The policies of deficit
spending by governments to prop up economies through the pandemics have created
imbalances that will, it is assumed, at some indeterminate time in the future,
create a situation in which the only two options are hyperinflation or default.
Inflation vs default.
The “New Normal” is evolving, and we do not
yet know what it will look like, or fully how the transition will happen. We do
know that governments are printing massive amounts of debt to attempt to save
what they can of their economies, with the hope that post-pandemic growth can
accelerate and recover economies to pre-pandemic ‘health’. But that growing
debt is a burden on countries and will stay as a burden for some time to come.
I keep reading that there are two
options to deal with debt growth; inflation or default. I’m not sure that
either is the actual ‘end game’. Certainly, a huge amount of money is being
conjured out of the air and being pumped into economies. In the US Congress has
just approved a $1.9 Trillion spending package, on top of a $2 trillion
spending package last year, all on top of existing government expenditure. The
UK government has been paying salaries at 80% since last April or so, and will
continue to do so until September or later this year. That is effectively
paying 80% of a huge number of Britons' salaries for over a year.
Not surprisingly, but seemingly strangely also
we see personal savings rates increase, at the same time that unemployment is at record levels (I do not believe the US unemployment numbers of
6.5% or whatever they are saying it is, those numbers are fantasy).
But there is another option, and I expect this is what we will see - a "Super-Twist" of extreme long-dated government debt, bought by governments from themselves (and paying themselves interest at very low rates).
Inflation
Inflation has been the tool for managing down
large debt for centuries, and there is an expectation that this is what will
happen now. I’m not sure. Inflation requires there to be more "money" than "goods", with the oversupply of money chasing fewer goods. This certainly
is true at the higher end, with inflation in luxury goods, art and property
(higher end). But that means that the excess money is in relatively fewer
hands. “The rich get richer” argument. Well, if the rich are getting richer,
than the products and assets that the wealthy are purchasing must either expand
in quantity, or those products and assets will increase in price. Classic
supply and demand pricing.
But if the income levels at the ‘not rich’ end
of the economy are not increasing, and the quantity of products, services, and
assets are remaining constant, then there should be little inflation at that
level. In fact, prices in many cases are increasing while incomes remain
stagnant or increase at a pace slower than the cost of those goods and
services. But there has been creeping inflation underway for
decades in the developed world, with wages effectively stagnant and production capacity exported to lower-wage economies.
There are numerous examples of the management
of inflation figures in developed countries, driven by the use of ‘hedonics.’
for the calculation of inflation. If you get greater functionality from a
smart-TV and pay more for that TV, there has been no inflation because
you are getting more for your money. Therefore, the increased ‘hedonistic’ value
of the greater functionality offsets any increase in the price paid. The fact
that all TVs now have greater functionality and a similar cost to previous models does not equate to inflation, even though without the additional functionality, the unit's cost would, or should, reduce. When it comes to consumer
electronics, this generally is true. But when it comes to higher education, it
is impossible to apply hedonics to a 500% increase in the cost of a four-year
university education in the US.
The average cost of attending a four-year
college or university in the United States rose by 497% between the 1985-86 and
2017-18 academic years, more than twice the rate of inflation. (Forbes, 31August 2020)
That is
twice the rate of the underlying inflation figure. Yet, the underlying inflation
figures have been manipulated to ensure an overall lower figure. Why? There are
several reasons, but a primary reason is the pegging of some national
benefits (such as Social Security, the US national superannuation scheme) to
the “Consumer Price Index” (CPI) measure of inflation.
In the UK, the introduction of a £9,000 per
year tuition fee for almost all universities has certainly ‘inflated’ the cost of
higher education to little or no additional benefit for students.
So there has already been ongoing inflation.
The assumption has been that the fiscal stimulus will automatically result in inflation across all goods and services as the mechanism for the paying down or managing the debt.
