Debt and Inflation Fears: Investing’s Obsolete Dogmas?
“When the facts change, I change my mind. What do you do?” — John Maynard Keynes (Apocryphal)
One of the things I admire most in people is when they are able to change their opinions based on new evidence, take responsibility for past mistakes, and move on. Given that description, you can imagine what I think of politicians . . .
But in the world of economics and investing, some concepts have become indistinguishable from articles of faith, or dogma. People cling to them despite the evidence and the consequences.
1. Inflation Hysteria
That expanding central bank balance sheets — printing money — means higher inflation is a prime example of one of these articles of faith.
Twelve years of evidence in Europe and the United States show that all that money printing has not only not led to inflation but, if anything, had deflationary consequences similar to what Japan has experienced for decades.
Yet some economists and investors still insist that the monetary stimulus of 2020 will inevitably tip the scales towards rising inflation.
2. Debt Leads to Austerity.
Another article of faith: High government indebtedness must be paid with higher taxes down the road and as such is bad for future economic growth. Thus, if debt becomes too high, austerity measures will be required to balance the budget.
Yet, more and more research shows that the fiscal belt tightening enacted in Europe and the United Kingdom amid the Great Recession and the eurozone debt crisis has caused more damage to growth than high debt-to-GDP ratios ever could.
“When the Facts Change . . .”
Of course, 10 years ago, I believed in both these dogmas. Like so many Germans, I am naturally averse to debt and fearful of inflation. For some of my fellow citizens, these phobias become central to their identities, with sometimes tragic consequences.
Today, I have severe doubts that either of these articles of faith hold true. And in return, people who know me from a decade ago and debated me back then now dismiss me. Their argument: I was wrong 10 years, so why should anyone listen to me today? Well, as John Maynard Keynes may have said . . .
Enter Olivier Blanchard. Blanchard is among my economic heroes because he is one of those rare economists who doesn’t tie their identity to a particular school of thought. In the early 2010s, he was chief economist at the International Monetary Fund (IMF) and pushed hard for austerity measures in the aftermath of the financial crisis and the eurozone debt crisis. Soon after, he made an astonishing U-turn, admitting that he had underestimated the negative consequences of austerity on growth.
Blanchard’s reputation — and that of the IMF — took a big hit from the mismanagement of the eurozone debt crisis and some people won’t listen to him anymore. I say we should listen to him now more than ever and give his views more weight than those of other economists who act like broken records and repeat the same dogmas over and over again.
Today, Blanchard makes an eloquent case as to why we shouldn’t introduce austerity measures after this crisis. In short, it is a matter of impact. Austerity reduces economic growth. Balancing a budget that would otherwise run a 3% to 5% deficit can easily precipitate recession in countries emerging from crisis and almost certainly reduces growth by roughly 1 percentage point per year for several years in a row.
In the end, the cost of austerity is an almost one-to-one reduction of GDP. Meanwhile, cutting the deficit to zero reduces the debt-to-GDP ratio after three to five years by maybe 10 percentage points. The impact on the cost of government debt, therefore, is in the range of a few basis points (bps). Hence, the benefit of reducing debt levels is measured in fractions of a percent of GDP, while the costs add up to several percentage points of GDP.
The austerity measures practiced over the last decade made no sense and we should avoid a return to them. But that is not to say that austerity is always ineffective.
We know today that the cost of austerity can be reduced if it is backloaded: A country starts with small austerity measures and gradually ramps them up year by year. Similarly, deficit reduction can stimulate business confidence and encourage investments that offset the negative effect reduced government spending has on growth.
However, I am somewhat ambivalent about these arguments. I continue to think that they are correct in theory, but in practice I believe the impact of austerity on business investment is so small as to be negligible. Otherwise, why didn’t businesses invest like crazy during the last episode of austerity?
But just because I remain doubtful about these arguments today doesn’t mean that I won’t change my mind down the road. If the facts change, I will change my opinion. And so should you.
For more from Joachim Klement, CFA, don’t miss 7 Mistakes Every Investor Makes (And How to Avoid Them) and Risk Profiling and Tolerance, and sign up for his Klement on Investing commentary.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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