The coming year will be a turning point in the 30-year decline in developed world inflation. That will not be because inflation reappears suddenly in 2012.  In fact, expect the opposite.  It may well be that 2012 brings a deflationary thunderclap centered in Europe.  But the response will likely be a reluctant and tacit concession to the urgent need to reflate to attenuate disaster.  It is possible, but not necessary, that the departure of one or more countries from the Eurozone marks a turn to reflation.  The euro itself is deflationary in the current circumstances, and either euro devaluation by the European Central Bank, or selective devaluation by exit from the Eurozone amount to the same thing – the rejection of a threat of deflation.  The worse it gets in 2012, the greater the subsurface pressure for eventual inflation. 

 

A deflationary thunderclap from Europe would not be the first.  The American government did not rescue Lehman Brothers in 2008.  Just six months before, Bear Stearns was ushered down the aisle by shotgun and wedded to JP Morgan which, while involuntary, was better than dismemberment by wild animals.  Instead, Lehman was allowed to meet that fate, with losses of 70% to 80% to its unhappy creditors.  Not since the 1930s was a systemically important American financial institution valued by autopsy.  That recalled the famous “Liquidate, liquidate, liquidate” advice of Andrew Mellon to Herbert Hoover. In 1931, such policies contributed to the Great Depression, which in turn contributed to the eventual demise of the deflationary gold standard, and the secular turn to more inflation.  We will return to that inflation later.

 

The logic of the American government’s abandonment of Lehman was punishment of moral hazard.  Such conviction lasted three days, until the collateral calls following the Lehman insolvency caused the same government to bail out AIG.  Their successors in the Obama Administration have said clearly that there shall be no more Lehmans.  This is the avowed indemnification in which the markets now believe. 

 

Alan Greenspan thus has his revenge.  The former Federal Reserve chairman has been derided for his rescue of financial markets when Russia and Long Term Capital defaulted in 1998.  The low rates that followed are held responsible for a massive housing bubble, in general congealing to the “Greenspan Put,” the idea that risk takers could, well, take risk, since the central bank would bail them out if it busted badly enough. 

 

Markets have now come to believe in an even broader fiat money put option.  The fiat money put is the global descendant of the Greenspan Put in the U.S.   Since governments have used up their ability to engage in the Keynesian antidote of borrowing yet more to attenuate pain, the only device left is the central bank.  Whether or not the long-run effect of excessive currency debasement is destructive, the urgency of the moment trumps long-run importance.  The putative infinitely expandable central bank balance sheets will expand infinitely, so the thinking goes, because sin beats apocalypse.

 

The financial markets’ anticipation of action by European policymakers was transparently a belief that the fiat money put is predictable.  But this faith—and it is only faith—that governments will get it right has been proved wrong before.  So how to appraise the likelihood that it is correct this time?  That depends upon one’s confidence in central banks’ ability to withstand pressure.

 

There are two constraints on the expansion of central banks’ balance sheets, referred to largely metaphorically as printing money.  One is statutory, the other is fiduciary.

 

Statutory constraints upon central banks’ behavior are limited or even perfunctory.  The Bank of Japan has few constraints, and has exercised its freedom by buying all kinds of assets.  Those include even risky ones such as real estate investment trust shares.  Such risky central bank acquisitions are so far regarded as bohemian in the developed western countries.  For now.

 

Other central banks vary in their statutory ability to expose themselves to risk.  The Federal Reserve in the U.S. has a relatively restrictive statute in its birth certificate, the Federal Reserve Act of 1913.  That law proscribes risk taking of most kinds, generally requiring secured lending to financial institutions only.  The only peephole is Section 13 (3) of the Act, which allows for riskier lending in “exigent” circumstances. This is just the provision in the Federal Reserve Act that was invoked to keep Bear Stearns afloat long enough for the wedding gown to be zipped, and the Maiden Lane deals to be closed.

 

The statutory limits to central banks behavior vary, therefore, but are liberal.  Purchase of government bonds payable in one’s own currency exposes a central bank to no loss other than purchasing power.  The ECB’s purchase of Italian and Spanish bonds arguably does expose them to impairment losses if there is a restructuring, but this has for now been removed as an obstacle by the ECB’s refusal to submit their Greek holdings to restructuring, supplemented by the shelving of private sector involvement in restructurings, at least for the moment.

 

A question over time, therefore, is the fiduciary responsibility of central banks.  In a paper money world a currency is only as good as its issuer.  The defining issue facing central banks is that they are increasingly left to fight all of governments’ battles against economic and financial contraction.  Expansion of government spending, and thus borrowing, is increasingly constrained by having done too much of it in the past.  The only weapon left is the putatively infinite ability of the central bank to borrow by creating bank reserves out of thin air.

 

The question facing investors, then, is guessing the behavior of central banks.

 

The correct guess is that they will choose, at times under considerable stress, to fight the deflationary effect of outstanding debt when it becomes imminent.  The alternative is to risk a reprise of the Great Depression.  The likely long-run price of doing so is inflation, but central banks express great confidence that they can and will act to restrict inflation if and when it rises to the level of threat.

 

But what if that occurs before the stock of debt is reduced to more sustainable levels and does not act as a brake on economic growth?  We have referred before to the body of work that has emerged on the issue of natural limits to indebtedness.  The developed world appears to have reached, and in many cases passed, such levels.  The Bank for International Settlements¹ produced a study showing that debt limits growth at levels below those that developed countries have already reached. The speed limit is 85%-90% by sector, and those limits have been passed (Chart 1).

