Daily Archives: September 21, 2011

What do deficits mean? Part 3, debt over the long term.

So how do we deal with a large debt over the long term? There are two things that determine how difficult debt is to pay back. The first is quite easy to understand, and it’s something everyone has to deal with: interest. The higher the interest, the more debt costs. Right now, as I pointed out in the last entry, debt is cheap for the government. That was the bond rate graph. That doesn’t do anything for debt we have from the past, but it does mean further borrowing is cheap.

The second factor is inflation. I think when economists start talking inflation a lot of people either get bored or suspicious. The basic concept is very simple, inflation is the rate at which prices go up. If you have 2% annual inflation, then a dollar today will effectively be worth 98 cents a year from now. So if you borrow $100 today at 2% interest, and there is a 2% rate of inflation, in a year you’ll owe $102, but the value of that debt will be the same. The $102 you owe after a year of inflation is worth the same as the $100 you initially borrowed. This means that a 2% inflation rate offsets a 2% interest rate. This is why inflation is so incredibly important to the banking and finance industry, their earnings and profits are directly tied to interest.

So, allowing for higher inflation would make it easier to pay down the national debt by offsetting the cost of interest. And right now it would do double duty, it would also make it easier for families to get out from under high debt caused by the housing collapse. That is, assuming wages rise with inflation, which has been a safe assumption in the past. This is, I think, where a lot of people object. I’m not entirely clear on the objections, if it’s suspicion of supporters of such measures, trust in those who oppose them, a gut feeling that inflation is bad, or just a feeling that using inflation to help repay debt is somehow unfair. Regardless, it’s a tool that can be used to help reduce the burden of the debt.

Does this mean our debt isn’t a problem? No, not at all. But this does mean that we aren’t on the edge of a cliff. The problem we’re facing isn’t a toxic buildup of interest, our debt and interest are manageable. The long term problem is a large and growing deficit. So what do we know about that? Next up: spending.