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Inflation and Sovereign Debt – Why The Best Is Yet To Come

Was it good while it lasted? A world where Australia dug, China made, America consumed and Europe united. Doesn’t matter much anymore. It’s over.

The really important questions are: what’s next? And what do you do about what’s next?

But First, When Did ‘It’ End?
At what point were the good times over? The answer might tell us when they’re set to begin again. So let’s ponder what marked the beginning of the end.

Perhaps the good times ended when the world went off the gold standard and onto the inflation standard.

Perhaps the Great Depression of 1929 marks the point at which prosperity and stability began to look finite. After all, it also marks the birth of the idea that government intervention should deal with all problems, particularly recessions, rather than letting them run their course.

We’ve got a beef with that idea. Its growing dominance has seen recessions become steadily worse in terms of unemployment. Check out this chart from Zerohedge to see what we mean. You’ll notice unemployment seems to be worse and taking longer to recover almost in chronological order of recessions.

But the Great Depression and the gold standard are things of the past. In 2001 the bear market in US equities began in stealth – that could mark the end of our prosperous age. Take a look at this chart. You’ll notice we’ve been going sideways since about 1998.

S&P 500
Click here to enlarge

 

Source: Yahoo Finance

 

The layman on the street would say that our modern age of prosperity ended in 2007 and 2008 when the global financial crisis got hot. But Kevin Rudd and his cronies around the world had other ideas. They handed out cash, sometimes all too literally, to stimulate spending. So the hangover was dealt with by the hair of the dog treatment. In the Land of Oz, we didn’t even have a recession.

And so, you might notice, the point that will mark the beginning of the end of our brilliant run of prosperity may not actually be behind us. No, to quote the famous economist Frank Sinatra, ‘the best is yet to come’.

So what is going to mark the beginning of the end of prosperity, profits and stability? It will be, as it has pretty much always been, a sovereign debt crisis. In which country it starts doesn’t matter much. We’ll explain why in a second. But first, our best guess is that it will start with one of the PIIGS – probably Spain or Italy.

Speaking of PIIGS, we spotted a hairy one this morning running past our hotel room here in Malaysia. It didn’t look terribly bothered about Europe’s sovereign debt mess. So why should you care?

Well, it would be rather nice to know when the storm finally blows over, right? That point will probably mark the bottom in stocks. And it would be rather nice to put some money to work at the bottom.

But Before Then
For things to get booming again, the fundamental imbalances facing the world economy must unravel themselves. We mentioned some of them at the beginning of today’s Money Morning. For them to correct, Australian digging will slow, manufacturing will rebalance with consumption in China and America, and Europe will go back to being more like the French again. (Argumentative and oddly patriotic.)

All of those imbalances are in fact already in reverse. The Germans at our hotel kept to themselves, the Americans ate out because of the prices and we didn’t spot any Australian mining magnates. The Chinese guests were terrified of the monkeys, who exhibited the main successful investment technique of the ASX for the last few years – opportunism and scavenging off the back of a Chinese free lunch.

So, if the imbalances are beginning to correct, is it time to buy? No.

Even the monkeys took to the jungle when the storm clouds gathered. And they’re on the horizon again. Yes, many of the world’s imbalances are on their way back to normality. But those good old governments have fowled things up again with a new set of problems – sovereign debt.

What’s surprising about this shemozzle is that it’s not the slightest bit surprising. The three act play has so often been repeated throughout history. Bubble, financial crisis, sovereign debt crisis.

Usually what happens in the closing scene is that a combination of default and lots of inflation is used to get past the sovereign debt crisis. So if we’ve seen this all play out before, the investment solutions must be straight forward too. But you guessed it, this time is different. At least in this respect.

What we haven’t really managed to have before is a situation where most of the world is in a sovereign debt crisis at the same time. That has several implications, especially for investors.

Firstly, inflation usually helps countries struggling with sovereign debt in two ways. First, it makes the debt run up far less in real terms – because $1 today might only be worth 60 cents in the future thanks to inflation. More importantly, it makes exports more viable, as inflation weakens a currency – making export goods look like bargains to would-be buyers. And exports are good for growth.

But if everyone is stuck in the same hole at the same time – and everyone comes up with the same inflation solution – then the export benefit is lost. You might have seen this situation play out when the Brazilian President, Dilma Rousseff, complained to Obama about US monetary policy being too loose.

Add in the fact that issuing debt will become expensive for governments if markets get a whiff of inflation and you don’t get much of a benefit from inflation at all.

In fact, the higher the inflation, the more interest rates on government debt will rise, the more that interest will cost. That in turn will spur more inflation. The spiral could quickly reach levels that are so destructive to the economy that any export advantage from a cheaper currency is completely lost.

By this time, it’s likely central banks will have to fund governments outright – buying their debt with freshly printed money. Even more inflation.

And that’s just one scenario.

Another Option
But, maybe, after playing that sequence of events out in their mind, politicians around the world will decide to default instead. Rather than print money to pay off debt, they will simply repudiate the debt. That would mean we have a deflationary shock on our hands. A really bad one considering most banks of the world would cease to exist. A wipeout of sovereign debt would mean a wipeout of the banks’ net worth because they hold so much sovereign debt.

Predicting the obvious has never really been a strong point of politicians. Or economists. Still, we’re not sure a deflationary shock is off the table. That means you shouldn’t bet the farm on inflation in the meantime.

Nick Hubble
Editor, Money Morning.

This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter