South Africa
Fiscal Consolidation Maintained
February 23, 2010

By Michael Kafe, CFA & Andrea Masia | Johannesburg

Summary

To the relief of market participants, Minister Gordhan's maiden Budget address tabled in parliament on February 17 kept the country's inflation target framework intact, proposed a marginal tightening of exchange controls on commercial banks in the wake of the recent global credit turmoil, and unveiled an improving fiscal trajectory under what appears to be a very conservative management style.

On the macro front, the 2010 GDP growth forecast was upgraded to 2.3%Y (from 1.5%Y in the Oct-09 Medium-Term Budget Policy Statement), and is seen averaging some 3.0%Y over the upcoming three years (2.5%Y previously); 2010 CPI inflation is seen at 5.8%Y (6.3%Y previously); and the current account deficit is now forecast at 5.8% of GDP by 2012, the end of the Medium-Term Expenditure Framework, compared to -6.9% previously.

Interestingly, the good macro news did not translate into any meaningful improvement in the Treasury's fiscal outlook. We believe that this was by design, and should help avert a sovereign rating downgrade (currently BBB+, outlook negative) as the fiscal outcome turns out to be better than official estimates project. 

No Change to Inflation-Targeting Regime

With regards to inflation targeting, the Treasury reaffirmed its commitment to the present inflation-targeting framework as spelt out in the Constitution, highlighted the need for the SARB to improve communication with the public about the role of monetary policy in supporting economic growth and employment, and reminded the SARB of the explanation clause under which temporary breaches of the target band can be accommodated, but need to be explained to the public. In short, there was no change to the inflation-target mandate - simply better communication required.

Theoretical Tightening of FX Controls for Banks Should Have No Impact on the Rand

With regards to exchange control, commercial banks are now allowed to invest up to 25% of their deposits offshore (previously 40% of total liabilities). While this is in principle a theoretical tightening in exchange controls, we must point out that, as at December 2009, South African commercial banks had no more than R151.5 billion (some US$20 billion) in deposits and advances offshore. This is only 7% of total liabilities of R2.2 trillion. Hence, the ruling is unlikely to force repatriation of assets. Effectively, the net impact on the currency should therefore be neutral.

Upward Revisions to GDP Growth - Playing Catch-Up

The Treasury upgraded its 2010 GDP forecast from 1.5% to 2.3% (Morgan Stanley: 3%), and asserts that the 2010 FIFA World Cup should add some 0.5pp to GDP growth in 2010. The latter is right in line with our own estimates (see South Africa Chartbook: Gauging the Consumption Impact of the 2010 FIFA World Cup, January 25, 2010). It also brought its 2009 GDP estimate a touch closer to our -1.7% forecast. The details of its 2009 forecast were somewhat intriguing, however. First, it downgraded its household consumption expenditure forecast from -3.1% to -3.5% (Morgan Stanley: -3.5%), and upgraded its forecast of government consumption expenditure from 5.4% to 5.7% for the year (Morgan Stanley: 4.7%). The upward revision in government expenditure implies a whopping 22%Q growth in 4Q09. We think that such a reading is unlikely, given that the 2009 public sector wages and salaries only rose by 10.5% in 4Q09, and that the overall goods and services budget for the fiscal year is broadly unchanged at R147 billion.

Second, the Treasury upgraded its gross fixed capital formation estimate from 3.5% to 4% (Morgan Stanley: 3.6%), implying a 4Q09 print of 7.4%Q. Again, we believe that this forecast is optimistic, given our dim view on private sector fixed investment spend (most companies' order books are still relatively thin, and the government's own infrastructure budget has been scaled back marginally). Third, keeping all things equal, and assuming no errors and omissions, the Treasury's revised 2009 GDP constituents imply a further significant inventory drawdown of some R48 billion in 4Q09. This is overly pessimistic, in our opinion.

