The mega-cycle is coming to an end

Is hyperinflation inevitable?

by DETLEV SCHLICHTER

One of the major lessons of the financial crisis thus far should be that every bond constitutes credit risk – even those issued by sovereign states and banks. Conceptually, that should be obvious, but the investment management industry has long treated government bonds as “safe assets”, at least those that are issued in the government’s own fiat money. Similarly, the debt of major banks was also considered particularly credit-worthy, not least because of the implicit government support the banks enjoy courtesy of their systemic importance. If the present and ever-evolving financial crisis has now turned the spotlight on the considerable and constantly growing debt load of sovereign states after already highlighting the overstretched balance-sheets and thin capital bases of most banks, it is thus equally exposing the long-standing irrational exuberance of bond investors who, for decades, have happily piled into these bonds.

I should probably declare an interest here. I spent almost two decades in the bond business. I have been part of it and I think I know it well. But don’t take my word for it, look at the Barclays Capital Global Aggregate Bond Index, a reasonable representative of the current market place for investment-grade rated, liquid bonds around the world. Its present market capitalization? A mind-blowing $ 40 trillion, more than half of which is made up of government bonds (and mind you, these are only the most liquid ones – governments have even more debt outstanding).

Only about 16 percent of the global bond universe is debt issued by corporations. Of that, about half is from financial institutions. Investing in global investment grade bonds is practically synonymous with investing in government bonds, government-related enterprises, government-supported mortgage-backed securities or government-regulated and supported banks. Only a tiny fraction of the market is occupied by truly free-market enterprise.

Paper money encourages debt accumulation
Lenders have always been happy to give their money to the state and its proteges. After all, contrary to the rest of us who have to earn an income in the market place by producing something that the fickle consumer will – hopefully – spend money on, the state can simply tax the winners of capitalist competition at the moment they come into the money – and share the loot with the state’s financiers. It is evidently safer to become a stakeholder in the state’s monopoly of taxation than a lender to an entrepreneurial enterprise.

But there are limits to how much the state can tax the population (even in Sweden), and despite their taxation-privilege, states do in fact have a history of getting into fiscal problems, losing the trust of their creditors, and even defaulting. These risks seemed to be further diminished, however, with the establishment of complete fiat money systems, in which the state (or the state’s very own – Stalinist term coming up – central bank) can produce as much money as it likes, practically at no cost and thus without limit; money that can be used to pay the state’s creditors.

The advent of complete paper money systems was even more meaningful for the banks. In a system of hard money (such as a proper gold standard), lending to banks should come with a health warning. For the past 300 years, banks have derived a considerable portion of their profit from creating deposit money, that is, from issuing instantly redeemable claims to money proper (gold or state paper money) with only a fraction of these claims being backed by the type of money they constitute a claim to. This is called fractional-reserve banking, and whatever you think of it, it is clear that it makes banks particularly risky, and it is the reason why the history of banking has also been the history of occasional bank runs and panics. All of this, the advocates of unlimited state-controlled fiat money promised us, should now be a thing of the past. Bank reserves are no longer hard commodities of essentially inflexible supply but fully elastic fiat money under the guidance of enlightened economists. In the paper-money printing central bank the banks now have a “lender of last resort”.

“What could go wrong?”, the bond investor asked. Lending to banks and states is practically risk-free. The state won’t let the banks fail – the fall-out is politically unacceptable. And in a full paper-money system, the lender-of-last-resort can produce unlimited bank reserves to bail out the banks. Equally, the state can always pay. The cost of overspending can be socialized across all paper money users via inflation. Higher inflation may be a nuisance but as long as it remains somewhat contained it shouldn’t be intolerable, and most bond investors, such as pension funds or insurance companies, seem to consider their obligations to their customers to be mainly nominal ones anyway, not real ones. As long as they can repay the promised notional amounts of dollars, euro, pounds or yen, they have done their job, regardless what those monetary units may buy in the end. Within limits, bond investors prefer inflation to outright default.

This system makes states and banks appear as particularly credit-worthy borrowers and thus provides a powerful incentive for states and banks to borrow. Which is precisely what they did. And they did a lot of it.

Our present complete paper money system only dates back to 1971, when Nixon shut the gold window (to allow the state to run larger deficits, of course!), and it should not surprise anybody that overall levels of indebtedness have exploded over the past 40 years. In 1971, net debt in the United States was about 150 percent of GDP. In 2009, it was 370 percent.

The mega-cycle is coming to an end

That elastic money is a source of economic instability we should know since the British Classical economists demonstrated it more than 150 years ago, and certainly since the Austrian economists (Mises and Hayek) explained it even better a little less than 100 years ago. In a nutshell: Investment funded with proper saving leads to sustainable gains in wealth; investment funded by money printing leads to boom-bust cycles. But our brave new system of unlimited fiat money is a system of super-elastic money. When the investment boom turns into a bust, the central bank can lower rates and print even more money. Debt deflations and bank defaults are things of the past, so are cleansing recessions. The business cycle can be extended. The super-credit cycle has arrived. The debt load never shrinks. It just keeps growing. Can this go on forever? No, it cannot. And the endpoint has been reached, I think.

