This morning, Consumer Price Index (CPI) figures indicated that monthly prices were exactly flat in November compared with the month before. On an annual basis, CPI came in at 3.4%, a slight slowdown compared with last month. At its peak earlier this year, annual inflation got as high as 3.8%, but with economies slowing, oil falling and retail discounting, it seems that price increases are tamer.
But looking long term as an investor, having a view on inflation over the next decade is critical to successful investing. One camp is arguing that we will have very high inflation. Gold and silver price performance over the past few years clearly indicates this. With central banks simply printing fiat currencies in huge quantities, this can only lead to substantial inflation in the coming years, the argument goes. Perhaps even hyperinflation.
On the other hand, the bond market implies that inflation will be around 1.9% per year over the next decade. That is, the difference between 10-year Treasuries today and TIPs (1.95% - 0.05%) is a mere 1.9%. That is a pretty low inflation expectation and far lower than where we are today.
Without doubt, as overleveraged G-7 countries pay down debt, growth overall will slow. Government austerity measures imply more taxes, less spending and fewer jobs. This is disinflationary at the least, and can potentially lead to deflation. The deflationists argue that this overhang will persist for years as the world pays down debt, and the smart trade is to own Treasury bonds.
So, which will it be? Inflation, deflation, or is there a chance of hyperinflation?
Structural Problems in the US
Before I get to the inflation question, let me get a couple basic assumptions out of the way. First, it’s highly unlikely that politicians in the United States will ever balance our budget. Maybe I am a cynic. But as I see it, a fundamental flaw we have as a country, structurally speaking, is that there is a duration mismatch between the life of a politician, and fiscal responsibility.
Since there is no balanced budget requirement under our Constitution, politicians are in fact almost encouraged to spend as much today as possible today in order to get re-elected tomorrow. Leaders that attempt to rein in spending, and act fiscally responsible, are the ones who get voted out of office. What politician would vote to cut spending and/or raise taxes to balance the budget? Being fiscally responsible is enormously unpopular. It reduces GDP growth, puts voters out of work, hurts job prospects and in the case of raising taxes, takes more money out of voters' paychecks.
GDP Properly Viewed
That brings me to GDP and how it is perceived. Without doubt, almost every person, economist or otherwise, would agree that GDP growth is the most important economic goal for a country. Yes? Well, to some extent it shouldn’t be. What our leaders and central bankers don’t understand, is that a country doesn’t grow wealthy simply by expanding GDP. Just like you don’t become wealthy because you spend more on your credit card. At the end of the day, GDP is no different than spending. In fact, GDP, by definition IS spending.
Remember this formula from Econ 101?
GDP = C + I + G + X
C = consumer spending, I = investment spending, G = government spending, and X = net exports. Net societal wealth is not driven by spending, but rather wealth is driven by saving. You get rich by building net worth, not by borrowing as much as possible to buy a giant house. Many people learned that the hard way during the US housing bubble.
Along those lines, our political leadership has been driven to increase GDP, even at the cost of borrowing billions, nay trillions of dollars now, in the pursuit of growth for growth’s sake. The flaw is, when spending exceeds income, as it has in the US now for decades, eventually you go broke. Interest expense eats away at what could otherwise be money well invested in education, infrastructure, you name it. And as our government has borrowed more and more year in and year out, we as a country are now broke.
Total government debt now exceeds $14 Trillion. The debt ceiling debacle last August resulted in a very weak plan to cut $2.5 Trillion from our deficits over 10 years. That is not nearly enough. That implies only cutting $250BB per year on average, but deficits are $1.5TT per year. Even assuming GDP grows at an annual rate of 2.5%, the US government needs to borrow another $10TT to fund the next decade’s worth of deficits.
