Taming the beast / 謝國忠
2009-06-17


The US could benefit from inflation as long as it doesn't push the government into default



Andy Xie

Updated on Jun 16, 2009






A tide of inflation fear is sweeping financial markets: the oil price has doubled in three months, the US Treasury yield has surged by a third in one month, gold is nearing its record high again and agricultural commodities are all soaring. The rising prices are taking place amid weak demand. Inflation fears are driving the surge.






The market is getting it right this time. The US is targeting a 5 per cent-plus inflation rate for the foreseeable future. It is the only way to speed up relief for indebted American households. Inflation works well when debts are locked into long-term fixed rates and don't need new financing. The recent wave of mortgage refinancing, for example, has put many American households in an excellent position to benefit from inflation. If inflation surges, American household income will rise with it, but the debt will remain locked into the previous low rates. Of course, the people who lent to American households will be robbed by inflation.






However, the US government isn't quite ready for high inflation. It has US$11.4 trillion in outstanding debt, and that is growing by over US$6 billion per day. The average maturity of the federal debt is only four years and, hence, a quarter needs refinancing every year. With US$2 trillion net financing for 2009, the federal government needs to raise about US$10 billion per day. If the Treasury yield continues to surge, the expected interest burden for the federal government may spiral out of control. At some point, the market may stop lending to the US government, if it expects it to go bankrupt.






The government bond market is usually a Ponzi scheme. Governments rarely run budget surpluses to pay off old debts. They almost always borrow new money to pay off the old and spend the difference. A check of modern history will show that most countries have experienced a government debt crisis. These were about defaulting government debts accumulated over decades. Government bonds are usually viewed as safe, as they rarely default. But, that is only the case as long as investors are willing to lend. When the bonds do default, they do so on all the debt they have borrowed. The safety of government debt is a self-fulfilling market expectation. Hence, when interest rates are high and government financing need is great, the expectation bubble can burst.






When the market stops giving money to the federal government, the Fed can step in and print it, to monetise national debt. However, that will almost certainly lead to a dollar crash and hyperinflation. Russia did it in 1998: it did wipe away the national debt but, with investors shunning Russia afterwards, it remained poor for many years. Only surging oil prices have brought prosperity back. Is the US ready to "do a Russia"? I think not. America still has enough credibility to charter a more profitable path that would impoverish its creditors slowly.






The Fed will probably talk tough on inflation soon and may raise interest rates before the end of the year. Though its action may calm bond vigilantes, it could spark panic over liquidity among commodity and stock market speculators. A market crash is likely. The Fed may need to respond to the liquidity panic with soothing words and more purchases of Treasuries. It will have to skilfully navigate between bond vigilantes and liquidity junkies. The idea is to fool both: they should be made to believe in the Fed's determination to fight inflation and later to support growth. The reality will actually be stagflation.






The ideal path for the Fed is for interest rates to stay well below inflation - keeping the real interest rate negative - and for the US dollar to decline gradually. The former minimises the US debt burden and transfers it to foreigners. The latter draws manufacturing back to the US. It won't be easy to pull off such a feat. The liquidity junkies are easy to manage. They speculate with other people's money and desperately want to be fooled. It takes little to make them jump.






Bond vigilantes, however, are not easy to pacify. They are ardent wealth preservers and will run at the first sign of inflation. However, they may not be as tough as before. Everything else is inflated already. When the consumer price index inflates, to devalue money, there are no places to hide. If the Fed performs well, the bond vigilantes could become pussycats too.






"Feeling lucky" must be hard-wired into the human psyche. When Homo sapiens evolved on the African Savannah, the ones with a penchant for trying new horizons prospered. It was the right strategy in an underpopulated world. One group that felt lucky left Africa for Eurasia and got really lucky; they got the ultimate free lunch - the rest of the world for nothing. We are all their descendants. We are all born with the "get lucky" gene.






Today, however, the world has 6.6 billion people. Everything is taken. So we have created financial markets to satisfy our "get lucky" urge. In this virtual world, central bankers play god and print pieces of paper for us to fight over.






Over the next five years, governments and central banks will suck investors into subsidising economic growth through volatility. We have seen this in the tech world before. Nasdaq attracts people with its ups and downs. Volatility creates the illusion that one can get lucky and become rich.






Over the past 20 years, hundreds of billions of dollars have been poured into tech space. The money has spawned many technologies to benefit mankind. But investors as a whole have not made money.






The same will happen to the stock market in general. A weak economy needs low-cost capital, preferably negative, to maximise employment. No one will put money into a sure loser. Volatility creates the possibility of winning. Nothing turns Homo sapiens into willing losers like a chance.






Andy Xie is an independent economist