Conservative Revenue Estimates

Despite the upward revisions to 2010 GDP, the Treasury chose to maintain its revenue projections broadly unchanged. In fact, the estimated tax take was revised downwards for a number of tax handles. We found it particularly interesting that, despite its apparent upbeat forecasts on private sector investment spend, the Treasury chose to scale back its estimate of corporate tax receipts from R158 billion to R149 billion, largely because of its view that corporate tax revenues may lag the recovery. 

Medium-term tax revenue estimates have also been pared back by R33 billion and R11 billion in 2010/11 and 2011/12, respectively, although the 2012/13 estimate was increased by R1.6 billion.

We have a much more constructive view on corporate tax revenues. The latest monthly revenue collection data highlight that, after a relatively sluggish performance in the first half of the fiscal year, corporate tax collections have now reached a cumulative R114.6 billion by the end of the third quarter. This is just R34.4 billion short of the Treasury's full-year estimate of R149 billion. And with economic activity in the final quarter of this fiscal year (Jan-Mar) likely to be much stronger (Morgan Stanley forecast 3.5%Q) than in 1Q09 when GDP contracted by 7.4%Q, we believe that it is only reasonable to expect the Treasury to rake in close to the R48.2 billion corporate tax receipts posted in 1Q09. We also expect VAT receipts to come in higher than the Treasury expects. In fact, with year-to-date VAT receipts having already soared to 74.8% of budget as compared to 70.5% for the same period last year, we are inclined to bump up our full-year estimate to R150 billion, from R145 billion previously.

Optical Income Tax Relief

Finally, we could not help but notice that although the Budget awards personal income tax relief of R7.2 billion (including threshold adjustments), it hopes to get back R1.8 billion from tighter fringe benefit rules on cars, R3.6 billion from an increase in fuel taxes and R2.25 billion from higher sin taxes. In all, the tax proposals are set to increase the income tax burden by R0.6 billion.

The Minister also stated that "we may have to raise taxes in future to fund our public spending commitments". A recovering economy and increasing tax burden are certainly not reflected in the projected tax revenue stream, in our view.

Infrastructure Budget Trimmed; Total Fiscal Expenditure Unchanged

With regards to expenditures, not much has changed. The Treasury's allocation to public corporations has been scaled back significantly, but this is offset by a rise in other transfers and subsidies. We note, however, that the Treasury's estimate of the infrastructure budget over the next three years has been scaled back from R872 billion to R846 billion, thanks largely to a squeeze in provincial and municipal budgets as households defaulted on municipality bills.

Modest Tweaks to Deficit and Financing Requirement

On the whole, the fiscal deficit forecast for 2009 comes out in line with our estimate of 7.3% of GDP versus the Treasury's earlier forecast of 7.6% of GDP. For the next three years, the Treasury's targets are virtually unchanged at 6.2%, 5.1% and 4.2% of GDP, respectively, for 2010/11, 2011/12 and 2012/13. The 2010/11 forecast in particular is much higher than our own estimate of 4.8%, which is based on better revenue collection than the Treasury has priced in.

As a result of the conservative revenue estimates, the Treasury now expects the general government borrowing requirement to rise from initial estimates of R173 billion to R182 billion in 2010/11, R155 billion to R166 billion in 2011/12 and R145 billion to R155 billion in 2012/13. However, the overall public sector borrowing requirement falls marginally, thanks to lower borrowing by non-financial public enterprises.

The Treasury expects the public debt profile to rise marginally over the coming years. While the issuance of Treasury bills is largely unchanged (presumably because of the rollover risks associated with short-term paper), the Treasury hopes to raise domestic bond issuance from R129 billion to R138 billion in 2010/11, R116 billion to R129 billion in 2011/12 and R104.2 billion to R117 billion in 2012/13. Foreign loans, on the other hand, are expected to come in marginally lower over the forecast years, thanks to the cancellation of procurement loans associated with the purchase of eight Airbus A400 aircraft for the Department of Defense (see South Africa: Macro Outlook: Consolidation Underway in 2010, January 15, 2010). The Treasury also hopes to introduce two new inflation-linked bonds maturing in 2016/17 and 2021/22.

