How Inflating Away Debt Works
There’s an old business adage “There is no new way to go broke, it is always too much debt”. As applicable to governments as it is to businesses and individuals, that is the challenge before the world today.
Debt can either be repaid through surplus earnings, defaulted on or effectively eroded through inflation. As governments seem unable to deliver anything but deficits the first option is off the table. In our new globally interconnected world so is the second (look at the efforts by its sovereign creditors to keep little old ‘unimportant’ Greece afloat). That leaves the third; inflation. We’ve written of this before and it won’t be new to regular readers. The inflation scenario is only really effective if it delivers negative real rates – i.e. inflation is higher than the nominal interest rate. That has been the case for most developed countries around the world for some years now though to date they have struggled to get any kind of inflation despite near zero rates. Some are even ‘hard wiring’ it through making the nominal rate negative (ala Japan, EU, Swiss etc). The sad irony is it has encouraged record debt accumulation taking advantage of the (now) low rates. What happens when those rates rise on all that debt??
Whilst there has been much written of the effects on the poor saver in this scenario it seems only more recently that headlines are starting to talk of stagflation (per our article on Wednesday). From today’s Weekly Wrap:
“The December CPI report saw headline inflation rise for a 5th consecutive month up 0.3%, and up 2.1% from a year ago, the highest since June 2014. Of note was rent inflation which rose a whopping 4.0% in December, the highest annual increase since December 2007, pushing shelter inflation up 3.6% Y/Y.
But whilst costs are rising we saw more evidence this week that wages aren’t, when, for the 80% of Americans in production and nonsupervisory roles, data this week showed real wages actually dropped for the first time since 2013 prompting the Bloomberg heading "Costs are rising, while pay isn’t: is the U.S. on the road to stagflation?" “
When an economy remains moribund (and so wage growth) whilst inflation rises everyone hurts, not just the savers.
So as the world hits an all time record high debt to GDP ratio of 325%, how effective is inflating it away? The following excerpt from The Economist a few years back highlights the scale of the problem:
“Mr Valli argues that a central bank trying to achieve this aim would face three challenges
1. to create inflation in the current context of large economic slack and private/public sector deleveraging. 2 to do so in a way that faster inflation leads to negative real interest rates, thus generating a transfer from investors to the government and 3 to deliver negative real rates that are sufficiently large and/or last sufficiently long to allow for a significant reduction of the debt/GDP ratio”, and
“Mr Valli proposes four options - a series of increasingly large inflation surprises with accelerating inflation; steady negative real rates with a stable inflation rate; a one-off surprise inflation jump; and higher inflation that is more than offset by a rising inflation risk premium.
For Option 1, he suggests a real rate that starts at zero and falls by 1 point a year (-1%, -2% etc). This would reduce the debt-to-GDP ratio from 100% to 60% within 12-13 years but at the cost of very negative real rates (-12%) by the end, which look implausible. For Option 2, a steady negative real rate of -5% would take 25-30 years to cut the ratio from 100% to 60%, but at -4%, it would take 100 years. For Option 3, a one-off inflation shock would have to be 40% plus in a single year to get the needed effect, which would have other consequences.
And if all this went wrong, higher inflation but rising real rates would cause the debt-to-GDP ratio to soar, probably doubling over 10 years.”
Negative real interest rates is where gold truly shines. Economic crises (likely triggered by too much debt) are where gold truly shines. Hands up who thinks governments around the world are going to start delivering surpluses any time soon?