My Comments on Spiegel’s Post on How Monetary Policy Threatens Savings

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Spiegel, a widely-read German magazine, has published a trilogy of articles on inflation in German that it has also translated into English. The theme is “How Monetary Policy Threatens Savings” and I see this as a must-read for those interested in a German framing of the present debt crisis. This post is my extended commentary on the view expressed by Spiegel, including my own thoughts on the correct framing of the crisis and present policy solutions.

The inflation threat people worry about

The Spiegel article represents the conventional thinking about monetary policy, government budgets and inflation within German policy circles and amongst many in the German voting populace. The crux of the problem in the German view is debt, whether that debt is private or public. And the threat people worry about from the present policy responses is currency debasement and inflation. But more than that, I believe the real threat from today’s policy response is specifically an unequal distribution of inflation, with the worst impact felt by the lower and middle classes. That last point about redistribution via the uneven impact of inflation is important in terms of understanding the German view as well as how the threat of inflation is presented in Austrian economics, a school of economics that has gained currency during the financial crisis.

Let me call out a few quotes that get at this in greater detail.

Germany’s central bank, the Bundesbank, has established a museum devoted to money next to its headquarters in Frankfurt. It includes displays of Brutus coins from the Roman era to commemorate the murder of Julius Caesar, as well as a 14th-century Chinese kuan banknote. There is one central message that the country’s monetary watchdogs seek to convey with the exhibit: Only stable money is good money. And confidence is needed in order to create that good money.

The confidence of visitors, however, is seriously shaken in the museum shop, just before the exit, where, for €8.95 ($11.65) they can buy a quarter of a million euros, shredded into tiny pieces and sealed into plastic. It’s meant as a gag gift, but the sight of this stack of colorful bits of currency could lead some to arrive at a simple and disturbing conclusion: A banknote is essentially nothing more than a piece of printed paper.
It has been years since Germans harbored the kind of substantial doubts about the value of their currency that they have today in the midst of the debt crisis. A poll conducted in September by Faktenkontor, a consulting company, and the market research firm Toluna, found that one in four Germans is already trying to protect his or her assets from the threat of inflation by investing in material assets, for example.

I think this leading anecdote from Part 1 of the series is perfect in getting at the psychology behind worries about inflation and the value of the currency. People are waking up to the fact that fiat money has no intrinsic value. It is simply a promise to repay in kind, with the legal tender whose value is based on the individual states’ ability to tax and the demand for the currency that comes from this taxing power and legal tender role. There is nothing tangible backing these pieces of paper. That’s why the Bundesbank can shred money and hand it out as souvenirs. Ultimately, however, that leaves people a bit uneasy because it makes plain the lack of intrinsic value at a time when many believe policy is designed to reduce the value of the currency.

Here’s another passage that gets at the redistribution fear.

Andrew Bosomworth can offer some insights into how this form of indirect theft of assets is taking place. When Bosomworth, the head of portfolio management in Germany for PIMCO, the world’s largest investment management firm, talks about the calamity that the debt crisis will bring upon mankind, he sounds like a concerned doctor. “The industrialized world is stuck in a severe debt and growth crisis,” he warns. “The central banks are fighting the disease with monetary infusions of previously unknown proportions, and the side effect is a slow but dangerous devaluation of money.”

Bosomworth argues that a gigantic redistribution from the bottom to the top has begun. “Gradual inflation has a numbing effect. It impoverishes the lower and middle class, but they don’t notice,” says Bosomworth. He believes that the Germans’ fear of inflation is more than justified.

This is the Austrian economics view, namely that inflation results over a period of time. And those who are able to transform their at-risk assets before inflation sets in will gain a redistributive advantage over those who cannot. In the Austrian view, it is banks and others with direct dealings with financial asset trading and government who will be in the most advantageous position, while those on fixed incomes and invested in fixed assets will be net losers. So, traders and bankers will be switching into inflation hedges while others geared to fixed income will be losers if and when inflation arises. So far, this is what we have seen as a result of negative real interest rates and commodity price inflation. Note here that the real economy and investment risk is not generalized inflation. Rather it is negative real interest rates that cause losses to fixed income investments. It is commodity price inflation associated with altered portfolio preferences due to central bank government bond purchases. And it is the risk of losses related to deflating asset prices when policy support is removed.