Treasury to Draw on FX Sterilization A/C - Eventually!

Subject to an agreement with the Reserve Bank on monetary management arrangements, the Treasury has now agreed to draw down on its hitherto-sacrosanct ring-fenced sterilization accounts at the SARB for short-term cash management purposes (see South Africa Chartbook: ZAR Resilience Despite Fiscal Deterioration, July 29, 2009). It aims to keep R40 billion in operational cash balances this year, and now has access to a further R66 billion, were the need for short-term bridging finance to arise. The latter will probably be a last resort, as there must be inordinate amounts of paperwork involved here.

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Euroland
Greece and EMU: Between a Rock and a Hard Place
February 23, 2010

By Elga Bartsch | London

Government bond yields and CDS spreads in the EMU periphery remain elevated and markets are brimming with talk of crisis and of contagion in the euro area. The direction of the contagion measured by the co-movements in country spreads or CDS spreads suggests that liquidity is the main investor concern at present. If investors were instead getting concerned about solvency, the contagion would likely change direction, we think. Instead of spreading across the EMU periphery, contagion would likely start spreading towards the core of the euro area. This is because it will likely be the core countries, who are the biggest creditors to the euro area periphery, that would be hit in the extreme event of a sovereign debt restructuring. Alternatively, in the more likely case of financial assistance being granted to Greece by other euro area countries, it also would likely be the core countries that would need to stem most of the funding costs. Together with the precedent set by such financial assistance, this also dilutes their credit quality.

In our view, the statement issued at the EU summit on February 11, 2010 has caused the liquidity risk to diminish. This brings the solvency risk back into focus, we believe. Instead of worrying whether the Greek debt office can tap into the bond market, investors will likely go back and look at the long-term solvency situation in Greece and the repercussions of a potential bailout for the credit quality of the core countries. One way to position for such a change in the direction of potential contagion concerns is to be short 10-year Bunds outright or underweight France versus the periphery in a European government portfolio (see European Interest Rate Strategist - Sovereign Risk in Context, February 5, 2010).

The euro zone endgame with respect to the support granted to Greece still remains elusive though. In the wake of the political commitment by European governments to "take determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole", financial markets are trying to get some sense of what the endgame for the euro zone could look like. Given the complexity and the fluidity of the situation, this question is best tackled by discussing different scenarios. We present these below.

Just this weekend, there were fresh media reports about how a potential plan for a bailout might look. One of the leading German news magazines, Der Spiegel, outlined on Saturday how a bailout for Greece might look. According to the magazine, which has seen an internal paper prepared by the German Finance Ministry containing some initial ideas, the rescue package would have a size of €20-25 billion. This is the same range mentioned by an unnamed IMF official earlier who spoke to Reuters about a potential package for Greece.

According to Der Spiegel, the funding of the rescue package would be shared by euro area countries according to their share in the ECB's capital. The support package would consist of loans and guarantee, with the German portion of around €4-5 billion being stemmed by KfW, a state-owned bank. The involvement of state-owned institutions such as KfW or CDC in France had been mentioned by Le Monde already a few weeks ago. The financial support would be strictly conditional, according to the staff memo. In our view, the Spiegel story is credible and consistent with other news and comments. Initially, a spokesman for the Finance Minister was not willing to deny the existence of the paper, but equally refused to confirm its authenticity based on the fact that it was only an internal memo. The spokesperson added that, as before, Greece needed to deliver on the additional austerity by mid-March. Based on those austerity measures, euro area governments would decide how to proceed. Mark your diaries for the Eurogroup dinner on March 15.

