Will We Deal With Our High Debt/GDP Ratio by Purposely Inflating?

January 15, 2010

Will we inflate away our soaring high federal debt to GDP ratio??

Some people have raised the possibility that we will simply inflate our way out of debt.  They say we have strong incentives to do so and they point to the years following World War II as an example of how we did it once before.

Joshua Aizenman of U.C Santa Cruz and Nancy Marian of Dartmouth published a timely paper on this subject in November entitled, Using Inflation to Erode the U.S. Public Debt. It’s worth your attention. This blog has used some of Aizenman’s and Marian’s data.

At the end of World War II, the ratio of publicly held debt to GDP was 108.6 percent.  Currently it is over 50% and is projected to reach 100% in ten years.

From 1946 to 1956, the ratio was reduced 40% by inflation alone.  The inflation rate over this period was 4.2%. Inflation turned bonds into certificates of confiscation.

Will this happen again?  Are the comparisons of the two periods valid?  My answers to these questions are “no” and “no”.

First, it needs to be said that the 4.2% inflation of 1946-1956 was not a conscious policy choice. As early as 1948-49 economists recognized that the Fed’s commitment to pegging the Treasury Bill rate at under 1% made the Fed “an engine of inflation”.  Monetary policy was rendered impotent by the pegging.  It was finally abandoned in 1951.

Also, the wage and price controls of the war years had suppressed prices.  When abandoned, prices rose very rapidly for a short period of time, and accounted for a significant part of the inflation of the first post-war decade

The average maturity of the debt in 1946 was 9.2 years.  It is now 3.9 years. Inflation does its nastiest work over extended time periods, so the shorter average maturity creates less incentive to inflate today than in 1946.

In 1946, an inconsequential amount of our public debt was held by foreigners. Today about 48% is held by foreigners; China and Japan account for 44% of that 48%.  One the one hand it is much easier politically to let inflation confiscate foreigners’ wealth than our own.  But, at the first whiff of inflation, foreign debt holders would act fast to protect the real value of their dollar holdings.  The dollar and financial markets would crash.

While Treasury Inflation Protected Securities (TIPS) certainly detract from the temptation to inflate the debt away, but only 7.5% of the debt is in TIPS.

In 1946 there was a huge backlog of demand for goods, created by both the depression and the war.  Additionally, there was a very low level of private debt, and an immense store of liquid savings available to activate that demand. The situation is quite different today.  The store of savings is low, and debt is high.  There is no great demand backlog.

Today, the Federal Reserve has considerable ability to become restrictive.  I believe that, if necessary, the Fed will consider fighting inflation a priority, even if it were to restrict economic growth.  For the time being, when we are operating the economy at well below capacity,  inflation is not going to happen, and the Fed will not face that kind of unpleasant choice.  But at some point in the decade, choosing between growth and inflation will be on the table.

There probably is some long-term rate of inflation that is compatible with reasonable economic growth, perhaps even necessary for growth. What that rate is is just a guess, but let’s say it’s 2%, and that any rate above that would be the result of either purposeful monetary policy or irresponsible fiscal choice at a time when excess capacity was no longer present.  (By the way, a 2% inflation rate raises the inflation index 22% in ten years and 4.2% raises it 51%.)

My conclusion?  Inflating away the debt load is not likely to tempt the Fed or Treasury.  But Congress is another story.  If they try it, either consciously or unconsciously, the markets would turn chaotic very quickly.  The dollar would collapse and interest rates would soar.  That’s why a credible plan to deal with the deficit is so crucial.

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The Trend is Good, but its Speed is Not

January 9, 2010

The chart below is intriguing.  It was compiled by  Mark Zandi, a quite reputable economist at Moody’s economy.com.  I am not an econometrician, but I thought the major effect of the stimulus was later than indicated here, perhaps by as much as two calendar quarters.  If Zandi is correct, it means that the economy ex the stimulus was in even deeper trouble than we thought in the first nine months of 2009.

It also says loudly that the economy will increasingly have to make it more on its own as we travel through 2010.  That’s another argument in support of  weak, unsatisfactory growth ahead.

Where is the growth going to come from?  In my judgment it will come from the following (listed in order of magnitude): (1) a switch from inventory liquidation to inventory accumulation, (2) a slow but consistent rise in consumer spending, (3) an improvement in our trade balance, (4)a solid increase in corporate capital spending, primarily on info tech equipment and software, and (5) some improvement in residential construction from the current extremely depressed level.

