Friday, April 8, 2011

Austerity And Inflation Will Go Together

You can hardly turn over an investing advice newsletter without finding a recommendation to buy TIPS, or Treasury inflation-protected securities, to preserve the purchasing power of your dollar-denominated savings.

Economists and investment pros look out three years and can't believe we aren't due for a powerful flush of inflation. The usefulness of their favorite hedging advice, however, depends on the U.S. government actually carrying out the promise embodied in TIPS, honestly to apply an inflation adjustment to protect holders from loss of purchasing power due to the government's own mismanagement of the currency.

Will the spirit and letter of this guarantee be observed? The question has to be asked because Washington has shown no hesitancy to delegitimize legitimate claims by vilifying those asserting them—GM and Chrysler debt holders being the most recent examples. By the time the TIPS question comes up, moreover, the slope will likely have been greased by states and municipalities reneging on promises made to government retirees and bond investors. It will have been greased by governments around the world setting example after example of the many flavors of default. The justice or lack thereof in each such case is not the question. What matters is to recognize that government promises are not written in stone.

Take Japan: It has debt in the hands of its citizens amounting to an improbable 225% of its non-growing GDP, at a time when an aging citizenry will be wanting to cash out its savings to support its retirement, including workers and business owners now prematurely retired by the recent earthquake and tsunami. Already policy makers at the Bank of Japan are openly talking about using the central bank's printing press to finance rebuilding, incidentally setting course to inflate away some of the government's existing obligations.

Take Europe: It continues to hope enough time can be bought with bailouts that transform the obligations of smaller countries into obligations of the larger ones to avoid either an open default or inflation default. The little-advertised prop behind this hopeful scenario is a money-printing program by the European Central Bank to support banks and governments that otherwise would already be belly-up.

Austerity and inflation are not incompatible. Austerity will be a buzz term everywhere as political leaders decide, brutally, which promises to which groups of voters or interests can be junked. When and if Washington has decided to reduce the real value of debt in public hands through inflation, don't dismiss the possibility that it would seek a way to make TIPS holders—or any other politically vulnerable group—shoulder their "fair share," perhaps through targeted taxes.

The same is true, of course, of Social Security and Medicare recipients, who think their benefits are indexed for inflation or otherwise protected because they pay for covered services. What is the perennial threat to arbitrarily slash physician reimbursements except a backdoor default on Medicare benefits? For that matter, even the most desirable kind of entitlement reform (e.g., the Paul Ryan plan) involves cashing out younger people's future benefits at some realistic discount to reflect the improbability of their ever being paid in full. With each year that realistic implied haircut only steepens as federal finances become more hopeless.

All this, let's make plain, is setting the stage for a potential inflation solution to the developed world's vast debt overhang, both official debt and unfunded promises to future retirees. Think it can't happen here? It can, especially when countries representing more than 60% of the world's GDP, including Europe, Japan and the U.S, are seeking the same escape from unaffordable commitments.

Central bankers like Weimar's Havenstein or Peru's Coronado or Zimbabwe's Gono didn't set out to become hyperinflationists. They made the best of a bad dilemma, financing the state through money printing rather than letting it collapse into anarchy. Many investors lately have had recourse to "Lords of Finance," Liaquat Ahamed's depressive book about the 1920s, in which he observes that Rudolf Havenstein, faced with a choice of evils, took a central banker's pride in executing hyperinflation well.

A wise short seller once told us the secret of his profession: People always underestimate how bad things can get. That is, they see the cliff coming and put faith in decision-makers to avoid the cliff. The problem with the metaphor is there is no cliff, just a succession of decision points in a worsening situation. Have no fear that our decision-makers will impose both fiscal austerity and inflation on us when it becomes absolutely unavoidable. The momentous question is whether they will do anything productive in the meantime.

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