Janus was the Roman god of beginnings and transitions. His two heads simultaneously looking at the past and the future. Will our economic future mirror our recent past with relatively mild deflation, or will massive government debt create far more devastating outcomes?
Government borrowing has been a serious issue for the majority of developed nations for many years prior to the debt crisis of 2008 (which created the worst recession since the 1930’s). But the current level of both annual deficits and cumulative debt now makes the potential for the default of sovereign debt a distinct possibility.
In his new book “Endgame: The End of the Debt SuperCycle and How It Changes Everything,” John Mauldin, along with his co-author Jonathan Tepper, has written a detailed analysis of sovereign debt starting with how we got here and, of course, looking forward to the Endgame.
- Is there a limit to how much governments can borrow?
- What does this mean for interest rates?
- What about other asset classes?
- Does the Endgame of too much debt lead to deflation, inflation, or the type of hyperinflation that has destroyed many currencies over the last 100 years?
While we’ll cover some of the observations that John makes, I would recommend all of you get a copy of this book.
2008 has illustrated what occurs when individuals acquire too much debt (primarily through housing) and how the required repayment of that debt can destroy both wealth and income (through unemployment).
Today, governments around the world have taken it upon themselves to try and borrow their way out of recession and, at the same time, continue to “guarantee” entitlements such as pensions and health care that they know cannot be afforded.
As Greece, Ireland and Portugal have shown, bond markets can say no to governments by requiring interest rates that would impress a loan shark. It is almost inconceivable that any of these countries can raise taxes, lower benefits and repay their outstanding debt without some type of default. Current bondholders (primarily German and French banks) will receive a serious haircut (something I have not been able to experience for many years).
Consider the chart below (The End of the Debt Supercycle) which shows the current level of government debt (as of 2010) for several major developed countries. On average, their debt-to-GDP ratios are under 100% (but now increasing rapidly). However, if you add in the present value of their unfunded liabilities related to pensions and health care, that average rises to almost 500%. These promises cannot be afforded and thus will change. This is also part of the Endgame as Mauldin sees it.
The charts to the right and below (taken from a report just completed by the Economist magazine) show how much the state’s share of the national income of developed countries has grown. As you can see it averages almost 50%. Even if it went to the theoretical maximum of 100%, you could not fund the liabilities related to healthcare, education, welfare and government pensions. And if there is any doubt in your mind as to whether a government can support its people entirely, remember what happened to the Soviet Union.
“Endgame” starts with a look at where we are now and, specifically, “Why Greece Matters” as it is likely the canary in the coal mine. The middle of the book looks at the Inflation / Deflation argument and Mauldin illustrates how often the end result of excessive debt has been hyperinflation. The last part of the book considers specific potential outcomes for the U.S., Europe, Japan, Britain and Australia (which is experiencing its own housing bubble right now) along with a section on emerging markets.
Of course no book that focuses on doomsday outcomes would be complete unless the authors had ideas of how one should manage wealth in this environment.
I would like to focus on two areas:
- The Inflation / Deflation debate
- Building a portfolio that would perform well in either scenario
The Inflation / Deflation Debate
Usually when governments or individuals reduce debt, the results are either deflationary or disinflationary (prices do not drop but the rate of inflation does). There are several reasons for this:
- As consumers repay debt, they also reduce consumption. That creates excess capacity in society to produce both goods and services. Typically, unemployment rises (as it did in 2008) and prices will either drop or rise far less rapidly than before.
- In many cases, in order to pay debt, assets have to be sold and that in itself creates the vicious circle of those assets’ values declining, because now sellers outnumber buyers. This happened to almost all asset classes in 2008 and early 2009. In the U.S. alone, net worth-to-GDP per household dropped from over 600% to less than 450% (partially recovered since). This “reverse” wealth effect increases individuals’ desire (need) to save and exacerbates their reduced consumption. Deleveraging is deflationary.
- Collapsing house prices have a greater impact on the wealth effect than falling equity markets, since the majority of wealth in the developed world is locked up in housing. More than five years ago, John Mauldin wrote that in some years during the 2000’s more than 60% of U.S. GDP was created because individuals could borrow money on their homes as if they were ATM’s. Obviously, this period is over and may never return.
- The Velocity of Money. Nobel prize-winning economist Milton Friedman wrote that inflation was always a monetary issue caused by the creation of money by central banks. All things being equal, that is probably a reasonable observation. However, there is another factor that affects inflation and that is the velocity of money. Simply put, central banks may be able to “print” money, but they cannot force banks or individuals to spend it. If they do not spend it and instead use it to reduce debt or save it, then the velocity of the money supply will drop and there will be less inflation than one might expect with all of this new found money floating around. The graph above (Equation of Exchange) from “Endgame” shows how much the velocity of money has been dropping over the last 13 years.
