How much a dollar really cost? The question is detrimental, paralyzin' my thoughts
I hope to answer that question for you, Kendrick, and to do so as intuitively as possible.
TL;DR - inflation is going to turn our dollar from the piece of paper which was able to buy a tank of gas and groceries in the 20th century to toilet paper by the end of the 21st century.
This is the first question we need to understand for some background. It is a fiat currency, meaning that it is not backed by any actual asset. Insofar as that’s the case, there are two reasons it has value:
People take it
Network effects are essential to money, and currently, all vendors in the United States (albeit, by the coercion of the state) and many across the world accept it for exchanging goods and services.
People trust it
This article might change your mind, but historically the US dollar has been one of the most stable global currencies. When I ask people why they trust it, however, the answers are not compelling. It’s usually something to the degree of, “I grew up with it” or “That’s the way it is.” Just because something is a certain way doesn’t mean it ought to be that way.
Inflation is an increase in the supply of money. The Federal Reserve aims to keep it at 2% per year, and historically they have done a good job.
An increase in the supply of money means everyone’s money is diluted, which is known as decreased purchasing power; put simply, you can buy less stuff with your money. On average, $1 would become worth $0.98 the following year. This is because prices increase to offset inflation: a $1 chicken tender will become $1.02, for example. Effectively, the economy recalibrates based on when more money is introduced into it.
Like anything in moderation, many economists believe a little bit of inflation is a good thing. This is because it incentivizes people to spend money. A rational person would want to buy something before it gets more expensive, and he/she would want to save less because doing so would make their money become less valuable.
Unfortunately, inflation hasn’t occurred in moderation as of recently. We had 6.2% inflation this past year.
This means $1 last year is worth around $0.94 now, and a $1 chicken tender now costs $1.06 (and more if we throw in supply chain issues too).
Why is this?
Debt is borrowing money from others. We do it all the time with mortgages for homes, student loans, credit cards, etc.
Why would people or institutions lend out money?
Well, to make more money! That is achieved via interest, which is the “cost of borrowing”. If I asked you for $10, and we’re not close friends, you would want me to pay you back more than $10 -- let’s say $11. That extra $1 is interest (10% rate), and you would want it because if you didn’t lend me the money you could have earned more investing the $10 elsewhere (on some jpegs maybe?).
To recap, interest is the “fee” for borrowing, and the principal is the amount you borrowed.
There’s a lot of creative ways to structure debt. Mortgages have homeowners paying a mix of the principal and interest each month. Credit cards require a minimum payment (of the principal) and potentially a lot in interest each month.
Bonds are a way to make debt investable at scale.
Effectively, bondholders are buying an IOU that pays them in periodic interest payments (also known as coupon payments). Those interest payments are typically every six months and the same amount each time, which is why they are known as “fixed-income”.
This is how companies and governments borrow money, as there’s not a bank that has enough money to lend them all the money they’re looking to borrow. Even if a bank has enough money to do so, they want to diversify and lend to a lot of different people instead of one entity.
How bonds typically work is that the principal is not paid back until the end of the bond’s lifetime.
Before we can fully understand the problem around this high inflation, there’s one more piece of the puzzle you need to understand…
We spend a lot. In 2021, we spent $6.8 trillion despite having just over $4 trillion in revenue (taxes), a $2.8 trillion deficit.
How does deficit spending work: what happens when we spend more than our taxable revenue? The government needs to borrow money, and it does so by selling bonds (also known as Treasuries).
This past year, $413 billion (over 10% of revenue) was spent on the interest on our debt. This is just the cost of borrowing without paying any of the principal down.
That’s a lot of interest, but when you look at the principal amount owed, it’s a pretty good deal. We owe $28.4 trillion in debt, giving us an effective interest rate of 1.4% (dividing the interest by the principal).
We’re currently in the best-case scenario. Super low rates mean makes it cheap to borrow. This is why so many homes are being bought: low rates make mortgages more affordable.
I wish I had a 1.4% interest rate! My credit utilization is a lot less than Uncle Sam’s.
Unfortunately, nothing good lasts forever. Interest rates tend to increase when inflation occurs. This means borrowing becomes more expensive.
Why do rates increase? Lenders want to make money, and inflation makes that tough. If I bought a $100 bond that pays me 2% per year, and inflation is at a rate of 2%, then they cancel each other out in a way. So maybe I won’t buy the bond unless it pays me 3% per year.
President Biden’s 10-year plan projects that in 2031 we’ll be paying $914 billion in interest on the national debt. This is already egregiously high, but there are more problems.
First, this assumes interest rates will remain low -- 2.8% to be precise. However, they have been as high as 15.8% in times of economic despair.
Second, the velocity of spending remains high. The projection is that the debt will be $39 trillion by 2031.
A realistic scenario is that rates hike up to 7%, as was the case during inflation in the 1970s. The result is over $2.7 trillion in interest! That’s a majority of the taxable revenue base and a large percentage of the budget, even if you assume moderate tax hikes.
In short, the government is borrowing money to pay for the cost of borrowing money it already borrowed and spent. They’re digging themselves into a hole, and the American people are eating the dirt sadly.
Just like we have a credit score, the US government has a credit rating. Because the US is deemed to be good at repaying its debt (we have not defaulted… yet), investors view bonds as a safe asset.
However, if the US continues to overleverage itself, investors will begin to question whether the US can pay bondholders reliably. This is especially relevant if interest payments continue to become a larger part of the budget.
As a result, investors will want more yield -- i.e., a higher interest rate. Keep in mind this is in addition to the already increasing interest rate due to inflation. And, a higher interest rate means that interest payments will only increase further, making this all even more cyclical.
There could be a point where the lenders do not want to be paid in USD but some other currency.
For context, we should first understand, who is lending the US all this money?
Americans - both directly by purchasing bonds or indirectly through retirement accounts, pension funds, etc.
Other countries
If lenders want other forms of payment, the US will need to exchange dollars for them.
Specifically, let’s say the US has to start paying part of its interest in Euros. Right now, a Euro costs around $1.12.
If the dollar is so inflationary, why would someone holding Euros want to trade it for dollars? They will if the price is right. Maybe they’ll give up their Euros but at $2.00 per Euro. This means the dollar is weakened substantially in relation to the Euro.
If we scale down the government’s spending to that of an individual, who we’ll call Uncle Scam, here’s how it breaks down:
Uncle Scam makes $21,700 a year
Uncle Scam spends $38,200 a year
This means Uncle Scam has $16,500 in additional credit card debt
Uncle Scam has a $142,710 balance on their credit card
This means Uncle Scam spends ~$2,000 a year in interest (1.4% rate)
For the average person or company, there’s a point where one becomes so indebted that others will not want to lend unless the interest rate is one’s kneecaps. However, the US government has had the privilege to avoid this problem by having a stable currency and paying its debt with this currency that it can create more of. Unfortunately, it has not been stable recently, and our increased spending will only further its instability.
I do not have a good answer here myself, but I want to raise the questions to get some better answers.
What can the US government do to dig itself out of this hole?
What can we as Americans do to hedge against this inflation?
In this world, nothing can be said to be certain, except death, taxes, and taking a shit. It’s for the latter that I’m confident the USD will be excellent toilet paper.
To hear more from me on money, toilet paper, and much more, follow me on Twitter at @thedanhepworth
Ilustration creds: Fran Manzi