In 2007, the dislocations created by easy money finally came back to bite the banks in a major way: U.S. subprime was the first domino, and then the larger mortgage-backed and asset-backed complex caved in. The banks had to call the cavalry: the state and the central bank. The socialization of the fallout has since been pushing state finances over the edge. Ireland and Spain, formerly states with relatively low debt-to-GDP ratios, are already insolvent or on the way to insolvency courtesy of the implicit backstop they provide to their overstretched banks.  Complacent observers in the UK are still congratulating themselves for staying outside the euro, obviously missing the point that their own government is running deficits similar to those in Greece and Spain, as is the United States government. I don’t see that many differences between the various economies and major currency areas. Wherever I look I see similarities. Everywhere fiscal positions are unsustainable, and everywhere the central banks provide the ultimate backstop and stem themselves valiantly against the liquidation of the accumulated dislocations.

It is clear that in the paper money system the solvency of state and banks is ultimately underwritten by the printing press. The central bank is, according to the logic of the paper money economy, the designated ultimate bulwark, the final line of defense against bank runs and government bankruptcy. All that heavy borrowing by the states and banks over previous decades has accumulated massive claims against the printing press. These claims are coming due — now.

Is there any chance that the central banks can wiggle their way out of this trap?

‘Stimulus’ is failing

The comforting fable currently propagated by the policy establishment and large parts of the media is that this is just another business cycle, to be overcome with the usual recipes of easy money and government ‘stimulus’. Of course, it is nothing of the sort. We are in the inevitable endgame of our four-decade old system of unrestricted fiat money.

If the ‘stimulus’ of easy money were to get much traction – which is obviously difficult given the already accumulated debt load – it would generate more growth via the creation of more debt. Monetary stimulus and debt reduction are mutually exclusive. If easy policy “worked” now it would only create a temporary relief by adding to the underlying problem and setting the stage for an even larger crisis in the future. After all, this is precisely why we are in this mess.

Poor bond investor. It is clear that the debt load is now too big. It will not be repaid in anything of comparable value to what the bond investor put in. And there are not even credible plans on the table for stabilizing the debt load. Look at Greece – the goal appears to be to return the country to international debt markets so it can borrow again. That a sovereign state should live within its financial means seems to be too fantastical a notion.

Default or inflation?

Will this massive dislocation of excessive debt be rectified via default or via inflation? Sadly, I think it will be both in the end.

The endgame will include inflation, and probably hyperinflation. Not because this would be a chosen policy path, not because policy-makers would try to inflate the debt away – which would be a truly suicidal undertaking.

Instead, I expect policy-makers to do what they always do: muddle through. The debates about a few spending cuts and austerity measures here, and a few tax increases there will continue. But all of this has to occur against a backdrop of low interest rates and very easy money. As Lehman and Greece have shown, once the market loses confidence in a borrower and demands considerably higher yields, a new dynamic develops and default becomes inevitable. The system is so overstretched, it needs low rates and tight risk premiums as far as the eye can see.

As Lehman and Greece have also shown, default – although the cleaner, more honest and ‘capitalist’ thing to do in order to scale back the debt – is unacceptable for political reasons. The fallout for banks, pension funds and insurance companies would be too painful. Additionally, it would put upward pressure on interest rates and risk premiums on other debt as bond investors would want to protect their other investments through higher yields. But market yields and risk premiums must be kept at artificially depressed levels by all means available in order for the overstretched credit edifice to stagger on. Increasingly, everybody is too big to fail.

No exit strategy.

There is no exit strategy for the central banks. None of the major central banks can (or will be allowed to) meaningfully raise lending rates or shrink their balance sheets. On trend, the opposite will happen. Ever more assets will have to be supported via money injections, either directly from the central bank or via easy funding rates for the banks, which in turn help keep asset prices at elevated levels.

The key ingredient that will give the process a new dynamic is changing expectations among market participants. The users of paper money and the holders of debt will ultimately demand higher yields. Already, enough of the easy money that is being created to prop up the banks and the bond market is spilling into the broader economy to raise measured inflation. If, at any point, people decide to reduce their cash holdings out of fear of rising inflation, the velocity of money will rise and inflation will accelerate even without a meaningful further expansion of broad monetary aggregates. Cash becomes a hot potato.

At this point, the central banks would have to hike rates meaningfully to restore confidence in the state’s paper money. This, however, is strictly verboten given the central bank’s present role of system-wide backstop. The central banks cannot be the trusted guardians of fiat money’s purchasing power and the “lenders-of-last-resort” to the entire financial system at the same time. But buying substantial amounts of debt in order to keep risk premiums from expanding or bond yields from rising has already become established central bank policy for the U.S. Fed, the Bank of England, and the ECB.

The position the central banks have been maneuvered into is not an enviable one. They are boxed in. When rising inflation concerns and/or rising fears of defaults lift market yields and risk premiums, the central banks have to expand their balance sheets and print more money to keep the system from contracting – thereby adding to fears of inflation and even to fears of ultimate default, as easy monetary policy must obstruct the deleveraging process on the margin.

When more and more savers exit the bond market and the market for bank deposits out of concerns about inflation and excessive debt levels (something that, I may add, is not happening yet but that I consider a matter of time only), the central banks will have to step in and use the printing press to support the bond market and the banks – this will lead to the concerns of savers about the purchasing power of their savings to rise even further.

It is precisely such a vicious circle that is the main threat to a paper money economy at an advanced stage of debt accumulation. I hate to say hyperinflation is inevitable – few things are. But I consider it highly likely. Be prepared!