So, $14TT plus another $10TT in debt totals $24TT by the year 2021. If you include Social Security and Medicare, then the present value of these obligations becomes unfathomably large. I have seen estimates as low at $50TT, to as high as $200TT for our entitlements. In any case, you cannot ever repay even the low end of that, call it $64 Trillion ($50TT plus $14TTof total debt today) on a $15TT economy. Our fully loaded Debt/GDP of 357% dwarfs even Greece’s awful Debt/GDP ratio of 160%.
In my opinion, the only likely solution our government has is to increase inflation. While European countries attempt to de-lever, US officials (and amazingly bond investors) seemingly are far less concerned about it. Call Treasury bonds the best house in a bad neighborhood. Politicians lack the will or mandate to enact tough budget-fixing measures, clearly evidenced by the recent failure of the deficit reduction “super committee.”
Our flawed two-party system is also to blame. Republicans are dead set against tax increases, and Democrats are determined to spend as much as possible. One side refuses to increase the topline (revenue) and the other side refuses to cut spending (costs). That is a problem, regardless of your political persuasions.
The politically expedient solution will be to raise taxes in a stealth manner. That is via inflation, the “most pernicious” of taxes.
A Very Rough Balance Sheet of the US Government
Below, I offer a rough view of our government’s balance sheet. I admit that this is simplistic, but wanted some framework to see how much inflation we needed to build back the United States' balance sheet.
Breaking it down, our government has:
Assets = $30TT. That is, the assets of our government are represented by the taxing authority on a $15TT economy. There aren’t any meaningfully valuable nationalized companies or industries in the US, the government simply collects what others produce. There might be $1TT of land held by the US government, but it’s still a drop in the bucket. Would we really sell our National Park System?
To get to $30TT, I assumed a 12x multiple, or 12 X 2.5TT in annual revenue. I also considered the fact that governments typically get into trouble at around 150% Debt/GDP. Which tells me that the market views 1.5x to 2.0x GDP as about the max level of debt you can put on an economy before it spirals into insolvency. I.e., here I used the high end at 2.0x GDP.
Liabilities = $55TT, that is assuming we can cut entitlements (Social Security and Medicare) by 20%. I believe a crisis will force some cuts here. I used the low end forecast for entitlement obligations of $50TT, cut them to $40TT, and added our current debt of $14TT. This could be way too optimistic, entitlements are often considered politically “untouchable.”
Equity = Negative $25TT.
This is one conservative measure to calculate what the government in the United States needs in funding just to get to breakeven. We are in a very deep hole, perhaps too deep to ever climb out of. $25TT is a lot considering that the entire world’s GDP is around $60TT.
Note that this balance sheet didn’t forecast the $10TT in additional debt that the government will likely take on over the next decade. The point of this is to show that as of this minute, if we raised $25TT, then we could fund Social Security and Medicare, and with a near balanced budget, have a decent balance sheet going forward.
What our central bankers have to do, since raising taxes and cutting spending seem pretty darn unlikely, is to attempt inflate our way out of this mess. Since liabilities are mostly fixed, our government’s easiest escape route is to grow its assets by creating inflation. This example, while clearly a gross approximation, shows that we need to create $25BB in additional assets to at least get a grip on this country’s fiscal problems.
With a $15TT economy, that means that prices would need to increase by 80% over some reasonable time span to close the gap in spending. (Unless the government decided to default on entitlement programs and/or its bonds. But that is a most improbable scenario.). The specific math is $15TT X 17% (which is total government revenue) X 1.80 (price increase needed) X a 12x multiple to get to an asset figure that is $55TT, or $25TT higher than our existing asset base of $30TT.
Over 10 years, that means to fix our balance sheet, we need to create annual inflation of 6% a year, every year for 10 years. That would create a gross change in prices of 80% compounded over that time span.
For the record, I did ignore CPI adjustments and TIPs and other cost of living adjustments to the liability side of the balance sheet, but kind of figured that productivity and natural GDP/population growth would likely be enough to offset this. I also wanted to keep this analysis relatively simple and provide a framework for discussion. Feedback is welcome.
