The 2 Percent Inflation Target is Toast

You want your returns to keep up with inflation. The government needs you to fail.

We had a related discussion Monday evening, focused on the dim outlook for investing. Audio here:

Last Thursday, in the conversation hosted by Reason TV (short excerpt here, full version here), Lyn Alden had several things to say that I’ve been pondering since.

She used the term “repression,” which in this context means financial repression. When the government of an underdeveloped country gets into trouble, it will often turn to printing money, causing inflation. Residents want to take money out of the country so that the value of their savings does not get wiped out by the inflation. The government responds by slapping on currency controls and capital controls. She pointed out that one way residents can get their money out of the country without government interference is via Bitcoin.

She also pointed out that our situation today may be more comparable to the late 1940s than the 1970s. In the 1970s, the government debt was reasonably low relative to GDP. Accordingly, the government could tolerate high interest rates in order to stop inflation.

At the end of World War II, government debt was roughly 100 percent of GDP. The government could not afford high interest rates, which in any case would have increased government expenditures. So the government kept interest rates low, at least until 1951. For American households, this meant that the return on their savings did not keep up with inflation. This is called a negative real interest rate by economists and financial practitioners. With financial markets much less fast-paced and globalized than they are today, households did not have much choice but to have their savings eroded by negative real interest rates. They experienced financial repression.

Today, the ratio of government debt to GDP has returned to 100 percent. And Lyn Alden points out that repression—keeping interest rates below the inflation rate—is likely to be the case now, just as it was in the 1940s. But there is an important difference.

In 1945, the large government deficits were behind us. The government had to spend a lot on paying interest, but in the 1940s and 1950s, tax revenues exceeded non-interest spending, bringing down the ratio of government debt to GDP.

Now, the large government deficits are in front of us. The need to spend on Social Security and Medicare means that tax revenues are projected to be below non-interest spending. The outlook is for the ratio of government debt to GDP to keep growing until. . .until. . .well, something has to give.

Inflation is the government’s only choice

The politicians won’t solve the problem by cutting deficits. And they won’t explicitly default on the debt. The only choice left is to inflate away the debt. That is why I say that the 2 percent inflation target is toast. I think it is much more likely that over the next five to ten years inflation will be at least 5 percent than that it will fall back to the vicinity of 2 percent.

But inflation won’t solve the government’s debt problem if interest rates keep going up. If inflation is 5 percent, then the interest rate on government debt will have to be less than that in order to keep the government debt from exploding. In other words, we have to live with negative real interest rates.

In the near term, it is possible that we will experience a recession in the aftermath of the banking crisis. Households, businesses, and banks will all try to increase liquidity. That tends to reduce economic activity.

But a recession will not necessarily tame inflation. Even if it tapers off briefly, it is likely to return.

Households and corporate treasurers with funds to put to work want a positive real interest rate. We want to earn a return that at least keeps up with inflation.

Our government needs for us to fail.

In another excerpt of the Reason TV episode, I said that the American government just nationalized the banking system. They provided a full backstop to every bank deposit, not just deposits up to $250,000.

As surely as night follows day, strict regulation will follow the expansion of deposit insurance. Otherwise, banks could get away with wild risk-taking, knowing that the FDIC and the Fed will take the down side.

The form that regulation is likely to take is a requirement that banks undertake less lending to the private sector and instead hold more of their assets in the form of government securities. This will help keep the interest rate on government debt down. The rate of return will be below the rate of inflation.

Banks in turn will have to offer interest rates to depositors that are below the rate of inflation. Households and corporate treasurers will be confronted with negative real rates.

We will be looking for ways to escape from negative real rates. We will be tempted by financial instruments that offer higher rates of return. If creative financial institutions are able to provide us with such opportunities, and if our preferences for safety are satisfied by these new instruments, we will pull our money out of banks and into these alternative outlets for savings. This is known as disintermediation.

Note that crypto does not (yet) offer workable disintermediation. Bitcoin’s price is volatile—you have to worry about buying when it is overpriced. “Stable coins” solve the volatility problem. But if they are pegged to the dollar, then they don’t deal with the problem of the dollar itself depreciating via inflation.

The government is not going to like disintermediation. Disintermediation will threaten the health of banks, raising the specter of further bailouts. It also will make it harder for the government to keep the interest rate on its debt well below the rate of inflation.

That brings us back to the word repression. We can expect government to enact policies that make alternative investments at best unattractive and at worst illegal.

To repeat, as households and corporate treasurers, we want the funds at our disposal to earn a return that at least keeps up with inflation. And the government needs for us to fail.

Have a nice day.