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World Global Strategy

World Global Strategy

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World Global Strategy

9 October 2009

Popular Delusions
Inflation is always and everywhere a fiscal phenomenon
Dylan Grice (44) 20 7762 5872 dylan.grice@sgcib.com

Even before the “Great Recession”, unfunded fiscal obligations made government finances an 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.

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. Just like the baby boomers of today’s 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. 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. Albert Edwards has always said the Ice Age would end in substantially higher inflation because political desperation to avoid Japan’s 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 * 750% To tal net liabilities (funded and unfunded), % GDP **



0% Germany Spain France * 201 OECD pro jectio ns 0 ** 2005 estimates o f to tal Fiscal Imbalance
Source: Gokhale, OECD






Popular Delusions

In 2005 net government debt stood at around 40% of GDP. The chart on the front page shows the OECD’s 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 wouldn’t be too interesting. But they’re 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 you’re 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 doesn’t 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)


1 5

1 0


0 Germany Spain France Italy UK EU US

Source: Gokhalle (2009), see footnote for link


See “Measuring the Unfunded Obligations of European Countries” by Jagadeesh Gokhale


9 October 2009

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 I’ve done in the chart above. Now, I thought quite hard about using this chart because the numbers were so big I didn’t think they’d 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 don’t like them doesn’t mean we should ignore them. So I’ve 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 can’t afford to pay. They default. The only difference is that they default via inflation. A proxy for the government’s “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 aren’t 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 4 3.5 3 2.5 2 1 .5 US 1 0.5 0 30/1 /04 1
Source: Bloomberg



1 /30/2005 1

1 /30/2006 1

1 /30/2007 1

1 /28/2008 1


Actually, that was based on 2005 numbers. I suspect an updated figure now would be around 9-10%

9 October 2009


Popular Delusions

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9 October 2009

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