Inflation vs Austerity

When facing unsustainable sovereign debt dynamics, a country which is a currency printer* may response with any of the following three approaches (ranked from most to least common): fiscal austerity, a period of heightened inflation, and default. The conventional wisdom is that default is so devastating that it should be avoided at all costs, and while this may not necessarily be reflective of reality (see Iceland, among others) I do not intend to challenge that assumption here.

I would like to debate inflation versus fiscal austerity as approaches to unsustainable sovereign debt. Once again, conventional wisdom (which weighs in overwhelmingly on the side of austerity) appears to have stifled any real discussion in this direction. I suspect that this is due to policymakers’ memories of the stagflation era, and the extraordinary efforts of Volcker et al required to get inflation under control. This has led to a “don’t let that rabbit out of the hat again” mentality, effectively removing a period of heightened inflation from  policymakers’ toolkits.

Not being old enough to remember the aforementioned era removes leaves me more suited to engage in a measured assessment of inflation as a sovereign debt policy tool. The way I see it, the fear of inflation becoming ingrained is misplaced. I am a subscriber of the balance-sheet recession theory (is there really any debate left here?) which posits that the private-sector deleveraging we are witnessing causes considerable deflationary pressures in the economy. In such an economy, if monetary authorities generate elevated inflation, inflation may be brought back into target ranges simply by scaling down or reversing the inflation-stimulating policy.

Sticking to more conventional economics, concerns over ingrained inflation are still misplaced. Inflation-indexed wages negotiated by unions have been identified as a major driver of the persistence of inflation in the 1970s. Due to the sustained downtrend in union density in developed economies, this simply would not be a factor this time around, implying much less inflation "staying power."

A final argument against persistent inflation is the credibility that policy makers have attained in 15 to 20 years of largely successful inflation targeting. If policy makers were to explicitly target a given level of inflation until government debt fell to a predetermined level (or for a pre-specified period of time), and commit to a reversion to more traditional policy thereafter, I suspect that such commitments would be viewed as credible by the private economy.

Having established the reversibility of heightened inflation in today’s context, let’s consider its effects. With the exception of inflation-linked notes, all debt is denominated in nominal currency units, which means that inflation of say 5% is a very effective method of reducing the national debt burden. Who suffers from such a policy? Two demographics: (1) creditors (ie the rich), who have the real value of their savings eroded, and (2) the poor, who feel the most acute pressure from rising price levels. The middle class also feels the squeeze of rising prices, but not to the same extent as the poor. While no solution to unsustainable government debt is pleasant, these consequences are arguably more efficient than those of austerity.

In the case of austerity, the brunt of the pain is borne by the lower and middle classes. This is because, when compared with the rich, this area of the income curve is more reliant on government programs than the rich. Naturally, the poor again are the hardest hit, as they are the most reliant on government programs. Given that they are not as reliant on government spending the rich are left relatively unscathed. Additionally, fiscal austerity tends to lead to sustained periods of below-trend growth (or more usually, widens and sustains an existing gap between trend and realized growth), which has serious ramifications across the income spectrum.

Furthermore, taking the cynical view, inflation is also arguably more efficient from a social unrest perspective. While inflation leads to a slow burn of discontent (via slow, steady increases in price levels), government austerity has much more recognizable, tangible effects, such as the cutting of wages in the public sector, or a reduction in welfare benefits. Such identifiable consequences may come to represent rallying points for social unrest.

The reasoning above leads me to conclude that elevated inflation should at least enter the policy arena, although admittedly it would have to be precluded by an integration of monetary and fiscal policy, similar to  that advocated by Cullen Roche at The Pragmatic Capitalist (here).

*Currency printers (ie the US and UK) differ from currency users (any member of the EMU) in that they determine their own monetary policy, and therefore inflation.

The High-Yield Freeze

Recently there have been a number of comparisons between financial conditions today and those of Q4 2008. A lot of these parallel that have been drawn are tenuous, but one I do think is relevant is the high-yield primary market.

High yield issuance has been going gangbusters over the last couple of years, setting records in 2009, 2010, and was recently on pace for another record in 2011. However, the latest bout of financial instability has left investors unwilling to allocate fresh money to this sector, reducing the flood of high-yield issuance to a tiny trickle over the last 10 weeks.

