G20 agrees inflation is solution to crisis: John Kemp

-- 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.

LOSS-SHARING MECHANISMS

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.