Default by Inflation Is the Real Drama in the Global Debt Market
The real drama of default in global markets has not been the federal debt ceiling negotiations in Washington but the write-off by inflation. The issue of whether it turns out that the US Treasury for a few weeks has been slow in servicing its debts—with all delays subsequently rectified—is a sideshow. We could regard this as camouflage for the ongoing real write-off operation. In this, countries led by the US, where a great inflation emerged during the pandemic and Ukraine war, have achieved big reductions in the real value of their debts.
The governments have also gained from a reduction in the total nominal market value of their fixed-rate debts due to the rise in interest rates. Those gains do not show up directly in national accounts. Rather, they are opportunity cost savings. Governments will not have to pay the prevailing higher level of interest rates on that part of their debts which are in fixed-rate form until far-off maturity dates. The savings for government show up in investor wealth statements and balance sheets in so far that they are based on present market values rather than fictitious historic cost. As long as the losses are on government bonds held by the central bank, there is no benefit to big government—it is all a wash in consolidated accounting across the public sector as a whole.
This real write-off by inflation occurred without any of the political wrangling feted by interminable commentary in the financial media. A dance of high inflation stakes has occurred, featuring the central bankers, politicians, and their cronies. The first and biggest dance was when the Fed stuck to its zero interest and quantitative easing policies through the first two years of the pandemic (2020–21), citing with great confidence its central scenario of transitory inflation. The Fed was silent or dismissive about alternative possible scenarios. Chief Jerome Powell told us with great aplomb that the Fed was not even thinking about when the discussion should begin on lifting interest rates from zero.
Incredibly, at least in hindsight, the Fed announced its new framework of “flexible inflation targeting” in August 2020, already well into the germination period for the great pandemic inflation. The idea was that higher inflation for sometime in the future was welcome to “make up” for the long years of inflation less than the 2 percent target during the 2010s. Big government, in all its branches and alongside powerful outside interests—including the private equity barons, who would benefit from a reduction in the real value of their debts in a shock outbreak of high inflation—happily tolerated the complacency.
The same choreography has played out in the high-inflation countries of Europe including the United Kingdom, Italy, France, and Spain. Yes, there was some resistance within the European Central Bank (ECB) from Germany and Holland, but mooting this was a general concern in its policy board to avoid a return of European debt crisis. Remember that as late as July 2021 the ECB rolled out its new monetary framework of quasi-flexible inflation targeting, a year later than the Fed, albeit in a greener and less explicit form. The message was that the ECB would be more tolerant of inflation overshoots than undershoots as it was harder to get inflation up than down!
Japan and Switzerland have been outliers in the dance of default by inflation. There has not been a real write-off in Japan or Switzerland on anything like the scale of the high-inflation countries. Over the four-year period of 2020–23, the estimated fall in purchasing power of the domestic money has been around 17 percent in the US, 20 percent in Italy, and 5 percent in Switzerland and Japan.
In Switzerland, a low public debt to gross domestic product ratio (around 40 percent) means that big government would not join an inflation dance with the central bank. In Japan, it’s quite the opposite. Japan’s crushingly high public sector means there is visible danger of the government and the National Diet joining the Bank of Japan in a dance. The musical theme would be high optimism about future inflation despite continuing very low interest rates. The collapse of the yen against the Swiss franc reflects the specter of eventual real default by inflation in Japan. The yen/Swiss franc exchange rate has soared from 112 on the eve of the pandemic to 153 now.
Japan’s real debt write-off is small so far. High consumer price index inflation did not emerge in the second half of 2021 and early 2022 because household and business spending in the US, eurozone, and United Kingdom remained remarkably cautious. But that restraint could be fading now during a powerful rise in the Tokyo stock market alongside a crescendo of foreign optimism (the so-called Buffett boom) and the super cheap yen. So, the future of inflation in Japan might well be very different from 2021–22.
The low inflation then, however, helps to explain the so far stubbornly bad time profile of Japan’s gross general government debt to gross domestic product—rising from 238 percent in 2019 to 259 in 2020 and to 261 in 2022, eventually falling this year according to the International Monetary Fund to 258 as consumer price index inflation rises (3.2 percent year-over-year in May and long-term interest rates at below 0.5 percent). By contrast, the same ratio in the US rose from 109 in 2019 to 134 in 2020, falling back to 122 this year despite a general government deficit running now at 5–6 percent of gross domestic product. In Italy, the same ratio was at 134 percent on the eve of the pandemic, rising to 155 in 2020, and falling to an estimated 140 percent this year.
Big government is duly celebrating, but there are others joining the inflation party even if sobered by coincidental losses. Consider the indebted corporations looking forward to a future of much higher interest rates and yet enjoy income streams which tend to rise in real terms. Private equity enterprises earning revenues from long-term contracts supplying public sector services (for example in healthcare or prisons) are one obvious example, but there are many others. They welcome a real debt write-down by inflation. In the same vein are the indebted homeowners who are incurring losses (small so far in the US in general but greater in some foreign hotspots) on real estate but who expect their salary incomes to rise with prices.
The bottom line: we should not underestimate the potency of the coalition dancing to the tune of optimistic central bank narratives. Therein lies the danger to economic and financial health, not at the short-lived tensions related to US debt-ceiling legislation.