- Government Austerity. I realize this is in fact an oxymoron along the lines of “jumbo shrimp”, but we are starting to see the impact of governments such as Greece, Portugal and Ireland having to make drastic budget cutbacks in order to get financial support from the European Central Bank and the International Monetary Fund. Less government spending creates less consumption. Unfortunately, it can also trigger additional recessions which, in turn, reduce government revenue and potentially make the fiscal situation even worse.
From a borrower’s perspective, deflation is the worst outcome since the face value of the outstanding debt actually increases over time in “real” currency and the cost of servicing rises because even though the payments are fixed, the value of those payments is going up.
Borrowers want inflation that reduces both their debt service burden and the value of their overall debt.
The largest borrowers are governments, so the ideal solution to their debt issues should be inflation. Let’s consider the arguments:
- Governments can, through their central banks, create money and use it to finance their own debt (Quantitative Easing, or QE). In theory, once the economy recovers, they would end quantitative easing because their revenues would rise and their expenses would fall as employment increased, company profits rose and consumption resumed. A perfect solution with only a few unhappy bond-holders sitting on long-term government debt with interest rates insufficient to cover the impact of inflation.
- Over the last 100 years in particular, all countries have experienced a significant amount of inflation. Since 1911, the cumulative inflation rate in the UK is 8600% and in the U.S. and Canada 2500%. That means a pound is worth barely more than a penny and a dollar is worth less than a nickel. At the same time, however, our real standard of living is far higher than it was before World War I. So inflating away debt seems to be good for society and looks to be providing a free lunch for governments as well.
The inflation argument is very strong since it has been the de facto standard for over a century (absent the depression years). However, I have a problem with the conclusion that governments can inflate away their liabilities over time and repay their debt-holders with worthless paper. Nice theory, but the facts do not support it (except for countries who simply default on their debt, which we will look at later with hyperinflation).
Let’s consider the interesting (if apocryphal) story of “Basil Cliveden’s Trust.” Basil, as you may have guessed, is English. 100 years ago, Basil’s great-great-grandfather established a 100-year trust for the future Basil and settled it with £1000 of British gilts (government bonds). The gilts matured in 10 years and interest was to be reinvested with the gilts renewed at the end of each decade.
In 100 years, the capital of the trust was to be given to Basil. Now as I noted above, the impact of 8600% inflation on £1000 is devastating and, in fact, the original bonds would now only be worth about £12. Of course, we have to factor in the interest on the bonds and the fact it has compounded for 100 years. From the British government’s perspective, they will be ahead as long as the total value of the current trust is less than £86,000 (86 x £1000). Unfortunately for them, Einstein was right when he said compound interest was the eighth wonder of the world, because Basil’s trust has just over £300,000 in it as a result of earning an average interest rate of 5.9% for 100 years.
So the government was not particularly effective in using inflation to reduce its real obligations to Basil and his trust. The primary reason for this is that lenders understand the impact of inflation on debt and require a margin over inflation to insure the purchasing power of their money over time. Sometimes they can lose; for example, when buying very long term bonds with fixed interest rates just before an inflationary period (such as the 1960’s and 70’s). But over time this tends to provide real positive returns.
And if you think Britain is upset about its total obligations to Basil, consider how the Canadian government feels about their accumulated debt owed to Basil’s Canadian cousin, Iggy Harper. Iggy’s trust was settled with $1000 and has now grown to $225,000. The bonds would have had to grow to a value of about $25,000 to compensate Iggy for 100 years of inflation. That means that his trust has earned a $200,000 profit for him after inflation. A very reasonable return.
As you can see, even when governments are borrowing in their own currencies they have difficulty paying back money borrowed at a later date with “cheap” currency. In the vernacular of the street “the vig” (interest) they have to pay is almost always more than the benefits they may receive from inflation.
Furthermore, many of the long-term benefits funded by governments such as pensions and healthcare are directly or effectively adjusted with inflation. Higher inflation will not have reduced these future liabilities for the state.
Having said all of this, there is a form of inflation that destroys both the value of bonds and other debt instruments and, eventually, currencies. This is hyperinflation and there have been at least 28 different versions of this experienced around the world in the last 100 years as shown below (Hyperinflations in History).
