IT’S CHINESE GROWTH. No, it’s the FOMC. No, it’s leveraged money. No, not leveraged money, real money. Or maybe it’s Chinese retail … or failed Abenomics. Hang on, perhaps it’s Greece.
All wrong. It’s about inflation.
Yes, China is over-borrowed. But then so is the rest of the world. Haven’t we all at some time played around with the US debt-clock and wondered how the States can keep going? And don’t we sit around constantly bemoaning other people’s household debt?
Then, on the other hand, we are aware that maintaining the economy at its current level, even forgetting growth, is dependent on borrowing. And I don’t mean bringing purchases forward, but a constant addition of new debt.
I have taken lots of stick for being a believer in austerity – when defined as living within our means – not as a means to an end, but as an end in itself. But despite my dislike for deficits, I can see where they fit in and what their purpose can be. The simple truth, however, is that we live – and no longer only in the West – with a socio-economic model that appears to have running deficits (both public-sector and domestic) programmed into its DNA. How else could it be that Maastricht codified a 3% annual deficit to GDP ratio as being entirely acceptable?
BUT LET’S STEP back briefly and think the most simple of thoughts. A deficit is a deficit until the end of the financial (or in the case of governments, fiscal) year. The moment the accounting period ends, the deficit is added to the debt stock. So irrespective of how high or low the deficit has been, it moves from the deficit/GDP column to the debt/GDP column. The assumption is that, unless the debtor – in this case the government – starts to run a surplus, the debt pile will continue to grow. That is true but of course, only in nominal terms. Focusing on nominal debt is, however, fatuous as the greatest and most loved redeemer of that debt is and remains Mr Inflation.
Governments sit in a highly privileged position in that they own, at no cost to themselves, the perfect inflation hedge. Fiscal revenues are inflation-proofed; if prices go up, so does the tax take, just as it does when wages rise. On the liability side, of course, inflation debases the debt pile and hence all is well. In other words, don’t worry too much about the deficit, because inflation will eventually take care of it.
But then along comes a period of low to no inflation and all of a sudden the equation no longer works. That, it would appear, is where we are currently stuck.
The greatest and most loved redeemer of all debt is and remains Mr Inflation
INDEED, DEFICIT TARGETS should possibly not only be defined in terms of their relationship to GDP but also, if not entirely, to net fiscal revenues. I think the time has come to go one step further and to add inflation to the mix. Running a deficit of 3% of GDP is a very different animal depending on whether inflation is at 5%, 3% or zero. The same of course applies to the debt stock.
If the deficit is 3% of GDP and the debt 60%, then an inflation rate of 5% ensures that the value of the debt is eroded at more or less the same speed as it is being built up. Thus, in the 1970s and 1980s when inflation was in high single or low double-digit figures in many Western countries, inflation was busily paying off the national debt. When it all became a bit too obvious that the government was holding all the cards, the British, for instance, conceded that up to 10% of outstanding debt instruments could be issued in the form of inflation-linked bonds, thus handing a limited amount of its inflation option to the investment community, which was at the time watching its bond holdings being hollowed out.
It’s not hard to understand what effect inflation has on government finances and yet one rarely, if ever, hears the subject broached. Running deficits in inflationary times and doing so in non-inflationary or deflationary ones are totally different kettles of fish.
IN A DOMESTIC environment the situation isn’t all that different. Our parents’, and to some extent my own generation, became wealthy because inflation lifted us out of our mortgages. I have an elderly friend, now in his mid-80s, who has seen the first house he bought in Berkshire in the early 1950s for £5,000 trade in the market at £50,000 and eventually, quite recently, at £500,000. Heaven knows what the chances are of a young person in their 20s being able to buy the same house as a first home today, let alone see it being worth a hundred times what they paid for it in 60 years from now.
Thus, if we discount the chances of a repeat of the debt-devouring inflation that in many ways defined the 70s, the 80s and to a lesser extent the 90s, the probability of egregious wealth creation by Mr Inflation seems modest.
Alas, the problem seems to be that we see the benefits of funding growth and consumption through borrowings, but we forget what it takes in order to pay back what we have borrowed without having to put our hand in our pockets or cut back.
Inflation might be the bane of investors’ and savers’ lives in nominal terms, but it is more than just a boon to debtors: it is what keeps them alive. And that in turn oils the wheels of growth.
Inflation isn’t, in the final analysis, something to fear but something to pray for. In fact, like rain, it is something we loathe but something which we can under no circumstances survive without.
