The Great Reflation Experiment

The question we have been focused on for some time now is whether we end up with inflation, or deflation, and what that endgame looks like. It is one of the most important questions an investor must ask today, and getting the answer right is critical. This week, we have a guest writer who takes on the topic of the great experiment the Fed is now waging, which he calls The Great Reflation Experiment.

One of my favorite sources of information for decades has been and remains the Bank Credit Analyst. It has a long and
storied reputation. One of their enduring themes has been the debt super cycle. Investors who have paid attention to it have been served well. I am taking a little R&R this weekend, but I have arranged for my friend Tony Boeckh to stand in for me. Tony was chairman, chief executive, and editor-in-chief of Montreal-based BCA Research, publisher of the highly regarded Bank Credit Analyst up until he retired in 2002. He still likes to write from time to time, and we are lucky enough to have him give us his views on where we are in the economic cycles. Gentle reader, we are all graced to learn from one of the great economists and analysts of our times. Pay attention. Central bankers do. You can read his extensive bio at and I will tell you how to get his letter free of charge at the end of this letter.
And, he told me to mention that his son Rob is now helping him write, so there is a double byline here. Now, let’s just jump in.

By Tony Boeckh and Rob Boeckh

The Crash of 2008/9 should be seen as yet another consequence of long-term, persistent US inflationary policies.
Inflation doesn’t stand still. It tends to establish a self-reinforcing cycle that accelerates until the excesses in money and credit become so extreme that a correction is triggered. The bigger the inflation, the bigger the correction. Once a dependency on credit expansion is well established, correcting the underlying imbalances becomes extremely difficult. Reflation has occurred after each major correction, and this one is proving no exception. Return to discipline in the current environment would be too painful and dangerous. Once on the financial roller coaster, it is very hard to get off. Moreover, the oscillations between peaks and valleys become increasingly large and unstable.

Policymakers, money managers, and most forecasters have argued that the crash was a “black swan” event, meaning
that it had an extremely low probability of occurrence. That is grossly misleading, as it implies that the crash was so far beyond the realm of normal probabilities that it was unreasonable to expect anyone to have foreseen it. That argument has been used to justify the widespread complacency that prevailed in the years leading up to the crash. Policymakers are still failing to recognize the systemic causes of the crash and seem to believe that enhanced regulation will prevent history from repeating. While it is true that regulators were asleep at the switch or looking the other way, they were not the cause.

The Debt Super Cycle

The real culprit is the US debt super cycle, which has operated for decades, mostly in a remarkably benign manner. The inflationary implications of the twin deficits (current account and fiscal), as well as the steady increase in private debt, have been moderated by the integration of emerging markets into the global economy. The massive increase in industrial output from China, India, and others has enabled persistent credit inflation in the US to occur with virtually no consequence to date (other than periodic asset price bubbles and shakeouts). How long the disinflationary impact of emerging-market productivity growth will persist and how long these nations will continue loading up on Treasuries, will be instrumental in determining the course that the Great Reflation will take.

Tougher regulation is surely appropriate, but it will not stop the next inflationary run-up unless the system is fixed. In the final analysis, newly minted money and credit must find a home somewhere.

Some Background on US Inflation

Inflation, to be properly understood, should be defined as a persistent expansion of money
and credit that substantially exceeds the growth requirements of the economy.
As a consequence of excessive monetary expansion, prices rise. Which prices go
up and at what rate depends on a number of factors. Sometimes it is the prices
of goods and services that are the most visible symptom of inflationary
pressures. That was the case in the 1970s when the Consumer Price Index (CPI)
hit a peak rate of 14% per annum. Sometimes it is the prices of assets such as
homes, office buildings, stocks, or bonds that reflect the inflationary
pressure, as we have seen in more recent years.

