Inflation, Default, or Super-Twist

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.