Assuming the pace that was observed from January through the end July of this year were sustained, there is approximately $65B in 'missing' issuance. Making the further assumption that high-yield corporations have a marginal propensity to spend which approaches 1, this 'missing' issuance represents as much as .5% of annual GDP. With government expenditure set to contract in 2012, any marginal reduction in private investment is not a welcome sign for the economic recovery. Let's hope this market thaws sooner rather than later.

Why the Euro Doesn't Work

Currently there are two existential problems in the euro area. The first is a relatively recent development and must be dealt with immediately, while the second has been building for about a decade and requires longer-term solutions:

1. The positive feedback loop between insolvency in the European periphery and stresses in the European banking sector.
2. The long-term structural divide between unit labour costs in the north and the south of Europe.

Let’s start at the beginning – ironically the second problem above. Before anyone gets pedantic, I realize that what follows quite a stylized story (ie short on details) but I am simplifying for the sake of clarity.

Before the nations now known rather pejoratively as the European periphery joined the euro area, their workers were kept competitive with those industrious Germans through a regime of flexible exchange rates. For example, if the Portuguese were not innovating as quickly as the Germans, the Portuguese escudo would depreciate against the German mark, making Portuguese products relatively cheaper (all else equal) and thereby allowing the Portuguese to compete with the Germans in international trade.

When the euro was introduced, this mechanism disappeared and the European periphery rapidly lost competitiveness with the core.

Seems like a raw deal right? Well not entirely. The upside for these chronically uncompetitive countries was that, despite all of structural differences between the economies, the bond markets began treating debt issued by any European government as essentially the same credit (assuming an implicit mutual guarantee). This allowed these countries to fill the gap created by the erosion of their domestic private sector with government spending financed by cheap debt issuance.

This was all good until it wasn't. Once people woke up to state of the sovereign finances in these countries (initially just Greece), they rushed for the exits. With European policymakers refusing to take bold action to resolve the crisis, it spread and evolved to the point where we stand now - uncomfortably close to the abyss.

The next post will describe in more detail why policy fixes introduced have been insufficient, and detail the policy prescription necessary for Europe to extricate themselves from the mess they have found themselves in.

Note: I have not included Ireland in this discussion because I consider both its path to fiscal ruin and the steps to recovery be considerably different from the nations detailed above.

Rececssion Ahoy!

On Friday, the ECRI publicized their call that the U.S. economy was headed for a recession (here). This firm has a respectable track record of forecasting turns in the business cycle, so this is a particularly noteworthy call.

Most of the financial commentary I have read so far has been forecasting a garden-variety recession (should one even occur), with corporate earnings falling 10-15%. While I have yet to be able to quantify the effect on corporate earnings, I take issue with comparisons to historical recessions for a number of reasons.

Starting with the C in Y = C + I + G + X, the consumer is still balance-sheet constrained. Historically, when consumer income fell, consumers would borrow money to smooth their consumption. With the American consumer leverage sitting as high as it is, it is likely that consumer spending will fall more than in historical recessions (higher flow through from falling consumer income).

Moving on to investment, while I am not expecting a total credit market freeze for highly-rated corporates,  the high-yield primary market has been effectively closed for nearly three months. Historically, high-yield names have not been a meaningful proportion of total corporate issuance, but in the last two years, we have seen $600B in high-yield issuance, which I suspect has significantly inflated business capital expenditures (admittedly some of this issuance was debt-for-loan swaps). With this group of firms locked out of the primary market (and higher-rated firms behaving in line with historical experience) I expect there to be a larger decline in business investment than has been seen in historical recessions.

Government. Given the hysterical obsession with cutting spending (and taxes) in the House, I cannot see the U.S. passing any marginal stimulus until after the 2012 elections. If this is the case, government expenditures will actually contract relative to 2011. This is in direct contrast to historical recessions, wherein the government traditionally inflates expenditure in an attempt to stimulate the economy.

I do not have any strong feelings on net exports and feel that it is probably a wash.

Throw in European and Chinese tail risks, and the risks to the consensus recession forecast are clearly overweighted on the downside.

I should clarify that I am not saying with 100% certainty that teh U.S. is headed for a recession (although I do believe that a recession is more probable than not), but rather detailing my thoughts on the nature of the recession, should it occur. I will flesh out these thoughts in upcoming posts.