When inflation becomes pervasive, and other conditions are supportive, it can engulf a whole industry. We saw
this in the financial sector in the period leading up to the crash. The
supporting conditions or “displacements,” to use the terminology of Professor
Kindleberger, were financial innovation, deregulation, and obscene profits and
salaries. These drew millions of bees to the honey. All great manias are
accompanied by malfeasance, in this case the biggest Ponzi scheme in history
and many other lesser ones. It is relatively easy to steal when prices are
rising and greed is pervasive. Overspending and a general lack of prudence
always become widespread when a mania infects the general public. Rational
people can do incredibly stupid things collectively when there is mass

The origins of post-war inflation go back to the late 1950s and early 1960s, though
some would take it back much further. In the 1960s, the US dollar started to
come under pressure as a result of US inflationary policy and foreign central
banks’ ebbing confidence in their large and growing dollar reserve holdings.
The US responded with controls and government intervention in a number of
areas: gold convertibility, the US Treasury bond market, the Interest
Equalization Tax, and, ultimately, intervention on wages and prices. These
moves clearly flagged to the world that external discipline would be subjugated
to domestic employment and growth concerns. The policy was formalized when the
US terminated the link between gold and the dollar in August 1971, essentially
floating the dollar and setting the US on a course of sustained inflation. Of
course, the dollar floated down, which, among other things, triggered the
massive rise in general prices in the 1970s.

The next episode of credit inflation began in the 1980s, paradoxically triggered by
the success of Paul Volcker’s move to break the spiral of rising general price
inflation through very tight money. He succeeded famously, and the CPI headed
sharply lower along with interest rates, setting the stage for the massive US
debt binge and the series of asset bubbles that followed. It was easy for the
Federal Reserve to pursue expansionary credit policies while inflation and
interest rates were falling.

The Great Reflation Experiment of 2009

Private sector credit, the flipside of debt, maintained a stable trend relative to GDP
from 1964 to 1982 (Charts 1& 2). After that, the ratio of debt to GDP rose
rapidly for the 25 years leading up to the crash, and is continuing to rise.
The current reading has debt close to 180% of GDP, about double the level of
the early 1980s. The magnitude and length of this rise is probably
unprecedented in the history of the world. Even the credit inflation that was
the prelude to the 1929 crash and the Great Depression only lasted five or six

Prior to government bailouts and stimulus, the panic, crash, and precipitous economic decline of 2008/9 were
clearly on track to be much worse than the post-1929 experience. The
pervasiveness of leverage – from banks to consumers to supposedly
blue-chip companies – and the illusion of stability in the system, were
fostered through the 25 years that this credit bubble has grown, basically
uninterrupted. The speed and magnitude of the bailouts and stimulus – the
end of which we won’t see for a long time – aborted the meltdown.
However, the story is far from over.

The Great Reflation Experiment ultimately has two components. The first is a rise in federal government
deficits, debt, and contingent liabilities. The second is an expansion of the
Federal Reserve’s balance sheet. Both are unprecedented since World War II. US
federal government debt is likely to reach close to 100% of GDP over the next 8
to10 years, according to the Congressional Budget Office (CBO) and supported by
our own calculations (Chart 3). Anemic growth, falling tax revenue, increased
government spending, and bailouts of indigent states, households, businesses, along
with an aging population, will all undermine public finances to a degree never
before seen in peacetime. According to CBO data, government debt could reach
300% of GDP by 2050 as contingent liabilities are converted into actual
government expenditures. This massive peacetime deterioration in public
finances will have grave consequences for living standards and asset markets,
particularly in the longer run.

In the short run, huge deficits and growth in government debt are necessary. They will continue to play a crucial
role in deleveraging the private sector and in helping to fill the black hole
in the economy that has been caused by the sharp increase in household savings.
Further out, government deficits will put upward pressure on interest rates.
However, much of the economy, particularly housing and commercial real estate,
is far too weak to absorb an interest-rate shock. Therefore, the Federal
Reserve will have to monetize much of the rise in government debt, making it
extremely difficult to unwind the explosion in the Fed’s balance sheet and
consequent rise in bank reserves – the fuel that could be used to ignite
another money and credit explosion.