Altogether, an educated guess would put real GDP growth from 4Q2009 to 4Q2010 at around 3%.  There will be some job growth, but not enough to reduce unemployment significantly if at all.  The 2010 Census will employ as many as 1.5 million short-term workers, then disappear.  By year-end 2010 we’ll be hard pressed to reduce unemployment significantly.

The best we can say now is that there is trend of improvement in place. It’s slow moving and will continue that way.  The 4Q 2009 GDP growth will look pretty good thanks to less negative numbers for inventories and net exports, but  it sure felt lousy.

Corporate earnings are expected to be up strongly in 2010 as higher volumes combine with reduced cost structures.  Wall Street expects earnings for the S&P 500 to be up 35-40%, to $75-$80, with the largest gains in materials and industrial companies.  The stock market has already registered it’s optimistic earnings expectations in substantially higher prices, resulting in a price-earnings ratio of 14-15.  Not cheap, but not very expensive IF the earnings expectations come true.

Lot’s of unanswered questions still out there. The Fed’s exit strategy strikes me as necessary to longer term confidence.  Investors need to have faith that the Fed has a strategy and understand what it’s main elements are.  The condition of the banking system is still questionable, given the weakness in commercial real estate, and the”shadow inventory” of houses, houses still owner-occupied, but with no mortgage payments being made and lenders hesitant to foreclose. And there is also a huge volume of mortgage resets coming this year, some substantial number of them being interest-only that will now have to begin repaying principal.

I would also mention oil prices as an important unknown.  A substantial increase in energy prices amounts to a large tax increase on consumers that, if it occurred, would hold back the recovery.

The chart below (from Contrary Investor) compares the stock market recovery of 2003-2004 to the recovery since March of 2009; over 50% then, and about 72% now.  Rather interesting to see how these recoveries followed about the same track.  (read 2003 on the left scale and 2009 on the right scale)

It’s also interesting to examine, as Contrary Investor did last week,  the contrast between the end points of the recoveries, year-end 2003, and year-end 2009.  Here are a few of the statistics:

2009         2003

Final Sales to Domestic Purchasers (yr to yr)

(3.5)          6.0

Industrial Production  (yr to yr)

(5.1)          2.1

Housing Starts

574k          2.06 mill

Disposable Personal Income (yr to yr)

1.4             5.9

Cap Goods Orders ex defense and aircraft

(10.2)       10.2


Extremely different environments, as you can see.  Earnings in 2003 had risen by about 17% and would rise another 25% in 2004. In 2009 earnings gained about 10% and are expected to rise 35-40% in 2010.  Stocks were entering a two-year flat period at the end of 2003.  It’s better than 50-50 that we are entering a similar flat period today, in my judgment, even if the current high earnings expectations are met.

SOME THOUGHTS ON VOLATILITY

I think most of us recognize that stocks, while rewarding over the long-term, carry a higher degree of risk than we might have thought prior to the financial crisis/recession.  In fact, after you look at the numbers below, documenting large market moves over the past 13 years (a very short period for true long-term investors such as endowments and pension funds, but a long period relative to an individual’s prime years of investing) you might well conclude that stocks are very, very risky.

MAJOR STOCK MARKET CHANGES 1996-2009

January 1996 to September 2000                                         +156.3%

September 2000 to  October 2002                                            -46.0%

January 2002 to October 2007                                                   +104.9%

October 2007 to March 2009                                                           -57.7%

March 2009 to January 2010                                                             +71.7%

Some person in the future, looking at this astoundingly volatile record, would ask what the hell was going on? Digging deeper he would see the bursting of two bubbles, the tech/dot.com bubble of the late 1990’s, and the housing bubble of 2003-2007.  He would also find that the U.S. economy grew at below trendline rates, despite an explosion of private and public debt, leading ultimately to a financial crisis, deleveraging,  a severe recession, and growth that was inadequate to prevent a chronic rise in unemployment.

This future researcher will, of course, know what follows, whereas we don’t.  Did we learn from this period how to make both the economy and the stock market safer and more stable? Or did we, after seeing how government policies were effective in preventing a depression, embark on the future with high confidence that ‘anything goes’, and return to using high leverage to play financial games again?