For inflation to be the tool of choice to
reduce the debt it will require policies that alter the distribution of
income or constrain the quantity of goods and services available. The
classic way to accomplish this is through changes in the taxation system,
shifting the tax burden toward higher incomes while reducing the tax burden on
lower incomes, and/or through employment policies that encourage unions and
mandate higher wages. Tariffs act as a stealth means of inducing inflation through the imposition of an additional cost on products, effectively inducing inflation through artificial scarcity.
Increasing wages without increasing the stock
of goods and services will drive up prices, based purely on the increase in
money chasing the finite goods and services. Classic supply and demand at the
middle and lower income levels. There will be inflation in areas such as
housing (in the suburbs and ‘country towns’ and zero, limited or even negative
inflation in cities) because the population continues to rise at a rate faster
than additional housing stock is being built. That is classic supply and demand
inflation, and until the housing stock (in the US and in the UK, for example)
has grown – in the places people want to live – the unit price of housing will
increase to meet what the market will accept.
But general hyperinflation needed to
devalue the debt sufficient to ‘pay down the debt’ will not be happening anytime
soon. The (policy) conditions to allow this are not in place yet and will be avoided
until there is no other option.
In the US (and in some other
“capitalist” countries) the policy changes required to allow (or not avoid) hyperinflation will be opposed as much as possible by business interests and
shareholders; the managerial and rentier class that are the beneficiaries of
lower wages. These people (as a group and as individuals) control government
policy through the economics of the American electoral system, and policies
that will boost individual incomes at the expense of the wealthy will not be
acceptable (even under a Democratic administration).
Default
The alternative being discussed (in
speculative writing) is a default in portions of the debt. Of course, this has
never happened, except in country after country. It has not happened in the US and the UK, Japan, and other major developed economies. Default is the
last refuge of countries that cannot continue to access international
financial markets and therefore no longer able to finance their debt. But there
are countries for whom international markets for their bonds are an “also” and
not an “only” option.
For countries such as Argentina, default has
been a strategic tool used once access to international markets becomes
impossible based on existing government financing capacity. Other countries
such as Greece have used “debt restructuring” to avoid any overt default.
The default route, including debt
restructuring, comes at a terrible cost, with countries finding themselves cut
off from financial markets, and being unable to meet obligations to their own
populations.
Economies are destroyed. Banks are destroyed, companies cannot access
revolving credit for operational expenditure, purchasing, payroll, etc. The national productivity gains that accrued during
the borrowing and spending years (if some of that borrowing actually funded
capability creation) are wiped out, and the entire economy performs a “hard
reset”. Deflation across the board results in economies that, eventually,
restart at a lower cost base, impacting profits for corporations and tax income
for the government. Infrastructure project come to a halt, and social support
networks collapse.
Argentina, Venezuela, Zimbabwe and Greece are
examples, each responding in different ways. Argentina is the serial offender
of Latin America with a cycle of recovery and exuberance, followed by
over-borrowing and collapse. Venezuela and Zimbabwe are similar in that they
converted national productive assets into social programmes to buy the support
of the masses, only to ultimately “run out of other people’s money”, yet still
not learn and restructure their economies for recovery. Both remain mired in
poverty and hopelessness.
Greece has restructured its economy, and until
the pandemic hit, the economy was growing again, within a huge debt overhang that was being
managed.
Furthermore, in all cases of default, the losers will be the asset holders, and that means the wealthy, who see their net worth slashed.
And as the wealthy control
the setting of policy and the justification of policy, and as they wish, first
and foremost, to protect their own assets and interests, we can be confident
that policies that may lead to default in the shorter term (3 – 5 years) will
be avoided.
But what if these
policies will result in a future potential default situation? Almost any policy
will be acceptable if expected to preserve wealth in the short to medium
term. Stimulus spending is meant to ensure the preservation of wealth by
reducing the risk of a systemic collapse or a market implosion. To avoid those,
ongoing imbalances are acceptable, because the alternatives are so frightening.
That is where we are now.