The paper seen by Der Spiegel is only an internal memo with initial ideas, not an official German government position or an agreed on European action plan. And, indeed, the German Finance Ministry subsequently issued an official denial of having concrete plans for a financial rescue package. Nonetheless, the Spiegel story suggests the possibility of Greece receiving financial support in exchange for taking additional austerity measures. Late last week, there were already signs that Greece - among other things - might hike its VAT by one or two points. This VAT hike is likely one of the additional measures proposed by the Eurogroup at its mid-February meeting. A VAT hike is a measure that the Greek government so far had said it would not take. It is possible that the prospect of up to €25 billion of euro area-backed funding is a plausible reason for a change of mind. For now, though, the Greek government stressed in a separate statement that it is not seeking financial assistance from the EU. While that is very likely to be true, the Greek Finance Minister is reported to have demanded that Europe tell financial markets what a rescue package would look like in order to facilitate the upcoming syndicated bond issuance in a meeting with local politicians.

In the present situation, it is important to understand the angle by which policymakers will approach the issue and what the hurdles - both legally and politically - are that they would need to overcome in order to provide financial assistance to the Greek government.

1. Our base case is that Greece will be able to muddle through. As we discussed in detail in a recent report (see European Economics: Whither Greece, January 25, 2010), our base case is that Greece will be able to turn around its fiscal situation without actually receiving financial aid. The political commitment by EU leaders to provide support underpins this base case to the extent that it reassures markets and keeps them open for Greek funding needs. Since we published the report, the European Commission and ECOFIN have formally endorsed the Greek stability programme. Next to that, European institutions have imposed tight deadlines on the Greek government to specify more details of the programme and to implement it. The Greek government has also been asked to present additional measures to fend off some of the perceived risks to the programme by mid-March.

In addition to a highly ambitious austerity package, the Commission issued recommendations on a broad range of economic reforms, notably structural reforms needed to revive the country's long-term growth prospects and to strengthen its competitiveness. These broad economic policy guidelines are nothing short of the complete overhaul of the Greek economy ranging from labour market reform, to product market deregulation to liberalising the network industry. In our view, such a combination of fiscal austerity and structural reforms is key to minimising - over the long term - the negative effects of the proposed budget savings on domestic demand. If the government manages to convince the Greek population that the austerity programme marks a turning point towards a better long-term growth outlook, this could crowd-in private sector demand.  Such non-Keynesian effects of fiscal policy - which work via altering the long-term expectations of companies and households - are rather common. They are more likely given Greece's high level of government debt.

Fiscal fundamentals aside, the question is whether the markets will give Greece enough time to prove that it can turn its fiscal position around. This is where the risk surrounding debt rollover comes in. Markets seem very focused on the liquidity risk at the moment - and we will also be carefully watching events in the coming weeks. Yet, the next few weeks are probably equally relevant regarding the medium-term solvency risks because it will become clear whether the Greek government will be able to push through its ambitious austerity package.

The political commitment by European leaders, even though the details of the financial assistance haven't been finalised yet, should have limited the liquidity risk considerably, we think. However, more than the yield level, investors are likely sidelined by current market volatility. Here the elevated noise-to-news ratio out of European capitals does not help to calm down markets. Another liquidity crunch could potentially loom next year, when the redemptions almost double compared to this year and when there is a non-negligible risk that Greek government bonds could no longer be eligible as collateral at the ECB. That said, so far, peripheral countries, including Greece, have been able to come to the market in recent weeks. And if needed, they could also resort to additional measures, such as issuing bonds that trade well below par, to give investors some protection against the risk of default.

2. In the more likely of the two outside scenarios, Greece would get financial assistance from other euro area governments. Due to legal constraints, we feel that emergency lending would be more likely than an outright bailout, if Greece needed external financial assistance. This is because a bailout would be a violation of the EU Treaty (for details see Whither Greece? January 25, 2010). Meanwhile, emergency lending would be compatible with the Treaty and has been extended to other countries in the past. In our view, an EMU-sponsored initiative to provide financial support is more likely than an IMF-led assistance. But we would not completely rule out the latter either. 

