By now it's an article of faith within the sound money community that most
major countries have borrowed so much that they're left with only two options:
default on their debt through mass-bankruptcy and a new Great Depression, or
inflate it away through stepped-up currency creation.
This is an investment thesis, since a given country's choice will determine
which asset classes rise and fall.
But it's also a criticism of the people and policies that put us in this box.
The presidents, prime ministers, senators, central bank heads and investment
bankers who presided over the global economy of the past 30 years screwed up
monumentally, leaving today's savers, entrepreneurs and workers to clean up
their mess.
Because acknowledging this stark choice between inflation and Depression is
such an admission of failure, it isn't discussed in these terms on the official
side of the debate. There, the tone is more measured and the promise is that
the next tweak will more-or-less painlessly return the system to a stable equilibrium
of steady growth, full employment and incumbent electoral success.
But at some point the fig leaf has to fall and the truth -- that there are
no painless solutions, only different types of pain -- will have to be stated
explicitly. Here's a glimpse of that future in the form of an old (2010) column
by New York Times columnist and Nobel Prize-winning economist Paul Krugman:
Not in ourselves.
I think it's fair to say that a majority of economists believe that excessive
private debt played a key role in getting us into this economic mess, and
is playing a key role in preventing us from getting out. So, how does it
end?
A naive view says that what we need is a return to virtue: everyone needs
to save more, pay down debt, and restore healthy balance sheets.
The problem with this view is the fallacy of composition: when everyone
tries to pay down debt at the same time, the result is a depressed economy
and falling inflation, which cause the ratio of debt to income to rise if
anything. That is, we're living in a world in which the twin paradoxes of
thrift and deleveraging hold, and hence in which individual virtue ends up
being collective vice.
So what will happen? In the end, I'd argue, what must happen is an effective
default on a significant part of debt, one way or another. The default could
be implicit, via a period of moderate inflation that reduces the real burden
of debt; that's how World War II cured the depression. Or, if not, we could
see a gradual, painful process of individual defaults and bankruptcies, which
ends up reducing overall debt.
And that's what is happening now: as this story in today's Times points
out, the main force behind the gratifying decline in consumer debt appears
to be default rather than thrift.
So basically, we can do this cleanly or we can do this ugly. And ugly is
the way we're going.
Some thoughts
Even now, four years after Krugman's rhetorical trial balloon, policy makers
and economists refuse to admit that inflation is a form of default. But things
are going so badly for these guys pretty much everywhere that before long they'll
be forced, as Krugman briefly was, to start spinning default-through-devaluation
as the smoother, less painful version of an act that in most walks of life
is seen as shameful.
Of course, one person's smooth transition is another's swerve into a ditch.
Savers now accepting 0.5% interest on bank CDs will be shocked to find out
that the government is explicitly trying to devalue the currency by 5% a year,
giving those CDs a -4.5% annual return and making saving for retirement --
or even preserving capital -- impossible.
But leaving aside the moral failings of inflation, Keynesian economic theory
also has a glaring analytical flaw: a seeming inability to think through the
secondary and tertiary effects of policy. To take one obvious example, if a
country begins to explicitly default on its debts by lowering the value of
its currency, then the rational response for people within that system is to
borrow as much as possible at current low interest rates with the goal of paying
back the loans in massively-cheaper money. So...the policy of shrinking current
debt through inflation actually leads to a surge in new borrowing and (presumably)
an even bigger debt problem in the future. But because it generates "growth" in
the short run as the proceeds of all those new loans are spent, it appears
to work for a while, which seems to be what matters in this theoretical framework.
Krugman's admission is also a big step on the journey to the Austrian
economics crack-up boom, which hits when a critical mass of people figure
out that the government is going to make the currency worth less each year
for a really long time. Individuals and businesses lose interest in holding
the currency, instead spending it on real stuff as fast as it comes in, thus
setting off an asset bubble/hyperinflation.
And about WWII fixing the Great Depression, sorry, but the US invasion of
Europe followed a decade of private sector debt defaults which lowered total
debt/GDP by more than half. By 1939 the US had already deleveraged and was
ready to start growing again. The fact that Washington then increased spending
and borrowing is almost irrelevant -- or maybe actually negative because the
bullets, tanks and planes the government bought were subsequently used or destroyed
without adding to US real wealth. So a case could be made that the 1950s and
1960s would have been even better economically if WWII had never happened.
