Commonly-accepted wisdom says that we can inflate our way out of our debt crisis.
***
But as I have previously noted, UBS economist Paul Donovan has demonstrated that governments can't inflate their way out of debt traps, saying:
The
problem with the idea of governments inflating their way out of a debt
burden is that it does not work. Absent episodes of hyper-inflation, it
is a strategy that has never worked.
It
is a commonplace on the right that we're going to have enormous
inflation, not because Ben Bernanke will make an error in the timing of
withdrawing liquidity, but because the government is going to try to
print its way out of all this debt.
Joe Weisenthal notes that it doesn't quite work this way:
As this chart shows, instances of declining debt-to-GDP
rarely coincide with periods of inflation. If it did If it did, we'd
see more dots in the lower right-hand quadrant.
The
bad news for central bankers is that creating currency isn't like, say,
diluting shareholders in a company. You're always rolling your debt,
and the market's response to an inflationary strategy is (not
surprisingly) higher interest rates. It's a treadmill, and it's
extremely hard to get ahead.
Inflating
your way out of debt works if you're planning to run a pretty sizeable
budget surplus--big enough that you won't have to roll your debt over.
Otherwise, your debt starts to march upward even faster, as old notes
come due, and you have to roll them at ruinous interest rates.
Hyperinflation might wipe out that debt, but also your tax base.
Analysis shows even a sizable hike in CPI won't do much for companies or households that owe money.
Analysis
released by Leverage World, a publication of debt research firm Garman
Research, showed that companies that have issued debt at a coupon rate
of 8%, as is typical for non-investment grade issuers, would have to
see inflation hit 23% to inflate away the amount of debt they owe in
5.5 years. That’s the average amount of time that investors would have
to hold such debt to compensate for the risk of default.
But
investors would refuse to do so under such a scenario, Chris Garman,
principal in the research firm, noted—not with yields on such debt
currently running at 18%.
As Mr. Garman put it in the publication, inflation at that level “would crush the appeal of an 8% coupon.”
And while issuers would have to roll over their debt, they would find it impossible to do so. As he put it in an interview with Financial Week, “They’re staring down the barrel of an 18% coupon.”
Investment
grade companies are in better shape. The same can’t be said for other
public—or government—borrowers. Indeed, overall debt levels for the
private and public sectors now run at roughly 3.5 times nominal GDP.
That compares with 1.5 times from 1945 to 1980 and in the early 1920s.
To
return to that level, Mr. Garman estimated that inflation would have to
rise to around 12% or GDP increase by 75% over the next five years.
Either scenario, he said, is hardly likely to materialize.
At a
more realistic level of 3% real GDP growth and 2% inflation, Mr. Garman
said, it would take 15 years before the overall U.S. debt level fell
back under 1.7 times nominal GDP.
“There has been some talk of a rise in inflation as a panacea for distress and default,” he wrote in his report.
His analysis shows that such expectations vastly underestimate what’s required.
Prominent economist Michael Hudson wrote in February:
The
United States cannot “inflate its way out of debt,” because this would
collapse the dollar and end its dreams of global empire by forcing
foreign countries to go their own way. There is too little
manufacturing to make the economy more “competitive,” given its high
housing costs, transportation, debt and tax overhead. The economy has
hit a debt wall and is falling into Negative Equity, where it may
remain for as far as the eye can see until there is a debt write-down...
The
Obama-Geithner plan to restart the Bubble Economy’s debt growth so as
to inflate asset prices by enough to pay off the debt overhang out of
new “capital gains” cannot possibly work. But that is the only trick
these ponies know...
The global economy is falling into depression, and cannot recover until debts are written down.
Instead of taking steps to do this, the government is doing just the
opposite. It is proposing to take bad debts onto the public-sector
balance sheet, printing new Treasury bonds to give the banks – bonds
whose interest charges will have to be paid by taxing labor and
industry...
The economy may be dead by the time saner economic understanding penetrates the public consciousness.
