Sean King

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Knoxville, Tennessee, United States

Saturday, November 27, 2010

Stephen Green...

...repeats the false "debtors love inflation" meme.

As the folks over as Daily Reckoning have noted, this is only true for those very few debtors who actually retire their debts with the increasingly less valuable cash. But permanent debtors, such as the United States and most other sovereigns, not to mention many consumers and businesses, never pay down their debt significantly. Rather, they simply refinance it as it matures. Thus, with the prospect of sufficient inflation, that refinancing will happen at much higher rates of interest. And, given our current debt load, rates at even 1990's levels would be enough to sink us.

This idea that inflation benefits debtors has got to go.

UPDATE:>At the end of his post to which I orginally linked above, Mr. Green responds to my critique as follows:
When ten trillion dollars pays off half the national debt, or buys a pair of shoes, who gives a good got-dam about the interest on the re-fi?

I'm not sure that I understand his point (which is undoubtedly more of a reflection on me than him). I believe he is saying that, once the price of goods reaches a certain point, interest on the re-fi no longer matters.

But I think it does for the simple reason that, in a severely over-leveraged economy, skyrocketing interest rates will prevent prices from approaching the levels he supposes in the first place. When private sector leverage is great, spiking interest rates results in massive defaults by those debtors who can't print their own money (i.e., debtors in the private sector). And, where that private sector debt is significantly greater than government debt, such massive defaults can only be deflationary as money "disappears" in a reverse multiplier effect.

For instance, as Robert Prechter has noted, between September 2008 and June 2010 (or the period of QE1), the Fed (here in the US) purchased $2.46 trillion of bonds with money that it manufactured out of thin air. And yet, this increase by Fed was more than completely offset by deleveraging in the private sector such that total US debt outstanding declined by nearly $300 billion during the same period. In other words, the private sector paid down or wrote off nearly $2.75 trillion of debt during a period when the Fed was only able to "create" $2.46 trillion of new debt money to offset it. Most of this decline in total debt was due to write-offs and not pay-downs, so had interest rates spiked during the last year rather than continuing their decline, the numbers would be far, far worse.

However, in defense of those who argue that "inflation is good for debtors", it must be noted that there are some limited scenarios (which don't seemingly apply to present day Europe or the US) that might be the case. One such scenario occurs when government debt as a percentage of GDP is quite high, but where private sector debt levels (business and consumers) are much lower--for instance, where government debt is running, say, 100% of GDP, but total business and private debt only accounts for maybe 50% of GDP. In this scenario, governments can "steal" productivity from the private sector through modest inflation.

They do this by having the central bank purchase the government's debt with invented (notice I don't say "printed") dollars. These newly invented dollars, used to buy government debt, find their way to banks where they are subsequently loaned out to productive entities (businesses or those who work for them) time and again via the multiplier effect. Businesses and consumers readily borrow the available money from the banks under these circumstances because their current debt burden is modest and easily serviced. Thus, taking on more debt gives them an opportunity to grow their business or finance their lifestyle without significantly raising the odds of default. This multiplier effect results in the supply of dollars in the economy increasing at a much faster rate than the supply of goods, bidding up the price of goods and creating inflation. People's incomes and spending rise (in dollar terms if not in true spending power terms) as a result of this inflation, and this increases tax revenues in dollar terms. Thus, government receives more dollars with which to retire and/or service its debt, at little or no cost to itself, all thanks to this inflation which acts as a hidden tax on the public.

But, this scenario isn't possible where the productive sector of the economy is so debt laden that it already struggles to service its current debt load, and this is undoubtedly the situation that US and much of peripheral Europe finds itself in today. Private sector debt in the US (and much of Europe's periphery) dwarfs government debt many times over. The private sector in these countries is already struggling to service existing debt levels even with interest rates a unprecedentedly low levels (as evidenced by record high defaults, foreclosures, and bankruptcies and subsequent bank failures). Thus, in the present scenario, any additional liquidity injected by central banks through monetization of debt won't find its way into the economy via new/additional loans and therefore can't create inflation via the multiplier effect. This will be true for the EU for the foreseeable future regardless of whether Germany decides to go it alone or not.

That is, unless these governments do away with a central bank altogether and begin to truly print their own money, in the literal sense, using this new money to retire or service its debts (as in the Weimar Republic or Zimbabwe). While such a move to directly print money is possible and is certainly not unprecedented, even talk of it would instantly trigger fears of hyper-inflation, resulting in an almost immediate spike in interest rates in any newly issued private sector debt. This spike in rates would in fact likely precede the actual introduction of the printed money into the economy, or at least would coincide with it. Thus, increases in money supply due to the government actually, directly, and literally printing money to pay its debts would be immediately offset by drastically higher rates. While this rate spike wouldn't matter too, too much to the government (which can simply print even more money to pay its interest), it would have catastrophic consequences on the still over-leveraged private sector of the US or EU, both of which would be required over time to refinance already unmanageable debts at the new skyrocketing rates.

Unable even to make the necessary interest payment on the debt under these conditions, private sector defaults, bankruptcies and foreclosures would become the rule rather than the exception. Banks would fail at an even faster rates. Government expenses would increase drastically, (due to the cost of bailouts, funding the social safety net, etc.) while its tax revenues would collapse as the economy shrank (due to failed businesses going bankrupt). This would trigger the need for the government to print yet more money to pay its bills, which spikes rates further, resulting in a vicious cycle that decimates the private economy.

And, because the private economy's debts dwarf the government's, the money/credit exiting the system as a result of the collapse of the private sector dwarfs in dollar terms, at least for quite some time, the amount of new money printed by the government to pay its debts/bills. The result is a massive, write-off driven deflation of the entire economy.

Thus, unlike in the Weimar Republic or Zimbabwe examples, runaway inflation is all but impossible where the private sector is already over-leveraged (as is the case in the US and EU today) before the government intervenes. In short, before inflation could even gain a foothold in these countries, their governments would be faced with a deflationary collapse of their entire economies due to a collapse in the private bond market.

Depending how these governments react to such a deflationary collapse, runaway inflation might surface once things hit bottom--that is, once the vast majority of currently outstanding private debt is written off or paid down--but only once this happens. Thus, the key insight is this: When the private sector is as severely over-leveraged as it is in most of the Western world, inflation, if it comes at all, only does so after an extended period of deflation. And, this fact won't change for the peripheral EU nations regardless of whether or not Germany bails on them, and no matter how much they "quantitatively ease".

And so, I stand by my original statement: The idea that inflation is "good for debtors", at least overextended debtors, has got to go. Fortunately, significant inflation is a virtual impossibility in over-leveraged economies, as I have explained, but a government-generated fear of it (in the form of higher interest rates) may very well turn what would have been a slow, bearable, deflationary slide (a la Japan) into an outright deflationary collapse (a la the United States in 1930's, or worse). Thus, with all respect to Mr. Green, interest rates on the re-fi do matter in an over-leveraged economy, for they are the very thing that will prevent governments from taking (or at least successfully implementing) the inflationary measures that he anticipates. We need not worry about $10 trillion shoes anytime soon, at least not until AFTER a deflationary collapse (be it gradual, which is preferred, or sudden).

1 comment:

Anonymous said...

He didn't mean inflation helped. He meant what he said. Crap, why'd he link to this noise?