Beware reflation

July 6, 2009

jeffrubin— Jeff Rubin is Chief Economist at CIBC World Markets. The views expressed are his own. —

Fighting the recession will not be without its costs.

Washington has already racked up nearly a $2 trillion deficit to ensure that America’s credit crisis does not lead to a replay of Japan’s lost decade of economic growth. But it’s not the specter of Japanese deflation we should fear. Far from it. History shows unequivocally that it is reflation, not deflation, that is the dancing partner to these size public deficits.

Saddled with a deficit that will mortgage the future of a generation of taxpayers, Washington will turn to what it has always done to alleviate such fiscal burdens. It will monetize the deficit, using the subsequent burst of inflation to rob bondholders of their real return. While the bonds will mature at par, what that buys may be a whole lot less than what the bondholder expected, thanks to the inflation trail that always follows in the wake of financing such mega-deficits.

Bondholders who financed America’s World War Two deficits saw their bonds lose nearly 15 percent of their real value in the ensuing inflation that peaked at around 17 percent in 1947. Bondholders who financed the Korean War also lost from inflation, which quickly went from negative territory to almost 10 percent. And twenty years later investors were once again swindled by reflation out of their return from financing the deficits that arose during the Vietnam War. Inflation robbed those bondholders of nearly a third of their real return. The later two deficits were less than half today’s in relation to the size of the US economy.

Monetizing deficits, which is simply printing more money to pay for them, is particularly attractive for a country like the United States, whose greenback is still the reserve currency of the world. The fact that other countries want to hold your money allows you to sell them bonds that are denominated in your currency. That obviously gives the borrower a huge advantage, because the creditor is at the mercy of the borrower’s exchange rate. The easiest way to stiff a foreign creditor is through devaluing your currency. And the higher the inflation rate that a country runs, the more its currency will devalue.

Monetization seems to be even more attractive now. In the past Washington’s debt was owned by Americans. If Uncle Sam was going to cheat on its creditors, it was by and large American taxpayers that were lending Washington the money. Today half of America’s debt is owned abroad, much of it by central banks like the People’s Bank of China, which is the single largest owner of Treasury bonds in the world.

Why default on your own taxpayers when you can default on someone else’s taxpayers?

For the People’s Bank of China the risk lies with the future value of the greenback. While the Treasury bond will always mature at 100 cents on the dollar, a dollar could buy a lot fewer Yuan by the time a 10-year bond matures. Just ask the Japanese.

The greenback lost 40 percent of its value against the yen between 1971-1981. All of a sudden those once juicy Treasury yields weren’t so appealing after you took your foreign exchange losses into account. If the dollar could lose 40 per cent against the yen over the lifetime of a 10-year bond, who is to say that it couldn’t lose 60 per cent against the currency of the ascending Chinese economy over the next 10 years.

Of course that prospect is not lost on the Chinese. Their appetite for Treasury bonds is not aroused by the allure of earning rich returns but by the need to keep their Yuan undervalued against the greenback, and hence supportive of China’s huge trade surplus with the US. But the need to protect export-led growth is already becoming less important and it will become even less so in the future.

Already it is apparent that it is the Chinese economy, not the American economy, that will lead the global recovery. And what are driving the Chinese recovery are not shipments to Wal-Marts but sales in its own vast internal market. Already Chinese vehicle sales have surpassed the US numbers, and soon the Chinese auto market will leave the ever-shrinking North American one in its dust.

And when a full recovery comes, and with it the return of triple digit oil prices, exports to the US will become even less important to China as the exploding cost of transoceanic transport will more than offset China’s wage advantage in everything from steel to refrigerated food.

If China is no longer going to rely on exports to the US, it doesn’t have to worry about the Yuan appreciating against the greenback. And if it doesn’t have to worry about the Yuan appreciating against the greenback, it doesn’t have to show up at the record sized Treasury auctions that will soon lie ahead.

The world of zero inflation and zero interest rates will very quickly come to an end.

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