 

^1. Cecchetti, Mohanty and Zampolli, The Real Effects of Debt, September 2011, Bank for International Settlements Working Paper 352.

 

 

 

Chart 1.  Debt as a Limit to Growth

 

Sources:  BIS and GR-NEAM Analytics

 

The paradox facing such countries is that debt reduction hurts growth, which makes it more difficult to grow into the debt load, placing yet more contractionary pressure on spenders, including governments.  It is prospectively a vicious circle.

 

So if inflationary pressures begin to build at some point, the central banks are at war with themselves.  The risk is that they must intermittently fight deflation, then inflation, and at some point they must choose between the two.  At that point they are caught between the collision of an irresistible force of inflation, and the immovable object of debt.

 

They will choose inflation, because it is the only politically admissible choice, as Herbert Hoover discovered.  But they will choose inflation surreptitiously, because it is the way to devalue their liabilities, which are in developed countries typically denominated in their own currencies. Even Germany will eventually recognize that debasement of peripheral countries’ liabilities is relatively painless, given the alternatives of default and the massive banking system stress that would result.

 

This is why financial markets are behaving as they are.  The rise in volatility of market prices occurs when investors do not know how to price assets.  Markets must engage in a daily handicapping of who wins—debt or inflation?  This has important implications for financial market valuation.

 

Volatility has not yet reached the 2008-2009 level, but it may.  In Chart 2 we show the rise in bond risk spreads.

 

Chart 2.  Bond Risk Spreads

 

Sources:  Bloomberg L.P.  and GR-NEAM Analytics

 

 

The rise in volatility is pervasive and not limited to credit markets.  As the Eurozone crisis has escalated this year, it has affected all markets.  Consider the daily volatility of stock markets in Chart 3.

 

Chart 3.  Stock Market Moves Over 2% in One Day

Sources:  Bloomberg L.P.  and GR-NEAM Analytics           

 

 

There is a widespread view that risk assets are attractively valued.  Spreads are wide and price/earnings ratios are low, the thinking goes, so it is time to buy. There are two problems with this.  First, profit margins are exceptionally high.  It may be that this produces an illusory image of valuation.  Second, those apparently low valuations may represent fair value in a world of higher debt levels that constrain governments’ ability to respond as they have historically.  Consider the increasing severity of cyclical declines as debt levels have risen in the U.S. in Chart 4.

 

Chart 4.  S&P 500 Declines and Debt 

 

 

Sources:  Bloomberg L.P.  and GR-NEAM Analytics           

 

 

Markets, then, are gradually getting it right.  Risk assets deserve a derating.  They should be inexpensive in a world that is itself riskier than it was.  Valuation levels for stocks and credit assets that were cheap in the past are not as cheap today, and may in fact be fairly valued.  We are circumspect at parallels with Japan, because of certain factors that make that economy not necessarily predictive of the developed world in general.  Nonetheless, the Japanese market is instructive on the question of risk, debt and valuation.  For the last 10 or 15 years, many people have proposed that the Japanese stock market had performed so poorly that it had become attractively valued.  Each time it rose on a cyclical basis to its previous high, could not rise further, and then fell to a new low as shown in Chart 5.

 

 

 

 

 

 

 

 

 

 

 

Chart 5.  Japanese Stock Market

Sources:  Bloomberg L.P.  and GR-NEAM Analytics

 

 

Over this period the ratio of Japanese government debt to GDP rose inexorably to the world’s highest, even as the private sector was no longer leveraging up.  This is a rational response to declining government flexibility, since at high debt levels government, as the economic insurer of last resort, is using up its ability to insure.  Lower valuations under those circumstances are correct.  Viewing the stock markets’ performance in this context explains the rising severity of cyclical declines (Chart 6).

 

Chart 6. Japanese Stock Declines and Government Debt

 

Sources:  Bank of Japan, Bloomberg L.P., Haver Analytics and GR-NEAM Analytics

 

The logic of rising inflation over time in reducing excessive debt levels relative to GDP is clear.  There is ample historical evidence that this has occurred before.  In an excellent recent paper, Reinhart and Sbrancia¹ showed the role of negative real interest rates (the excess of inflation over interest rates) in reducing government debt to GDP.  The developed world emerged from World War II with very high debt to GDP ratios.  With the removal of wartime price controls inflation rose and contributed mightily to reducing the debt load, known as financial repression, as shown in Table 1.

 

Table 1. Debt Liquidation Through Financial Repression, 1945-1955

 

	Public Debt/GDP
Country	1945	1955 (Actual)	1955 (Calculated as Would Have Been Without Repression Savings)	Inflation
U.S.	116 %	66 %	144 %	4.1 %
U.K.	216 %	138 %	234 %	3.9 %
Italy	67  %	38 %	120 %	9.6 %

 

Sources: BIS and GR-NEAM Analytics

 

Inflation did wonders to relieve the debt pressure on governments.  Inflation remains a time-honored answer to relieving governments’ financial pressure.

 

The developed world is riskier than it was, and should be valued accordingly.  That is a dour conclusion, but avoiding it does not mean that one can outrun it.  Perceptions of what makes risky assets attractively valued need to be adjusted for the context.  Valuation levels that were attractive when the world was less indebted are not as attractive today, and are attractive only at lower levels since valuations have not yet anticipated eventual inflation.  The investments that will do the best are those that benefit from inflation and the negative real interest rates that result, since ultimately that is the choice governments will make.

 

 

 

 

^1. Reinhart and Sbrancia, The Liquidation of Government Debt, November 2011, Bank for International Settlements Working Paper 363.

 

 

 

 

(c) GR-NEAM

www.grneam.com