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European, American and Asian politicians are increasingly facing difficult choices for meaningful fiscal consolidation. These choices can in turn influence market movements. Important steps, however, are being delayed, causing an economic and political environment of "muddling through."

The link between politics and markets is not new. What is different now is that there are many countries where the functioning of the government is hampered by debt problems. In the eyes of the public and businesses this creates an image of constant insecurity. And because the public and private debt is so very difficult to solve, policymakers grab easier solutions like restructuring or monetizing debt. Such solutions, however, have disadvantages.

Political dysfunction

In the U.S., Europe and Japan this has led to the path of least resistance; debt monetization. This is implemented in the form of quantitative easing or what's called "financial repression," an indirect policy initiative that actually imposes on individual and institutional investors to hold government bonds. In a complex political decision climate, political dysfunction and polarization has often led to monetization.

For example, the Federal Reserve decided shortly after the presidential elections to expand "QE3", while the budget abyss - fiscal cliff - was far from being settled. The same thing has taken place in Japan, where the new political leaders actively sought a closer cooperation with the Japanese central bank seeks to stimulate the economy.

Stagflation

The big question is whether monetization leads to inflation. Based on the experiences from the 60s and 70s one would expect a return of stagflation. Under a structurally high unemployment environment in many countries, monetization may generate higher average inflation.

However, it is useful to take into account that the fiscal consolidation in the sixties and seventies was less pronounced than now. In addition, the labor unions had then more power to negotiate higher wages. Today, wage moderation and fiscal policy adjustments have a greater negative and disinflationary impact on economies.

Money Press costs nothing

This explains why politicians tend to directly or indirectly increase pressure on central banks to intervene to stimulate growth. The printing press costs nothing, and it is a politically attractive way to avoid a disastrous scenario. Recent data from the IMF and the Bank of International Settlements show that households and non-financial sectors in developed economies have government bond holdings up to a size of 100% to 200% of their respective GDP. Simultaneously, since 2009 central banks have accumulated about USD 3.5 trillion in government bonds onto their balance sheets.

Higher inflation

In short, the trend in the U.S., Europe and Japan points strongly to the direction of further monetizing debt and deficits. The impact on inflation is not felt in wages or labor, but on the financial markets, where asset prices are at an increased elevated level. In time, the policies of deficit financing may have financial markets experience higher asset price inflation than pre-crisis. This trend in asset prices may continue in both bonds and stocks whereas at some point markets may seriously question how effective monetary policy is, if economic fundamentals continue to lag. Thus far there remains a large 'wedge' between asset prices and the economy.

Source: The Politics Behind Debt Monetization