US debt sets stage for inflation

By Jim Jubak

It's too soon to bury the U.S. dollar as the global reserve currency, but it is time to start thinking about writing its obituary.

For years now, as the U.S. trade and budget deficits have mounted, the strongest support for the dollar as the world's money was the lack of a viable alternative. The Japanese economy is too sick for investors to put their faith in the yen.

The euro has its own problems. The European Central Bank may be the staunchest inflation opponent in the world now, but each country in the union still runs its own budget, and some -- Italy, for example -- are facing a combination of stagnant growth and aging populations only slightly less daunting than Japan's.

But now the dollar faces a serious effort by creditor nations such as China to manufacture a credible alternative.

Creating that alternative, whether it's the Chinese yuan or some version of a global currency such as the SDR (special drawing rights) of the International Monetary Fund, would take years, to be sure. And in the short run, the global financial crisis has sent panicked investors running for the shelter of liquid currencies such as the yen and the dollar. On March 30, for example, the dollar climbed 0.7% against the euro. (See my March 3 column, "Euro, yen make dollar look good.")

In the long run, however, make no mistake: The dollar's days as the world's reserve currency are numbered. And we have no one to blame for the dollar's demise but ourselves.

Inflation, weak dollar may be best exit

Even in the best of worlds, one in which the Federal Reserve were run by a chairman with truly godlike powers instead of a mere mortal such as Ben Bernanke or Alan Greenspan, the U.S. dollar would be in trouble. A godlike Fed chairman would be able to remove the $8 trillion (or whatever this crisis will finally cost taxpayers) from the U.S. money supply, a process called sterilization, without causing appreciable inflation and without causing the U.S. economy to come to a grinding halt again.

But as difficult as achieving that balance would be in practice, no one in the world really believes that the United States intends to fight inflation too vigorously or support the dollar too strongly. A combination of high inflation and a weak dollar really is the best way to get out from under the mountain of debt that we've run up while "fixing" this crisis.

Let's do some back-of-the-envelope math.

Modest projections, impressive effects

Say the new debt that we have to pay off runs to $8 trillion. In a world with no inflation at an interest rate of 2% (a blend of the current yields on the five- and 10-year Treasury notes), interest payments alone come to $160 billion a year in current dollars. Paying down the debt over 30 years -- the way you and I would on a mortgage -- would require an additional $267 billion a year in current dollars. That's $427 billion we don't have each year. (The unfunded liabilities for Social Security and Medicare -- what we've promised to pay but haven't put aside money to cover -- came to $102 trillion in 2008, according to the report of the trustees for those two programs.)

Put inflation and a declining dollar into the equation, though, and things get better. At 3% inflation, that $160 billion in interest payments is really worth just $155 billion in constant dollars after a year. That's a savings of almost $5 billion in one year. The principal is worth 3% less in constant dollars every year as well. In 30 years, even if we didn't pay down a cent on that amount, the principal would be worth just $3.2 trillion in constant dollars.

Some savings, huh?

The savings are even greater if the United States is paying off some of its interest and debt in depreciating dollars. About 50% of U.S. public debt is held by overseas investors and governments. Assuming roughly the same ownership for the new $8 trillion in debt, a 3% annual depreciation of the dollar would save $2.5 billion in constant dollars in interest costs in the first year and would reduce the value of the 50% of the principal held overseas by about $2.5 trillion.

And those effects would come from just very moderate inflation and a very moderate decline in the dollar.

At a 5% inflation rate, the constant-dollar value of that $8 trillion in debt falls to just $1.7 trillion in 30 years. That's a constant-dollar savings of $6.3 trillion.

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The savings get even bigger if you combine the effects of inflation and a declining dollar, but my back-of-the-envelope calculation gets at the central point: The United States stands to gain big from a policy of higher inflation and a cheaper dollar. (Higher inflation and a depreciating dollar would raise U.S. interest rates as overseas investors demanded higher rates in order to stay even. But the very size of the debt and the ability of the U.S. government to reduce interest payments by locking in lower rates with longer maturity bonds still would make inflation and depreciation a winning combination.)

Continued: Deficits even in good times

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