Ticking Away: The Inflation Time Bomb

The public debt will pass $12 trillion this week, up another trillion since March. With Obama’s left flank calling for a second stimulus – which is really a third stimulus if you count George Bush’s tax rebates – there’s still no serious discussion about how to deal with debt. The bond market is telling us not to worry. But if history is any guide, the bond market is wrong.

(Click chart to enlarge in new window)

In particular, I’m referring to TIPS, Treasury Inflation Protected Securities, which reflect long-run inflation expectations. The current spread on TIPS tells us to expect annual inflation averaging a bit over 2 percent for the next 30 years. That would be fairly benign. And fairly wrong.

Why? Because it assumes U.S. political leadership will put the country on a sustainable fiscal path. That’s not going to happen.

In a note to clients last month, Société Générale strategist Dylan Grice explained the connection between debt and inflation. Turning Milton Friedman on his head, Grice argued that “inflation is always and everywhere a fiscal phenomenon.” Money printing may be the vehicle that causes inflation, but the “root cause” tends to be “a government unable to pay its way.”

You see, the real inflationary threat isn’t the $12 trillion public debt, which on its own is serviceable. The problem is $63 trillion worth of unfunded obligations for healthcare and social security. Putting these figures in context, the U.S. government’s total liabilities are 19 times current tax receipts. “Bear in mind that the U.S. consumer is widely seen as dead in the water with debt at 1.3 times income,” says Grice.

There are three ways to confront this mountain of debt.

Scenario 1: We essentially default, like Argentina, refusing to pay our debts once they’ve become too burdensome to service. The dollar would crash as the United States loses access to capital markets. The government would be forced to print money to pay expenses.

Unlike Argentina, however, we print the currency in which our debt is payable, so this scenario most likely won’t happen.

Scenario 2: We default through inflation. Policymakers are so desperate to avoid Japan-style deflation that the Fed will keep printing money to buy risky assets while Treasury pours on the stimulus to keep people employed. The Fed says it won’t run the printing press to pay the debt, but if the only alternative is default, they’ll have no choice.

Scenario 3: We put Medicare and Social Security on a sustainable path, cutting benefits or raising taxes dramatically. This would require a level of political will we’ve never demonstrated.

Right now, TIPS are betting on Scenario 3. I hope they’re right, but just in case, I’m planning for Scenario 2.

Comments

[cyclingscholar:]

Mr. Winkler: place 4 gamblers in a circle. Everyone borrows 1 trillion dollars from the person on his left. Repeat 9 times (4x9=63, for you publik skool community organizers). The group collectively owes 63 trillion dollars to itself. Should I worry?

Nov 10 03:33 PM

[Davewmart:]

Discovery is going to happen at some time in the markets no matter how much they try to fiddle it.
My bet is that there will be a domino effect, with one of the countries collapsing and that effect rapidly spreading to others.
Prime candidates would seem to be the UK, Spain, Ireland and Japan.

Nov 10 03:47 PM

[user396040:]

If monetary policy is tight enough, it can reduce inflation even in the face of a big deficit - this is what happened in the early 1980's. The problem is that the price for the reduction of inflation is a severe recession. I think that this is quite possibly a problem down the road, but focusing on it now would be like worrying, in 1942, about the potential unemployment that will result when we win the war and all the troops come home. We have a much bigger immediate problem to deal with - the possibility of a deflationary downward cycle.

Nov 10 04:18 PM

[User 353732:]

The current trajectory is for BOTH inflation and economic compression. This is not merely the result of great public debt but of vast irredeemable debt that is being financed with fiat and now fake dollars.
It is the flight from dollars that will accelerate the dollar denominated inflation in most ,maybe all, hard assets. Once hard assets begin to inflate , with a lag, all essential goods and services(not just imports) must begin to inflate since hard assets, including agricultural, fiber and timber assets, are the foundation of any economy.
The Middle Class will ,in parallel, experience declines in real, after tax, discretionary income which will ensure a lack of confidence which will continue the economic compression.

Nov 10 04:51 PM

[paulsjj:]

FDR said that "we owe itto ourselves". We have representative governmentg. What this means that the Government borrows and prints the money that congress (our representatives) spend and we have to pay fore it in taxes, inflation, and lost purchasing power. The 0 t0 0.25% Federa; Funds Rate is riping off our savings. Are we dumb or what???