Finally, there is a third quote from the first article related to government money.

In the eyes of PIMCO executive Bosomworth, Bernanke’s approach marks a departure from the Fed’s independence. “We are experiencing a ‘reverse Volcker moment’ in the United States,” he says. What he’s referring to is this: After the oil crises of the 1970s had driven up inflation in the United States, former Fed Chairman Paul Volcker rigorously combatted inflation with high interest rates. During that period, the Fed emancipated itself from the government’s influence. “Today the Fed is increasingly becoming subservient to fiscal policy,” Bosomworth says critically.
The US government debt has just exceeded the $16 trillion threshold. Inflation could help reduce this enormous mountain of debt. “The alternative is to reform and save — and to accept higher unemployment as a short-term consequence,” says Bosomworth. “But that isn’t as attractive politically.”

Instead, the US government is behaving the way governments have always behaved when their debts have gotten out of hand. The history of money is a history of almost constant devaluations.

This is a view that I used to fully support but now believe is only partially correct because economics is not a morality play. Yes, governments want to use inflation as a means of reducing the real burden of indebtedness. I usually point to the UK’s post Wordl War II reduction in debt to GDP without default as the model. But, the reality is that government deficits are the flip side of private and trade sector surpluses. Therefore, to the degree you do have a private debt problem as we do today, you need private surpluses and government deficits to reduce the real burden without default or debt forgiveness. So, you can’t really posit this as a question of fiscal irresponsibility. Rather it is a political question of who the winners and losers are in the workout phase of a private sector leveraging and deleveraging cycle.

The Beautiful Deleveraging

I like the way Ray Dalio expresses this. He says that we are in the midst of a deleveraging after a period of secular leveraging, meaning that we have increased debt burdens relative to income, earnings, and GDP across business cycles. That means that debt burdens have risen over a generation or more. See, for example, this June 2008 post “Chart of the day: US Household debt” or this October 2008 post “Charts of the day: US macro disequilibria”.

So, the problem is that we have reached ‘Terminal Debt’ a point where this private sector leveraging is no longer possible, especially with short-term policy interest rates at record low levels. The credit accelerator that raised GDP growth via a rise in monetary aggregates and credit that consistently outstripped the rise in nominal GDP is poised to move in reverse. That’s what deleveraging means. In real terms, deleveraging means a lower credit growth (or even credit contraction) that translates into lower real GDP growth. Deleveraging also means an increased private savings that translates into government deficits. All of this is axiomatic. And because the leveraging was a secular event, the scale of the deleveraging is quite large, making it likely to be a secular event as well. There is no way around this.

Many policy makers understand this scenario. And they have three tools at their disposal to alleviate the burden associated with this process. Dalio identifies them as austerity, restructuring and money printing. The following passage is especially good:

Deleveragings occur in a mechanical way that is important to understand. There are three ways to deleverage. We hear a lot about austerity. In other words, pull in your belt, spend less, and reduce debt. But austerity causes less spending and, because when you spend less, somebody earns less, it causes the contraction to feed on itself. Austerity causes more problems. It is deflationary and it is negative for growth.

Restructuring the debt means creditors get paid less or get paid over a longer time frame or at a lower interest rate; somehow a contract is broken in a way that reduces debt. But debt restructurings also are deflationary and negative for growth. One man’s debts are another man’s assets, and when debts are written down to relieve the debtor of the burden, it has a negative effect on wealth. That causes credit to decline.

Printing money typically happens when interest rates are close to zero, because you can’t lower interest rates any more. Central banks create money, essentially, and buy the assets that put money in the system for a quantitative easing or debt monetization. Unlike the first two options, this is an inflationary action and stimulative to the economy.

How is any of this “beautiful?”

A beautiful deleveraging balances the three options. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money. When done in the right mix, it isn’t dramatic. It doesn’t produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down. That’s a beautiful deleveraging.

We’re in a phase now in the U.S. which is very much like the 1933-37 period, in which there is positive growth around a slow-growth trend. The Federal Reserve will do another quantitative easing if the economy turns down again, for the purpose of alleviating debt and putting money into the hands of people.

We will also need fiscal stimulation by the government, which of course, is very classic. Governments have to spend more when sales and tax revenue go down and as unemployment and other social benefits kick in and there is a redistribution of wealth. That’s why there is going to be more taxation on the wealthy and more social tension. A deleveraging is not an easy time. But when you are approaching balance again, that’s a good thing.