History of Inflation and Adjustments
In the 1970, inflation doubled prices just from 1973 to 1980. That was 7% annual inflation. To me, this 6% inflation scenario makes a lot of sense. It’s not too high to cause political backlash, and in any event, the BLS will report lower CPI levels. Hedonic pricing, basket weighting and owner’s equivalent rent are just a few of the tools that the BLS uses to understate real inflation. While true inflation will run at 6%, CPI will be reported at 3-4%, but excluding food and energy it will appear to be in check at say 2-3%.
Case in point: this year through November, CPI was up 3.4% vs a year ago. However, excluding food & energy, CPI was reportedly only up 2.2%. I still don’t quite understand why bond investors ignore food and energy prices. Just because they are volatile, doesn’t mean that people don’t use them. In fact, a Consumer Reports survey earlier in 2011 found that 10 of the most commonly bought grocery store items were up an average of 12.2% year over year.
Healthcare costs are only 7% of the weighting of the index, despite the fact that healthcare expenditures are 18% of GDP, and are some of the highest inflation rate goods in the CPI basket. So, with healthcare costs skyrocketing every year, and food prices up too, I think CPI is understating true inflation by a good 1-2% perhaps.
On a side note, GDP is adjusted by a GDP deflator, which is 2.1% this year. Why is it 2.1% when CPI is 3.4% and true inflation higher? Over-reporting GDP is one means to keep our Debt/GDP ratios seemingly more attractive. Another topic altogether, but I think quite alarming.
The argument for deflation is that since every consumer and every government in the world is overleveraged, they are cutting spending, not borrowing money and raising taxes. The resulting diminished demand for goods, in conjunction with an oversupply of labor and capacity, can only lead to falling prices overall.
In the US, the Fed’s QE programs have bolstered bank balance sheets, but banks haven’t used this capital to lend to either individuals or corporations. In fact, with housing in the dumps, and corporations concerned about the economic outlook, lending will remain weak for awhile. In Europe, fiscal austerity measures will crimp spending for years perhaps, reducing GDP in the PIIGS countries, and slowing demand for goods. Inflation is rare when there is such slack in the system.
This can only lead to weakness in the economy for awhile. But even in 2008 with a near financial collapse, prices only fell 3.2% in the US. Since then, inflation has crept up a little every year: 2% in 2009, 2.4% in 2010, and 3.4% this year to date.
Given this, I generally don’t buy a long term deflationary scenario. We may get another year whereby the Euro unravels and economies contract along with pricing. But I don’t see it being very likely except for a one year event ala 2008. To me, the threat of deflation is the classic central bankers excuse to print more fiat currency to paper over deficits. Instead of deflation, I think the right outlook is that inflation will remain low. Perhaps for one to three years. Then it will take off.
By that time, bank balance sheets will have been repaired in the US and in Europe, money will flow much more freely (ie money velocity will pick up), lending will pick up, and I think a 6% inflationary expectation is as good as any.
From an investment perspective, owning long duration fixed rate bonds seems like a bad idea. Short duration bonds look far more appealing. In fact, ten year treasuries look like a short at 1.9%. Long term, the Fed HAS to create a lot of inflation to keep our government afloat. Do you wonder why oil prices are still near $100 a barrel, when the economy is barely growing even this year?
In the short term, equities and even gold feel dangerous, especially as Europe approaches a potential run on the bank so to speak. But longer term, equities, commodities and precious metals are the best place to be in an inflationary environment. With the printing presses of every major economy ready to print significant quantities of fiat dollars, yen, and pounds, taxation via inflation seems to be the G-7 country’s path to fiscal responsibility.
Even the ECB won’t allow a sovereign or major bank collapse, despite the seeming unwillingness to monetize debt today. But it will eventually come around to printing euros too. When it does, look to buy beaten up European stocks, and look for inflation to pop.
Disclosure: I am long GLD.