There’s a reason for the record steepness in the yield curve these days. The huge gap between short-term and long-term borrowing rates isn’t just because capital markets quite rightly don’t believe that today’s virtually free borrowing rates in the money market are going to last. It’s also because of something a little more lasting than central banks’ current infatuation with near-zero interest rates.
Inflation may be a dirty word in the bond market, but it’s soon going to be a siren’s song for governments as they struggle to finance their mountains of newly minted public debt. Trying to reflate yourself out of a debt crisis may conjure up memories of the monetary histories of Brazil or Argentina, but good old Uncle Sam has a pretty good track record himself. And in some cases, he faced deficits that, in relation to the size of the American economy, were half of what he faces today.
Bondholders who financed World War II were repaid for their patriotism by a huge bout of post-war inflation that robbed them of nearly 15 per cent of their real return. Those who bankrolled the Korean War didn’t get hit quite as badly, but the resulting rise in inflation nevertheless whittled away at their returns as well. The folks who financed the Vietnam War deficits got burned the worst—the triumphant return of double-digit inflation swindled them out of nearly a third of the return they were owed from their US Treasury bonds.
Without fail, monetizing large government deficits has triggered massive rises in inflation in the United States and elsewhere. In the US, the huge deficits that followed on the heels of World War II saw inflation peak at almost 20 per cent in 1947. When they ran the printing presses to pay for the Korean War, it jumped from negative territory to nine per cent in less than a year. And when the Federal Reserve Board once again greased the presses during the Vietnam War, inflation soon made a triumphant return to double-digit territory.
Monetizing deficits has never been more attractive for the United States, which today benefits from its foreign lenders’ willingness to be repaid in US funds, putting them at the mercy of the US dollar exchange rate. The easiest way to stiff your foreign creditors is to devalue your exchange rate, and the fastest way to do that is to stoke your inflation rate.
Back in the old days, when Uncle Sam swindled his creditors through inflation, he was burning his own taxpayers, since Americans owned over 90 per cent of US debt after World War II. Today less than half of America’s debt is domiciled in the country.
Why screw your own taxpayers when you can screw somebody else’s?