Inflation, Debt, Return on Capital, and Inequality

One of the most striking conclusions to be drawn from Thomas Piketty’s masterful work Capital in the Twenty-First Century is that the postwar era, from 1945 to the present, was an anomalous period economically, unlike any other period in history.  Prior to 1910, the developed world experienced centuries of very slow per capita growth.  That era came to an end with World War I, which was soon followed by the Great Depression and World War II.  This catastrophic period destroyed much physical capital.  It was necessarily followed by a period of great economic and social activity as the developed world strived to rebuild and reconstitute itself.  Business was good and economic growth was high.  Incomes grew quickly and a middle class emerged as a significant social and economic construct.  However, since about 1970-1980 growth has been slowing down and appears to be returning to its low historical norm.

It is interesting to ponder what such a return to the norm might mean for the future.  After all, most of us born prior to about 1980 grew up and formed our opinions and expectations during this unusual and abnormal era.  More ominously, perhaps, economists formed their theories of how the world works during this period as well.  We could be in for a nasty surprise.

Piketty points out that not only was high growth unique to this postwar period, but high inflation as well.  He provides this plot of the rate of inflation since 1700 for four developed countries including the US.

The rate of inflation hovered around zero up to the time of the first world war, grew by various amounts during the war and postwar years, began to fall but experienced a significant blip around 1980, and then resumed its fall in all countries.  One could examine this chart and conclude that we appear to be returning to the historical norm of very low inflation.  An indefinite period of near zero inflation is not something we have experienced in our lifetimes.  If we are entering such a period, it would be a good idea to ask what this might mean for our economies and for our societies.

Piketty provides some insight into the role inflation has played in the past and what role it might play in the future.  In the following chart he discusses the history of British national debt and the role of inflation and government decisions.

Britain accumulated an enormous public debt in fighting the Napoleonic Wars, reaching almost 200% of GDP (national income is closely equivalent to GDP).  The British government needed money to conduct these conflicts and chose to borrow it from its wealthy citizens, who could afford to lend it, rather than tax them to obtain it.  The earnings on this national debt became the basis for a long and steady period of growth in wealth for the already wealthy.

Piketty defines two forms of capital (wealth), that with nominal value and that with real value.  A government bond has nominal value and if the value of currency appreciates or depreciates this value remains constant.  Real capital, such as real estate holdings or stocks in a company, will tend to follow the inflation rate.  The British government debt was held as bonds with nominal value.  Since inflation was around zero for the next hundred years this form of wealth retained its value and provided a steady income. 

The British could have reduced their national debt by taxing the earnings from this debt.  Instead it chose to shelter its wealthy from such an inconvenience, and practiced a century of austerity instead.  Austerity generally means that the poorer you are the more you suffer from a decrease in government services.

“The most interesting historical example of a prolonged austerity cure can be found in nineteenth-century Britain….it would have taken a century of primary surpluses (of 2-3 points of GDP from 1815 to 1914 to rid the country of the enormous public debt….Over the course of this period, British taxpayers spent more on interest on the debt than on education.  The choice to do so was no doubt in the interest of government bond holders but unlikely to have been in the general interest of the British people.  It may be that the setback to British education was responsible for the country’s decline in the decades that followed.”

The British acquired an even greater public debt by the end of World War II.  This time, however, inflation was running at around 4%, relatively modest for that period, and the national debt quickly disappeared.  Nominal assets such as government bonds get clobbered by inflation and debts are quickly paid off with depreciated currency.  The four countries in the first chart all benefited from historically high inflation in disposing of the wartime debts that had accumulated.

“Historically, this is how most large public debts were reduced, particularly in Europe in the twentieth century.  For example, inflation in France and Germany averaged 13 and 17 percent a year, respectively, from 1913 to 1950.  It was inflation that allowed both countries to embark on reconstruction efforts in the 1950s with a very small burden of public debt.  Germany, in particular, is by far the country that has used inflation most freely (along with outright debt repudiation) to eliminate public debt throughout its history.”

The fact that inflation has decreased considerably in recent years means that a significant fraction of the debt accumulated in countering the Great Recession will likely have to be repaid in the more traditional way: taxes and/or austerity.  With European countries—and the US—possessing debts hovering around 100% of GDP:

“There is hope that European austerity might last only ten or twenty years (at a minimum) rather than a century.  Still, that would be quite a long time.  It is reasonable to think that Europe might find better ways to prepare for the economic challenges of the twenty-first century than to spend several points of GDP a year servicing its debt, at a time when most European countries spend less than one point a year on their universities.”

The ease with which inflation allowed governments to finance large expenditures without acquiring burdensome debt left the impression that inflation was a social good that would allow an expansion of government services at little cost.

“In the twentieth century, a totally different view of public debt emerged, based on the conviction that debt could serve as an instrument of policy aimed at raising public spending and redistributing wealth for the benefit of the least well-off members of society….in the nineteenth century, lenders were handsomely reimbursed, thereby increasing private wealth; in the twentieth century, debt was drowned by inflation and repaid with money of decreasing value.  In practice, this allowed deficits to be financed by those who had lent money to the state, and taxes did not have to be raised by an equivalent amount.  This “progressive” view of public debt retains its hold on many minds today, even though inflation has long since declined to a rate not much above the nineteenth century’s, and the distributional effects are relatively obscure.”

Piketty regards the redistribution that occurred in the twentieth century due to inflation as a powerful mechanism for social change, but he warns that inflation is devastating only to certain types of wealth.  Nominally-valued bonds held by the wealthy are affected of course, but so are the savings of the non-wealthy affected as well.  Inflation only works when lenders have not prepared for it.  Anticipation of inflation will now quickly drive up the interest lenders will demand for the purchase of government debt and any spending benefit from depreciating currency disappears.

It is possible that inflation might also have a redistributive effect in transferring wealth from those whose earnings come from investments to those whose earnings come mainly from wages.  As it happens, wages and average return on capital tend to follow the increase in consumer prices.  Modern wealthy investors now anticipate the effects of inflation and move their assets around to compensate.  Assets that perform well in periods of low inflation can be converted to assets that perform well when inflation is high

“Some people think, wrongly, that inflation reduces the average return on capital.  This is false, because the average asset price (that is, the average price of real estate and financial securities) tends to rise at the same pace as consumer prices….it is likely that inflation changes the distribution of this average return among individual citizens.  The problem is that in practice the redistributions induced by inflation are always complex, multidimensional, and largely unpredictable and uncontrollable.”

Piketty even surmises that inflation could act to benefit the wealthy because they are in a better position to gain access to the opportunities and expertise required to obtain higher than average rates of return on their capital.  It takes wealth to accumulate wealth.

A future of low growth rates and low inflation would seem to involve stagnating wages and a healthy return on capital.  That is what the past tells us.  The past also tells us that if we wish to both retire national debt and redistribute wealth, the most efficient and fair way is to impose a small but progressive tax on wealth.  That is the message Piketty has bequeathed to us.