation of 1976 inflated the 1976 addition, and like that for prior years going back to the oldest debt in the accumulation.

For debt, each year's increase -- and only the increase -- is inflated by that same year's inflation. It works for the increase just like it works for GDP, because the increase in debt is a flow, just like GDP is a flow. But the accumulation of debt is a stock, an accumulation created over many years. And the inflation in any one of those years inflated only that one year's contribution to the total. If you have to read this paragraph 20 times before it sticks in your head, do it.

We will look today only at 1978, the debt and GDP for 1978. We have the end-of-year values for 1978. But we also have the start-of-year values. For debt, the start-of-year 1978 value is equal to the end-of-year 1977 value (because debt is a stock). For GDP, the start-of-year 1978 value is zero (because GDP is a flow).

Don't worry about what the numbers are, when you read this. Just look at what I'm doing with them. Pretty soon maybe you will be figuring it the way I do.

GDP went from zero to $2351.6B during 1978. Economists figure inflation affected the whole thing, our nice round 7.0% inflation. So I would say that the $2351.6 B number is 107.0% of what GDP would have been if there was no inflation in 1978. With no inflation that year, GDP would have been 2351.6 divided by 1.07, or $2197.8 B.

Nonfinancial Debt increased from $2895.4B to $3290.0B during 1978. The inflation of 1978 inflated the difference, the $394.6B that was added to the accumulation during 1978. The 7.0% inflation makes the $394.6B 107% of what the increase would have been if there had been no inflation. With no inflation that year, the increase in debt would have been $368.8B. Add this to the starting value ($2895.4B) to get a number for what domestic nonfinancial debt would have been if there was no inflation in 1978. The number I get: $3264.2B.

Using FRED's source data as a place to start, I get debt-to-GDP ratios of 1.391 for 1977 and 1.399 for 1978. We could round them both to 1.4.

Using my numbers, figuring zero inflation in 1978, I get 1.391 for 1977 (same as above) and I get a ratio of 1.485 for 1978.

With seven percent inflation in 1978, FRED's number, we got a debt-to-GDP ratio of 1.399. With zero inflation in 1978, we would have got a debt-to-GDP ratio of 1.485.

Rounded to two decimal places, 1.40 versus 1.49. Rounded to one decimal place, 1.4 versus 1.5. The difference: one tenth of a percentage point. In ten years, it could amount to a whole percentage point increase in the debt-to-GDP ratio. In the 20 years of the Great Inflation, perhaps a 2-point increase in the ratio. In other words, from a so-called stable 1.4 at the beginning of the Great Inflation, the debt-to-GDP ratio might have increased to 2.4 -- a ratio not seen in reality until 2008!

I'm not saying my estimated debt-to-GDP ratio is realistic. Far from it; we only looked at 1978. What I'm saying is: Inflation makes a big difference in the numbers. It looks like what I did -- taking the inflation out of the numbers -- is what made the difference. In the real world, inflation going into the numbers is what made the difference. Inflation was the intruder. Inflation came along, inflation so severe that economists started calling it "great", and it started changing the numbers. In particular, as we have seen here, the inflation changed the debt-to-GDP ratio and changed it severely.

Inflation invalidates the simple debt-to-GDP calculation because debt is a stock and GDP is a flow, and inflation changes stocks and flows in different ways.

Let me make my point clear. I took inflation out of the GDP for one year only: 1978. And I took inflation out of one year's increase in debt for the same year, 1978. But I did not change the number for debt accumulated before 1978. This is the only thing I did that is unique: I assumed that the inflation of 1978 affected only the addition to debt in 1978. Not to the whole of that debt.

The way debt-to-GDP is usually figured, nominal values are used for both debt and GDP. Inflation is in both the numerator and the denominator of the ratio. Therefore, inflation divides itself out of the calculation: out of GDP, and out of the year's increase in debt, and out of the starting balance of debt. With my calculation, I made sure the 1978 starting balance was not adjusted for the 1978 inflation. That's the only difference.

It makes a world of difference.

Did I forget to tell you about the Great Inflation?

Many economists say debt was "stable" before the 1980s. If you show them a graph of debt increasing rapidly since the early 1950s, they show you a graph of debt-to-GDP and point out that from the early 1950s to the early 1980s, the graph runs flat at 1.3-to-1 or 1.4-to-1 or maybe 1.5-to-1, but always flat and stable.

What agenda drives this nonsense?

Economists like to use "domestic nonfinancial debt" in their calculations, TCMDODNS at FRED. TCMDODNS includes the debt of governments, consumers, and nonfinancial businesses. It leaves out only the debt of financial business, the fastest growing debt of all. 

No problem. We can do it their way.

Lately I've been changing the "frequency" of the data from quarterly to annual, which gets me back to a 1946 start date, instead of to 1951 -- or back to 1945 if I go fetch the data item myself.

Anyway, here is TCMDODNS since 1946 and during the so-called "stable" era:

Graph #1: Domestic Nonfinancial Debt, 1946-1980

It reminds me of the covid graphs from early 2020: No problem, no problem, it's going up slowly, what's the worry?

IT'S A GODDAMN EXPONENTIAL CURVE. IT GOES UP FROM THE START AND IT WILL NEVER STOP GOING UP UNTIL WE DECIDE TO MAKE IT STOP.