What makes all the difference between the ugly and the beautiful?

The key is to keep nominal interest rates below the nominal growth rate in the economy, without printing so much money that they cause an inflationary spiral. The way to do that is to be printing money at the same time there is austerity and debt restructurings going on.

The goal of policy, therefore, is not to prevent the deleveraging but rather to enact the right mix of policies in order to prevent economic collapse, social disorder, or impoverishment of the general population as the deleveraging occurs. If too much ‘austerity’ is applied, then you can get debt deflation. If too much money printing occurs, you can get currency debasement or inflation. And so on. For example, in Europe, we are seeing the effects of an ugly deleveraging that is heavy on austerity. The result is economic collapse, social disorder and poverty.

As I have noted in the past, how policy responds in terms of determining the mix is a political question about division of spoils between debtors and creditors/savers. My view is that both sides will lose some but savers will lose the most because of negative real rates which reduce real interest income that are combined with fiscal tightening which also reduces income. But, this is a fundamentally deflationary crisis because of the debt overhang. Inflation that isn’t matched by income gains when household debt is the problem leads to demand destruction and recession.

Thoughts on government debt

The biggest problem in defining the outcomes has to do with the sectoral balance that makes government deficits the flip side of trade/private surpluses. To the degree a private deleveraging occurs, some of it will cause a reduction in trade deficits or an increase in trade surpluses. But most of the private deleveraging will be felt as a public dissaving, increasing public deficits. More attention needs to be paid to this. Why can’t people understand national accounting?

It’s when I see this that I make a change to Dalio’s terminology. Austerity as it’s presently conceived is about reining in government deficits. The reality, of course, is that this essentially means reducing private surpluses and thus would be a de-facto reflationary policy if it succeeded. However, what really happens is that the public sector cut/tax increase is not met with private dissaving. Instead, it reduces private income and induces default or private cuts in order to meet the still burdensome private debt burden. What austerity really means in the context of deleveraging policy responses is private sector austerity i.e. increased private sector net saving, not public sector net saving. So, for the private deleveraging to occur via austerity, what you would need is a private saving that occurs as a result of either lower taxes or increased income, the exact opposite of public sector austerity.

The problem here is that in the euro zone, the public sector’s policy space has been significantly reduced by the artificial limitations placed on national sovereignty by the single currency. Wynne Godley has it right on this and his 1992 post predicting crisis is mandatory reading. In effect, what the single currency does is force a deflationary response to the crisis by accelerating the deleveraging to occur in much greater measure through private sector default.

My view on the spectre of Inflation 

Central banks are trying to negate the deflationary fiscal tightening now ongoing. But their efforts will not be enough. ‘Money printing’ is a misnomer for what central banks are doing, as I recently outlined. Fiscal policy ‘prints money’ by adding net financial assets through deficit spending, which is why fiscal policy is the route through which deleveraging occurs as the private sector net saves. Monetary policy ‘money printing’ simply alters the composition of private sector assets and therefore distorts the prices of those assets.

Remember that bank reserves do not allow banks to make more loans because they are used to target interest rates. Central banks must supply banks with all of the reserves the system requires at a specific interest rate target in order to hold that target. Otherwise, the demand for reserves would increase and push up the interest rate. Right now, with rates at effectively zero percent, the US has a ton of excess reserves because the demand for reserves at that rate of interest is lower than the amount of reserves being added by the Fed through its asset purchases. The Fed buys financial assets with base money when there is no demand for that base money given the lack of creditworthy borrowers seeking credit to absorb that base money as reserves backing loans. This is the process as it happens and you have to remember this because it is often stated in a tail waging the dog kind of way where the reserves must be there for the loans to be made, as if excess reserves are a source of future inflation.

In sum, the problem with central bank policy is not that it leads to consumer price inflation except via commodity and food prices. Central bank policy is problematic in that it adds a re-distribution effect to asset prices that causes asset price inflation in some assets and a relative deflation in others. Money balances increase, bolstering the demand for assets closely associated with money like government bonds. But as low nominal interest rates and negative real interest rates bite, portfolios shift to alternative asset classes with higher risk profiles like equities, high yield bonds and inflation hedges like commodities and precious metals. What gets lost in the portfolio preference shifts induced by easy money is the relative dearth of capital available to other assets. My view on this is still in flux because I have traditionally seen this from an Austrian perspective, meaning I see central bank ‘money printing’ as inflationary for asset prices across the board. But, the question I now have is more about the second Austrian principle around easy money and the relative inflating of prices and how that distorts capital allocation. On the whole, I will not be concerned with consumer price inflation until we are closer to high capacity utilization except to the degree asset price inflation feeds into commodity and food prices.


