Inquiring minds are reading The "Miracle" of Compound Inflation by John Mauldin. Here are a few paragraphs worthy of a closer look.

Albert Einstein is famously quoted as saying, "Compound interest is the eighth wonder of the world." And compounding is indeed the topic of this week's shorter than usual letter, but compounding not of interest but of inflation.

First, let's look at nominal GDP over the last 11 years, from the beginning of 2000. The data only goes through the third quarter of last year, so sometime this year it is quite likely that GDP will top $15 trillion.

Now, to see this in an interesting graph, the Fed has real GDP based on 2005 dollars. You can see that we are about back to where we were in 2008, prior to the crisis, and growing well below trend. But if we adjust for inflation, growth has not been close to what it was in nominal terms.

Now let's run through a few "what-if" scenarios.

What if the next 11 years look more or less like the last, with 4% nominal GDP growth? That would mean that in 2022 nominal GDP would be 50% larger than now, right at $22.5 trillion. But that is with only 2% inflation.

What if inflation were 4%, with the same growth? Then nominal GDP would be $30 trillion! What a roaring economy, except that gas would $8 a gallon (assuming current levels of supply and demand). In essence, you would need $2 to buy what $1 buys today. Don't even ask about health-care costs. If your pay/income did not double, you would be in much worse shape in terms of lifestyle. That is the insidious nature of inflation.

But let's think about that from a federal budget perspective. Let's assume we get 20% of GDP in federal tax revenues, which is roughly a little higher than the historical average. That means total tax revenues would be in the range of $6 trillion. With 2% inflation, revenues would be just $4.5 trillion. If the federal government froze its spending at current levels for 12 years (no inflation adjustment), we would be running large surpluses under either scenario.

Higher inflation means US debt is easier to pay back, as nominal GDP is what we pay taxes on, not inflation-adjusted. Inflation is a tried and true method of dealing with too much debt. Inflation is also just another word for default, but it sounds so much better to the ear.

Whoa!

• What about interest on the national debt?
• What if we have inflation without the growth?
• What about wage growth and revenue assumptions?
• What about health-care costs and other government expenditures?

Mauldin is correct about the "insidious nature of inflation" yet provides an example that suggests inflation is the government's best friend. Let's quickly dispel such thinking starting with a look at interest on the national debt and health-care costs.

Health-Care Costs

Mauldin said "Don't even ask about health-care costs." Well we have to ask about them. If health-care costs rise sharply, so will Medicare and Medicaid expenses unless they are capped.

Mauldin proposed such a cap to make his "what-if" model work.

Unfortunately, it is not rational to assume such a cap, nor is it rational to think other government expenses such as road-work, food stamps, education spending would be capped either.

Interest on the National Debt

Speaking of caps, there is no way to cap interest on the national debt except by eliminating the debt entirely.

I discussed interest on the national debt in Interactive Map: Paul Ryan vs. Obama Budget Details; Path of Destruction

Here are the pertinent charts but please take a look at the entire post if you have not seen it.

Deficit: Obama vs. Paul Ryan

Paul Ryan made good headway for three years, then fell flat for another 7. This is no way to shrink the national debt or reduce interest on the national debt as we shall see in a moment.

Obama's proposal is abysmal. He made some progress for a few years, then went into reverse.

Interest on the National Debt: Obama vs. Paul Ryan

The above chart shows the effect of cumulative failures to shrink the deficit.

Note that in 2021 president Obama proposes to spend over $900 billion a year on interest on the national debt. This is sickening, not amusing.

Paul Ryan would have us spending $687 billion on interest in 2021. His deficit proposal for 2021 is $731 billion.

CBO Analysis

Mauldin continues, and gets back on much firmer ground with a critique of CBO analysis.

What the CBO Assumes

The Congressional Budget Office makes projections, based on various Congressional tax bills, as to what future income and expenses might be. But to do that they have to make assumptions about the growth of the economy and inflation.

You can go to their website and see their economic forecasting. The data I will be discussing is on page 7, in http://www.cbo.gov/ftpdocs/120xx/doc12039/EconomicTables%5B1%5D.pdf.

Let's look at one of the tables. Note that they have nominal GDP at $24 trillion in ten years (not far from my 2% inflation scenario above), but they assume rather robust economic growth for the next five years (beginning with 2012) of well over 3% and inflation down around 1.5%. Not a bad world if we could get it.

 

Let's look at one of the tables. Note that they have nominal GDP at $24 trillion in ten years (not far from my 2% inflation scenario above), but they assume rather robust economic growth for the next five years (beginning with 2012) of well over 3% and inflation down around 1.5%. Not a bad world if we could get it.

What Happens at "Modest" 4% Inflation?

Now that we have interest rate and inflation assumptions from the CBO, let's take another look at what might happen with 4% inflation.

The CBO projects the CPI will peak at 2.3% except for 2017 at 2.4% (quite an assumption). The CBO also projects short-term interest rates to be about 2 points higher than CPI, and 10-year rates at 3 points higher than the CPI.

Using those guidelines, at 4% inflation, short-term interest rates would be 6%, and 10-year rates would be 7%.

National debt will rise to $23-26$ trillion in the Obama -Ryan scenarios shown above. At 4% inflation (and 6% interest rates) what would interest on the national debt be?

At 6% interest, interest on $26 trillion would be $1.56 Trillion a year. However, that statement assumes we got to 2021 and then interest suddenly spiked to 6% and all the revenue assumptions held up. It would not work that way in practice.

Remember that we are running budget deficits and adding to the national debt under every scenario proposed so far. If we had 4% inflation along the way, interest on the national debt would rise sharply every year and that amount would add to the cumulative debt, as would any revenue misses.

If we had 4% inflation, would we have the revenue growth as presumed in Mauldin's "what-if" example? I highly doubt it. However, we can be sure that government expenditures would rise.

Also note that even IF revenues rose with inflation, so would government expenditures on health-care, road work, education, food stamps, etc unless one makes irrational assumptions.

Thus any scenario that suggests a budget surplus is possible with 4% inflation is preposterous.

What About Another Recession?

Finally, and as Mauldin correctly pointed out, the chance of a recession in the next 10 years is quite high.

Indeed, I think it is likely there are two or more recessions in the next decade. Thus, the CBO estimate, Ryan's estimate, and president Obama's estimate are all unrealistically optimistic.

Locking in Long-Term Rates

Ironically, the Fed could take advantage of low interest rates now by locking in favorable long-term rates now just as corporations have done.

Instead of buying treasuries and bloating its balance sheet, in theory, the Fed could have been selling treasuries, locking in debt at exceptional prices under 4.5% for 30 years, or 10-year debt at 3.4% (and could have done much better some time ago).

I said, "in theory" because that action would have reduced money supply, and Bernanke believes tightening money supply in the Great Depression made matters worse.

Exit Strategy Will Put Upward Pressure On Yields

Today the Fed has a different problem of its own making.

The Fed's balance sheet is stuffed with treasuries. Attempts to unload them would put upward pressure on yields regardless of what Bernanke says about his exit strategy (or lack thereof).

Impossible to Inflate Out of This Mess

People suggest all the time, that the government or the Fed can inflate its way out of this mess.

However, careful analysis including a look at interest on the national debt and other government expenditures shows there are no "miracle" cures from inflation.

Indeed, inflation is never a cure, it is the disease. Deflation is the cure, but it sure will not be painless. In the meantime, the Monetarist clowns at the Fed and the Keynesian clowns in government are simply digging a bigger hole.