After several EMU-outs seemingly refused to support a financial rescue operation, it is not possible anymore to use an EU lending vehicle such as the balance-of-payments assistance facility or the European Investment Bank (EIB) - two options we discussed previously (see Whither Greece?).  Against this backdrop, a concerted bilateral aid package such as the one reported by Der Spiegel is a feasible alternative. The European Commission has already indicated that it stands ready to coordinate such a concerted effort, if needed. A bilateral aid package gives donor governments flexibility to choose the appropriate action within their national framework.

In all cases, policymakers in the donor countries will assess the best option with a view on whether a rescue operation would boost their chances of being re-elected. Hence, it is important to also bear in mind the political landscape in countries such as Germany, France or Italy to get a sense of how likely governments are to put taxpayers' money on the line. Given the domestic political pressure and faced with sizeable budget cuts themselves, governments might be tempted to issue a guarantee instead of lending directly. The advantage from the governments' point of view is that unless the guarantee is drawn, it remains off-balance sheet and outside the regular budget. However, guarantees need to be approved by national parliaments. Given the press reports about widespread corruption and tax evasion in Greece, legislators might be reluctant to support a bailout.

At the end of the day, it will be exposure of the domestic financial sector that will likely win the argument in favour of granting support. In any case, an emergency loan would likely only come in exchange for additional commitments on the part of the Greek government. Hence, the ability of putting such a rescue operation together will rest on the ability of the Greek government to make such commitments and to deliver on them. 

An attractive alternative to avoid the moral hazard issue and the conditionality question would be to create a lender-of-last-resort facility for euro area sovereign issuers. In our view, such a lender-of-last-resort facility would need to be funded by other euro area governments. Like a central bank, who acts as a lender of last resort to banks, the funding could be provided at a penalty rate. Similarly, if Greece or other peripheral countries would like to obtain a guarantee for one of its bond issues, they would be charged for such a guarantee; exactly like banks were charged during the financial crisis. The charges earned by a lender-of-last-resort facility could be used to prefund a rescue fund for a future financial crisis.

By charging governments for the usage of this emergency liquidity, the pressure would stay on these governments to reduce their budget deficits quickly. In our view, it would be unwise to take away the disciplinary effect of rising funding costs. As promising as this idea might sound in theory, it would be the first time that an emergency lending facility would be charging above market rates. Usually, emergency lending comes at subsidized interest rates.

Did you know that Greece has been ‘bailed out' by the EU before? In December 1985, Greece obtained a loan of 1.75 billion ECU from the European Union under the Balance-of-Payments assistance facility. Although its currency only formally joined the European Exchange Rate Mechanism in March 1998, it was suffering a balance-of-payments crisis in the mid-1980s despite an extremely strong USD, which eventually led to the Plaza Accord in July 1985. At the time, the feeling in Europe was that "the economic situation of Greece has shown a marked deterioration in the balance of payments, a fall in the foreign exchange reserves and a rapid increase in external indebtedness" (see Council Decision of 9 December 1985 concerning a Community loan in favour of the Hellenic Republic (85/543/EEC)).

Even though it was acknowledged at the time that the problems were mostly of a domestic nature, the loan was approved on a number of conditions, notably a reduction in the budget deficit of 4pp in both 1986 and 1987. The pressure from the European Union only temporarily reduced the Greek budget deficit. The bailout failed to make any meaningful difference for the debt dynamics over the medium term. At first sight, the size of the loan is quite small. But applying the Greek inflation rate to the sum shows that it would correspond to €12.5 billion in today's money. Rescaling it to the size of the economy gets to the €20-25 billion range talked about at the current juncture.

3. We believe that a debt restructuring is the least likely outcome. But it is not totally impossible either. Greece only defaulted five times since its independence in 1829 according to C. Reinhart's and K. Rogoff's study This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises published in 2009. This compares to eight times for Germany and France and 13 times for Spain since these countries gained independence.

Interestingly, there is a historical precedent for a default in a monetary union: the default of the US states in the 1840s. We discussed this historical episode in detail in a recent report (see Whither Greece? page 15 ff). As we argued in that report, even a debt restructuring is highly unlikely to break up the euro. A debt restructuring would likely cause some serious volatility in the euro area financial system. Greece is not only highly indebted, but its debt is also, to large extent, held by foreign banks. Beyond the data on cross-border bank exposure via lending to the government or via lending to Greek banks, there is no reliable macro data that would allow us to predict the potential fallout from default.

