9 Min Read
-- John Kemp is a Reuters columnist. The views expressed are his own --
By John Kemp
LONDON (Reuters) - G20 leaders have endorsed a strategy that will transfer loan losses from banks and creditors to taxpayers (via government debt guarantees) and savers (via money creation and inflation).
In their summit communique, they committed themselves to a strategy of reflation and moderate inflation in the medium term. While this is plausible and consistent, it has profound implications for asset allocation. It favors borrowers and owners of equities, commodities and other real assets, at the expense of savers and those holding cash balances and government debt.
I have written elsewhere that the underlying cause of the crisis was the massive explosion in corporate and household debt (especially in the United States and other Anglo-Saxon economies) relative to the nominal cash flows (GDP) needed to service them.
This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which would only be serviced if the economy continued its swift and uninterrupted expansion).
The overall level of indebtedness has simply become too large relative to the corporate and household cash flows available to support it in the United States and other Anglo-Saxon economies. The solution to the crisis must involve a reduction in the outstanding volume of debt, an increase in nominal GDP, or some combination of the two, to reduce the debt-to-GDP ratio to a more sustainable level.
By definition, reducing the debt-to-GDP ratio involves acknowledging some investment expectations were unrealistic and will never be realized. Contractual obligations have to be re-opened, losses allocated.
The increasingly acrimonious policy discussion over the last six months has really been about finding a mechanism or formula for sharing these losses. There are four candidates:
*Bankruptcy, which would transfer losses from failed loans and investments to banks, lenders and investors;
*Loan restructuring, interest concessions and cramdowns, which would also transfers losses to the creditors;
*Toxic asset insurance and loan guarantees, which transfer losses to taxpayers;
*Money creation, quantitative easing and inflation, which transfer losses to savers and others on fixed incomes.
Each loss-sharing mechanism involve some breach of contractual rights. The heated debate over the crisis is really about who should bear the costs of bad decisions made over the past decade -- which contracts should be honored and which should be breached.
In the last two months it has become increasingly clear that debt contracts will be honored in nominal terms while losses will be transferred to taxpayers and the public through a mixture of loan guarantees, cheap state lending and money creation designed to stimulate inflation.
In the United States and elsewhere, creditors have successfully pressed the case that their contractual rights and expectations should not be disappointed.
Instead, the response has increasingly focused on debt guarantees, publicly funded programs for buying toxic assets from banks at above-market prices, and massive credit creation through central bank quantitative easing (QE) programs, together with large volumes of more traditional fiscal stimulus.
The G20 program builds on this approach by focusing on monetary emission and credit creation. The centerpiece of the agreement was up to $500 billion in new lending resources for the International Monetary Fund (IMF); creation of $250 billion in new monetary instruments in the form of IMF Special Drawing Rights; $250 billion in trade financing from export credit guarantee agencies and others; and $100 billion of additional lending by the multilateral development banks.
There are good reasons for this approach. By sustaining and then increasing real output and prices, the policy response aims to maintain nominal GDP and the cash flows that could validate many though perhaps not all loans and credit instruments.
Moreover, while losses properly belong to the banks and investors who advanced the money in the first place (and received compensation for risk in the form of interest and dividends), losses are so large that forcing this relatively narrow class to bear them alone risks wiping many of them out entirely. A range of socially useful institutions (including commercial banks) would disappear.
So it makes sense to "socialize" some of the losses and spread them over a much wider pool of people - taxpayers (via government rescues) and the public (via inflation). The principle is the same as fire or unemployment insurance.
The only question is what society can expect from investors in return for its agreement to bear some of the losses: the attempt to condition rescue programs and access to public funds upon changes in behavior or structural reforms is running into trouble.
The real problem with this spend-and-monetize way out of the crisis is that it is (inevitably) inflationary in the long run.
The monetarist relation (MV=PT) linking changes in prices (P) and output (T) to money supply growth (M) and demand for cash balances (V) is a poor predictor of inflation in the short run. Demand for cash (V) is simply too unstable and tends to offset changes in money growth (M). At present, huge demand for cash balances is successfully sterilizing the massive increase in the quantity of money created by central bank QE programs.
But in the longer term, there are strong links between credit creation and the rate of inflation (as measured broadly in consumer and asset prices). As the crisis passes and demand for cash balances falls to more normal levels, the massive amount of new liquidity pumped into the banking system will start to exert powerful upward pressure on consumer and asset prices.
In theory, quantitative easing can be reversed by issuing government debt to the banking system. Fiscal stimulus programs can be wound down through spending reductions and tax increases. In practice, the degree of fiscal and monetary tightening policymakers are contemplating for 2012-2014 is unprecedented and will prove almost impossible to implement smoothly.
No government has ever attempted to reverse this degree of fiscal and monetary support outside of wartime and post-war demobilization.
Moreover the policy is based on a fundamental misapprehension. Trying to restore output levels and the growth trajectory which prevailed before the crisis broke will itself stoke enormous amounts of inflation.
The downturn has created cyclical slack. But before the crisis there were clear signs of inflationary pressure in the global economy (evident in soaring energy and raw materials prices, as well as rapidly rising wage rates in China and some other emerging markets) as demand outstripped supply.
If policymakers try to replicate the boom conditions of 2006-2008 to validate most debt contracts, they will also restore the inflation problem.
Investors should brace for a strong bout of consumer and asset price inflation over the 2011-2015 period. Beneficiaries will be holders of equities (linked to inflation-driven increases in cash flow) and commodities (especially where producers have significant pricing power). Losers will be holders of cash and fixed-income securities, who will see returns driven down below the inflation rate.
It may not be fair, but policymakers will pick the pockets of a large number of taxpayers and savers to avoid wiping out certain classes of investors entirely. Risk-averse savers will be made to pay a price for their caution as the real value of their capital erodes.
In the circumstances, investors would probably be wise to take advantage of current QE programs to offload government bonds and other fixed-income instruments at the top of the market onto central banks willing to pay over-inflated prices for them, and consider strategies designed to protect capital in a reflationary environment.