The bottom line is that the Fed is in a very difficult position. Its room to maneuver is either small or nonexistent,
and the markets understand this. That is why there is a sharp divergence between
those worried about price inflation and those fearing a lengthy depression.

Implications for Investors

Investors are also in an extraordinarily difficult predicament. From the peak in 2007,
household wealth declined by about $14 trillion, over 20%, to the first quarter
of 2009. Tens of millions of people had come to rely on rising house and stock
prices to give them a standard of living that could not be attained from
regular income alone (Chart 4). They stopped saving and borrowed aggressively and
imprudently against their assets and future income, some to live better, some
to speculate, and many to do both. That game is over.

Pensions have been devastated and people’s appetite for risk has declined dramatically. The return on safe liquid
assets ranges from 0.60% to 1.20%, depending on term and withdrawal penalties.
Reasonable-quality bonds with a five-year maturity provide about 4%. Bonds with
longer maturities have higher yields but are vulnerable to price erosion if
inflationary expectations heat up. As for equities, people now understand that
blue chip stocks carry huge risk. GE, once considered the ultimate “bullet-proof”
stock, dropped 83% in the panic, and Citigroup lost 98%. Revelations of massive
fraud schemes have further damaged trust and confidence in markets.

Against this backdrop we offer a few thoughts. First, an increase in price inflation as
reflected in the CPI is a long way off. The degree of excess capacity in the
world is probably the greatest since the 1930s, although excess capacity does
get scrapped during recessions. Western economies will remain depressed for
years, and China will also be important in keeping inflation down. Its capital
investment is larger than the US’s in absolute terms. It is currently 40% of
GDP and growing at 30% per annum. Profit margins in China will probably get
squeezed, which, together with the huge amount of underemployed labor, means
that the Chinese will keep driving their export machine at full throttle,
continuing to flood the world with high-quality, inexpensive goods. Therefore,
investors who need income are probably safe holding reasonably high-quality
bonds in the five-year maturity range. A bond ladder is a very useful tool for
most people. Holdings are staggered over, say, a five-year time frame, and
maturing bonds are invested back into five-year bonds, keeping the portfolio
structure in the zero-to-five-year range. In this way, some protection against
a future rise in price inflation and falling bond prices can be achieved.

Second, massive monetary stimulus is good for asset prices in the near term (e.g.
stocks, bonds, houses, commodities) in a world of very weak price inflation and
a soft economy. That is true as long as the economy does not fall apart again,
which is very unlikely given all the stimulus present and more to come if
needed. Therefore, investors who can afford a little risk should own some
assets that will ultimately be beneficiaries of the wall of new money being
created and thrown at the economy.

There is a major risk to our relative near-term optimism, and that is the US dollar. Foreign central banks
hold $2.64 trillion, overwhelmingly the largest component of world reserves.
The US role as the main reserve currency country is compromised by its
persistent inflationary policies and current account deficits, a subject high
on the agenda at the recent G-8 meeting in Italy and referred to frequently by
China, Russia, Brazil, and others. Foreign central banks fear a large drop in
the dollar, which would cause them potentially huge losses on their reserve
holdings. They don’t want more dollars, and yet they don’t want to lose
competitive advantage by seeing their currencies go up against the dollar. To
preserve their competitive position, they have to buy more when the dollar is
under pressure. On the other hand, since the 1930s the US has never subjugated
domestic concerns to external discipline. Officials may talk of a strong-dollar
policy, but their actions always speak differently. Their attitude towards
foreign central banks is, “We didn’t ask you to buy the dollars.” The US has
typically seen such buying as currency manipulation to gain an unfair trade

The most likely outcome is a nervous dollar stalemate or, as Lawrence Summers once
described it, “a balance of financial terror.” The most important central banks
will continue to hold their noses and buy the dollar to keep it from falling
too sharply. However, this is a fragile, unstable situation, and the dollar
must fall over time. Investors need to diversify away from this risk. There are
three obvious ways.

