The inflation time bomb
The public debt will likely pass $12 trillion this week, up another trillion since March. With Obama‚Äôs left flank calling for a second stimulus ‚Äď which is really a third stimulus if you count George Bush‚Äôs tax rebates ‚Äď there‚Äôs 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.
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I‚Äôm referring to Treasury Inflation Protected Securities, TIPS for short, in particular those that reflect long-run inflation expectations. The current spread 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. I highly doubt it will happen.
In a note to clients last month, Soci√©t√© G√©n√©rale strategist Dylan Grice explained the connection between debt and inflation. Turning Milton Friedman on his head, Grice argued that ‚Äúinflation is always and everywhere a fiscal phenomenon.‚ÄĚ Money printing may be the vehicle, but the ‚Äúroot cause‚ÄĚ of inflation tends to be ‚Äúa government unable to pay its way.‚ÄĚ
You see the real inflationary threat isn‚Äôt 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‚Äôs total liabilities are 19 times current tax receipts. ‚ÄúBear in mind that the U.S. consumer is widely seen as dead in the water with debt at 1.3 times income,‚ÄĚ 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‚Äôve 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‚Äôt 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‚Äôt run the printing press to pay the debt, but if the only alternative is default, they‚Äôll 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‚Äôve never demonstrated.
Right now, TIPS are betting on Scenario 3. I hope they‚Äôre right, but just in case, I‚Äôm planning for Scenario 2.