Saturday, October 31, 2009

Inflation in China--->default in the US

An interesting truth emerges from the discussion in the previous post for a given theoretical maximum rate of repayment of debt (government budget surplus), the interest on the debt must be less than (rate of repayment)*GDP/(total debt). Let me give an example. If the theoretical maximum budget surplus is 5% of GDP, and debt is 80% of GDP, then any interest rate over 6.25% would mean the country was insolvent. In this case, inflation and economic growth are an enemy of the state, for if nominal GDP growth>6.25% the country is insolvent, but so long as inflation+GDP growth<6.25% the country can remain solvent. For a country like Japan with a debt 170% of GDP, a maximum budget surplus of 5% of GDP would imply that nominal GDP growth>3% implies insolvency for the country. This is a worry that has been getting no small amount of play in the media recently, as the demographics of Japan are decreasing the savings rate and major Japanese investment entities are starting to divest themselves of Japanese (Samurai) bonds. Looking back at this reality though, it is no wonder they have had a lost decade!

The issue of a necessary current account surplus presents another dilemma for US policy makers. How do we get a budget surplus without an accompanying current account surplus? This is, by definition, limited by the amount that savings exceeds investment:
(1) Budget surplus/deficit (taxes-gov spending) + domestic (saving-investment) = CA (exports-imports)
And how do we get a Current Account surplus without decreasing the relative value of our currency (which in turn stokes inflation)? The only way that I can see this is possible is if there is significant deflation in other countries. This would allow us to devalue our currency while not stoking domestic inflation. However, is this likely in an era of tightening supplies of oil and other natural materials? Not unless we have a concurrent worldwide depression. Healthy economic activity will lead to higher natural resource prices and worldwide inflation pressures.

Of course, this dilemma is inoperative until there is some demand for repayment of money loaned to the US government. But when that day comes, healthy economic activity and inflation abroad would lead to a default on US borrowing.

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