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When Governments Can't Borrow, Hyperflation
Is Often the Result
The Lessons of History
By VICTOR SPERANDEO
When governments cannot borrow, hyperinflation is frequently the result.
Economist Philip Cogen defines hyperinflation as a non-annualized inflation rate of 50% or more in a single month. This rare occurrence should not be confused with the inflation the U.S. went through in the 1970s, which was moderate, almost normal, by comparison.
Unlike normal inflation, which may be attributed to a variety of factors, hyperinflation has a single cause: It occurs when a government cannot borrow money because its debt has risen so much that investors believe they will never be paid back with close to the same purchasing power. As a consequence of this flight of confidence, such a government is forced to print money to meet its obligations. This further undermines the value of its currency, often culminating in a frenzied collapse. That is hyperinflation, and only governments and central banks cause it.
The first occurrence of hyperinflation was in France between 1789 and 1796, when the revolutionary government paid its bills with paper and forced its creditors to accept payment or be guillotined. Since 1920, there have been 29 more hyperinflation events around the world, the most recent being in Zimbabwe beginning in 2007. From Robespierre to Mugabe, government profligacy and the printing of money were the chief causes.
U.S. government debt is now over $13.7 trillion (not including estimated states' debt of $2.8 trillion and agencies' debt of $3.0 trillion). The average rollover period for the debt is 49 months. With recent deficits running over $1 trillion a year, the Treasury issues new debt and refunds old debt at a rate of about $4.3 trillion a year. A nation needs to inspire a lot of confidence to keep that Ponzi scheme alive. Unfortunately, markets know that even the U.S. government will print money to meet expenses when necessary.
All of this spending and financing has occurred in a period of historically low costs of sovereign borrowing. According to Ibbotson Associates, the compounded total return for long-term U.S. government bonds between 1926 and 2009 was 5.42% a year, while the consumer price index measure of inflation was 3.01% a year over the same period; over the past 49 years, those rates were 7.02% and 4.12% respectively. As I write, the 30-year U.S. government bond's yield is 4.21%—29% less than its historic return since 1926 and 67% less than the rate since 1961.
This leads to the question, being asked from Beijing to Brussels: Does the risk match the reward? A negative response to that question could lead to hyperinflation.
Potentially, investors in U.S. debt will begin something similar to a run on the bank, selling Treasuries, even at severe losses.
In our system, the Federal Reserve can buy all the paper the Treasury can issue, and the Treasury can pay the government's bills with the Fed's newly printed Federal Reserve notes. But at some point, the scales will tip, and debt investors will decide they won't be repaid with the same buying power. Historically, that break point occurs when a government borrows an amount equal to 40% of its expenditures over an extended period of years.
Look at the federal budget for fiscal 2009. That year, the budget deficit was $1.55 trillion, with total expenditures of $3.52 trillion. If the government borrows the entire amount of the deficit, it would have a borrowing rate of 44% of total expenditures. In 2010, the figure also has exceeded 40%. Can this imbalance continue without triggering a hyperinflationary spiral?
The Congressional Budget Office projects this borrowing rate will be coming down substantially by 2014. If this fairy tale came true, Armageddon will be postponed. But the CBO projections are optimistically skewed. As of the beginning of 2010, the CBO's projections for 2012 through 2014 are for real GDP growth of 4.4% annually. The last years in which growth was that high were 1997 through 2000—a period of amazing strength.
That 4.4% real growth was reflected in the S&P 500 stock index, which appreciated 28.56% compounded annually from 1995 and 1999, breaking the prior five-year record of 23.89%, set in the 1950s. Currently, the S&P 500 shows a net loss over the past 10 years and a five-year annual return of only 0.33%.
To believe that 2012 through 2014 will repeat the strongest period of GDP growth in decades is unrealistically optimistic, unless some major innovations occur.
Tax collections depend on gross domestic product. If real GDP is lower, tax collections will be lower. If tax receipts are lower, deficits will be higher. If real annual GDP growth is just 3%, actual revenue will be 1.4 percentage points lower than the CBO projects, and the amount of borrowing based on gross expenditures will surpass 50% of GDP.
At this point the government debt buyer asks the questions posed earlier: Can a nation financing 50% of its budget expenditures in the debt market grow itself out of a collapse? Is the reward likely to match the risk of owning government debt?
Without the support of foreign buyers, government spending will have to be paid with newly printed money, and the inflation consequences will be dire. Historically, nations default when the bulk of the debt is owed to other nations, but the U.S. still owes most of its debt to its own citizens.
Gold trading at more than $1,350 an ounce, despite no appreciable increase in the consumer price index, is much more understandable when you realize that in periods of hyperinflation, gold tends to appreciate by 2,000% to 50,000% against a hyperinflated currency.
Do the gold bugs know something we don't? In time, the markets will surely say whether this is so. But unless drastic measures are taken to change the trend of deficits, or unless purchasers of U.S. government debt ignore all rational measures of risk, a psychological breaking point is approaching. When this happens, history tells us that hyperinflation is not far behind.
VICTOR SPERANDEO is a professional trader and money manager with over 45 years of experience on Wall Street.
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