The first is investing in high-quality US equities that have a majority of their
earnings and assets in hard-currency countries.

The second is investing in gold and related assets. Gold will probably remain in a tug of war for some time. On the
negative side, it is faced with nonexistent global price inflation, even
deflation, and a sharp decline in jewelry demand. On the positive side,
concerns over U. monetary and fiscal debauchery will almost certainly heat up.
As the odds of the latter increase, gold will be a major beneficiary, and
investors should have a healthy insurance position in this asset class.

Third, most foreign currencies will also benefit from these fears, and hence investors can also protect
themselves by diversifying into non-dollar assets in the best-managed
countries. Some of these are emerging markets like China, which are liquid, in
surplus, fiscally stable, and still growing well in spite of the global
economic downturn. If and when the world economy begins to recover, and should
price inflation stay low, asset bubbles are likely to recur. Where and when is
always hard to tell in advance. Good prospects are in emerging-market equities,
commodities, and commodity-oriented countries.

So, to sum up, in the next six to 12 months we look for a weak but recovering US economy, a continued
deflationary price environment, pretty good asset and commodity markets, and
continued narrowing of credit spreads. This view is based on the assumption
that the new money created has to go somewhere, a stable to modestly falling
dollar, and an anemic world economic recovery next year.

A buy and hold strategy has been bad advice for the past 10 years. The S&P is down 45% from its peak in
early 2000. The investment world is likely to remain very unstable in the face
of the difficult longer-run problems discussed above. Investors, whether they
like it or not, are in the forecasting game, and forecasting is all about time
lags. The exceptional circumstances of the current environment make any
assessment of time lags extraordinarily difficult, and mistakes will continue
to be costly. For that reason, holding well above average liquidity, in spite
of the paltry returns, is sensible for most people whose pockets are not deep
enough to absorb another hit to their net worth. They are in the unfortunate
position of having to wait until the air clears a bit and more aggressive
action can be taken with higher confidence. Warren Buffet has properly reminded
us on numerous occasions that a price has to be paid for waiting for such a
time, but then most of us aren’t as rich as he is.

A Beach, New York, and Maine

I want to thank Tony and Rob for writing this week’s letter. You can go to their
website, and see some of their recent letters, or send an email to and get put on their regular list for the free letter.

As you are reading this, I am hopefully reading on a beach, relaxing under an
umbrella. Tiffani and Ryan are on a cruise in the Caribbean. They just got
back the wedding videos from last year, and they are a hoot. They had one
cameraman with an old Super 8 camera, so that video looks like something from
the 60s. At some point they will put it on You Tube. Interesting to contrast
the old format with the new.

I get back late Monday, and then leave early Wednesday for a quick trip to New
York and then on to the Shadow Fed fishing weekend organized by David Kotok. My
youngest son, now 15, will be with me for our fourth trip. Maybe this year I
can catch more than he does. So far, it has not even been close in either
quantity or quality.

Each year, we make small bets (bragging rights are more on the line) on where the markets will be the next
year. So far, I am money ahead, as I get a few calls right. Last year the
financial markets were just starting to melt down as we met. It will be
interesting to see if any of us came close this year. There are some fairly well-known
names in the room, so it will be interesting to see who got it right. And even
more interesting to try and figure out where we will be next year at this time.
I will report back.

And that blank spot that was my fall travel calendar? Looks like I will be going to South America in the fall
(Argentina, Brazil, and Uruguay). A few other dates look to be firming up. It
has been way too long since I was in South America, and I am looking forward to

Have a great week.

Your going to mix in some sci-fi with the economics reading analyst,
John Mauldin

Copyright 2009 John Mauldin. All Rights Reserved
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