Last inflation sprial in the Seventies
The first thing to note is that the last bout of inflation the US has experienced was in the Seventies. This means you’d have to be close to sixty years old to have lived through an inflationary period as a working adult. Said in a different way, almost no one who is writing and speaking about the inflation threat today has any practical experience of the phenomenon. To my mind, most of these commentators have no clue about what inflation is or does.
Inflationary expectations = the key
Excessive government stimulation of the economy–either through money or fiscal policy–shows up as inflation when it changes the mindset of companies and employees. In an inflationary environment, everyone accepts the idea that prices are bound to rise pretty continuously and across the board. Companies find no resistance to raising the prices of their goods and services. Workers find no difficulty getting wage increases that allow them to at least pay these higher prices. Everyone buys today because prices will surely be higher tomorrow.
No one in the US has thought, or acted, this way for three decades. No one sees any reason to do so now. In fact, recent experience continues to argue that this is a foolish way to behave. Look at what happened to people who thought internet stocks would keep going up forever. It’s the same thing that happened to people who thought that real estate in Miami or Las Vegas was a one-way bet. In today’s world, P&G is talking about lowering prices of its branded household products because of the threat from private label. I think this is the main point most commentators miss.
With 9% of the workforce unemployed, and many new job entrants from the past two or three years underemployed, it’s hard to see upward pressure on overall wages for years. With consumers cutting back and trading down, it’s equally hard to see companies being able to raise prices. They’re not. They’re lowering them instead.
The real inflation risks
There is a nexus of inflation-related risks to the US, however, but they’re not the garden variety ones we’re used to thinking about. They’re hard to handicap, but no less real because of that. They revolve around the size and composition of our government debt, and the need to run large government budget deficits (that is, borrow a lot more) to repair the damage to the economy done by the financial crisis.
Treasury debt held by non-government entities (the biggest government holder being the Social Security Trust Fund, holding $2.5 trillion of a $4 trillion total) is about $7 trillion. Of that, $3.2 trillion, or about 45%, is held by foreigners. The largest holders are China, Japan, the oil exporting countries and Russia, which together own over half the foreign portion.
The fact of large foreign participation in the Treasury market means lower interest rates for government borrowing. For countries with large trade surpluses with the US, Treasuries are a deep, liquid market which has traditionally acted as a safe haven for these funds. Recently, foreigners have bought between a third and half of new Treasury issues being offered.
1. What if foreigners decided not to buy new Treasuries any more at today’s prices? It’s not clear where they would invest their trade surpluses instead, but let’s just say they did stop buying. If so, the Treasury would have to raise the yields on new securities until either foreigners came back to the market or the issues were absorbed totally by American buyers.
By far, the most damaging consequence of such a decision would be the implied lack of faith in US government debt. In addition, higher yields, by themselves, would mean lower prices for stocks, further slowdown in the US economy, and lower prices for already-existing Treasury issues. Higher interest rates would be a positive for the dollar, but the confidence question would work in the opposite direction.
So, if foreigners stopped buying, they would certainly suffer a loss on their existing holdings, which currency movements could either add to or subtract from. To the extent they are trading partners with the US, a further slowdown here would have negative effects on their economies as well.
2. Suppose foreigners decided not only to stop buying but to begin selling some of the US government bond holdings they now have. This would produce all the negative effects of 1. on a magnified scale. The lack of confidence statement would likely do severe damage to the US. And the act of selling would by itself put downward pressure on the dollar.
The inflation angle?
How does inflation enter into this?–through the currency. A significant dollar decline would not only be a loss of national wealth, but it could also dramatically increase the dollar price of foreign goods and services. US companies would raise domestic prices and shift their sales efforts toward foreign customers. At some point, foreigners would also begin to buy up US assets, raising their prices as well. Inflation might be the least of our problems, but it would be one of them.
From the foreigner’s point of view, if a country like China started to sell Treasuries, the price of the bonds would drop sharply almost immediately. The resulting difficulties for the US in financing its deficit could cause a severe economic contraction, which really damage the export sectors of our trading partners.
How likely are 1. or 2. to happen? At this point, extremely unlikely. Neither 1 nor 2 is the best alternative for the foreign bondholder.
Why are either on the radar screen at all? Two reasons:
1. A country like ours that’s out of financial balance because of budget deficits can get back into balance either through internal adjustment (raising taxes, cutting government spending) or external adjustment (currency and global interest rate changes). Politicians around the world prefer the second kind of adjustment, because they are closely identified with, and blamed for, the first. So lenders watch closely for any attempt to repay loans in depreciated currency (what gold bugs like to call by the old-fashioned term “debasing” the currency).
2. In the current crisis in particular, our Congress hasn’t demonstrated much, if any, understanding of the relevant economic issues. There was a period of weeks during which the world thought neither Congress nor the current administration would be able to come to grips with the country’s financial problems and begin to fix them. Mr. Obama has already made a number of suggestions about pork barrel projects that could be eliminated, as well as changes to the tax laws that could bring in more revenue. Congress has rejected all of the Obama proposals. With these early warning signs present, it’s not a great surprise that foreigners appear to be limiting their buying of new Treasuries to the very shortest maturities.
Although for foreign bondholders selling is at the moment by no means the best investment alternative, if Congress tries–deliberately or accidentally (through not understanding what it is doing)–to repay debt in inflation-or currency-diluted dollars, it could well give foreign holders little other economic choice.