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9 October 2009
Popular Delusions
Inflation is always and everywhere a fiscal phenomenon
Dylan Grice Even before the “Great Recession”, unfunded fiscal obligations made government finances an
(44) 20 7762 5872
dylan.grice@sgcib.com accident waiting to happen. The crisis has merely brought forward the day of reckoning. The
question isn’t whether developed governments will “default” on them, with attendant
consequences for other asset classes, it’s when and how. Yet long-term inflation is priced at
2% in the US. This could be the biggest pricing anomaly across markets today.
Q Believe it or not, the first great inflation occurred in third century AD Rome. The territorial
limits of empire had been reached several decades earlier and the huge army, which in
former times had financed itself (through the conquest of new, plunderable and taxable
lands), was now needed to protect the border from barbarian invaders.
Q Just like the baby boomers of todays developed world, that cohort of Roman society
which had once been its engine of growth became its unsustainable financial burden,
straining imperial finances so thoroughly that the government could only fund itself by
debasing the coinage. The silver content of a denarius, which had been 75% in 180AD, was
a mere 0.02% by 270AD. Fiscal pressure had caused the first inflation and the Empire would
never regain its former greatness.
Q And since this early Roman experience the theme has repeated itself again and again.
Medieval Europe, Sung China, revolutionary France, America during its civil war, Weimar
Germany and arguably even post WW2 Britain and America, all saw inflations in which
money was the vehicle, but the root cause was a government unable to pay its way.
Q Albert Edwards has always said the Ice Age would end in substantially higher inflation
because political desperation to avoid Japans fate would drive government debt to such
extreme levels that default would be inevitable. Driven by an age old dynamic, this is exactly
what is playing out now.
Official government debt ratios look OK, unofficial ones (including unfunded obligations) don’t
Official Net Debt, % GDP * To tal net liabilities (funded and unfunded), % GDP **
750%
500%
250%
In 2005 net government debt stood at around 40% of GDP. The chart on the front page shows
the OECDs projections of the same ratio (red bars) for 2010, where it is expected to average
about 60%. If these numbers were an accurate reflection of governments true indebtedness
the long-term inflation expectations built into the bond market wouldnt be too interesting.
But theyre not. Official government debt statistics such as those represented by the red bars
on the front page chart are based on the outstanding stock of government debt, which is only
a subset of governments true liability. The rest of it is effectively off balance sheet (SIV like)
in the form of promised but unfunded future pension and health benefits.
Such commitments are the product of welfare systems designed to fund aged citizens by
taxing current workers. They work smoothly when the population is growing as there is a
constant supply of young workers to pay for each pensioner. But when population growth
slows, so does the ratio of new workers to pensioners and the schemes become underfunded.
This is exactly what is beginning to happen now throughout the developed world.
The grey bars on the front page chart correct for this. They represent calculations by
Jagadeesh Gokhale 1 of governments total liabilities when the unfunded obligations are added
to the official numbers. They are truly eye watering, almost unbelievable in fact. The best of
those charted is Spain, with a total liability to GDP ratio of only 244%. The worst are France
and America with liability to GDP ratios approaching 550%.
And in case youre thinking these estimates are the product of some maverick economist
desperately seeking attention, Gokhale is a senior fellow at the Cato Institute and former
advisor to the US Treasury, the Cleveland Fed and the AEI. His work on the US estimates was
co-authored with Kent Smetters, a professor at the Wharton Business School. Of course, that
doesnt make them correct or mean that we should blindly follow them, but they are at least
grounded in some credible and serious thinking.
Govts’ liability to income multiples (net actuarial liabilities as a multiple of current tax receipts)
25
20
15
10
0
Germany Spain France Italy UK EU US
1
See Measuring the Unfunded Obligations of European Countries by Jagadeesh Gokhale
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Popular Delusions
To properly gauge just how heavy this burden is, consider that the levels are only shown as a
share of GDP. A better way to look at sustainability is to compare the liabilities to income,
which Ive done in the chart above. Now, I thought quite hard about using this chart because
the numbers were so big I didnt think theyd be taken seriously. What they imply is
government failure, which until we glimpsed it in early 2009 was not something we had really
had to worry about for a very long time.
But upon reflection I decided that they are what they are best estimates, honestly produced.
That we dont like them doesnt mean we should ignore them. So Ive gone with them. They
show that government liabilities range from 6.5x government income in Spain, to 19.3x
government income in the US. Bear in mind that the US consumer is widely seen as dead in
the water with debt at 1.3x income.
Gokhale says that if governments saved roughly an additional 8% of GDP from today and
continued that saving for ever they would defuse the time bomb. 2 I say fat chance.
Governments act no differently from anyone else faced with debts they cant afford to pay.
They default. The only difference is that they default via inflation. A proxy for the governments
default risk premium, therefore, is the inflation expectation implied by the bond market
which the chart below shows is only 2% over the next 30 years. Bear in mind that US inflation
has averaged 4% since 1946 and 3% since 1983 (by which time Volker had successfully
brought inflation under control, and less than 30 years ago). At current pricing, markets clearly
expect an improved inflation performance over the next 30 years. In Europe the numbers
arent much more realistic, running at just under 2.5% in France, to 3.5% in the UK.
The last era of problematic inflation witnessed was the 1970s. It saw equity valuations and
corporate bond yields reach levels seen only during the Great Depression, and considerably
worse than the March 2009 panic. US bond yields rose above 15% and commodities enjoyed
one of the all-time great bull markets. So bear in mind, whether we like it or not, we all exist in
the orbit of government. The mispricing of inflation implies a mispricing of everything else.
Is this the most obvious anomaly across markets today? US implied 30y average inflation is 2%
4.5
3.5
2.5
1.5
US UK France
1
0.5
0
30/11/04 11/30/2005 11/30/2006 11/30/2007 11/28/2008
Source: Bloomberg
2
Actually, that was based on 2005 numbers. I suspect an updated figure now would be around 9-10%
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Popular Delusions
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4 9 October 2009