Nonetheless, Europe needs to have a plan on how to contain the fallout on the rest of the euro area both in terms of the other sovereign borrowers and in terms of bondholders, notably banks and insurance companies. Bondholders would likely have to take a haircut on their holdings relative to par. Historically, the median haircut in sovereign debt restructurings over the last 15 years was around 35%.

It is clear from the EU Treaty that the ECB cannot fund government deficits or debt directly. It was for this reason that the ECB decided not to purchase government bonds directly when both the Federal Reserve and Bank of England did. However, a continuation of the unlimited liquidity provision by the ECB would probably help. But there are risks attached to such a strategy - from a monetary policy point of view (creating the next asset bubble), from the financial stability point of view (further delay in cleaning up the European banking system) and from an operational risk point of view (putting the balance sheet of the ESCB at risk). At the moment, banks can still get unlimited liquidity from the ECB. Banks can and have used this liquidity to buy government bonds in what we have called indirect quantitative easing (QE) via the banking system.

But now the ECB is gradually reducing the maturity over which the liquidity is available. This will also gradually reduce the extent of indirect QE, we think. Having already phased out the one-year tender back in December 2009, the ECB will likely do the same with the six-month tender in April. Eventually, the ECB will probably also dial-back the additional three-month tenders. While euro area banks will still be granted unlimited access to the weekly main refinancing operation, MRO, the reduction of the maturities causes longer-dated EURIBOR contracts to rise back above the refi rate even though the EONIA overnight rate remains anchored near the deposit rate for now by the unchanged conditions on the MRO.

As a result, the overall liquidity in the system is still entirely determined by the bidding behaviour of banks. Only once the ECB decides to switch the MRO back to a variable tender or once it starts to mop up excess liquidity through reverse refis, etc. will the liquidity available to banking system becomes limited again. Despite still providing unlimited liquidity, the steepening in the money market curve caused by the reduction in the maturity spectrum amounts to a monetary policy tightening, driving up funding costs for banks.

How does it all end? Eventually there won't be a backstop for a global sovereign crisis. It is the nature of a global sovereign crisis that there is no backstop. Initially, of course, small countries such as Greece can be contained by larger countries, such as Germany and France or a concerted euro area action. Eventually, however, markets might start to question the ability of large industrial countries to stem the crisis. After all, this sovereign crisis is global in nature as it follows an unprecedented global financial crisis (see Sovereign Crisis Roadmap, February 11, 2010).

In our view, the crisis comes in two flavours: inflation risks and credit risks. On the one hand, there are countries that have their currency and can print to meet redemption and coupon payments. On the other hand, there are countries that don't have this option. These are the countries within the euro zone. In the first case, the sovereign crisis should eventually lead to higher inflation premia being priced into the bond market (see Rising Inflation Risk, February 16, 2010). In the second case, the sovereign crisis plays out in higher credit default risks being priced into the bond market.

As different countries around the globe grapple with the aftermath of the financial crisis, their institutional set-up and social preference will be key in determining their ability to take tough decisions in the years ahead. Institutional features such as the degree of central bank independence, the ability of the electoral system to generate clear political mandates and the extent of autonomy at lower levels of government will shape the eventual outcome.

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United States
We Can't Inflate Our Way Out
February 23, 2010

By Richard Berner | New York

Inflation is not the solution.  It's tempting to think that the US can inflate its way out of its fiscal problems.  A faster, sustained increase in prices would erode the real value of past debt, and higher future inflation would - other things equal - reduce the real resources needed to service and pay back the promises we are making today.  And there is no mistaking the staggering value of those promises.  On our projections, federal marketable debt held by the public, which we estimate will be 60.7% of GDP at the end of F2010, will jump to 87% of GDP in the next decade - a level not seen since the post-WW II period (1947).  In absolute terms, such debt will more than double over that period from its January level of US$7.2 trillion.   