You can go from the relatively mild 53% monthly inflation in Belarus in 1994, to the 10-quadrillion% monthly price change in Hungary after WWII. In most cases, the end result is total destruction of paper assets, default on debt and the requirement for a new currency to be issued. There are exceptions to this such as Brazil, whose annualized inflation reached more than 6000% in 1990. Now it is 6.3% and the Brazilian Real is a strong currency, as is the country overall. Unfortunately Brazil is the exception and not the rule.
So will the U.S. or other developed countries experience hyperinflation and, as a result, default on their debt? Mauldin and Tepper do not think so because of:
- the independence of central banks to control the money supply (this might change if they lose that independence), and
- the relatively quick responses that bond markets have to any borrower they deem to be in trouble (witness Ireland, Greece and Portugal).
But if governments’ response is to pressure their central banks to continue with QE while making no sincere effort to control deficits and spending, then the risk of hyperinflation will change.
Hyperinflation is an unlikely outcome, but not impossible.
We would be remiss in not showing how well Canada has done in leading the G7 in fiscal responsibility. (And yet we continue to have significant waste in our overall public spending…)
- Canada has the lowest deficit-to-GDP ratio in both 2010 and 2011 (the current rate is expected to be about 2.7% vs. almost 10% in the U.S. and an average of almost 7% in Europe and Japan).
- Canada has the lowest overall debt-to-GDP ratio even when one includes all provincial debt (62% combined net debt based on the latest by TD economics).
- Canada is the only country where both major political parties forecast a balanced budget by 2014-2015.
Considering that it was only 16 years ago that we had one of the largest annual deficits and highest debt-to-GDP in the G7, our change has been remarkable. It also shows other nations it can be done without destroying jobs or wealth.
Building an Investment Portfolio for Inflation and Deflation
Before I get into what investments should work well in deflationary or inflationary environments, I would like to give my own comments as to why I lean towards a balance between the two. In fact, I can see extended periods of low inflation which will drop to mild deflation during recessionary periods and that this will last until a significant amount of the excess leverage built up over the last several years is reduced.
What will make me change my mind, is how governments respond to deficits, debt and entitlements. If they put their heads in the sand and continue with kicking the can down the road, then the greater long-term risk is inflation. So far, at least a few countries are making the right noises. However, until big players such as Japan and the U.S. get serious about fiscal management, I remain open to changing the position below.
My main reasons for expecting mild inflation/deflation are:
- Very little power for individuals or unions to increase incomes when spare global capacity is so large.
- Individuals are repairing their balance sheets and will increase savings for retirement. That means less consumption.
- Technology is likely to continue to allow us to see increases in overall productivity and a reduction in the costs of many goods and services.
How does this translate into a strong balanced investment portfolio? To explore one answer, let’s consider the recommendations of two well-known authors who took opposites sides to this question.
Gary Shilling (PhD) is a respected economist who has been forecasting for more than 40 years. He is strongly in the deflationary camp and has just written his latest book “The Age of Deleveraging.” Below are his main thoughts and specific investment recommendations.
Another point of view is expressed by Tony Boeckh (former CEO of the world class Bank Credit Analyst). He sees government spending triggering an eventual reflation (see his book “The Great Reflation“), but not hyperinflation. His specific recommendations are below.
What I found interesting with both books – and several others I have read recently – is how many investment classes they agreed on, including income-producing real estate (especially rental housing in the U.S.), dividend paying stocks, and energy companies.
In fact, their major differences are that Shilling sees 30-year Treasury bonds as an investment with great potential returns in a deflationary environment, but Boeckh sees just the opposite and wants inflation-linked bonds. They also disagree about strong currencies. Boeckh likes the commodity providers (Australia, Canada, etc.) and Shilling feels the U.S. will enter a period of resurgence.
Nevertheless, more in common than you think.
In a perfect world you would have a portfolio that would do well in both environments. This is where cash flow becomes so important. The three things they agree upon are income-producing real estate, dividend-paying stocks, and energy companies – all asset classes with steady current income that would react well to added inflation, but would not decline appreciably with mild deflation.
To what these gentlemen have said I would add the following:
The issues raised in John Mauldin’s book “Endgame” are critical to our future and the protection of our families and our overall wealth. Once you have read the book you might decide to get more involved politically in what your MLAs and MPs are doing with your money. Are they willing to tackle serious funding shortfalls with realistic solutions?
We are in the Janus Dilemma. We have enjoyed a profligate past which has seen both private and government debt rise to record levels; meanwhile, governments have made commitments to fund programs with future dollars they do not have. Our future would look bleak indeed if it were not for the discipline that markets are capable of providing.
Janus may be able to look both into the future and past but we are the ones who can affect our future by learning from our past.
What do you think: are we headed for inflation or deflation? Let us know in the comments below!