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Inflation: A Silver Lining by Sven R. Larson

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Inflation: A Silver Lining

A Peasant Paying his Bill (17th century), a 8.3 x 12.3 cm etching by Adriaen van Ostade (1610-1685) located in the Metropolitan Museum of Art.

Inflation is now at a point where it is having a seriously negative impact in both Europe and North America. Its repercussions are no longer limited to economic hardship from eroding paychecks. Changes in monetary policy, designed to restrain inflation and hopefully reverse its rise, are leading to rising interest rates and making life with debt increasingly costly. 

The rising cost of living is the price we are all paying for over-spending, both private and public. Its cause, while complex and worthy of an essay of its own, is inevitably tied to a decade’s worth of extravagant monetary policy. Thanks to exceptionally low interest rates and a virtual cornucopia of abundant credit, households, businesses, and governments across the Western world have mortgaged tomorrow for indulgence today. 

When the bill comes due, there is no other way to pay it than the hard way. Given the deteriorating debt situation in other parts of the world, primarily China, that bill can come due at any moment.

However, the cost of debt and inflation notwithstanding, there is actually a silver lining in the wake of rising inflation. It is hard to find, but it is there. While finding it will not help struggling families here and now, over time it could be the saving grace that inspires future generations to live a financially and fiscally more virtuous life than we have done. 

The key to finding that silver lining lies in the very changes to monetary policy that have taken place in recent days. Central banks have started tightening the supply of money, signaling that the days of easy credit are now coming to an end. That signal is directed at all debtors, both private and public, but most immediately the latter. 

For several years now, central banks have been buying government debt, also known in the U.S. as treasury securities, to help governments finance their budget deficits. Starting in the U.S., those days are rapidly coming to an end. The Federal Reserve, the U.S. central bank, is rapidly reducing its purchases of treasury securities, forcing the federal government to borrow money from the general public instead. 

The Federal Reserve is also signaling that there will be increases in interest rates, something that the Bank of England has already done. It just raised its key rate from 0.1% to 0.25%. Meanwhile, the European Central Bank is also starting to slowly reduce its treasury-security purchases and the National Bank of Hungary pushed its interest rates higher as recently as December 15.

All these changes in monetary policy are coming in response to inflation: the central banks recognize that their own sustained monetary expansion has now awoken the sleeping giant of inflation. The goal now is to avoid trapping us in the same protracted inflation period we experienced 40 years ago. 

We better hope they succeed. In the early 1980s, inflation rates in the double digits were part of life. Other countries have had more recent encounters with destructive levels of inflation. 

However, that does not mean the alternative is painless. On the contrary: as central banks tighten their money supply, interest rates will inevitably go up. The sharper the banks reverse course, the faster interest rates will rise. 

Families struggling to pay for their weekly grocery bags will be squeezed from the other end by the cost of their credit card debt. Anyone looking to take out a car loan will pay more, as will homeowners with flexible rates on their mortgages. Families looking to buy their first homes will have to re-calculate their budgets.

Rising interest rates are inevitable if we want to combat inflation. They are the result of tighter monetary supply and will serve an essential short-term purpose. At the same time, they are also the conduits for the silver lining that inflation can bring us. 

That silver lining, unlikely as it may seem, is stronger property rights. 

Though harsh in the short term, rising interest rates will motivate a long-term reduction in indebtedness across the economy. Less debt means property owners are on firmer financial ground. Families will find that their finances are more resilient, they have more control over their lives and can more easily make bigger choices like changing career, moving, or having more children. 

Where private property is not jeopardized by high debt, people foster a culture of self determination. High debt, on the other hand, can be morally and financially debilitating. While most people with debt dutifully make their regular payments, in practice the debt reduces the owner from proprietor to buyer of a service from the bank. When the mortgage on a house equals most of its value, and when the loan on a car exceeds what it is worth, loan payments effectively constitute a lease on the house or the vehicle. 

In fact, debt is such a problem today that many young people find it difficult to even imagine a life without it. What used to be a transitory period in a person’s life—mortgages and car payments—have become lifelong companions. Credit cards and student loans add to the burden and to the shackle around our ankle. The obligations to a creditor can restrict our choices of where to live, what career choices to make, and whether or not we can start a business. 

It is important to recognize, of course, that private debt is a voluntary transaction. No person is legally obligated to take on any debt of any kind. When we decide to take out a second mortgage or buy a car with payments that max out our monthly budgets, we do so at our own peril.

At the same time, it has become increasingly difficult—especially for younger families—to build a life without going heavily into debt. The reason is primarily found in the very relaxed monetary policy we have seen over the past decade, both in America and Europe, but debt has been on the rise for longer than that. According to statistics from Eurostat and the Organization for Economic Cooperation and Development (a Paris-based intergovernmental organization), over the past quarter century households in most European countries have gone deeper into debt. 

