The Fallacies of Inflating Away Debt

``In an inflationary world, deficit spending and an easy-money policy have other reasons. Deficit spending is resorted to simply because of inability to balance the budget. It is purely involuntary. An easy-money policy is advocated because it seems to make possible a speedy reduction of the interest and debt burden of the government and the balancing of the budget without imposing higher taxes. Sometimes it is urged also as a command of social justice. The latter argument is of course based upon pure illusion. Small savers pay the bill directly or indirectly via savings banks and insurance companies, whereas large capitalists, who are interested chiefly in equities, harvest the profits from refunding operations.” L. Albert Hahn The Economics of Illusion

In the US, many harbor the delusion of inflating away the massively expanding debt levels as the ‘best alternative’ policy. Such advocates appears guilty of the following sins:

One, interpreting past performance as future outcome. A semblance of success during the previous incidences allowed for the deferment of the day of reckoning because debt levels had been low, or otherwise said, the economy can yet afford to pay for such policies.

Nonetheless, the untold truth is that the subsequent growth in such imbalances has ensured the reemergence of such boom-bust cycles with greater magnitude of impact.

Two, extensive “blind” faith on governments, to ably prevent collapses in spite of evidences, proved to be a myth.

The multifaceted ‘innovative’ Fed programs (TARP, TALF, Maiden Lane LLC, TSLF, MMIFF, Reciprocal currency swaps et. al.) failed to prevent or forestall the 2008 meltdown, this serves as another patent example of government failure.

Figure 6: Federal Reserve Bank of Minneapolis: Duration of Current Recession

Another fiction is the idea that inflationary policies has shortened the duration of recession period (see figure 6) or has alleviated its depth (figure 7).

Figure 7: Federal Reserve Bank of Minneapolis: Depth of Recession

Despite all expenditures thrown at the expense of the taxpayers, the 2007 recession has been the worst among the 10 post war recessions.

Lastly, they blithely ignore the unseen or unreckoned with ramifications of the shifting but continually expanding debt loads while depleting productive resources of the economy.

In other words, such advocates underestimate the degree of the impact from present policies.

Inflation Is A Political Process, From Risk To Uncertainty

Given the extent of the rapidly expanding debt levels, not only in the US but elsewhere too, relying on inflation to diminish real debt value could make the stagflationary period of 70s look like a picnic in the park.

This likewise risks provoking political unrest or war from prolonged or extended depression.

In short, those who embrace inflationary policies parochially forget that inflation is a political process and thus has political consequences.

As James Kunstler rightly explains, ``It would be sententious to explain how this destroys currencies, but wherever ‘monetizing debt’ has been tried before in history, that is the outcome. The result would be ruinous at every level and would lead straight to the second terrible force: social upheaval brought on by the conversion of economic problems into political turbulence.” (emphasis added)

In addition, while it is true that today’s monetary and fiscal deficit spending policies momentarily benefits asset market participants (that includes me), this view neglects the possible adverse repercussions from regulators to misjudge or miscalculate on the application of untried or untested tools that may trigger disorderly adjustments in the financial markets and the economy system.

Morgan Stanley’s Manoj Pradhan has this insightful observation,

``Central banks correctly describe programmes like quantitative easing as ‘unconventional'. Being far from the norm, policy-makers do not have much experience in dealing with such unconventional policies with nearly the same familiarity as the interest rate tool. When downside risks were dominating, policy-makers were only too willing to throw everything including the kitchen sink at the problem. For the most crucial passage of time in the past two years (the time since September 2008 when markets froze), central bank purchases of risky assets and government bonds (i.e., ‘active' QE) contributed to lower yields and spreads. Outright expansion of these programmes or the implicit threat that they could be enlarged in scope and/or size also kept yields and spreads from rising too much, and the real economy benefited from these developments. Selling assets purchased according to these ‘active' QE programmes could easily reverse those moves, particularly with a return to growth and the risk of inflation. With very little experience in handling such large unwinds along with the risk of derailing a hard-fought recovery by sending yields and spreads higher, central banks are unlikely to move particularly rapidly.” (emphasis added)

When policymakers ply on uncharted territories, instead of dealing with risks, we are transformed into dealing with non-Priceable Knightean “uncertainties”.