My view is that this is a fundamentally deflationary crisis because of the lack of credit growth potential in the private sector. Expansionary fiscal policy would alleviate some of this burden and cause inflation that reduced the real value of money. To the degree this policy response boosted real income without inducing capital misallocations, you would get sustainable real economic growth that would work in concert with inflation to reduce the real burden of debts without impoverishing people or inducing a debt deflation.

Creditors are resistant to this approach because it redistributes income from creditors to debtors due to the negative effect on the real value of money. And so, deficit spending is fought tooth and nail in order to allow creditors to extract as much wealth in real terms as their nominal credit contracts will allow. Deflation would be preferable to inflation for creditors. With governments in the thrall of banks, this policy response will maintain its primacy until and unless a debt deflation advances enough that it causes a massive social unrest.

Nonetheless, I believe the ‘inflationary’ route is inevitable because the impoverishment and crushing nature of the deflationary route cannot be tolerated in democratic societies. Likely, we will see mortgage cramdowns and debt foregiveness, government employment programs and reflationary fiscal policy at some point down the line. But this will happen only after the destructiveness of the present course is understood. As I like to say, first the deflation and then the inflation.

Source: Der Spiegel

Also see May 2010’s “Ray Dalio: Inflation is not just around the corner… yet

  1. David_Lazarus says

    When you mentioned that QE as inflationary and expansionary. That only really applies to the top of the income distribution. For those at the bottom it is inflationary and deflationary. The reasons are that QE has lead to commodity inflation and this directly impacts the majority of low income expenditure. They are also unable to boost their incomes and if asset prices are elevated by QE then long term rents will be higher and on stagnant wages that can only mean lower future spending as rents take even more of a share of the economy. So QE is also another tax on the poor. It maintains the debt burden to GDP.

    The west is now flooded with false market prices and that is why gold will do well over the next decade.

    Real estate is still massively over valued even in the US. Just because the prices seem to have stabilised they have not adjusted back to levels that are ultimately sustainable. The Fed has been trying to hold up asset values, otherwise the banks will become insolvent again. Trillions of liquidity and the banking sector close to insolvency again.

    You mentioned a generational leveraging and I think that the only long term solution is to allow that deleveraging to happen. If home prices fall substantially then buyers can eventually reenter the market. Many might have too go bankrupt to free themselves of odious debts to renter the market eventually.

    Credit growth will inevitably be negative for as long as it is necessary to deleverage. In the case of Japan they are still deleveraging. The solution should be to maintain deficits but to clamp down on private debts so that they do not create the same bubbles as before. This will mean a credit shortage for many years but then governments can push this towards business rather than consumption. This will encourage savings and reduce the long term risks for banks and the economy as a whole. The real problem that we have been facing is excessive debt and until that debt is either defaulted or paid it will be a burden on the economy. Private debts are only very slowly coming down and that is why the economy will be sluggish for decades.

    Your conclusion is spot on though with the fall of asset prices back to long term means is this deflation?

  2. Dave Holden says

    I prefer the term “optimal” deleveraging.

    I think the relationship between price structure and incomes is important. Debt allowed this to become very distorted. QE in my view sustains this distortion and introduces others, as such it should be seen as an short/medium term option during which the other two *private* sector options are pursued. To help in this fiscal policy should either be neutral or slightly expansionary with a view to long term investment.

    I think at the moment we are a long way from adhering to an “optimal” deleveraging.

    1. David_Lazarus says

      All markets are struggling to price risk and reward correctly, because of the fed actions. Though we really should not be surprised given the structure of the Fed and its role as a back up for the banks that own the Fed.

      Though with congress non functional right now then monetary policy is the only solution in town.

    2. Edward Harrison says

      Dalio has got some flak for using the term “beautiful” to describe any kind of deleveraging. So I agree with you Dave. Optimal would be a better way to phrase it.

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