Australians are growing increasingly furious about the cost of living. The newspaper stories, the social media posts, the TV news interviews…it’s all about how unaffordable everything has become.
But I’ve noticed that investors haven’t joined the chorus just yet. It’s as if they haven’t yet realised the ASX200 hasn’t even kept up with inflation for years.
Ironic, isn’t it? The only thing not going up during inflation is the one thing we want to go up…
But that’s precisely the point. We’re used to celebrating rising asset prices while consumer prices remain low. Now we’re learning the hard way that you can get the converse too. It’s a rebalancing mechanism, if you ask me.
The big question now is who will get the blame. The Reserve Bank of Australia is certainly under fire. And a lot of politicians in Europe and Argentina have gotten the chop over the cost of living recently.
Do you remember the last time German voters lurched to the right after enduring high inflation?
So far, the blame directed at leaders has been fuelled by accusations of incompetence. The central bankers and politicians don’t seem to know what they’re doing! How could they let this happen to us?
Unfortunately, they do know what they’re doing. And they didn’t let it happen, they made it happen. The inflation was part of a deliberate policy.
Now I know that reads like a conspiracy theory. It certainly doesn’t gel well with European Central Bank president Christine Lagarde’s claim that inflation came from ‘pretty much nowhere’. Then again, she was the source of the inflation. And she has been criminally convicted of financial negligence before…
But the evidence for my claim is rather strong. As the economist Ludwig von Mises explained in the 50s, inflation is by definition a government policy:
‘The most important thing to remember is that inflation is not an act of God; inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy — a deliberate policy of people who resort to inflation because they consider it to be a lesser evil than unemployment. But the fact is that, in the not very long run, inflation does not cure unemployment.
‘Inflation is a policy. And a policy can be changed. Therefore, there is no reason to give in to inflation. If one regards inflation as an evil, then one has to stop inflating. One has to balance the budget of the government.’
This time around, governments aren’t trying to use inflation to deal with unemployment. They’ve got a bigger problem on their hands. They’ve run out of other people’s money.
Sovereign debt levels are dangerously high. Interest expense is squeezing out all other government spending. That same government spending dominates economies, making it impossible to cut without sinking GDP. Tax rates are at levels even socialists don’t want to vote for.
Put all this together and you can see politicians are desperate. They need to find a way to finance the usual purchase of electoral votes, or the populists will take over. Where’s the money going to come from if debt and taxes are off the table?
The solution to too much government debt is inflation. Before I explain how, I’ll let a list of the worlds most famous economists point out that this is not a controversial statement:
By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.
John Maynard Keynes
There are only three ways to meet the unpaid bills of a nation. The first is taxation. The second is repudiation. The third is inflation.
It is a way to take people’s wealth from them without having to openly raise taxes. Inflation is the most universal tax of all.
Inflation is taxation without legislation
I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.
Friedrich August von Hayek
Avoiding inflation is not an absolute imperative but rather is one of a number of conflicting goals that we must pursue and that we may often have to compromise.
There are some obvious ways in which inflation helps finance governments. You get bracket creep into higher marginal tax rates, for example.
But the big one is less well understood. Inflation reduces government debt by the same means that it reduced your mortgage over the years. Over time, the debt you owed became worth less because the price of everything, including incomes, rose with inflation.
Just as mortgages measured in the thousands of dollars during the 70s seemed small to borrowers in the 80s, and mortgages measured in the tens of thousands during the 80s seem cheap today, so too does government debt seem much smaller after a spurt of inflation.
Reducing the value of money is a direct transfer of wealth from the saver to the borrower. The saver is you, the investor. And there’s no bigger borrower than government.
But there’s one big condition required for this ploy to work. Interest rates cannot be allowed to rise. That’s why politicians need central bankers on board with the plot.
If central bankers raise interest rates once inflation starts, this cancels out the beneficial impact of inflation on debt by raising the cost of borrowing.
Thus central bankers must pretend to be asleep at the wheel as inflation takes off. They have to tell us inflation won’t happen, isn’t happening and will be transitory, all while refusing to hike interest rates as prices soar.
Lenders to the government, bond investors, must also be fooled into believing these claims about inflation. If they get a whiff of what’s really going on, bond prices will crash as investors demand higher returns. That also raises the cost of borrowing for the government.
That’s what eventually happened in 2022. But not before a vast chunk of debt was inflated away successfully by governments and central banks.
If you agree with all this, the implications are a bit dire. First of all, it suggests that central banks and governments overdid it on the inflation side. They got a lot more than they bargained for. The bond investor frog jumped out of the pot instead of being boiled slowly.
Secondly, it also implies that governments and central banks aren’t finished yet. They’re going to need more inflation over a longer period of time to bring down government debt. But it must be done without people being aware of it.
Investors must wake up to the risk of inflation being used against them as a policy tool over long periods of time. To be honest, I don’t think politicians and central bankers have much choice.
Editor, Fat Tail Daily