*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.
NEW YORK Aug 2 As the two - or is it three? -
political parties in Washington now have 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
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"
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
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
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 5 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.
(Editing by Beth Gladstone)