We handled covid and debt the same way, pretending they were not problems. And our economy still has not recovered from either.

Take the debt from Graph #1 and show it in a Debt-to-GDP ratio:

Graph #2: Domestic Nonfinancial Debt relative to GDP, 1946-1980

I see first a lightening-bolt of downtrend, hitting bottom at 1.25 in 1951. Then, a persistent and rather rapid increase to 1.41 in 1963 and 1964. After that, it's flaccid -- or "stable", as they say. 

It is still 1.41 at the end there, in 1980, 1.41794. It rounds up to 1.42 this time, but I guess this is why economists say debt was "stable" before 1980, you get almost the same debt-to-GDP in 1980 as in 1963 and 1964.

I can see setting aside the lightening-bolt, because it happened before 1951 and because we can't see what happened before 1946. Myself, I would prefer not to say much about it except "there it is." But from 1951 to 1963 there was a pretty high-powered uptrend. I can see where it starts, and I can see where it ends.

Economists ignore this uptrend and say debt was "stable". I say 1951-1963 was the start of the problem of increasing debt. 

If the economists are right, there was no increase in debt before the 1980s. 

Did I forget to show you Graph #1?

 

If the economists are right, the 1964-1980 stability of debt was normal and natural. If I am right, it was abnormal and unnatural.

Did I forget to tell you about the Great Inflation?

Debt growth during the Great Inflation

The data is FRED's TCMDODNS (domestic nonfinancial debt) at annual frequency and end-of-period aggregation. FRED's data runs from 1946 to 2020.

I looked at five-year periods. The first runs from 1946 to 1951 (six years, but only five changes in debt. That's why economists call the first year T₀, methinks: so that when they get to the sixth year it can be T₅.) ... The first period runs from 1946-1951 and shows about a 26% increase in debt over 5 years. That data point marks the left end of the blue line, at 1951:

Graph #1: There is essentially no rapid debt growth after 1990!

"Debt increase" increases from around 30% in 1958, to around 40% in 1970, to around 75% in 1979. That is a helluva lot of increase. And by the way, it is the increase of debt: We're talking about the increase of debt here, in the 1960s and 1970s -- a time, economists tell us, that debt was stable.

The high point (84% in 1986) includes the years 1981 to 1986 and, of course, includes President Reagan's "Morning in America". The sharp downtrend after 1986 is related to the Savings and Loan crisis, which occurred during that time.

The high point just before the Great Recession (2007: 55% increase in 5 years) would be the housing bubble I suppose.

But what I want you to notice is the years before 1980, and the seriously massive increase in debt. These are the years when Debt-to-GDP graphs show two decades or more of no increase. The flat spot on those graphs, and the long increase on Graph #1, both occur during the so-called "Great Inflation". Nominal GDP was going up like crazy because of that inflation. Debt was going up like crazy too, as Graph #1 shows (though not so much because of inflation). And the debt-to-GDP ratio ran flat flat flat:

Graph #2

Those years were great. We could afford our debt. We could afford our debt because inflation was driving income up just about as fast as debt was going up. Just about as fast. That is also the reason we don't see increase from the 1960s to 1980 on the second graph.

Don't let anybody tell you debt wasn't increasing in those years!

Graph #3: Debt-to-GDP was stable while Debt went through the roof, because of the Inflation.

During the Great Inflation, nominal GDP increased as fast as debt. But that does not mean debt was "stable". It is also no coincidence that the so-called stability of Debt-to-GDP occurred during the Great Inflation. The "stability" was a result of the inflation!

 

Some time back I caught Scott Sumner talking about a household-debt-to-GDP graph. Sumner said:

What do you see? I suppose it’s in the eye of the beholder, but I see three big debt surges: 1952-64, 1984-91, and 2000-08.

Here's some of what I had to say about that:

Sumner sees one debt surge ending in 1964 and another beginning in 1984. Between those dates was the "Great Inflation". The inflation is the reason for what appears to be a flat spot on the graph. The inflation "eroded" debt.

The growth of debt continued apace.

I worked out compound annual growth rates for debt during Sumner's three "surge" periods:

• 1952-1964: 10.7%
• 1984-1991: 10.25%
• 2000-2008: 9.33%

and reported that:

During the famous flat spot of 1965-1983, the comparable rate of debt growth was 9.36%. That's near 90% of the growth rate for the 1952-1964 "debt surge" and it is higher than the growth rate for the third debt surge Sumner identifies.

There was no remission. Debt did not stop growing. It barely slowed.

Prices increased at a compound annual growth rate of 6.6% per year between 1965 and 1983, more than tripling during those years. There was no remission of debt. There was only erosion of debt because of the inflation.

 

If we think debt grew slowly before 1980 and fast after, it will influence the way policy is designed. If we design policy based on conditions that never existed, it means we don't understand our economy, and our policy will probably not work.

If we fail to understand what actually happened back in those years when the economy was good but then turned bad, we will not understand how to make the economy good again.

I guess we can always just get mad at the government. Kinda fun, isn't it, being "mad as hell". Just like the crazy guy in the movie.

Maybe they'll put that on our gravestone.