I predict future happiness for Americans if they can prevent the government from wasting the labors of the people under the pretense of taking care of them.- Thomas Jefferson.

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Thursday, February 10, 2011

How Governments Solve The Short Term Debt & High Inflation Dilemma

By Daniel R. Amerman, CFA


Misunderstandings can be quite expensive for investors, and this article will examine two common but mistaken beliefs about short-term government debt and inflation. The first belief is that because much of government debt is short term, and short term rates are likely to eventually rise rapidly with rising inflation, this means that the debt can't truly be inflated away. Therefore, many people think that even in a highly inflationary environment, the inability of the government to inflate away its debt means that literal bankruptcy becomes highly likely or inevitable.

A related belief is that Treasury bills in the US (and their equivalents in other nations) may be a surprisingly good investment for keeping up with inflation. The theory is that there is likely to be an initial loss when inflation first accelerates, but once short-term interest rates catch up with inflation, the investor is effectively protected.

As we will convincingly demonstrate herein, a government can use inflation to redistribute wealth from short term investors to the government - but it isn't actually the inflation that does it. The wealth redistribution is very real, but it comes from effectively taxing inflation, rather than from destroying the purchasing power of the investment principal directly. Ironically, most people are investing for the wrong risk, and are being distracted by what doesn't work for the government, while ignoring the little understood vehicle that governments around the world can use to avoid bankruptcy by appropriating the net worth of investors.

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