Justus For All

I have this “bother” running around in my head (whoever remembers Pooh Bear at a time like this?) whenever I think of the “link” between interest, government borrowing, and inflation.

It runs something like this (and, I acknowledge from the outset that I am no economist).

Assume annual inflation at 3%.

Assume Govt pays 4.5% interest on borrowings.

Assume interest paid at end of year.

Assume principal $10,000

Interest for year = $450
Total value at end of year $10450
Less tax on $450 (at 20%) $90
Investment at end of year $10360

REAL value (97% of $10360) $10,049.

ACTUAL (REAL) RETURN FOR YEAR $49 or 0.049%

Now, what does that mean?

If a government gets into fiscal deficit bothers then repayment of borrowings is much easier if the rein on inflation is slackened somewhat.

So, if the Fed sets the interest rate at (let us say) 4.25% then there is one thing certain.

Inflation in the next 12 months is likely to exceed that 4.25%.

As I showed with the numbers, even with the interest rate ahead of inflation, the return to the “investor” after tax can easily be zero and the cost to the government for the borrowing can just as easily be zero as well. Huh? Well how easy is it to justify increased tax collections (if not tax rate increases) with inflation as the reason?

As a “bother”, the thought takes the form of “how the government keeps the bulk of the population ‘poor’”.

So is the implication that the government can be financed with an indefinite pyramid-scheme-like rolling-over of debt? And where will the revenue for those additional interest payments come from? Borrowing? Why wouldn’t lenders get skeptical after a certain point and stop buying Treasuries? And if that happens, why wouldn’t interest rates spike, straining an indebted government and causing a recession?

Probligo,

I don’t know where you get some of your numbers, such as the Less tax on $450 (at 20%) $90.

Of course combating inflation is important, indeed many say it should be the only concern of monetary policy. However, you seem to have the relationship between interest rates and inflation backwords. Higher Federal Fund rates means LESS money in the economy which tends to lower inflation. I am not sure I follow your concern that government borrowing keeps (let alone is designed to keep) the populace poor.

Honest Partisan:

The implication is the government can continue to be financed as it has with a combination of taxes and financing. The additional revenue will come from larger absolute tax receipts from a growing economy and greater absolute debt while maintaining a balanced GDP to debt ration. We want to grow our debt at the same rate that we grow our economy.

Lenders would only get skeptical if they thought that either economic growth would fail to keep up with debt growth or that the U.S. government would be unable to enforce its tax demands. I see no sign at all of the later, and for the most part recent economic growth has slightly outstripped debt growth over the past couple of years. U.S. Treasuries remain the safest investment in the world. That is why we have so much ‘foreign debt.’

HP,
“And where will the revenue for those additional interest payments come from? ”

Most government fiscal borrowing (Treasury Notes) in NZ is for 10, 15 or 30 years. If over the term of the borrowing the inflation rate equals the interest rate on the bond plus the average tax on the interest, then the “interest cost” is neutral to negative to the government.

That process happens solely in the bounds of the investment/interest/tax cycle. See below my note to Dave on the tax rate I have used.

In direct accounting terms, payment of the interest on borrowings comes from increased tax (as incomes are inflated) or further borrowing (the hole that Rob Muldoon dug NZ into). Comparison of the latter to “pyramid schemes” is not entirely inappropriate.

Dave, last time I used my calculator, $90 was 20% of $450.

In NZ interest on Treasury Bonds is treated no differently to any other income. Is that not so in the US?

If 20% as a tax rate is not right, please I would be happy for you to correct it.

I chose 20% as a kinda minimum figure just to make the point. Obviously, if the tax on the investment interest is greater than $140 then the REAL NET RETURN on the investment is negative. If the tax on interest is $150, then the REAL VALUE of the investment is now $9,990.

This becomes even more important if I am saving for (example) a home.

Not only has my investment lost REAL value, but the value (PRICE) of the asset I want to buy is likely to have increased by 3%.
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As a matter of interest, there was one set of Treasury Bonds issued in NZ in the 1970s which were “inflation proofed”. The interest rate was set at (from memory) 2%, but the maturity value of the principal was to be adjusted by the CPI increase over the investment period. As you can imagine they were very popular. Also, as you might imagine, the government subsequently pressed for early repayment at 3 years instead of the original 10 years. The rationale behind these bonds was exactly as HP has said, as were the consequences.

Most government fiscal borrowing (Treasury Notes) in NZ is for 10, 15 or 30 years. If over the term of the borrowing the inflation rate equals the interest rate on the bond plus the average tax on the interest, then the “interest cost” is neutral to negative to the government.

This is one reason why fighting inflation is an important aspect of monetary policy. U.S. Bonds have typically outperformed inflation, although not by a whole lot. They are a very ’safe’ investment, but not one in which you make huge profit.

I understand you tax position now. I thought you were talking about this from the position of the government, not the investor. Whether or not you think buying bonds is a good investment for you depends on a lot of factors. If you don’t think a bond is worth the price, than you certainly should not invest in such an instrument. The popularity of U.S. Treasury Bonds on the world market would seem to argue that many people feel differently however.

I certainly claim no knowledge of New Zealand’s financial status or what has gone wrong or right there. I do my best just to keep abrest of the U.S. economy.

Probligo:

No such thing as a free lunch. Bondholders won’t buy if their expectation is that inflation will erode the value of their investments unless interest rates are raised to compensate them for that eventuality. Which, of course, presents other problems.