It cost a fortune to deal with the pandemic. And the energy crisis is costing some governments a second one. Debt-to-GDP ratios in many developed countries have soared past the levels that academics warn about. At some point, the economy just can’t sustain all that debt. And so, it must be reduced. But how?
There are two ways to cut government debt. Well, three if we include last weekend’s topic. But the textbooks don’t exactly mention that one. Instead, governments and central banks have two official options: default and inflation.
Default is a bad option, for the obvious reasons. It triggers noticeable financial chaos, technical defaults, official bankruptcies, and legal repossessions. All this can be immensely embarrassing to politicians…not to mention financially devastating for investors like us.
Let’s focus on the embarrassment, though. Because that’s what the decision-makers will focus on.
In 2012, an American hedge fund impounded an Argentine warship in Ghana. The country had refused to pay its debts, which the hedge fund owned. And so, they took the boat.
You can imagine the humiliation…
Therefore, inflation looks enticing. It avoids financial chaos and an official default, and corporate bankruptcies and repossessions are less likely because people can repay their debt with freshly created confetti money.
But inflating away your debts has its challenges, as governments and central bankers are finding out the hard way right now.
The policy of financial repression, as it’s known, requires a combination of high inflation and low interest rates. The aim of the game is to rob savers and investors of their purchasing power, but slowly enough to avoid panic. Specifically, it’s all about keeping inflation higher than interest rates on government bonds.
How does this benefit the government? Inflation devalues debt. Your mortgage 30 years ago…well, you probably didn’t have to borrow for 30 years to be able to afford repayments back then. But still, the size of your mortgage back when you borrowed must seem tiny today. Over time, inflation made that debt burden easier and easier to repay. The real value of that debt declined as the value of money fell.
It’s the same for governments. Look back through history and you’ll notice that government debt didn’t look so bad a decade ago…in terms of today’s numbers. Not long ago, we measured government debt in the billions, while these days we count in terms of trillions, passing tens of billions and hundreds of billions along the way.
The reason why is inflation. Over time, each dollar matters less. Which means debt, denominated in dollars, matters less.
Unfortunately, that also means investments denominated in money are worth less until you have to pay your taxes. Then the inflation bill is included.
Of course, savers and investors aren’t so keen on being dispossessed, even if it’s gradually. They want interest rates to compensate them for inflation. They want to earn more than inflation takes away.
But allowing this negates the benefit of inflation. If the interest bill on government debt is bigger than the inflation write-down, then financial repression isn’t really getting politicians anywhere.
That’s why you need a central bank to control interest rates. To peg them down, as the Reserve Bank of Australia explicitly did with its target on Australian Government bond yields, and as the Japanese central bank is doing now.
By letting inflation rip without hiking rates, the government’s debt can be paid off by making it worth less. And investors don’t get compensated by higher interest rates.
Of course, government debt is the lowest yielding in the world. So, governments benefit the most from the policy of financial repression. But it applies economy wide. Borrowers get to repay their debts with ease as prices rise, but their debts and interest rates don’t.
Unfortunately, it seems the politicians and central bankers overdid it. They cooked up such an inflation storm with their stimulus, energy crisis, sanctions, and QE that inflation went so high nobody could ignore it.
Right now, central bankers are raising interest rates to avoid inflation jumping out of control.
Bond yields spiked too, but not up to the rate of inflation. The frog didn’t jump out of the pot.
Does this mean financial repression is failing? Are interest rates going to compensate savers and investors for inflation, thereby wiping out the government’s gains in inflating away its debt? Have central bankers cornered themselves by causing so much inflation that they must abandon financial repression in favour of fighting inflation with higher interest rates?
The answer is, I don’t know.
But the consequences of the mistake have already begun popping up in the economy, especially in Europe, where inflation hit hardest thanks to the energy crisis.
Strikes and protests are wreaking havoc on economies over there. And the people on the picket lines have plenty of sympathy. It’s not like they’re asking for a real wage increase. They just want to keep up with inflation.
Unfortunately, that risks inflation getting out of hand completely. And so, central bankers and politicians are demanding wages don’t rise to compensate workers for inflation.
It seems workers are the collateral damage in the financial repression battle.
Here’s the interesting bit: Workers and investors are quite a political interest group if you combine them. And they’re angry.
But what could they ask for? One group wants wage increases that’ll fuel inflation, and the other wants interest rates that’ll compensate them for inflation.
It’s a recipe for the ‘70s — high inflation and high interest rates. The government’s pitch at financial repression is just going to cause chaos in the end.
Until next time,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
