Practical analysis for investment professionals
27 July 2020

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.

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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.

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“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.

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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.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.


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.

Image credit: ©Getty Images / Beau Lark / Corbis / VCG

About the Author(s)
Joachim Klement, CFA

Joachim Klement, CFA, is a trustee of the CFA Institute Research Foundation and offers regular commentary at Klement on Investing. Previously, he was CIO at Wellershoff & Partners Ltd., and before that, head of the UBS Wealth Management Strategic Research team and head of equity strategy for UBS Wealth Management. Klement studied mathematics and physics at the Swiss Federal Institute of Technology (ETH), Zurich, Switzerland, and Madrid, Spain, and graduated with a master’s degree in mathematics. In addition, he holds a master’s degree in economics and finance.

4 thoughts on “Debt and Inflation Fears: Investing’s Obsolete Dogmas?”

  1. Kirk Cornwell says:

    Yes, debt is just journal entries. Is inflation a measure of prices or the amount of money in circulation? “Things are different now”(?), yes, but the near, intermediate, and long-term results of Federal Reserve shenanigans are not a true test of MMT because of the COVID-19 factor. If the new trillions merely flow briefly before hiding in bank reserves, the continued slow velocity there may hide what is really happening for a while longer. Eventually the parabolic increases in M1 and M2 will show up in price levels. How society handles this after “forever low interest rates” will be fun to watch.

    1. Norbert Mittwollen says:

      “…all that money printing has not only not led to inflation but, if anything, had deflationary consequences…”

      If it has these consequences, why do CBs go on printing money like crazy in the first place? Shouldn’t they stop with it rather sooner than later to prevent prolonged deflation?

      Enjoying stable economic conditions of moderate growth and lately balanced budget in austere Germany to the envy of southern countries for long, I can confirm that inflation phobia is not the worst state of mind.

      Thus, your seemingly contradictory claim that “fiscal belt tightening… has caused more damage to growth…” is a bit puzzling. Or was it meant to point out the paradoxies of new or rather “alternative facts”, becoming more and more popular?

      The final recommendation to change opinion reminds me of the “new economy” bubble until 2000. Fortunately, my German phobia and contrarian resistance to change my opinion according to alternative short-term facts saved me from the severe consequences after 2000. Thus, I prepare for the worst and hope for the best as ever since the late 1990’s.

  2. James Weir says:

    Well done for having the presence of mind and clarity of thought to question dogma; when facts change you should indeed change your mind. And those points you raise are not the only questions conventional economics has struggled to adequately explain. May I suggest you read up on MMT, as many of your thoughts are aligned to its framework. I would further recommend you read serious work on it, not just journalists who mostly simply don’t understand it. If nothing else it will provide insight as to why fiscal austerity doesn’t work in situations like post-GFC Europe.

  3. Paul OBrien says:

    This is an important debate, but it contains a critical confusion:

    There is no “money printing.” At least so far.

    This is so for two reasons:
    1. “Money” no longer exists as distinct from “bonds.” The Fed and most central banks pay interest on reserves. So central bank “money” is just an interest bearing liquid government liability no different from TBills. And, of course, when interest rates are zero, even currency is just another zero yielding government liability.
    2. So far all central banks have done is swap their liabilities for other government liabilities. Total public liabilities are not changed. (One could argue that the Bank of Japan has explicitly funded new spending rather than doing a debt swap. But the amounts are not big enough to matter.)

    Does this mean we can relax about inflation? Of course not. Inflation is just the rate of decline in the exchange rate of government liabilities for goods and services. If the government creates enough liabilities and exchanges them for goods and services – or gives them to the public – that exchange rate will decline faster.

    Current low inflation does suggest public finances have been too conservative and central banks too inflation averse. But it doesn’t mean that investors can ignore inflation risk, especially as fiscal expansions grow.

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