The upside of inflation

Just another day in paradise here in the North American economy. The inflation rate in July rose to 3.2% in both the U.S. and Canada. It’s not bad, though—a 0.2% monthly increase in the U.S. and 0.5% in Canada.

July jobs reports were also positive. Canada lost 6,400 jobs last month, but is still up 283,700 jobs since January. The U.S. added 187,000 jobs, the second-lowest monthly gain of the year but still respectable. The U.S. unemployment rate fell from 3.6% to 3.5%; Canadian unemployment rose from 5.4% to 5.5% (equal to 4.8% in the U.S.).

Generally speaking, the economic news is more positive than negative. But this is America and there’s no law saying everyone has to interpret it that way.

Dow Jones’s Jeffry Bartash is a fanboy. “The U.S. was supposed to be in or near recession by now,” he noted the other day at Morningstar. “Instead, a resilient economy is seeking to pull off a treble—that is, 2.0% growth for a third consecutive quarter.” U.S. GDP grew 2.0% (annualized) in Q1 2023, 2.4% in Q2, and we’re “on track to show U.S. economic expansion at an annual 2.4% to 4.1% pace” in Q3.

At Bloomberg, Niall Ferguson prefers his glass half empty. “I am pretty darned skeptical about Jay Powell’s ‘soft landing,’” he says. “If the world’s pilots had the same success rate touching down as the world’s central bankers at achieving price stability, most of us would opt to drive.”

Not Bloomberg’s Tyler Cohen, though. Last week in the Washington Post, he had his boarding pass in hand: “The U.S. economy is great. Stop worrying about it.”

Okay. But if we stop worrying about the next recession, we need to find something else to worry about. Fortunately, there is always the national debt. It’s big, scary, and requires a little bit of context.

In 1915, the ratio of federal debt to GDP was almost nothing. World War I pushed the ratio from single digits to over 25%. The economic boom of the 1920s pushed it back down, then it jumped back up when the Great Depression hit. Then the cost of World War II drove the ratio to a then-all-time high of 106.3% in 1946.

Postwar prosperity drove the debt-to-GDP ratio down for 35 years. It rose during the 1980s because the government ran big budget deficits to win the Cold War, fell briefly in the 90s during the first internet boom, then rose in the 2000s due to the wars in Iraq and Afghanistan.

Since then, two catastrophic events have nearly doubled the ratio: first the Great Recession of 2008-10, then the COVID pandemic. In 2020 the U.S. debt-to-GDP ratio stood at a record-high 133.5% according to the World Bank’s calculations.

Americans aren’t the only ones in the boat, though. The largest economies in the world all saw their debt-to-GDP ratio rise dramatically in the pandemic meltdown. The average 2019-20 increase was 19.3%.

Since then, the ratio has fallen just as dramatically in 25 major economies. The U.S. ratio has fallen 14 percentage points to 121.7%. Canada fell from 118.9% in 2020 to 106.6% in 2022.

Why? Strong growth after the pandemic was part of it, but the bigger factor was inflation, says the Brookings Institution. “From 2020 to 2022, inflation reduced the debt-to-GDP ratio for advanced economies by almost six percentage points of GDP. Economic growth had about half the impact.”

Some people think we’re screwed because we aren’t willing to cut any of the three government programs big enough to put a significant dent in our deficits (defense, Social Security, and Medicare). Others think we’re screwed because we won’t raise taxes on the rich. The two camps don’t play well together so we can’t do some of both, either.

So it probably should be no surprise that three weeks ago, Fitch downgraded the U.S. long-term credit rating from AAA (its top rating) to AA+. Treasury Secretary Janet Yellen called the downgrade “entirely unwarranted” and “puzzling in light of the economic strength we see in the United States.”

The Heritage Foundation’s E. J. Antoni calls it “a default by another name,” and and a clear indication that “investors have become increasingly skeptical” about our ability “to pay back the nation’s debt in a timely manner.”

Fitch tells a different story. It doesn’t doubt that the U.S. is capable of dealing with its debt. The agency’s primary concern is “a steady deterioration in standards of governance over the last 20 years. Repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.”

In other words, Fitch is saying that our famous polarization between right and left has paralyzed us. Score one for Russian and Chinese troll factories. That’s exactly what they hoped to accomplish.

The post-pandemic bounce won’t last forever, but we’ve still got some breathing room to get our act together. Axios’s Felix Salmon points out that “this time last year, Treasury could borrow one-year money at 0% interest.” When you adjust for inflation, “that corresponded to a very attractive real rate of about -4%.”

Right now the government pays interest of “about 1.75% at the same maturity, but the real rate—after accounting for inflation—is an even more attractive -7%. In fact, if you take the one-year Treasury yield and subtract the rate of inflation, the result has never been this low.”

That’s good news, but it won’t be if we can’t get our dysfunctional government working again. Will Rogers said it best: “Even if you’re on the right track, you’ll still get run over if you just sit there.”

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