Debtflation

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Morgan Stanley has an interesting piece out this morning called Debtflation. In the past, they have raised alarm bells over what they see as embedded inflation in the loose monetary policy presently being followed by most central banks.  This particular piece focuses not on a general potential for inflation, but the possibility that central banks will explicitly target higher inflation in order to reduce high debt burdens – a policy advocated by Kenneth Rogoff.

The recent downturn has called many of the old certainties into question. In the world of central banking, a prominent victim of the downturn is the – previously orthodox – view that central banks should neglect asset prices when conducting monetary policy. Yet more recently, another major tenet of central bank doctrine is being challenged – the view that monetary policy should not be used to help out governments under debt pressure. We think that the risk of independent central banks creating some amount of (controlled) inflation going forward cannot quite be dismissed out of hand.

We have flagged inflation as a major long-term risk going forward: if the recovery is as tepid as we expect, central banks will be inclined to err on the side of caution when it comes to withdrawing the unprecedented conventional and unconventional monetary stimulus. But we believe that there will be a familiar additional source of inflation risk – the mounting public debt burden.  There is no doubt that, last winter, with the global economy slumping, central bankers welcomed the help they got from hugely expansionary fiscal policy. However, the result has been a massive increase in developed countries’ public indebtedness – the extent of the debt build-up in some countries resembles the consequences of wars. Historically, developed economies have escaped high debt by growing out of it rather than inflating it away or defaulting (with the notable exception of Germany and Japan). Growth after World War II for example was fast, not least because war-ravaged economies were rebuilding their capital stocks.

This time around, however, eroding the debt through faster growth may not be an option. Instead, growth in many developed countries is likely to slow significantly going forward as labour forces shrink due to the demographic transition. Worse, population ageing will impose added pressure on public expenditure through higher pensions and healthcare costs. If outgrowing the debt is unlikely, and if governments lack the resolve to cut spending and/or raise taxes sufficiently, the remaining options are default and inflation. No policymaker in the developed world – and, by now, few in the developing world – would want to countenance default as an option. This leaves inflation. The question is familiar: could central bankers be forced to engineer inflation – ‘monetise the debt’? Almost all developing world central banks are independent from an institutional point of view. Indeed, one of the main reasons for setting up independent monetary authorities is precisely to avoid pressure from governments to inflate away the debt. So, central banks cannot be forced by their governments to generate inflation (unless governments were prepared to change the statutes of their monetary authorities; this would in most cases require going to the legislature).

With governmental coercion being unfeasible, is there a possibility that independent central bankers might generate inflation out of their own volition? If nothing else, they would take a big gamble with their hard-won credibility. And history teaches us that the reason behind most, if not all, episodes of very high inflation has been monetary expansion to finance government expenditure or reduce debt (see "Could Hyperinflation Happen Again?" The Global Monetary Analyst, January 28, 2009).

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Morgan Stanley is saying in effect that it fears central banks inflating away private and public debt burdens by printing more money. It is not clear that quantitative easing really is inflationary (at least in the short-term). For this policy to actually produce inflation in an environment that is geared more toward deleveraging, we will need serious asset price inflation to spill over into the real economy – and this would require increases in asset prices that would be extremely destabilizing when the inevitable bust occurs. Most likely an asset bubble bursting would tip the global economy back into deflation. This is the Scylla and Charybdis problem I outlined in June. So, I am not sure central banks could pull this off even if they wanted to.

More from Morgan Stanley at the link below.

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Debtflation – Morgan Stanley

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