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The headlines have been rife with reporting on the rift between Republicans and Democrats in trying to deal with the enormous fiscal deficit and the burgeoning government debt of the United States. From a manageable 62 percent of Gross Domestic Product ("GDP") in 1998, U.S. government debt now exceeds 101% of GDP.

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This is not news. It would be hard to imagine an adult in business anywhere on earth that is not aware of the size of U.S. government debt. In fact, everyone has heard about the magnitude of the problem so often and for so long that they have become inured to it and no longer worry about the threat it poses to their financial well being. They should.

We have all heard the term Quantitative Easing ("QE") frequently over the past few years, as the governor of the central bank has taken the lead to try to stimulate economic growth or at least prevent economic collapse by ensuring there is a market for the $1 trillion the U.S. government is borrowing each year at rates of interest low enough that payments of interest won't exacerbate the problem. In doing so, they created a boom for bond investors and made gurus out of bond fund managers like Bill Gross of PIMCO (who deserves the accolade in any event as a brilliant manager).

QE is a nice term for printing money. Most people would be alarmed to think that it is fine for the government to pay its bills by simply printing more money. An elaborate charade is being carried out to disguise the situation, first by using terms like QE, which sounds positive, not frightening at all. And, we are told, QE is "driving up asset prices" like prices of stocks. As investors we like that too. In fact, most analysts fear the end of QE.

Rightly so, since QE is not likely to have a happy ending.

During the immediate post-first-world-war period, the Weimar republic in Germany was faced with substantial reparation payments to the countries that won the war. Incapable of meeting those obligations, it simply printed money, buying as much foreign exchange with the currency as it could. Before long, no one would accept German marks for foreign currencies and the mark devalued sharply.

As John Maynard Keynes wrote in his book, "The Economic Consequences of Peace"

The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance.

The parallel in the United States today is extraordinary. Over 15 years, the United States money supply has grown five fold, with 60% of the growth in the past five years.

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QE, as it is so elegantly called, simply means the central bank is buying bonds and mortgage backed debt at the current rate of $85 billion monthly, or in round number $1 trillion a year. By "buying" it means printing more money to pay for the securities it is purchasing.

A look at the chart shows the significance of adding $1 trillion of new money supply each year. It is not likely to cause "money supply" to decline. Money supply is an interesting concept, since it includes more than just cash in circulation, but also bank deposits. Of course, bank deposits are loaned out to borrowers by the banks that hold them, and new money supply is thereby created. Depending on how quickly this happens, how much of the loans become new deposits, etc. the amount of "money supply" is not always easy to predict.

The Federal Reserve Bank has soft-pedalled the importance of money supply after paying lip service to Milton Friedman's thesis that money supply is a predictor of economic growth and inflation.

It doesn't go so far as to say it doesn't matter but just far enough to water down its significance.

A chart of growth in money in circulation in the Weimar Republic has a similar shape to the U.S. money supply chart today.

Its significance in the Weimar Republic was hard to water down as displayed in the dramatic chart found on Wikipedia.

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In only five years, German marks went from being a stable currency to virtually worthless.

You might ask why the central bank of the United States has embarked on such a policy. The answer should not be a surprise. It really has little choice. The politicians in the United States do not want to face the music and deal directly with the issues. For years, they have purchased their votes by promising voters benefits for which their children must ultimately pay. It is politically hard to take back a so-called "entitlement." It is similarly hard to raise revenues through higher taxes.

The solution is to try to engineer a soft inflation over a longer period, and make the debt less and the GDP greater in nominal terms through general increases in prices. Higher nominal GDP means higher nominal tax revenues. The debt is fixed in principal and much of it with fixed rate interest, so the buyers of the debt will effectively get less than they are owed. In substance, the engineered low interest rates are a tax on savers and the inflation is a tax on financial assets.

I am not suggesting the U.S. economy or its currency is likely to go the way of the German mark during the Weimar republic. The central bank in the United States is led and staffed by competent economists and bankers who are well aware of the risks and the need to manage them. Regrettably, monetary stimulus is like pushing on a rope - it gives the economy the freedom to expand but does not compel expansion. Much of the money in the economy lies dormant in savings by individuals and on corporate balance sheets. As a result, no signs of accelerating inflation are yet present.

The risk is that if they do appear, the pet on the end of the rope they are pushing on is more like a tiger than a puppy, and it may be hard to hold back without a lot of force. The economists in Canada and the United States in the late 1970s were no fools, nor were the central bankers at that time. Despite the fact that the government fiscal position during the early 1980s was less troublesome than today, the inflation that did occur in part to rectify the fiscal imbalance was a major headache, requiring interest rates well into the high teens and low 20s to put the brakes on.

Of course the inflation of 35 years ago was as much to do with rampant energy prices as it was to do with fiscal imbalances. That period happily ended with stability, which has reigned for most of the time since.

Central banks today are providing leadership where governments have abdicated. For investors, this process is not only dangerous but also requires careful management. Maybe the central bank can pull this off without hyperinflation, and maybe not.

This suggests a portfolio should hold a meaningful position in hard assets - base metals, real estate, oil and gas properties, etc. Companies with world business and defensible pricing power are also likely to emerge unscathed and reward their owners. This does not mean that such holdings will immediately prosper if there is a spike in inflation like there was in the early 1980s. It simply means that, when the dust settles into a new equilibrium, prices will be higher and government debts will be more in balance with their revenues. Bond holders will have been skinned alive, and savers decimated. Investors in strong companies and hard assets will move up the wealth scale, many joining the 1% whose problems today are limited to the prospect of the higher tax rates the Republicans rail against. Oh, to be so lucky.

Source: Why Central Bank Policy Will Fuel Inflation