A recent research paper* by the Bank for International Settlements, entitled “The Future of Public Debt: Prospects and Implications” paints a terrifying prospect for the inhabitants of most of the developed world with deficits spiralling out of control for every western industrialized country under study and inflation a foregone conclusion as a result. Words: 1128
In further edited excerpts from the original article** Cam Hui (www.humblestudentofthemarkets.blogspot.com/) goes on to say:
Deficits to Persist – Regardless
What is more depressing about this study is that, regardless of the level of budget cuts (with or without cuts to promises made about entitlement programs), debt to GDP continues to skyrocket for the major industrialized countries of Japan, UK and US and what is even MORE worrying is the fact that, as the report states:
“Most of the projected deficits are structural rather than cyclical in nature. So, in the absence of immediate corrective action, we can expect these deficits to persist even during the cyclical recovery.”
Inflation is Coming – Regardless
The authors then conclude that all roads seem to lead to inflation and a tight monetary policy cannot prevent its resurgence, saying:
“When the public reaches its limit and is no longer willing to hold public debt, the government would have to resort to monetisation. The result, consistent with the quantity theory of money, is inflation and anticipation that this will happen may also lead to an increase in inflation today as investors reassess the risk from holding money and government bonds. In such an environment, fighting rising inflation by tightening monetary policy would not work, as an increase in interest rates would lead to higher interest payments on public debt, leading to higher debt, bringing the likely time of monetisation even closer. Thus, in the absence of fiscal tightening, monetary policy may ultimately become impotent to control inflation, regardless of the fighting credentials of the central bank.”
In other words, a Volcker-style approach of tight monetary policy in order to wring inflationary expectations out of the system may be futile. Inflation is ultimately a fiscal phenomenon. What’s more, bond market vigilantes won’t solve the problem in time as the report point out:
Simmering Fiscal Problems Coming to a Boiling Point – Regardless
“[B]ond traders are notoriously short-sighted, assuming they can get out before the storm hits: their time horizons are days or weeks, not years or decades. We take a longer and less benign view of current developments, arguing that the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point. In the face of rapidly aging populations, for many countries the path of pre-crisis future revenues was insufficient to finance promised expenditure.”
Unemployment and Debts/Deficits to Stay High – Regardless
The standard solution for believers of the free market is that organic growth, i.e. economic growth not from government stimulus, will eventually happen and, as such, we can grow our way out of trouble. The report believes that these structual deficits are so overwhelming that:
“We doubt that the current crisis will be typical in its impact on deficits and debt. The reason is that, in many countries, employment and growth are unlikely to return to their pre-crisis levels in the foreseeable future. As a result, unemployment and other benefits will need to be paid for several years, and high levels of public investment might also have to be maintained.”
Either USD to Collapse or Interest Rates to Go Much Higher – Regardless
Fiscal deficits do matter and interest on debt can overwhelm spending priorities. Long-time analyst Richard Russell, publisher of the Dow Theory Letters since 1958, wrote the following words about a year ago:
“The US national debt is now over $11 trillion dollars. The interest on our national debt is now $340 billion. This is about a 3.04% rate of interest. In ten years the Obama administration admits that they will add $9 trillion to the national debt. That would take it to $20 trillion. Let’s say that by some miracle the interest on the national debt in 10 years will still be 3.04%. That would mean that the interest on the national debt would be $618 billion a year or over one billion a day. No nation can hold up in the face of those kinds of expenses. Either the dollar would collapse or interest rates would go through the roof.”
Bill Gross of PIMCO also came to a similar conclusion about the trajectory of the US fiscal position:
“As the IMF… aptly pointed out, high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly. In the U.S., in addition to the 10% of GDP deficits and a growing stock of outstanding debt, an investor must be concerned with future unfunded entitlement commitments which portfolio managers almost always neglect, viewing them as so far off in the future that they don’t matter. Yet should it concern an investor in 30-year Treasuries that the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt? Of course it should, and that may be a primary reason why 30-year bonds yield 4.6% whereas 2-year debt with the same guarantee yields less than 1%.”
Is It Time to “Buy” Inflation?
The authors of the BIS working paper believes that all roads lead to inflation. I concur with that view and, as such, inflation hedge vehicles such as hard assets, commodities and shares of commodity producers have their place in every portfolio. However, I also believe that any commodity bull is likely to experience a high degree of volatility as gold’s surge from $35 in the early 1970s to $850 in January 1980 followed by a correction of 43% exemplified.
Here is the dilemma. The world faces a high degree of uncertainty about policy direction, which should result in gut-wrenching intermediate term market volatility. Global economies are currently mired in a fragile slow-growth environment, but inflation could break out at any time. Investment hedges that perform well in a runaway inflationary environment will do poorly in a recessionary period and vice versa. You can get the picture right and get hurt really badly in the interim.
– The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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