Adding fuel to the fire, a growing chorus of household-name economists from both sides of the political aisle appears to be advocating higher inflation as the remedy for our fiscal maladies.  Indeed, many believe that higher inflation will cure multiple ills, and that central banks should raise their inflation targets to as high as 4% from the current ones (some implicit) that cluster near 2%.  From a policy perspective, we couldn't disagree more.  As we see it, central bank responses to this financial crisis underscore the fact that inflation targets are medium-term goals to be met flexibly; they have not limited central banks from responding aggressively to the shock.  Specifically, we believe that the Fed's ‘credit easing' programs have restored the functioning of many financial markets and enabled policymakers to offset the constraint of interest rates at the ‘zero bound'. But the push for allowing more inflation to lubricate the economy is gaining adherents, so it's time for sober analysis. 

Our inflation view.  Let's be clear: Our view is that inflation will stay low - at or below 2% - for the next two years.  Near term, we expect that significant slack in goods, labor and housing markets will promote a decline in core inflation toward 1%, measured by the core CPI.  January's 0.1% decline in the core CPI is on track with that view.  Subsequently, we believe that narrowing slack, rising inflation expectations and commodity prices will promote a gradual move in core inflation back to 2% in 2011. 

However, there are some inflation tail risks: Monetary policy globally has been ultra-expansionary; left unchecked, massive fiscal deficits could eventually pose an inflation threat, and central banks, especially the Fed, find themselves under more political pressure than at any time since the Great Depression.  So, the fear that the Fed cannot take away the punchbowl any time soon is understandable.  While those tail risks are currently small, we agree with our colleague Joachim Fels - who has been warning of inflation risks for some time - that investors should consider inflation insurance.  But a recommendation to buy protection against inflation tail risks is very different from expecting that inflation will - or could - rise by enough to erode the value of the debt.

Flawed strategy: Three hurdles.  Indeed, we think three hurdles preclude eroding the real value of our debt with inflation.  1) Investors would recognize even a stealth inflation policy and would quickly push up yields.  2) Nearly half of federal outlays are either officially or unofficially indexed, meaning that increments to debt would rise with inflation.  3) And the Fed is unlikely to acquiesce.  Before examining those factors, it's worth looking back to see what history suggests.

The lessons from history may not apply.  On the surface, it appears that history contradicts our view.  After all, the combination of seignorage (the benefits to the sovereign from printing money) and unexpected inflation of the mid-1960s and 1970s pushed real rates sharply negative, limiting debt service and eroding the debt. 

My colleague Spyros Andreopoulos explores this issue in depth in a provocative recent piece (see The Return of Debtflation? February 10, 2010).  His calculations show that rapid nominal growth brought debt held by the public from 108.6% of GDP in 1946 to just 36% of GDP in 2003.  The calculations further show that inflation accounted for 56% of that decline, while real growth accounted for the remainder. 

Spyros acknowledges that his calculations implicitly assume that debt service is a constant share of GDP.  In reality, debt service varies with changes in interest rates, in the debt, and in the maturity structure of the debt.  So, if debt is growing relative to GDP and rates are rising with inflation, debt service/GDP will also rise, boosting the overall deficit and debt/GDP.  That limits the ability of policymakers to inflate the debt away.  Indeed, using an alternative framework, George Hall and Thomas Sargent calculate that during the period from 1945 to 1974, inflation accounted for only about 23% of the decline in debt/GDP. 

