As COVID-19 raised the spectre of economic collapse, mass unemployment and market turmoil, central banks and governments embarked on eye-popping programmes of monetary and fiscal stimulus. In just three months the US Federal Reserve (Fed) increased its balance sheet by US$3tn a level of debt which it had taken five years to accrue after the Great Financial Crisis. In addition, the US government has applied fiscal stimulus of (so far) US$2.5tn, creating a projected budget deficit for 2020 equivalent to 18% of GDP (including interest payments) and raising national debt to its highest level since World War II.
Many have argued that this cannot end well. Something has to give. That something, many believe, is inflation. Simply because the alternatives to inflation, when faced with too much debt, are so unpalatable. The trio of alternatives are default, austerity and raising taxes; all sapping demand when you need it most, as the economy sags all around you. When forced to choose between these, you can understand how attractive printing money is as a way out of such a choice, even at the risk of some inflationary heat.
The Fed’s statement in September that it “will likely aim to achieve inflation moderately above 2 percent for some time” lends support to this view but, as ever, things may be a bit more complicated than they first appear. The US, trading on its reputation as the world’s reserve currency, might be able to sustain high levels of debt without excessive inflationary consequences.
“They always print”
Ray Dalio, the head of Bridgewater, the world’s largest hedge fund, published an interesting book a couple of years ago called “A Template For Understanding Big Debt Crises” in which his team sifts through 48 debt crises from the past century and how they were dealt with. In 450 pages Dalio takes the reader across every continent to examine the pain caused to millions by humanity’s ingrained tendency towards economic mis-management.
“In the end, policy makers always print” is his pithy summary of how years of financial excess unravel. This, though, does not necessarily lead to inflation. For inflation to become a problem, six conditions are needed:
- A currency which is not a reserve currency
- Low official reserves
- Sizeable foreign debts
- Large and increasing budget and/or current account deficit
- Negative real interest rates
- A history of high inflation.
These six points are not of equal importance: reputation trumps all. If your economy is deemed to be of sufficient size and importance, if the rule of law and the respect of property rights are central to the way your country is viewed by the rest of the world, then you have an intangible asset which is potent enough to overcome worrying statistics. The trust of others is key.
Trading on good reputation
This trust is above all demonstrated by having a currency which the IMF recognises as a reserve currency. And the reserve currency which towers over all others is the US dollar. Dubbed an “exorbitant privilege” in the 1970s by the French President, Giscard D’Estaing, the Greenback’s status has allowed the US economy to battle its way through the ups and downs of booms, busts, the Great Moderation from the mid-1980s to 2007 and the 2008 Global Financial Crisis.
The magnetic power of a reserve currency to attract foreign funding allows an economy to live far beyond its means, despite the insistent warnings of doom-mongers. That is the trouble with forecasts. You can examine a country’s economic data, compare them with others and have legitimate reason to worry or be cheered. One thing you can’t reduce to a number and put into a spreadsheet is an intangible idea such as trust.
If you restrict yourself to five of Ray Dalio’s six points and exclude the country’s reserve currency status, you would have legitimate grounds to worry about the US economy. In a World Bank/IMF comparison of the financial health of 40 developed and emerging countries, the US does not score well. In the following table we rank these countries by how well or poorly they rank on these measures and come up with an overall ranking for each country.
Source: IMF World Economic Outlook Database and World Bank, October 2020.
If you tot up the rankings of these “Ray Dalio” inflation metrics, the USA is beaten only by Pakistan as a country where inflation could become a problem. This analysis, though, excludes the reserve currency status of these countries. As we have already said, your reserve status is crucial.
If you have a reserve currency you don’t have to worry about having sizeable reserves of foreign currency because everybody trades in your currency. So compared to other nations it is not surprising that the US has a tiny official reserve position.
Source: IMF, World Economic Outlook Database, October 2020
Crucially, a reserve currency status allows you to live beyond your means by attracting foreign capital without the need for eye-wateringly high interest rates. When you look at the twin budget and current account deficits of the US and Pakistan, they both have a history of sizeable shortfalls. The difference is the size of the interest rates required to attract that capital.
Source: IMF World Economic Outlook Database, October 2020
US and China: co-dependents forever?
So what should we make of the Chinese announcement earlier this year that they wished to slowly reduce their holdings of US treasuries? Stephen Roach, Senior Fellow at the Jackson Institute of Global Affairs at Yale has long warned of the risk posed by the economic embrace of the US and China, the “Great Consumer” and the “Great Producer”. This unhealthy marriage of convenience has seen a steady stream of cheap exports from China feed the consumption-led economy of the US and China’s own need to grow its way out of poverty through exports and investment. China has in effect been lending money to the US to buy its products, to the benefit of both.
Source: Federal Reserve of St. Louis
As you can see in the graph above, when China decides to pull back from lending to the US, then someone else has to lend to the US instead. In the absence of other foreign buyers, that “someone else” has been the Fed. Unless other non-Chinese foreign buyers compensate by buying in much larger quantities, then the Fed will find it difficult to rein its need to buy government debt and hence keep rates low.
Strong future inflation is the lot of the long list of countries in the table above with no reserve currency, deficits, excessive debt, limited reserves and a history of inflation. The US has the world’s greatest reserve currency, has no need for sizeable currency reserves and can hence borrow from abroad without much worry of triggering excessive inflation. But there is no doubt that the appetite of foreigners for US debt at this time of crisis is something to watch closely. Without this external support, being the owner of the world’s greatest currency leaves you with status but not the “exorbitant privilege”.
It is not yet time to worry about US inflation, but those stats on foreign buying of US assets need close watching.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
The information contained in this document is provided for use by investment professionals and is not for onward distribution to, or to be relied upon by, retail investors.
The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice. No guarantee, warranty or representation (express or implied) is given as to the document’s accuracy or completeness.
This document is issued for information only by Canada Life Asset Management. This document [is intended to be used as a sales aid and] does not constitute a direct offer to anyone, or a solicitation by anyone, to subscribe for shares or buy units in fund(s).
Canada Life Asset Management is the brand for investment management activities undertaken by Canada Life Asset Management Limited, Canada Life Limited and Canada Life European Real Estate Limited. Canada Life Asset Management Limited (no. 03846821), Canada Life Limited (no.00973271) and Canada Life European Real Estate Limited (no. 03846823) are all registered in England and the registered office for all three entities is Canada Life Place, Potters Bar, Hertfordshire EN6 5BA. Canada Life Asset Management Limited is authorised and regulated by the Financial Conduct Authority. Canada Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
 Ned Davis Research, CNBC, 28/09/2020
 IMF, World Economic Outlook database, October 2020