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Here’s a quick financial prediction; I’m interested to know what you think so please feel free to leave comments or send me an email. As I write this post we’re in the throws of a global economic crisis. The US Government’s response, i.e. a Keynesian approach to shoring up the economy through massive injections of capital, will have the inevitable effect of driving up national debt to historic levels. Eventually that debt has to be repaid, but I have a pet theory on how that painful reality is going to be softened: I think the federal government will pursue a strategy of intentional, controlled inflation. But why will they do this?

During an inflationary period, prices, wages, etc. all tend to go up. This has the effect of “cheapening” the dollar; what used to cost $1.00 now costs $1.50, therefore a dollar in the future is worth less than a dollar in the past. A side effect of this (or in our example, the primary motivation) is that debt incurred in past dollars can be paid with future dollars at a reduced cost. Let’s look at a simplified example:

Assume it’s 2007 and John works for a company that pays him $50,000 a year. By 2012 (post crisis) inflation has been underway for a while and prices have risen. John’s salary will rise as well, and while it may not rise as quickly as prices (a bad side effect of inflation), his nominal income is now $60,000 a year. Let’s also assume that John borrowed $1000 back in 2007 and now, five years later in 2012, he is ready to pay it back. Because of inflation the value of $1000 in 2012 will be less than it was in 2007 when John borrowed the money. So the net effect for John is that he can pay off old 2007 debt using cheap 2012 dollars; it’s a advantage to John and a disadvantage for the lender.

So lets get back to the US government and the massive amounts of debt they are accruing right now in 2009. Given the fact that the government can directly affect inflation through fiscal and monetary policy, why would they not pursue a strategy of controlled inflation? It’s an advantage to borrowers, both the US government as well as all of the individual borrowers who spent too much and saved to little. Unfortunately it’s a disadvantage for all of the people who saved their money, as well as all of the lenders (like China) who loaned the US a lot of money in pre-crisis times.

Any thoughts?