Inflation (II)-Inflation as Politics

A non-political starting point

Let’s begin by looking at the effect that changes in the rate of inflation can make on the real return from buying a 10-year bond.  Don’t worry about whether the example is particularly realistic.  I mostly want to illustrate what happens when inflation changes.

Assume we’re the lender and we’ve just bought the bond with a coupon of 4% at par for $1000. The transaction happens in the belief that inflation will be 1% per year, meaning an anticipated real return of 3% per year on the money we have lent.  This implies the present value of the repayment of principal is expected to be $905 and the present value of the coupon payments (ignoring any real gains or losses on their reinvestment) is, say, $360.  The total is $1265.

Suppose, right after we’ve bought the bond, inflation suddenly drops to zero and stays there.  Then the return of principal has a present value of $1000 and the coupon payments are worth $400.  The total is now $1400, which has just raised the cost to the borrower by about 11%, and boosted our return by the same amount.  We stand to make a windfall!

On the other hand, suppose inflation shoots straight up to 4% annually, completely wiping out the real return from the coupon payments.  The return of principal now has a present value of $675, and the coupons are worth about $335.  In other words, the borrower gets the use of the $1000 for ten years basically for free.  We have no more money at the end of the ten years than we had at the beginning.

Even worse, let’s say inflation gets dialed up higher, to 6% per year.  The principal repayment is now worth $558 in today’s dollars and the coupons are worth about $300.  So we’re suddenly taking a bath!?!  We’re in the position that we stand to lose about 15% of our money .  The borrower will have the use of the funds for ten years but will pay back far less than he borrowed in the first place.

The results:

inflation ends up being:         1%             0%                4%           6%

bond value is:                      $1265      $1400         $1000       $850

Where politics comes in

What relevance does this example have for politics?  Two points:

1.  The debt we’re talking about could easily be government debt.  In a country that has issued a large amount of bonds, the rulers can be tempted to reduce the real burden of their obligations by creating a little extra inflation.  (In a country with a progressive tax rate, this would also potentially increase government revenues by nudging citizens into higher tax brackets.)

If the country has borrowed from foreigners, this gambit has little chance of working, since international bond investors always have their antennae out to detect this sort of thing.  At best, foreigners won’t lend any more.  At worst, they will pull their money out of the country, causing interest rates to rise and the currency to fall.

If, on the other hand, the country has borrowed principally or exclusively from its own citizens, there’s a somewhat greater chance of success.  But there will still be the possibility of capital flight.  And higher tax rates may also increase the incidence of non-compliance with the tax code.

Some countries, chastened either by the adverse domestic effects of inflation or by a revolt of potential bond buyers, understand clearly what is at stake,  In a country like the US, on the other hand, whose legislators have little experience with this, the chance that the government will try this trick is higher.

2.  Within any country there will also be groups with opposing economic interests.  Typically, different political parties will be representing these groups.  One common (maybe universal) division of interests would be between capital and labor, between owners and laborers, between lenders (bond holders) and borrowers.

In the US before the Eighties, the Republicans were the party of wealthy capitalists and the Democrats were the party of the workers.  In the late nineteenth and early twentieth centuries, a period of sharp economic struggle between these two groups, the main issues may have been wages and working conditions, or the labor-intensive auto industry vs capital-intensive oil.  But one can also see Democratic legislators favoring inflation-creating policies that would erode the real value of already-existing capital (damaging their opponents) and lower the real cost of borrowing (advantaging their supporters).  When Republican lawmakers would be in power, they would do the opposite.

Framing political debate as the struggle between capital and labor is no longer a viable political strategy in the US.  But in developing economies it can easily be the main difference between political parties.  If so, investors must be alert to the use of inflation as a political weapon, with negative consequences for their investments.

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