by Hugh Giddy – Senior Portfolio Manager and Head of Research for Australian equities
Why do we trust money? Paper money or fiat currency* is essentially about trust. We exchange things for money: our labour, something we own like a house or car, or a creation such as a sculpture or a viral Tik Tok video. The stability of the purchasing power of that money is crucial in underpinning such trust. The few bolivars left at the end of my trip to Venezuela are now only a curiosity rather than of any value. Residents of high inflation countries instinctively favour more stable currencies, traditionally the US dollar.
Inflation fosters inequality. Low-income earners generally lack assets such as property or diamonds that should retain value in a high inflation environment. With the chief source of income their wages or government benefits, they suffer when these increase by less than living costs or with a time lag.
Inflation also fosters corporate inequality. As household budgets get squeezed, discretionary spending falls. Small businesses are reluctant or unable to pass on their rising costs for fear of losing business to competitors when the pie is getting smaller. Large businesses in consolidated industries or those selling necessities like power, telecommunications, and medicines can raise prices given stable volumes. Quality companies with stronger franchises – such as those we at IML favour – are likely to continue to thrive.
Most governments publicly recognise the need for price stability and embody this by setting inflation targets for central banks. This still implies a loss of monetary purchasing power over time, unless inflation is below zero at times to counter the positive inflation in the targets.
A beneficiary of inflation is the government itself. The issuer of currency naturally makes a return as the currency in circulation, a liability of the central bank, declines in value. Modern governments also tend to run deficits and accumulate debts. Debts decline in real value as prices rise.
Individuals and corporates with debt also benefit as debt principal repayment becomes less onerous. However, this benefit can be offset by the weaker economic environment and the higher interest rate demanded by lenders.
History reveals a structural bias toward inflation by governments despite pronouncements to the contrary. Emperors and kings spent money on wars that exceeded taxes, for example. They used to clip coins, or issue coins with lower precious metal content. However, before the advent of paper money and fiat currency, periods of inflation were often followed by deflationary episodes, resulting in overall price stability over long periods of time. In modern times government obligations and promises are politically unpalatable to withdraw, leading to a bias towards deficits and potentially onerous debt levels.
Enter economists who can “prove” whatever they want by creating models to fit their theory. Modelling is one of the scourges of modern thought, where policy is often justified based on some complicated model that is very sensitive to the choice of assumptions. Examples include the management of Covid (how many people one could associate with and over what radius from home, for example), to improbably precise forecasts of how much carbon dioxide will correlate with half a degree of warming over the next thirty years against the backdrop of the very complex global climatic system.
In economics it was postulated that central banks could effectively finance increased government spending by buying government debt at suppressed interest rates (putting more money into the system or money printing as government creates money to provide to itself) without incurring inflation. This is called Modern Monetary Theory or MMT, effectively the Magic Money Tree.
The poster child for MMT is Japan where the government has supported the economy post the bursting of the late Eighties bubble, leading to high levels of government debt. Interest rates on JGBs (Japanese government bonds) have remained low thanks to substantial purchases by the Bank of Japan. This effective money printing has not resulted in much inflation.
As governments imposed lockdowns to ease the pressure on hospitals in the early days of Covid, they supported economic activity with significant stimulus including direct payments, housing incentives and schemes like Jobkeeper in Australia. Most central banks lowered their rates to zero while committing to buy government debt through expanded central bank balance sheets, printing money to fund the stimulus. Many people believe that amidst the uncertainty, embarking on MMT was reasonable. The Covid downturn was relatively brief, and consumer spending was maintained thanks to stimulus and very low mortgage rates, although savers continued to be punished with negative real rates. Low rates pushed up asset prices including the most speculative vehicles such as cryptocurrencies, non-fungible tokens, special purpose acquisition companies, and already high house prices rose to even crazier levels in many countries.
The RBA was equipped with data showing cost pressures in many parts of the system, from energy to freight to the shortage of labour created by border closures and negligible immigration. Demand was strong from low unemployment, high house prices, and excess savings from money printing. In 2021 or even 2020 the RBA and other central banks could have acted in a timely fashion to at least neutralise interest rates. Neutral settings with such a backdrop were surely well above zero.
Instead, they invented a narrative that the inflation would be transitory, clinging to the utopian paradigm of MMT. Now with inflation at the highest level in decades it is difficult to see how they restore belief in their stewardship of our money without popping the bubble they sponsored. Forecasts are never easy, but it’s conceivable that house prices fall significantly, mortgage stress builds and unemployment rises, while inequality remains high. In the private sector having such unreliable models and being so wrong would mean loss of employment or failure of a business. In the bureaucracy, it’s a case of “Keep Calm and Carry On”.