The policies of deficit spending by governments to prop up economies through
the pandemics have created imbalances that will, it is assumed, at some
indeterminate time in the future, create a situation in which the only two
options are hyperinflation or default.
Another Way – Super-Twist
Do not expect the Fed or
the Bank of England, or any other central bank that can, to either stop funding
stimulus, to allow their currencies to collapse, or to default on sovereign
bonds or gilts.
Any increase in inflation
will convert into an increase in rates (the assumption is that rates provide a
view of future inflation) and a corresponding increase in funding
costs for governments. That vicious cycle results in governments being unable
to fund their debt, and are the hilltop of the slippery slope to
hyperinflation or default. Therefore, rates must and will be managed.
The provision of
guaranteed liquidity under any circumstances is the bedrock of managing the
markets. Too much liquidity and the markets turn into bubbles, while too little
liquidity and the markets could collapse. So central bankers must send the
message that there is unlimited liquidity, while at the same time drip-feeding
that liquidity into markets is required, all the while “ignoring” the
fire-hydrant of government spending. As the government borrows, in theory, liquidity is removed from the markets to fund that borrowing. The money has to
come from somewhere.
Instead of borrowing
solely from the markets, governments purchase from themselves (and from other
governments in the process of spreading their risk and helping to prop each other
up). The debt is purchased with varying maturities.
In 2011 the Fed
implemented Operation Twist, with the objective of reducing the yield curve and
extending duration of the Fed’s debt. Buy short duration debt to take it off
the table while selling longer duration debt at the same or similar rate,
pushing the debt out and reducing the yield curve, pushing down inflation
expectations.
There has been speculation about a “Century-Bond” in the UK before, with questions about who
would find such a gilt attractive. The basic answer would be the government itself.
Any government that can issue debt in its own currency and purchase it from
itself at such a long duration would be well incentivised to issue such debt. Of
course, long-duration gilts and treasuries will not go away, nor will they be
paid off. But at 1% interest the burden of debt required to impact annual
budgeting would need to be multiples of total GDP and the tax take. And such gilts
or treasuries held in ‘public’ hands would retain value and still be available
for exchange.
How long could the UK or
the US continue to issue such long duration debt (and purchase it from itself)?
As long as the markets will purchase that debt. And when purchasers disappear,
they can purchase it from themselves knowing that they will be making debt
payments to themselves at 1% per year.
But Bubbles?
As long as governments
are purchasing the debt at a rate that provides liquidity to the governments, they
will retain the monetary policy tools to add or remove liquidity to external
markets. As bubbles expand, excess liquidity can be drained off by shifting
purchasing of the long-duration debt to themselves, and likewise, liquidity
crunches can be avoided (or mitigated) by releasing funding to stabilise
markets.
Will they be able to
destroy “boom and bust”? I highly doubt it. But they will have the policy tools
(and the cash) to smooth the busts and rein in the booms. Boom too fast, and
liquidity will be removed. Likewise, the busts will see floods of liquidity to
stave off systemic collapse or depression.
Of course, we should
trust that those different governments will fail, increasing the
potential for a pan-economy systemic crisis. But coordination between Central
Banks should reduce the likelihood.
Am I placing too much
faith in Central Banks? Absolutely, in the "short term". I am also confident that the hubris of
success will lead directly to excess risk-taking by governments and Central
Banks resulting in instability. Will the system be self-correcting? Probably,
up to a point.
But there will be
bubbles, and policy-makers will accept those as the cost of stability. Squeeze
a balloon, and it will pop out somewhere else. Release the pressure, and the
balloon will return to its ‘stable’ shape. Prick the balloon, and it will burst.
Squeeze the balloon too hard, and it will burst. I trust the Central Bankers to
squeeze within boundaries, until they don’t.
But we are still ‘early’
in the process of managing financial stability and growth through unconstrained
government borrowing and expenditure. There will be many years to run before a
real bursting of the balloon.
