Members of the Retirement Income Industry Association and friends keep asking me a difficult question: Are retirement portfolios more at risk from inflation or from deflation? Look around, are your clients worried about inflation or do they seek protection from deflation? Some fear Weimar-like hyperinflation caused by excessive government spending. Others fear Great Depression-like deflation from unprecedented levels of stranded debt and de-leveraging. What is it going to be?
Some people become accidental tourists. Five years ago I became an accidental lecturer, when I began teaching each spring a master's program class in investment management. The class, "Principles of Finance," covers topics including corporate finance, the markets, the major asset classes and portfolio management. The students are young professionals mostly in their late twenties and early thirties. They want to advance their careers to become portfolio managers. They are an interesting group. Many work for RIIA members and I learn a lot from them. Teaching is a good way to learn. Students ask questions and seek answers in ways that will surprise but never disappoint.
The material makes it clear that one has to form an opinion in order to manage money. Going with the common wisdom is not enough. Going with the flow may feel good but will it make money? Acting based on the comfort of the common wisdom will, most likely, not help returns that come from buying low and selling high. One has to "zig" when others "zag." This means forming a personal opinion that may not agree with the common wisdom. As one student put it, we must defy what John Maynard Keynes observed: "Worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally."
As a class exercise, we all tried to form a personal opinion about inflation. We discussed questions such as these: How long will we experience inflation or deflation before we no longer do and why? What will come next and for how long? Soon, you realize that forming an opinion is always subject to change as new evidence is revealed.
Money, Credit & Expectations
Sources peg the amount of American money circulating around the globe at a number between $1 trillion and $2 trillion. Can we buy more or fewer goods with this money? Looking online, students found analyses substituting the Case-Shiller housing index for the Owners' Equivalent Rent that's used in the Consumer Price Index; for February 2009, this adjusted measure of inflation fell at a negative 5 percent, year on year, for the third straight month. Looking for other measures, some students created analyses comparing 10-year Treasury yields to TIPS. These analyses suggested, as of March 2009, an implied and rising "five-year, five-year-forward break-even" inflation rate of about 2 percent, meaning that inflationary expectations are on the upswing.
Also, sources peg the recent peak amount of total American debt at or above $50 trillion. While both money and credit can be used to buy things, they are not the same thing. Clearly with a credit-to-money ratio of 25-to-1, credit deleveraging is bound to have a big deflationary impact.
Taking a step back, other students focused on the current and unprecedented government bailout commitments currently estimated above $10 trillion and counting. If one were to add government entitlements such as Medicare, Social Security and public pensions, we have combined obligations that may be larger than $60 trillion. How will we pay for these obligations? Will solutions be deflationary (because of higher taxes and a depressed economy) or inflationary (because of printing more paper money)?
Moreover, students looking outside of the U.S. found data showing dramatic drops in industrial production as well as in global trade and in Japan in particular. We in the U.S.A. live at the core of our global trade world. Those who live at the periphery will feel the cold before we do and it is clear that they do.
Looking at additional relationships that could help resolve the continued uncertainty, students found interesting sources including John Williams of the San Francisco Federal Reserve Bank. Williams compares unemployment to inflation and shows their inverse relationships, suggesting impending deflation as unemployment increases. An extension of this theme can be seen also in demographic analyses suggesting falling aggregate demand resulting from the predictably declining consumption patterns of aging boomers.
It seems clear that economic production and consumption are dropping worldwide. It seems plausible that excessive debt, used to fund not only production but also consumption, becomes a cancer in the economic body. It is quite possible that this would bring deflation, and that we are beginning to experience this now.
When an economic body has cancer (negative marginal productivity of debt resulting from excessive total debt) one is not likely to cure the cancer with greater injections of stimulating adrenaline (government bailouts and deficit spending). A tough but viable treatment would be to let the losers fail so that others can put the freed-up capital to better use. If this is done early and often, the pain remains localized and may be tolerable. If one keeps avoiding the pain, rewarding the losers and penalizing the winners, the economic cancer of bad decisions may become generalized and intolerable. There are levels of pain that can be lethal to a system. Unprecedented government spending, bailouts and guarantees may bring such pain. Such pain includes inflation, and we may experience extremely high inflation at some point in the future.
We all have to form our own opinions as we advise clients. For now, with my students' questions and answers in mind, I will stick with a deflationary forecast for the current year, and will keep an eye out for both supporting and contrary evidence.
Francois Gadenne is chairman and executive director of the Retirement Income Industry Association in Boston; see www.riia-usa.org.