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After Coronavirus, We Will Have to Reckon with the Debt

Monday 30th March 2020

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Moral hazard is dead. Central banks have printed record amounts of money to save financiers and allow indebted governments to keep spending. Inflation is inevitable.

If all that sounds familiar, it’s because those were the views of buyers of gold and other inflation protection in 2009. They were wrong then, but they’re at it again—and this time they might be right.

Consider Ruffer, a bearish British investment house. It has been warning for a long time that the monetary regime that has held for decades was coming to an end and thinks the coronavirus crisis means its time finally has come.

 “Inflation and deflation are not opposites,” says Alex Lennard, investment director at Ruffer. “You can emerge from quite deflationary environments into very rapid inflation.”

Ruffer’s investors have made money this year in crashing markets thanks to its extensive use of options to protect against stock-price falls. They did well in the 2008 crisis, too. But their long-run bet is that the overhang of debt from the current shutdown will prevent central banks raising rates to combat consumer price rises, meaning inflation running in the mid-to-high single digits. Mr. Lennard says Ruffer last week bought 30-year inflation-linked Treasurys when they declined in price, adding to a longstanding position in 50-year U.K. inflation-linked gilts and gold.

This crisis is different in many ways from 2009, but the argument about inflation is the same. Will governments choose austerity and higher taxes to pay off the heavy debt incurred fighting the crisis? This route doesn’t lead to inflation, but it’s politically difficult. Instead, Ruffer expects governments to take the easy option and rely on central banks, perhaps even by directly financing government spending, a recipe for inflation throughout history. Such “helicopter money” is widely thought to be a possibility for the Federal Reserve, which has already reduced interest rates to zero.

Still, in 2008 Ruffer was wrong that deflation would be followed by inflation. It’s possible that governments might once again muddle through, relying on the deflationary forces unleashed by the internet and globalization to keep prices from rising—but it will be harder this time.

Jean-Claude Trichet, former president of the European Central Bank, says the most-optimistic debt scenario is that inflation rises only back to the 2% target, but rates stay well below that for a very long time. That would help to reduce the value of government debt in inflation-adjusted terms, with holders of the bonds suffering.

“Other scenarios would be much more dramatic, including either a sequence of defaults or hyperinflation triggered by very loose fiscal and monetary policies,” he told me. “The best-case scenario relies upon great soundness of fiscal policies, great effectiveness of structural policies and a combination of monetary policy and of micro- and macro-prudentials (regulatory policy) of extreme efficiency.”

“Its likelihood will be in the hands of our future masters,” he said. “As regards fiscal policies, what was observed since the [2008] global financial crisis does not bode well for the necessary future soundness.”

The lesson of history is that it could go either way. The result in the U.S. after 2008 was more akin to what happened in Japan after its housing and stock-market bubbles burst in 1990: Inflation never took off despite easy money and huge government deficits, but growth continued.

Financial Repression Bond yields below inflation hurt savers and ease debt pressure, but are rare in the U.S.

Stephen King, senior economic adviser to HSBC, points to the repayment of debt after the world wars as an example of the different options ahead. After World War II, rapid economic growth and a regime of deliberately low interest rates that allowed governments to borrow cheaply—financial repression—helped reduce the burden of debt. By contrast, after World War I, several large debtor countries reduced debt through default or hyperinflation. The U.K.’s fierce austerity as it insisted on a strong pound hurt the economy and failed to deal with the debt burden.

“It’s quite possible that, in the aftermath of all this, there will be attempts to claw back money from holders of capital,” Mr. King says. One option is the wealth taxes advocated by some Democrats, including Sen. Elizabeth Warren.

But it is politically easier to deal with debt with the help of the central bank. Financial repression can be used to keep interest rates below the inflation rate, reducing the value of government debt in real terms but costing savers and bondholders—and risking higher inflation. The Fed tried this policy after World War II, capping bond yields for six years and being subservient to the Treasury Department, before asserting its independence.

“Financial repression is a given,” says Frederik Ducrozet, a senior economist at Pictet Wealth Management and close observer of the ECB. Most countries will be able to cope with the additional debt without extreme measures, he thinks, although Italy may struggle without pan-European debt sharing, a version of which has already been proposed by French President Emmanuel Macron.

For investors, the short-term swings in markets have been so extreme that it’s hard to think beyond a few days, let alone the years over which the postcrisis debt resolution will play out. But it’s worth considering now, because the portfolio needed to cope with central banks either letting inflation rip or imposing financial repression would be quite different to one designed to profit from a return to what has counted as normal since 2009.

Source: James Mackintosh on WJS Website

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