The underlying difference against risk, to quote economist Frank H. Knight is that “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”.

In short, the law of unintended consequences has been increasing its role in the unfolding inflationary cycle.

The Bureaucratic Incentive Problem**

Besides, there has always been the question of incentives underpinning the actions of policymakers involved.

When unelected officials (e.g. Treasury or Central Banks) dabble with economic or financial policy tools or regulations or assume greater bandwith of power over their constituents, their accountability essentially remains the same.

Any adverse outcomes arising from their actions on the economic or financial sphere will only lead to, at worst, a job loss-but in most cases the same officials get enlisted with private firms they regulate. Since, to quote Ludwig von Mises, ``A bureaucrat differs from a nonbureaucrat precisely because he is working in a field in which it is impossible to appraise the result of a mans effort in terms of money”.

In short, it cost little for them to commit a policy error, since they’re not punished for it and are measured not based on money performances but on the impact during their tenure.

Hence, policymakers are likely to take actions that are designed for generating short term “visible” benefits at the cost of deferring the “unseen” cumulative long term risks, which are usually are aligned with the office tenure (let the next guy handle the mess) or if they happen to be politically influenced by the incumbent administration (generates impacts that can win votes).

So bureaucratic myopia seems in a natural state of conflict with the long term interest of the marketplace and can function as another vital factor in amplifying the risks of enabling future crises.

**Update: I forgot to include this portion

The Transitioning Political Phase: Shadows of Smoot Hawley and Financial Crisis Claims First Government-Belgium

We are now entering into the political phase of the current global crisis.

To begin with, the modern day version of the Smoot-Hawley Act seems to be in the process of resurrection.

This from Washington Post (bold highlights mine),

``Only a few weeks after world leaders vowed at a Washington summit to reject trade protectionism and adhere to free-market principles as they combat the global financial crisis, a host of nations are already breaking that promise.

``Moving to shield battered domestic manufacturers from foreign imports, Indonesia is slapping restrictions on at least 500 products this month, demanding special licenses and new fees on imports. Russia is hiking tariffs on imported cars, poultry and pork. France is launching a state fund to protect French companies from foreign takeovers. Officials in Argentina and Brazil are seeking to raise tariffs on products from imported wine and textiles to leather goods and peaches, according to the World Trade Organization.

``The list of countries making access to their markets harder potentially includes the United States, where critics are calling the White House's $17.4 billion bailout of the U.S. auto industry an unfair government subsidy that would put foreign competitors at a disadvantage.

``Though still relatively narrow in scope, the moves, observers warn, in the coming months may grow into a broader wave of protectionism. That could worsen the global financial crisis by further choking world trade, which is already facing its first decline since 1982 as the world economy sharply slows and demand dries up.

``In hard times, analysts say, nations are more inclined to take steps that inhibit trade, often with dire consequences. Trade restrictions imposed by countries trying to protect domestic industries in the 1930s, for instance, escalated into a global trade war that deepened and prolonged the Great Depression.

``Exporting firms tend to be innovative, dynamic and capable of generating good job growth," said Eswar S. Prasad, a professor of trade policy at Cornell University and senior fellow at the Brookings Institution in Washington. "If trade restrictions caused by trade wars shut them down, their suppliers shut down, job losses get worse, and you can quickly have a spiraling downward effect on the entire economy."

``To be sure, most of the measures taken to date appear to be within the limits of current international trade treaties, which grant countries some room to raise tariffs and contain loopholes that can be exploited to protect domestic industries.

``But the general trend toward protectionism could undermine what has been the steady march of free trade during the era of globalization, with export-dependent countries such as China standing to lose the most."

So the unintended consequences of bailouts are partially contributing to such movement.

Next, we have national governments falling under the weight of the financial crisis.

Belgium is reportedly the first of the victim.

This according to the Financial Times, ``The Belgian government last night became the first national administration to fall as a direct result of events linked to the global financial crisis.

``Belgium's King Albert II formally accepted the resignation of the coalition government led by Yves Leterme, prime minister - but ordered it to stay on in a caretaker capacity to deal with "day-to-day" business.

The political ramifications of the crisis carries a big weight to trade, migration and capital flows dynamics, hence requires to be monitored.

For us, protectionism is one major threat or risk that can bring about the modern day version of the Great Depression.