In the mean time, bad private-sector debt will be shifted onto the
government’s balance sheet. Interest and amortization currently owed to
the banks will be replaced by obligations to the U.S. Treasury. It is
paying off the gamblers and billionaires by supporting the value of
bank loans, investments and derivative gambles, leaving the Treasury in
debt. Taxes will be levied to make up the bad debts with which the
government now is stuck. The “real” economy will pay Wall Street – and
will be paying for decades.
What
I hear more and more, both from bankers and from economists, is that
the only way to end our financial crisis is through inflation. Their
argument is that high inflation would reduce the real level of debt,
allowing indebted households and banks to deleverage faster and with
less pain...
The advocates of such a strategy are not marginal
and cranky academics. They include some of the most influential US
economists...
The best outcome would be a simple double-dip
recession. A two-year period of moderately high inflation might reduce
the real value of debt by some 10 per cent. But there is also a
downside. The benefit would be reduced, or possibly eliminated, by
higher interest rates payable on loans, higher default rates and a
further increase in bad debts. I would be very surprised if the balance
of those factors were positive.
In any case, this is not the most
likely scenario. A policy to raise inflation could, if successful,
trigger serious problems in the bond markets. Inflation is a transfer
of wealth from creditors to debtors – essentially from China to the US.
A rise in US inflation could easily lead to a pull-out of global
investors from US bond markets. This would almost certainly trigger a
crash in the dollar’s real effective exchange rate, which in turn would
add further inflationary pressure...
The central bank would
eventually have to raise nominal rates aggressively to bring back
stability. It would end up with the very opposite of what the advocates
of a high inflation policy hope for. Real interest rates would not be
significantly negative, but extremely positive...
Stimulating
inflation is another dirty, quick-fix strategy, like so many of the
bank rescue packages currently in operation ... it would solve no
problems and create new ones.
Inflationists
make two mistakes when it comes to government debt. The first is in
assuming government debt is more important than consumer debt. (It will
be after consumer debt is defaulted away, but it's not right now.) The
second is that it's not so easy to inflate government debt away
either...
Inflationists act as if unfunded liability costs and
interest on the national debt stay constant. Also ignored is the loss
of jobs and rising defaults that will occur while this "inflating away"
takes place. Tax receipts will not rise enough to cover rising interest
given a state of rampant overcapacity and global wage arbitrage.
Yet in spite of these obvious difficulties, the mantra is repeated day in and day out.
Inflating
debt away only stands a chance in an environment where there is a
sustainable ability and willingness of consumers and businesses to take
on debt, asset prices rise, government spending is controlled, and
interest on accumulated debt is not onerous. Those conditions are now
severely lacking on every front.
Some have suggested that the country could just "inflate its way" out of its fiscal ditch.
The idea: Pursue policies that boost prices and wages and erode the value of the currency.
The
United States would owe the same amount of actual dollars to its
creditors -- but the debt becomes easier to pay off because the dollar
becomes less valuable.
That's hardly a good plan, say a bevy of debt experts and economists.
"Many countries have tried this and they've all failed," said Mark Zandi, chief economist at Moody's Economy.com.
It's
true that inflation could reduce a small portion of U.S. debt. The
International Monetary Fund (IMF) estimates that in advanced economies
less thana quarter of the anticipated growth in the debt-to-GDP ratio would be reduced by inflation.
But
the mother lode of the country's looming debt burden would remain and
the negative effects of inflation could create a whole new set of
problems.
For starters, a lot of government spending is tied to
inflation. So when inflation rises, so do government obligations, said
Donald Marron, a former acting director of the Congressional Budget
Office (CBO), in testimony before the Senate Budget Committee.
"[W]e
have an enormous number of spending programs, Social Security being the
most obvious, that are indexed. If inflation goes up, there's a
one-for-one increase in our spending. And that's also true in many of
the payment rates in Medicare and other programs," he said.