The so-called debt ratio, which measures household debt as share of disposable income, has increased steadily for the past quarter century. There are many reasons for this, among them stagnant household income, which has made it more difficult for people to save up for bigger expense items. A down payment on a house can be a daunting task for any young family; with middle-class earnings growing more slowly in the past 20 years than for most of the last century, heavy debt has become a necessity more than a choice.

Since 2012, interest rates have declined substantially, thanks to leading central banks engaging in heavy monetary expansion. This has slowed down the rise in problematic household debt: it has become easier for families to pay more on principals out of any given budget. However, most of the easing of the debt burden is due to property owners catching up on debt they could not pay for during the Great Recession a decade ago. 

Despite some respite in recent years, in many European countries household debt still exceeds 100% of disposable income. Lower interest rates have not solved the debt problem: all they have done is kicked the proverbial ball into the long grass. 

Rising interest rates will rewrite the role of debt in household finances. New families who are out to buy their first home will be forced to save up longer and buy smaller. Over time, this means that exposure to debt will be smaller. Unlike others who are more deeply in debt, this gives them a shot at making debt what it once was meant to be: a transitory period in their lives. 

To see what higher interest rates can do, let us compare Hungary and Denmark. These two EU member states, both with their own currencies and therefore their own monetary policy, are opposite poles when it comes to household debt. 

In 1995, the ratio of household debt to disposable income was 193% in Denmark and only 18% in Hungary. Ten years later, Danish household owed 282% of their income, compared to 49% in Hungary.

The debt ratio peaked at 340% in Denmark at the bottom of the Great Recession, more than four times higher than Hungary’s 82%. As of 2019, the two ratios were, respectively, 253% and 40%. 

As for interest rates, according to Statista, a leading private-sector producer of economic statistics, the two countries differ dramatically. At the end of 2019 the average interest rate on a mortgage loan in Denmark was a minuscule 0.56%; in Hungary, it was as high as 4.4%. 

The difference in interest rates does not explain all of the difference in debt ratios, but it is a key variable. Danish households de facto rent their lives from the bank, while their peers in Hungary have a good chance at building equity and perhaps even becoming debt free one day. 

As interest rates now start rising across Europe and North America, more families are likely to appreciate the Hungarian attitude toward debt and shy way from the Danish lifestyle.

As private citizens over time reduce their indebtedness in response to higher interest rates, they will also gradually restore the original meaning of the property right. They will no longer just be enjoying the services of a property—living in a house and driving a car—but gain the financial and moral independence that comes with ownership. 

There is just one dark cloud on the horizon, another debt cloud that casts an ominous shadow over the future of Europe’s taxpayers. That cloud is public debt. Overall, the member states of the Eurozone owe their creditors more than €11.1 trillion. This is equal to almost 84% of the total gross domestic product, GDP, of the currency union.

This means, plainly, that governments are almost as indebted as households. It also means that the rise in interest rates will increase the cost of government borrowing and spending. To be blunt: it will lead to higher taxes. If the interest on the total Eurozone government debt was to go up by two percentage points, households, and businesses in Eurozone countries would have to pony up a total of €222 billion more per year in taxes. The cost hike will of course be sharper in more indebted countries, but the macroeconomic repercussions would nevertheless be noticeable throughout the economy. 

This increase in taxes, which would materialize over time as government debt matures and is rolled over into new debt, would have to come out of the hard-earned paychecks of Europe’s workers. The tax hikes would also coincide with the rising cost of private debt. 

The problem with a simultaneous rise in debt costs in both the private sector and government is that the latter always has a legal right to claim our money first. If indebted governments want to, they can raise taxes without regard to the fact that taxpayers have to pay more for their own debt. 

Families working hard to reduce their debt burden find their efforts squandered by higher taxes.

If government does not allow private citizens to transition into a life with less debt, but instead socializes more of household income (raises taxes), the outcome will be weaker private finances, more deeply indebted households and, by consequence, a weakening of the property right as a social and economic institution.

It is essential that indebted governments ease their burden while prioritizing the path to less private debt for taxpaying families. This is essential if our economy is going to emerge stronger from the bad current situation. If government puts itself first, it will claim more of our time, our work, and our hard-earned paychecks. We have to work even more for government and even less to build wealth and prosperity for ourselves and our loved ones. 

To paraphrase philosopher G. Henry Moulds: if government prioritizes itself over private citizens, the outcome will be communized labor, not individualized equity.

Sven R. Larson is a political economist and author. He received a Ph.D. in Economics from Roskilde University, Denmark. Originally from Sweden, he lives in America where for the past 16 years he has worked in politics and public policy. He has written several books, including Democracy or Socialism: The Fateful Question for America in 2024.

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