I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Saturday Reflections, I take time out to reflect.
In an interview with Time magazine, the U.S. president said that “certain levels of inflation” could help pay down the national debt “very rapidly.” He also said that the Fed’s interest-rate policy is hurting the economy more than inflation.
He’s right in saying that inflation can help pay down the debt, but this isn’t without its harms to the economy.
Today I’m thinking about fiscal dominance and financial repression, two concepts that can help shed some light on the relationship between a country’s debt, inflation, and governmental actions.
High public debt poses a problem for a government because interest payments on the debt become a large and increasing portion of the budget, making it difficult for the country to spend money on the goods and services that keep it running.
In times of high debt, a country faces fiscal dominance, where a government’s financing needs drive monetary policy. In that case, price stability must be sacrificed in order to keep government debt manageable. The fiscal side of the government dominates the monetary policy side; Treasury, or the political leadership, makes explicit or implicit demands on the central bank.
This almost inexorably leads to financial repression, if the debt load is high enough, in which the government takes steps to channel loaned funds to the public sector on more favorable terms than they otherwise would be in a free market. Financial repression can include government buying of bonds to reduce yields, forcing certain institutions or other investors to buy more bonds than they otherwise would through regulation, outright interest rate caps, bank reserve requirements, and capital controls that restrict the movement of money across borders.
One form of financial repression is known as quantitative easing. This is when a central bank buys massive volumes of government bonds or other financial assets from commercial banks and private institutions. The selling banks are credited with newly created institutional reserves — new money added into the financial system.
In a free market, if a government runs massive fiscal deficits and expands the money supply, investors will demand higher interest rates to compensate for the inevitable inflation that develops. But in fiscal dominance and financial repression, the government doesn’t allow interest rates to float to help the economy reach equilibrium. Instead, inflation can blow up.
You might wonder why there wasn’t significant inflation over the past 15 years, as interest rates were held at or near zero, with various techniques of financial repression. We saw three main drivers of deflation during that time: the U.S. shale oil boom which brought significant new energy supply online, the rise of Internet commerce, and generally free trade policies around the world along with globalized supply chains.
Now many people point to the rise of AI as a new deflationary force, but it is anything but. Current AI models demand significant buildout of data centers and power plants, requiring capital expenditures and commodity inputs of a level never before seen. At the same time, increased geopolitical unrest and deglobalization mean that countries are being more cautious about sharing resources and supply chains.
In the coming decade, I’m expecting inflation to come and go, as it did in the seventies, but at higher levels than what we were used to in the 2010s. What does it mean for investing? I’m planning a Monday Money post with suggestions for portfolio allocation in this new regime (not really so new, as we’ve had high inflation since Covid, and poor bond returns). The quick answer is more commodities, lean towards natural-resource-rich country equities, boost your gold allocation (or add one if you don’t have it already), and avoid bonds until there’s clear evidence that governments are going to start large financial repression efforts (when bonds yields fall, their values go up).
For now I’ll leave you with a recent podcast interview with financial historial Russell Napier, all about financial repression and its implications for savers: