Over the next decade, in the aftermath of the current bear market, investors will ultimately need to make the right call regarding inflation or its antipode, deflation. Despite near-term deflation risks, the overwhelming consensus view is that sooner or later inflation will inevitably return.
This view seems to rely on two general propositions. First, the unprecedented increases in the Federal Reserve System’s balance sheet are, by definition, inflationary. Indeed, the Fed must print more money to restore health to the economy. Ultimately, we are led to believe, this process will result in a substantially higher general price level. Second, an unparalleled surge in federal government spending and massive deficits will stimulate economic activity, which inexorably leads to inflation.
This is not to say, however, that investors should bet on inflation as a portfolio strategy. Indeed, it could be a bad bet in the next decade. We may be heading instead into a dangerous disinflationary period. If this is the case, Treasury bonds produce a higher total return than common stocks.
Economic Theory
To many, the logic of betting against inflation seems counter-intuitive. After all, inflation often accompanies recoveries. However, this concept begins to make more sense with the understanding that inflation at this stage can precipitate another economic downturn. Indeed, the economy would likely relapse if inflation and interest rates were to rise amidst the current recession, or even in the early stages of a recovery.
In late stages of economic downturns, there are typically substantial amounts of unutilized labor and other resources. Both factory utilization and unemployment rates lag behind other economic indicators. For instance, in the current recession, unused labor and other productive resources have increased sharply. In April, the unemployment rate stood at 8.9 percent, up from a cyclical low of 4.4. This is the highest level since the early 1980s. Concurrently, the operating rate for all industries and manufacturing both fell to their lowest levels on record in March. Indeed, manufacturing capacity fell to 15 percent below the 60-year average.
With unemployment at its current rate, wages seriously lag behind inflation. If inflation were to rise, real household income would decline and truncate any potential gain in consumer spending. This could lead to further economic malaise.
The Fed’s Balance Sheet
In the past year, the Fed’s balance sheet, as measured by the monetary base, has nearly doubled from $826 billion last March to $1.64 trillion. While potentially larger increases are indicated for the future, the current figures are far beyond the range of historical experience. Many observers believe that this is the equivalent to printing money, and that it is only a matter of time until significant inflation erupts.
These gigantic increases in the Fed’s balance sheet, however, have not led to the creation of fresh credit or economic growth. The reason stems from the fact that the Fed does not control the broad stock of money, also known as M2. M2 is influenced by the public’s preference for checking accounts or cash, as well as the bank’s needs for excess reserves. Due to a surge in excess reserves, only $14 billion, or a paltry 1.9 percent of the massive increase of total reserves, was available to make loans and investments.
If this all sounds complicated… it is. But, the bottom line is that it is incorrect to assume that the massive expansion in reserves created by the Fed is inflationary. Economic activity cannot move forward unless credit expansion follows reserves expansion. That is not happening. Too much poorly-financed debt has rendered our current monetary policy ineffective.
The Non-Banks
The notion that all the Fed has to do is print money in order to restore prosperity is not substantiated by history or theory. Liquidity creation (or destruction) has two components. The first is the Fed and the banking system, and the second is outside the banking system in what is often referred to as the shadow banking system.
The highly-ingenious monetary policy devices developed by the Fed under Chairman Ben Bernanke may prevent the calamitous events associated with the debt deflation of the Great Depression, but they may not restore the economy to health quickly or easily. The problem for the Fed is that it does not control the money created outside the banking system.
Washington policy makers are now moving to increase regulation of the banks and non-bank entities, as well. This is seen as necessary as a result of the excessive and unwise innovations of the past ten or more years, including mortgage-backed securities, and a host of complex derivatives.
Massive Deficits & Inflation
Based on the calculations of the Congressional Budget Office, U.S. government debt will jump to almost 72 percent of GDP in just four fiscal years. As such, this debt ratio would advance to the highest level since 1950. The conventional wisdom is that this will restore prosperity and higher inflation will return.
Conventional wisdom rarely holds. The historical record indicates that massive increases in government debt will weaken the private economy, thereby hindering rather than speeding an economic recovery. This does not mean that a recovery will not occur, however. What it means is that time, not government action, will be the curative factor.
In short, government borrowing does not always lead to inflation. Consider the example of Japan from 1988 to 2008, when government debt to GDP ratio surged from 50 percent to almost 170 percent. Indeed, if large increases in government debt were the key to economic prosperity, Japan would be in the greatest boom of all time. Instead, after two decades of repeated disappointments, Japan is in the midst of its worst recession since the end of World War II. In the fourth quarter, their GDP declined almost twice as fast as that of the U.S. or the European Union.
The unmanageable Japanese government debt was created when it provided funds to salvage failing banks, insurance firms, and other companies, plus transitory tax relief and make-work projects. By 2008, after two decades of massive debt increases, the Nikkei 225 average was 77 percent lower than it had been in 1989, and the yield on long Japanese Government Bonds was less than 1.5 percent. As the Government Debt to GDP ratio surged, interest rates and stock prices fell, reflecting the negative consequences of the transfer of financial resources from the private to the public sector. In the aggregate, these policy actions served to impede, rather than facilitate, economic activity.
The Japanese experience mirrors U.S. history from 1929 to 1941, when the ratio of U.S. government debt to GDP almost tripled from 16 percent to nearly 50 percent. As the U.S. debt ratio rose, long Treasury yields moved lower, indicating that the private sector was hurt, not helped, by the government’s efforts. The yearly low in long Treasury yields occurred at 1.95 percent in 1941, the last year before full World War II mobilization. In 1941, the S&P 500, despite some strong rallies in the 1930s, was 62 percent lower than in 1929, and had been falling since 1936.
Thus, two distinct periods, separated by hemispheres and decades in time, indicate that stock prices respond unfavorably to massive government deficit spending and bond yields decline.
The U.S. economy, for its part, finally recovered during World War II. Some attribute this recovery to a further increase in federal debt, which peaked at almost 109 percent of GDP. However, the dynamics during the war were much different from those of 1929 through 1941 and today.
For one, the U.S. ran huge trade surpluses; we supplied military and other goods to allies. This lifted the U.S. economy through a massive multiplier effect. Additionally, 10 percent of our population, or 12 million persons, were moved into military services. This is equivalent to 30 million people today.
It is also worth noting that mandatory rationing of goods was instituted; people were essentially forced to use an unprecedented portion of their income to buy U.S. bonds or other saving instruments. This unparalleled saving permitted the U.S. economy to recover from the massive debt accumulated prior to 1929.
Taking Stock of Bonds
Since the 1870s, three extended deflations have occurred—two in the U.S. from 1874-94 and from 1928 to 1941, and one in Japan from 1988 to 2008. All these deflations occurred in the aftermath of an extended period of “extreme over-indebtedness,” a term originally used by Irving Fisher in his famous 1933 article, “The Debt-Deflation Theory of Great Depressions.” Fisher argued that debt deflation controlled all, or nearly all, other economic variables.
Although not mentioned by Fisher, the historical record indicates that the risk premium (the difference between the total return on stocks and Treasury bonds) is also apparently controlled by debt deflation. Since 1802, U.S. stocks returned 2.5 percent per annum more than Treasury bonds. However, in the U.S. from 1874-94 and 1928-41, Treasury bonds returned 0.9 percent and 7 percent per annum, respectively, more than common stocks. In Japan’s recession from 1988-2008, Treasury bond returns exceeded the return on common stocks by 8.4 percent. Thus, historically, risk taking has not been rewarded in deflation. The premier investment asset has been the long government bond.
It is reasonable to expect continued negative consequences on stock and bond returns stemming from the massive government deficit spending. Therefore, on a historical basis, U.S. Treasury bonds should maintain their position as the premier asset class as the U.S. economy struggles with declining asset prices, overindebtedness, declining income flows, and slow growth.
Lacy Hunt is a chief economist with Hoisington Investment Management.
