Inflation is an enemy of the people, but it’s a friend of government recklessness.
By Wolf Richter for WOLF STREET.
We have a situation here. Folks are out there promoting the idea that the Fed cannot keep interest rates at 4.5% for long, and that it certainly cannot hike interest rates to 5.0% or 5.5%, because the amount that the federal government pays in interest expense is spiking and the government cannot afford to pay the spiking interest expense, and the Fed will have to pivot any moment now and cut interest rates because otherwise the government would go bankrupt or whatever.
This stuff is now everywhere, propagated by all kinds of newsletters, and by bond fund managers and hedge fund managers that are losing their shirts with these higher interest rates, and the pivot mongers have grabbed a hold of it, and they’re on TV with this stuff, pushing the idea that the Fed must cut interest rates or else the government will go broke or whatever.
What these pivot mongers are willfully omitting is that tax receipts – which pay for the interest expense – have spiked by a huge amount, and that interest expense as a percent of tax receipts had hit a historic low in Q1 2022, and has ticked up from that historic low but remains near historic lows. Interest expense as a percent of tax receipts is the primary measure of whether or not the government can afford the interest expense: It was around 50% in the 1980s; in Q3 2022, it was 22.9%:
The thing is, inflation has been huge. Inflation means that government tax receipts are spiking, thereby lowering the burden of paying for the existing debt, thereby allowing the government to borrow more because the burden of the old debt gets extinguished by surging tax receipts due to inflation, which is why governments love inflation.
But inflation is an enemy of the people. And when inflation rises beyond certain low-ish levels – the Fed thinks that’s about 2% per its core PCE measure – it will ultimately tangle up the economy, leading to all kinds of long-lasting damage. And that puts the brakes on the government’s wishes to inflate away the results of deficit spending, namely ballooning debts and interest expenses.
What happened is this: The government’s debt spiked by 34%, or by $8 trillion, in three years, from $23.2 trillion Q1 2020 to $31.4 trillion today. In 2020 alone, $4.5 trillion were added to this debt. In 2021 and 2022, a combined $3.5 trillion were added (a rate of about $1.75 trillion per year). And it continues. This spike in the debt was caused by ridiculous amounts of stimulus spending, handed to businesses, state and local governments, and consumers.
This additional $8 trillion in debt, that 34% spike in total debt, quickly added a lot of interest expense for the government.
In addition, and gradually, old Treasury securities mature and are replaced by new Treasury securities with higher interest rates, and the higher interest costs of those new securities are filtering into the interest expense.
Fueled by the 34% in additional debt, and now gradually further fueled by the higher interest rates spreading into the overall debt, total interest expense in Q3 spiked by 24% from a year ago and by 43% from two years ago.
And this is the kind of scary chart the pivot mongers are circulating while omitting the huge spike in tax receipts and the historically low burden of this interest expense as a percent of tax receipts that we saw in the chart above:
Don’t get me wrong: This amount of deficit spending is nuts, it’s very inflationary and contributed to the spike in inflation we have now. It’s a terrible policy that Congress pursued. And there are a lot of issues with that. But the burden of this interest expense is not one of them – thanks in part to surging inflation.
Tax receipts spiked by 21.5% year-over-year and by 52% from two years ago. This is what pays for the interest expense:
Government interest payments as percent of nominal GDP, a classic measure of the burden of government interest expenses on the overall economy, plunged to historic lows during the era of Easy Money after the Financial Crisis, and it’s still in that low range, but has risen to the upper end of that low range:
Inflation will further eat into the burden of this monstrous debt. A big bout of inflation is the best thing that happens to the burden of government debt. That’s why governments love inflation.
This government love of inflation and deficit spending is precisely why modern central banks are supposed to be “independent” from the government so that they can tamp down on inflation, and let the government struggle with their deficits and debts.
And all this ongoing deficit spending, and the money from the prior stimulus spending that is still sloshing around at state and local governments, at businesses, and at consumers, will provide further fuel for spending, taxes, GDP, and inflation.
The path that government spending has been on for the past three years is clearly wrong-headed. And maybe someday, when interest expense eats up 50% of tax receipts as it did in the 1980s – and not 22.9% as it does today – then just maybe we might see some real discussion and action in Congress about curtailing these ridiculous deficits. But we’re a million miles away from that. And the Fed is doing exactly what it needs to do — hiking interest rates — to curtail inflation and to gently begin nudging Congress to take the deficits a little more seriously.
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