The Economist on the Inflation Tax

Greg Mankiw has a problem with one aspect of something in this discussion:

Investors who bought Treasury bonds in 1946, when yields were around current levels, did not suffer a formal default. But over the following 35 years they lost money in real terms at a rate of 2% a year. The cumulative real loss was 91%. By that standard, Greek creditors, who recently suffered a 50% loss via default, were lucky.

Greg’s comment is simply this:

Answer: The second number is inconsistent with the first. Note that .98^35=.49, so we get only a 51 percent cumulative loss. In fact, the price level from 1946 to 1981 rose by a factor of about 5, so holding currency with a zero nominal return led to a real loss of only about 80 percent.

Interest rates on Treasury bonds reflect the expected inflation rate at the time a person purchases the bond plus the real interest rate at the time. Treasury bonds in 1946 were generally around 2.5% so if actual inflation over the period that the person held the bond exceeded expected inflation, then ex post real rates would be lower that the real rate expected when the person purchased the bond. But eventually the bond matures and the person is free to renegotiate based on market conditions and the expected inflation rate when purchases new bonds. So was The Economist referring to 10-year Treasuries or 30-year Treasuries? Simply put – it is not inflation but unexpected inflation that leads to the type of losses described in this discussion. To fair, the discussion later admits:

The answer to that conundrum may be that default happens suddenly, whereas inflation and depreciation are slower, giving investors more time to adjust by demanding higher interest rates to compensate for their losses. This is particularly true in the case of short-term debt, such as Treasury bills; inflation is unlikely to do serious damage to a portfolio in the course of a few months.

Alas, the discussion goes off track in my view with:

But by buying bonds in the name of “quantitative easing”, central banks are influencing interest rates of all maturities these days. By holding down bond yields, the authorities are employing a policy some have dubbed “financial repression”, in which real returns on government debt are reduced. The idea is to make investors buy riskier assets, such as equities and corporate bonds. In effect, the bond vigilantes have been neutered.

Doesn’t financial repression suggest that interest rates are low because the Federal Reserve has suppressed market forces creating a difference between the market demand for government debt and its supply? One would think the real story is the incredibly weak state of the overall economy has been the driving factor in keeping real interest rates so low.