Inflation
would also make future U.S. debt more expensive, because inflation
tends to push up interest rates. And the Treasury will have to
refinance $5 trillion worth of short-term debt between now and 2015.
"[The
debt's] value could go down for a couple of years because of surprise
inflation. But then ... the market's going to charge you a premium
interest rate and say 'you fooled us once but this time we're going to
charge you a much higher rate on your three-year bonds,'" Marron said.
The
Treasury is increasing the average term of its debt issuance so it can
lock in rates for a longer time and reduce the risk of a sudden spike
in borrowing costs. But moving that average higher won't happen
overnight. And, in any case, short-term debt will always be part of the
mix.
Another potential concern: Treasury inflation-protected
securities (TIPS), which have maturities of 5, 10 and 20 years. They
make up less than 10% of U.S. debt outstanding currently, but the
Government Accountability Office has recommended Treasury offer more
TIPSas part of its strategy to lengthen the average maturity on U.S. debt.
The higher inflation goes, of course, the more the Treasury will owe on its TIPS.
Just
last week, the CBO noted that interest paid on U.S. debt had risen 39%
during the first five months of this fiscal year relative to the same
period a year ago. "That increase is largely a result of adjustments
for inflation to indexed securities, which were negative early last
year," according to the agency's monthly budget review.
What's
more, the knock-on effects of inflation are not pretty. A recent report
from the IMF outlined some of them: reduced economic growth, increased
social and political stress and added strain on the poor -- whose
incomes aren't likely to keep pace with the increase in food prices and
other basics. That, in turn, could increase pressure on the government
to provide aid -- aid which would need to keep pace with inflation.
If We Can't Inflate Our Way Out of the Problem, What CAN We Do?
So if we can't inflate our way out of this mess, what should we do?
The above-quoted CNN article says:
So where does that leave lawmakers? Facing tough choices.
Deficit
hawks and market experts have been calling on lawmakers to come up with
a strategy to stabilize the growth in U.S. debt, which would be
implemented only after the economy recovers more fully.
The idea
is to signal to the markets that the country is serious about getting
its longer term debt under control so that the burden of paying it back
doesn't consume an ever-increasing share of the federal budget.
The recommended exit strategies are pretty basic, if unpopular: tax increases and spending cuts.
But why raise taxes and cut essential services when we can stop unnecessary wars and unnecessary interest costs instead?
If we did these things, we wouldn't have to raise taxes or cut core services to the American people.
Stopping all wars which are not absolutely essential for the protection of the United States from massive and imminent attack is crucial.
And abolishing the central bank (or putting it within the Treasury
department) and taking over the money and credit creation functions
from the private banks may be an important part of the solution to our
debt trap. See this, this, this, this, and these:
Look at the pathetic state of pension funds. Bubble Ben has shown his hand, he wants asset reflation and "contained" inflation, and will do whatever it takes to avoid deflation. The latter is bad for banks and pensions.
"Default? Woo hoo! The two sweetest words in the English language: de-fault! De-fault! De-fault!"
That the only way to be free of the obligations. The 100 trillion in unfunded liabilies alone says this is the only answer. Besides think of how sweet a default would be. Then maybe no one would lend money to our insane, criminal, spendthrift looters...er... government.
USD devaluation, i.e. inflation
Right ... they are just two ways to describe the same thing ...
Look at the pathetic state of pension funds. Bubble Ben has shown his hand, he wants asset reflation and "contained" inflation, and will do whatever it takes to avoid deflation. The latter is bad for banks and pensions.
Unfortunately, those two goals are incompatible.
We solve it by listening to Homer Simpson.
"Default? Woo hoo! The two sweetest words in the English language: de-fault! De-fault! De-fault!"
That the only way to be free of the obligations. The 100 trillion in unfunded liabilies alone says this is the only answer. Besides think of how sweet a default would be. Then maybe no one would lend money to our insane, criminal, spendthrift looters...er... government.
You can't default as long as you're still borrowing.
And we won't as long as we can!