Printing money is a false economy

Fund Strategy - 18 Jun 2012 | By Peter Elston

Oscar Wilde said “anyone who lives within their means suffers from a lack of imagination”. Though I suspect his remark was not made in relation to economic systems it may be one that aids understanding of today’s global economic woes.

If you want to live within your means, somebody else has to live beyond theirs; your credit is someone else’s debt. The fact is that the dollar deposit in your bank account relates directly to a loan that was made by some bank to an individual or company, somewhere in the world, at some point in time. This ingenious system, also known as the banking system, matches the risk-averse with the risk-seeking at a certain rate of interest without them ever needing to meet. To sustain itself, however, the system relies on banks exercising restraint.

The problem is that unrestrained credit growth, indicated by growth in outstanding credit exceeding growth in GDP over a prolonged period, does not create real wealth. If you lend to someone to fund the purchase of an over-inflated asset, the real value of your loan is less than you think. Worse, if you lend to someone to fund their consumption you have no real collateral at all. The growth in credit as well as the growth in financial assets broadly has far outstripped economic growth in most developed countries. (Strategy continues below)

However, such an adjustment would be a terrible shock to the global economic system. This is why central banks are keen to prop up equity markets for fear that a slide would cause a negative wealth effect. In other words, they are attempting to keep the bubble inflated rather than allowing it to do what it wants to do: burst.

It is a game of ’chicken’ on a massive scale in which savers refuse to bow to central bank pressure to spend. Weak private demand in many countries is individuals’ and companies’ way of saying “We know asset prices are being manipulated so we’d rather keep our powder dry, even if it isn’t earning much”.

Having relied on consumers and companies in many parts of the developed world as a major source of demand globally, it is governments in those countries that have stepped in to fill the void. The American federal budget deficit as a percentage of GDP has averaged 9% for the past three years. Governments elsewhere in the developed world have run similarly large deficits, either because of loose fiscal policy or because austerity has resulted in falling tax revenues. Some countries have retained their haven status and seen bond yields fall while others have been punished.

But what is the end game? John Plender of the Financial Times noted in January that government debt levels in certain key developed countries are so high that bondholders will never be paid back in full. The question, he pointed out, was whether the default would be hard or via inflation. Rising government debt levels across the developed world reflect a surge in demand for savings from the private sector. However, this demand can only be satisfied with government bond issuance if faith that said bonds represent a store of value is maintained. The reality is that the collateral behind government bonds is not some real asset but the ability to print money, the effect of which is to inflate away the future liability and thus the real value of the bond.

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^{Peter Elston is the head of Asia Pacific strategy and asset allocation at Aberdeen.}

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