Tantalizing Report Discussed In Financial Sense Newshour Pocast

This week's Financial Sense Newshour podcast contained more optimism regarding gold, and presented a decade-long framework for investments. The host claimed that commodities, the asset class for the '00s, would continue to be so for the coming decade.

The second part of the third hour [.mp3 file] featured a discussion of an economic report by Joshua Aizenman and Nancy Marion. It's called "Using Inflation To Erode The Public Debt." Despite the fact that it's largely a technical-econometric report, it's a political sleeper. To their credit, the hosts of FSN recognized its significance. (There's a download link to the report itself on this page.)

Drawing a parallel to the government-debt overhang after World War 2, the "Using Inflation" authors claim that an inflation rate of about 5% over several years will reduce the debt-to-GDP ratio. A similar strategy worked back then, reducing the ratio from about 110% to about 70% from 1946 to 1955. In a time of stalled growth, inflation at a mid-single-digit rate has done the trick. [Explanatory note: The debt-to-GDP ratio uses nominal GDP, and of course nominal debt.]

With regard to the present, the benefits to the debt-GDP ratio are a little unclear. On the one hand, it's impossible for the U.S. government to scoop an inflation gain with TIPS. On the same hand, shorter maturities make it harder to benefit from inflating because the shorter rollover time means that (inevitably higher) compensatory interest rates can be captured sooner. On the other hand, large foreign ownership of U.S. Treasury securities means that part of the loss will be borne by foreigners. Also, TIPS make up only 10% of the total issuance held by the public. Weighing all the factors, the authors recommend a spell of 5%-or-so inflation for several years. They also discuss the downsides to such a policy: the risk of inflation jacking up to double digits, the risk the "bond vigilantes" will swoop in, and the risk that foreign holders will divest.


These two, perhaps unknowingly, have come up with a policy recommendation that has real resonance potential beyond the scope of their paper. There's already real worry about the effect of the ratio on future economic growth, making for a constituency that would be favorable to the relatively soft option of inflating. In addition, there are other factors in its favor.

Left unsaid is the effect of 5%-or-so inflation on the housing market. Residential real estate wasn't widely seeen as an asset with appreciation potential until the high-inflation '70s. Renewed inflation would bring back, in attenuated form, a force that did push house prices up back then. The amount of "excess capacity" in residential real estate can be cited as a reason why 5% inflation will not reignite a housing bubble.

The risk of foreign holders balking is mentioned, but unmentioned is the compatibility of such a policy with export promotion and a "getting tough with China" policy. One indirect effect of ramping up the U.S. inflation rate, unless this recommendation is adopted across the OECD board, would be a devaluation of the U.S. dollar. Such a devaluation would tie in nicely with the Obama Administration's recently-expressed plans to boost U.S. exports. Regarding the risk of Chinese abandonment of U.S. Treasuries, it can be mitigated if the European Union adopts the same policy for similar reasons as an expedient. If that duck's in the row, it becomes easier to say to PRC officials: "where else are you going to go?"

Even if not, a get-tough-with-China official can respond with: "so much the better. Let the dollar drop more; we need the exports. It's about time their own low-exchange-rate trade aggression came back to bite them in the [posterior]." This attitude can also serve as a jawboning stance to make the PRC government accept it as an expedient, if grudgingly.

Regarding rate risk: it's only a matter of time before government statisticians cotton on to the fact that total demand for U.S. Treasuries is both strong and deep, and that the bond vigilantes have gone on an extended vacation. Given the generally-recognized deflationary pressures on the U.S. economy, it's likely that a spate of 5% inflation will be interpreted as aberrational.

It would go better if outside parties were held to blame for it, as is standard when the U.S. government engages in sustained monetary meddling. I can't comment on this factor, as I'm not that quick in this department.

My conclusion may come across as facile, but my political radar says that this policy has really good optics. It's presented as a viable escape hatch in a time when one is sorely needed. Moreover, it's presented as based on a "solution" (expedient) that worked successfully in the past. It can be justified as being a temporary growth-substitute, used until real growth resumes on a long-term basis.

At the very least, real-estate holders who've taken advantage of 5%-or-so long-term financing rates will be grateful. Thanks to credit-standards tightening, the beneficiaries have largely been those who've paid their bills throughout this mess. Lowering their real rate to zero can be presented as the the government finally giving a break to the long-suffering, much-neglected bill payer.


This way of putting it isn't likely to be a selling point in D.C., but if I were a bureaucrat that was part of the economic-policy loop, I'd be busy making an expanded benefit-cost list and compiling supporting figures with the aim to push it. Given the recent crisis and huge demand for bonds, and given the Obama Administration's recent priorities, it'd be an easy sell in today's D.C.

The impact for gold, of course, is obvious. Pursuing such a policy would switch the gold bubble from nascent to full-blown, particularly since there'd be a lot of cynicism regarding the "temporary" part.