So we have this monster debt overhang in the US, and the answer is to just print up more money, right?
Of course, nobody would ever admit to that. Ben Bernanke will insist that the Fed is devoted to sound money practices. Tim Geithner talks about getting spending and taxing and borrowing under control (eventually). But come on, you know the printing press is part of the plan.
Unfortunately it won’t work says UBS economist Paul Donovan, in a report picked up by FT Alphaville.
While most investors today acknowledge that deflation is likely to be a feature for the OECD economies during the second half of 2009, inflation pessimists cling resolutely to the belief that inflation will inevitably return. “Fiscal deficits are rising dramatically” goes the argument. “Governments will have to create inflation to reduce debt:GDP ratios, as they have done in the past.”
The problem with the idea of governments inflating their way out of a debt burden is that it does not work. Absent episodes of hyper-inflation, it is a strategy that has never worked. Government debt: GDP burdens tend to be positively correlated with inflation. Market mythology has created the idea that inflation will help reduce government debt ratios. The facts do not support the myth. OECD government debt rises as inflation rises. Meaningful reductions in government debt will require a low inflation future.
As this chart shows, instances of declining debt-to-GDP rarely coincide with periods of inflation. If it did If it did, we’d see more dots in the lower right-hand quadrant.
The bad news for central bankers is that creating currency isn’t like, say, diluting shareholders in a company. You’re always rolling your debt, and the market’s response to an inflationary strategy is (not surprisingly) higher interest rates. It’s a treadmill, and it’s extremely hard to get ahead.
So why do we have this mythology, as Donovan calls it, of inflating our way out of debt? It’s probably because on the surface there’s some simple logic to it, though more importantly it’s a myth borne out of necessity. The opposite idea, that we’d actually have to cut spending and raise taxes (which is to say, actually pay off our debts) is just too painful to contemplate.
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