The case for financial repression: Mild inflation, low interest rates

August 1, 2011

Rick Ashburn is a chartered financial analyst and the founding Principal Chief Investment Officer of Creekside Partners, based in Lafayette, California. The opinions expressed here are his own.

As the two – or is it three? – political parties in Washington lurch toward a budget agreement, what are the longer-term implications of the situation we find ourselves in? We have a lot of public debt combined with the rather serious economic headwinds that rapid deficit reduction always entail. And at the same time that we need to reduce our debt load relative to GDP, our real GDP growth is likely to be sub-par.

There has been a lot of commentary in recent months about the possibility of reducing the nation’s debt by means of inflation. Simply put, a dollar of today’s debt can be repaid with a dollar sometime off in the future. If in the future there are twice as many dollars floating around relative to the size of the economy, the repayment of the old debt is only half as burdensome. Debt that seemed high in 2011 is only half as high after some decades of even modest inflation.

If inflation averaged merely 3.5 percent per year for 20 years, debt incurred today can be repaid at an effective 50 cents on the dollar. The compounding of that 3.5 percent inflation over 20 years results in a doubling of the price index — and a halving of debt still denominated in “old” dollars.

Modest inflation of the genuine kind, where wages rise along with prices, has certain advantages to economic growth. Primarily, it encourages capital investment and risk-taking since companies have some confidence that prices for their products will go up over time, allowing them to recoup their investment. Banks like modest inflation since it means their loan collateral will not decline in value. Consumers tend to spend money more readily, helping stores turn over inventory and keep workers on staff.

For all the benefits of mild inflation, who does not benefit? Conservative savers and holders of long-term bonds, that’s who. A bond yield of 3.5 percent results in a zero rate of return after inflation. Savers with money tucked away in low-yielding deposit accounts fall inexorably behind.

Should inflation begin to accelerate, the bond market will drive up interest rates until bond yields are comfortably higher than inflation. Should this happen in the normal course of events, the cost of servicing the public debt will increase just as fast as inflation would normally drive it down. There is no net gain in debt reduction. What we really need in order to “inflate away” our debt is combination of high inflation and low interest rates.

In the decades following the Great Depression and World War II, this is exactly what we got. At the same time (1945-1980) that inflation was averaging 4.5 percent, bond yields averaged only 4.8 percent. Inflation very nearly matched bond yields, and the government debt burden was largely inflated away. By one estimate, in just the first decade after 1945, the nation’s debt burden was less than half what it would have otherwise been. A policy environment where inflation is allowed to rise, while rates are held low, has been dubbed an age of “financial repression.”

More than one observer has jumped on this notion of financial repression as both a probable outcome of monetary policy, and perhaps a good one at that. It is the ultimate free lunch — modest inflation to spur economic growth, and low interest rates with which to finance it! As always, there is no free lunch in economics. Somebody has to pay — and whom? Conservative savers and owners of long-term bonds. Solution for investors? Don’t be in those two camps and you win all the way around.

But, what this policy expectation ignores are the extraordinary differences between today’s world and the immediate post-war world. In the decades following World War Two, interest rates in the U.S. were not set in the open bond market. The government bond market did not even trade freely until the early 1950’s. Bank deposit rates were capped by regulation. Money market funds didn’t exist, nor did the competition of interstate banking. The Fed and its friend over in Treasury were able to keep interest rates artificially low for nearly three decades.

If something can’t go on forever, it won’t. And this did not. The oil shocks of the 70’s, combined with deregulation of financial markets, allowed interest rates to move well ahead of the high inflation of the late 70’s and early 80’s. The age of financial repression was over.

We accept that, in the halls of power, there are those who would like the country to return to the inflation and interest rate conditions of post-war America. We do not disagree that such an environment might even be a good one. However, we do not agree that they will be successful. The target policy is mid-single-digit inflation (3.5 to five percent), but with bond yields held at or below that level.

Failure can occur in one of two ways: Inflation could fail to take hold, despite all efforts to trigger it. We make a distinction here between price increases driven by the supply and demand of resources such as energy and agricultural products. Those price increases translate to higher prices for all goods, but do not work their way into wage and salary increases and that type of inflation quickly peters out. The type of inflation that sustains over time, and drives down the cost of old debt, is a generalized rise in all prices and in wages. Simply put, a slack labor market is not the environment for such a generalized rise in prices and wages. Inflation could fail to take hold.

The other failure mode for the financial repression goal is that policymakers could fail to keep a lid on interest rates. Bank CD rates are no longer regulated, and the market for government bonds trades freely — and globally. We doubt the ability of the Fed and Treasury to keep anything more than a temporary lid on interest rates.

So, what does the wise investor do when faced with the prospect of a policy failure in either of these two modes? Pick asset classes that are likely to perform reasonably well under either scenario. In our view, a portfolio of the stocks of globally-positioned, well-financed companies that pay consistent dividends provides the prospect of long-term growth and income under a wide range of monetary conditions. We are avoiding assets that will do poorly under one or the other outcome. In particular, we are avoiding bonds with maturities any longer than about four years. At current stock prices, we are not fully invested in this target portfolio, and intend to buy on price declines.

Despite the fact that an environment of financial repression persisted for several decades in our recent past, and despite the fact that policymakers might want to return to those conditions, there is every possibility that they will fail. Failure is not, in itself, problematic. It is only problematic for an investor that has bet heavily on one outcome or another, and is wrong.

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An interesting piece Mr. Ashburn, and well-written. However, it is one of limited purpose (investment), and assumes stasis of a number of factors that seem destined to derail the trajectories you project.

I would be curious to hear your position on the interplay of just one of those factors: peak oil. It is widely acknowledged that in 2005, world oil production peaked. (U.S. oil production peaked in 1979.) Demand, however, has not peaked. In fact, all other things being the same, demand would be expected to grow substantially as the economies of the BRIC move forward and their infrastructure improves. Of course, all things will not be the same, and if we refuse to assume, without any basis other than optimism, that a replacement energy source will be developed, then we can expect demand to be conflated by increasingly oppressive prices.

Thus, declining production of fossil fuels alone, and particularly oil, will continue to drive inflation irrespective of the CBs’ money-printing policies. Energy depletion cuts across all sectors of the economy, and most sharply against those commodities that people (“consumers”) need the most: food, shelter and transportation. At some point, even communications can be expected to be impacted.

For these reasons, I believe your opinions are attractive, but only as a snapshot of where we are today. I frankly doubt they hold much predictive value over the long term. I’d be interested in how you would respond to that.

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