US Inflation, The Dollar, Debt, and Budget Deficits — There is no easy way out!

Inflation is the topic of the day. We blame it on Putin’s war.

Forget about Putin’s war. It’s not the only cause. Even if the war ends today, inflation will remain hot. It’s not about the pandemic either. Yes, it contributed, but the damage was already done. Budget deficits, high debt burdens, and “artificially” low interest rates created the inflation problem.

• US Budget Deficits are now unavoidable — and here to stay, for a long time.
• There is no alternative to the dollar — we are stuck with it.
• The Debt Burden can never be repaid — can only grow or be inflated away.
• The verdict is Inflation is here to stay — it is needed.

The USA has been running budget deficits for the last 10 years and will highly likely run deficits for the next 10 years, driving up debt by 15 trillion more.

USA Projected 10 yr budget from Richard Todaro, CFA

USA debt is currently at $30 trillion, and tax revenue was $3.5 trillion last year. If the interest rate is raised to 10% then interest alone could be $3 trillion.

Rising rates mean the government pays more in interest. The second-order effect is declining revenues. When rates go up, things get tighter, economy cools off, meaning lower gvt revenue. So, instead of raking in $3.5 trillion as initially budgeted, the government can rake in maybe $3 trillion.

This is why US rates can never ever go up to 10% again without the government going dead broke. When revenues go down, whilst interest payments go up, the government is faced with bigger deficits. Bigger deficits have to be financed. So, it has to borrow, again, but this time at the new prevailing interest rates, which are higher rates. This increases the debt burden. It quickly flies past the $30 trillion level. Within a couple of years, it could be at $35 trillion, and analysts will wonder how deb increased that quick.

If rates go up, the problem compounds. When that happens, rates have to eventually be forced down. Rates will highly likely be forced down way before inflation comes down, so inflation stays up, and rates cannot be raised enough to sterilize inflation. This leaves the Federal Reserve with fewer tools in the toolbox. They can still use a little bit of Quantitative Easing or Tightening.

A good old recession can normalize things a little bit, by reducing demand for goods and services allowing inflation to come down to lower levels. Hyperinflation can also be used to quickly make the debt so little and meaningless in a couple of years, allowing for a system reset to happen at the end of the hyperinflationary period. A reset is needed, either via a recession or via hyperinflation.

The problem with the current trajectory of ever-growing debt is that it overwhelms the system as interest payments increase. Every US president has tried to sort things out by trying to reduce debt, in theory, but in practice, they are eventually forced to increase debt, otherwise, the government shuts down. That’s the danger, a total government shutdown, bringing everything to a standstill because the government has no money to pay its workers and contractors.

The costs of attempting to tame inflation are exorbitant (hyperinflation, recession, reset). If the cure is more devastating than the disease, then it's better to go along with the disease. Maybe it's time to adjust to a medium to a long period of high inflation.

The global financial system needs the US dollar because there is no alternative to the dollar, at present. Whatever happens to the dollar, we all suffer the consequences, and we move on with it. Gold cannot settle trades, it is not liquid enough, it is difficult to audit other countries’ reserves, etc. Crypto hasn’t taken off, as yet. Yes, the tech is there, but what value do we agree to transfer on the chain. Russia recently built a payment system that can act as an alternative to SWIFT. It is blockchain-based. The question is what value (currency) do we transfer on that blockchain. Bitcoin is promising but it is still very volatile.

The Rubble and the Yuan are heavily controlled currencies that very few countries would be willing to trust. The Yuan is in itself a dollar-derivative because of its close peg. China's exports rely on a devalued Yuan. Becoming a reserve currency strips away export competitiveness. In the short to medium term, there is no real alternative to the dollar.

Inflation is the result. The causes were budget deficits and high debt. All of these are intertwined. There is no easy way to reduce a single parameter.

Ciao!