Those assumptions are critical in evaluating history, because it turns out that the US post-war experience was anomalous for three reasons.  First, a rapid decline in defense spending yielded a significant ‘peace dividend'.  Even with the GI Bill and the Korean War, defense spending tumbled from 37% of GDP in 1945 to 11% by 1955, bringing the deficit from 12% of GDP in 1945 to outright surplus by 1947.  Second, the Fed implicitly agreed to finance the war by holding down interest rates through the early 1950s.  The Korean War brought a surge of inflation and a recognition that the Fed needed more independence.  In 1951, the Treasury-Fed Accord empowered the Fed to raise interest rates to address inflation.  Finally, wartime legislation prohibited the Treasury from issuing bonds with coupons greater than 4.25%.  Consequently, debt managers shortened the maturity of issuance to get under the ceiling.   Higher inflation and market pressures eventually forced repeal and also brought down debt/GDP.   

Hurdles to inflating.  Looking ahead, as noted above, there are several hurdles to being able to inflate away the debt.  First, market participants seem unlikely to be fooled by unexpected inflation - certainly not for long enough or by enough to dent the debt.  Despite what some might view as inflation complacency, the transformation of financial markets over the past 50 years, including the growing use of instruments to protect against inflation, suggests much more sensitivity to inflation risks than in the post-war period. 

Indexation.  Second, nearly half of federal outlays are linked to inflation, meaning that increments to debt would rise with inflation.  Social Security, which accounts for one-quarter of Federal outlays, is officially indexed, and Medicare and Medicaid are ‘unofficially' indexed.  Indeed, over the period 2009-20, CBO estimates that these three programs will account for 72% of the growth in total federal outlays and about the same share of the growth in debt.  If anything, CBO's assumptions may be conservative, as they are required under current law to assume a sharp cutback in physician reimbursement payments under the Medicare program.  Those cuts have been delayed every year since 2003.

Enter the Fed.  Finally, while many view the Fed as politically constrained, we have no doubt that Fed officials will not tolerate a significant rise in inflation, much less encourage it.  Of course, starting in the mid-1960s through 1979, monetary policy did appear to sanction higher inflation.  Having been at the Fed from 1972 to 1980, I wouldn't say that then-Chairman Arthur Burns explicitly chose inflation; rather (and somewhat incomprehensibly) he didn't think inflation had much to do with monetary policy.

That was then.  As much as the Fed seems to be in disfavor today, there is no question among even its sharpest critics that the Fed should be independent and responsible for price stability.  And Fed officials are acutely aware of the pressure that large deficits put on the central bank.  As Kansas City Fed President Hoenig noted recently, "The founders of the Federal Reserve understood that placing the printing press with the power to spend was a formula for fiscal and financial disaster."

Venting market pressures: Rates or currencies?  Even setting aside all those hurdles, with core inflation declining again, it would take some time to boost inflation sufficiently to meaningfully erode the debt.  That's all the more reason to pay attention to the other ways that fiscal pressures may vent in financial markets.  Put simply, sovereign credit risk may not immediately create inflation risk; it may instead translate into real interest rate or currency risk.  Indeed, our call for a rise in nominal 10-year Treasury yields to 5.5% is a story about real rates, in which a revival of private credit demands collides with massive Treasury borrowing needs.  Global investors will likely demand a concession to buy US debt, or they will diversify away from it.  Financial markets will, when provoked, find ways to ‘punish the printers' - in this case, meaning those whose fiscal policies are clearly on an unsustainable path.

That's especially a risk in the current US political setting.  The decisions to retire by key senators on both sides of the political aisle are partly the result of moves to the left by Democrats and moves to the right by Republicans.  With both parties losing their moderate members in the middle, the distance between them becomes ever harder to bridge, and there is less mass in the center to achieve practical solutions.  And practical solutions to our budget and economic challenges are needed soon, in our view. 

For financial markets, there is an element of complacency around such gridlock.  Market participants are used to thinking that political gridlock is good: It prevents politicians from interfering with the marketplace.  The financial crisis clearly exposed the flaws in that reasoning with respect to appropriate financial regulation.  Indeed, gridlock today is more likely to be bad for markets, as our budget problems are directly the result of past policies and can only be solved with political action.  The risk is that further significant upward pressure on interest rates - significant enough to be perceived to threaten the expansion - may be needed before leadership emerges to break the logjam.

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