New Year, Same Worries

By any objective measure, 2009 was an absolutely stellar year for investment returns. But for obvious reasons, after 2008 and early 2009, no one feels like celebrating too hard. The future looks… perhaps not scary, but worrisome at the very least.

Maybe we should all lighten up, at least for now. All of that fiscal and monetary stimulus will continue to push the economy forward and markets up, at least for a while. I mean, what are you going to do? Sell your stocks and bonds and then let the cash sit around making about 0.1%? That’s no fun.

But (and there’s always a but) sooner or later all that cheap money and government spending will cause inflation, or so everyone says. That fear is driving much of today’s unease, and has driven up gold and oil to very high levels (in spite of declining oil demand and excess production capacity).

Certainly this inflation scenario is possible, but I do not believe it is the most likely outcome. The fear of inflation seems so wide spread that it is far more likely that before the governments of the debtor nations (mainly us!) are able to spend their way to inflation, lenders (i.e. purchasers of government bonds) will say “no way.” Put another way, governments will face a choice: Either show some fiscal and monetary restraint, or have rising interest rates forced upon them by bond buyers. Either way, it slows the economy and the worry becomes recession and deflation.

When that happens, the question will be which path will we take? Will the government and the Fed capitulate to the market, reigning in government spending and tightening monetary policy? I hope so, because even though this would be painful for a while it would finally be the beginning of the great unwinding of the excess leverage that drove our economy too far and too fast for too long. Perhaps we will finally come to grips with the fact that you can’t borrow your way out of having too much debt. While painful, this would set the country up for future prosperity for our children.

The other option is much worse. If our government can’t find some fiscal and monetary restraint then Treasury buyers will demand higher and higher interest rates as the government borrows to fund its spendthrift ways. This will quickly become untenable, because (as noted above) these rising interest rates on treasuries will drive up rates throughout the economy, pushing us back into recession and perhaps deflation. The feds will have two ways to get around this – one is quantitative easing (basically the Fed just runs the printing press to fund the deficit) but this would make the problem worse as world markets would panic at the prospect of the U.S. becoming Argentina. For that reason, I think that outcome is extremely unlikely.

The likely outcome in this scenario is actually much simpler, and (at first) much more benign. The government could start selling more TIPS (inflation protected treasury bonds). If investors start demanding higher rates on standard treasury bonds dues to concerns over our free-spending easy-money polices, then we can issue them TIPS at much lower rates because they are inflation protected. This will work and for a while will continue to enable our government to keep the good times rolling. But in the long run it is horribly insidious, because when inflation does begin to rear its ugly head both interest payments and outstanding principal amounts on TIPS will skyrocket. You can’t inflate your way out of debt when it is indexed to inflation, so the only two options then will be to (finally, belatedly) reign in spending and monetary policy (much more painful for having been postponed several more years) or just become Argentina after all and default on your sovereign debt.

So watch TIPS issuance – it could keep the party going a while longer, but too much could be a sign of even bigger problems in the long run.

BTW, did you see the article in yesterday’s WSJ titled “U.S., in Nod to Creditors, Is Adding TIPS Issues”? I wish I was making that up.