Nov 10 05:04 PM

[Between The...:]

Turning Milton Friedman on his head, Grice argued that “inflation is always and everywhere a fiscal phenomenon."

Friedman's quote was "inflation is always and everywhere a monetary phenomenon"

The monetary policy of the US is controlled by the Federal Reserve.
The fiscal policy is controlled by the Congress.
Bankers control the Fed, and more recently, Congress.
Thus, inflation is a banking phenomenon that just happens to be able to finance fiscal deficits. There was still plenty of inflation during the most fiscally hawkish periods of the 20th century, even with huge federal surpluses.

Nov 10 06:33 PM

[Socialism c...:]

That is NOT what has happened to the U.S.!!! We owe foreigners, and some groups of Americans are being systematically pillaged to prolong the debt-based spending to give entitlements to other groups, and to prop up the assets and lifestyles of the "ownership class."


On Nov 10 03:33 PM cyclingscholar wrote:

> Mr. Winkler: place 4 gamblers in a circle. Everyone borrows 1 trillion
> dollars from the person on his left. Repeat 9 times (4x9=63, for
> you publik skool community organizers). The group collectively owes
> 63 trillion dollars to itself. Should I worry?

Nov 10 06:58 PM

[Davewmart:]

There's a must read here:
www.bankofengland.co.u...

this is the Bank of England's analysis of the causes of the banking crisis, it's costs and remedies.
They put the bill so far at $14trn.

Nov 10 08:00 PM

[Mr. G:]

The current response to the concept of recession(receding backward) is obvious, refund the banking system with loans to prevent systemic failure of the credit system, keep the FED rate very low to encourage lending, and print money to stimulate the economy by lending to the biggest players.

This implies that the regulators designing policy believe in good faith that ultimately, the forces of capitalism intrinsic to a free market will ultimately prevail. During this process, the outliers are screaming socialism, inflation, and other expressions of doom and gloom, particularly from the right as they hypothesize that we must return to supply side economics.

Maybe I am missing the point, but we just experienced 8 years of an administration that strongly advocated "supply side" economics which led to an unregulated environment that almost destroyed our country. If conservatism means keeping what we had intact, I will pass on these theories.

Nov 11 11:37 AM

[swsprime:]

Good point Dave, but I don't think it will be the UK. They are due a change of Government in the Spring. It just changes from Labour to Tory every so often; what we call Buggin's Turn, and the new Buggins, sorry Political Party (Tory,) has already indicated its' going to put the stops on.

Ireland is a likely candidate, although their Euro group mates will probably bail them out.

What about Iceland? Iceland was a huge sub-prime player, lost its' shirt on the play and can't just print more dollars like the good ol' US can, so I think personally it will start there, where everything's busted. They can't even sell their biggest national product; fish, in their internal markets, their fishing fleet has to sail to the UK where they are still able to sell for cash. Looks like the Icelanders are headed back to the Stone Age.


On Nov 10 03:47 PM Davewmart wrote:

> Discovery is going to happen at some time in the markets no matter
> how much they try to fiddle it.
> My bet is that there will be a domino effect, with one of the countries
> collapsing and that effect rapidly spreading to others.
> Prime candidates would seem to be the UK, Spain, Ireland and Japan.

Nov 11 12:10 PM

[Davewmart:]

swsprime:
Iceland's gone. Next please?

Nov 11 12:53 PM

[cyclingscholar:]

By the way folks...my mistake, 4x9= 36, not 63. Lets have it be a group of 7, not four. Then ya get 63!

About 50% of the debt is owed to foreigners. Even so...lets get the anointed one to look em in the face and dare them to draw! The Chinese are worried about our dollar? Coming from a country which has defaulted on its debt a couple times in RECENT MEMORY, thats sure alot of nerve. The Europeans? After 70 years of freeriding on American defense, maybe we should just let those bills come due and deduct the PV of our NATO expenditures from the Deficit. We've cleaned up our air, our water, and our environment....so lets go to the UN and/or IMF and arrange a 'debt forgiveness for environmental action' like so many countries have done lately.

Whats good for the goose is good for the gander.


On Nov 10 06:58 PM Socialism cannot compete! wrote:

> That is NOT what has happened to the U.S.!!! We owe foreigners, and
> some groups of Americans are being systematically pillaged to prolong
> the debt-based spending to give entitlements to other groups, and
> to prop up the assets and lifestyles of the "ownership class."<br/>

Nov 12 12:37 PM