The FT today has a dynamite article with the abovementioned title by Gavyn Davies, Chairman of Fulcrum Asset Management. As the title suggests, Mr. Davies speculates that the vast holdings of government debt create the possibility that central banks may forgive some of it so as to further stimulate growth. It’s a quite electrifying thought. In the U.S. and EU governments at all levels are grappling with the conflicting objectives of stimulating growth and reducing indebtedness. So far one can question their success on both fronts, especially in southern Europe where continued austerity is exposing its one-dimensional weakness in impeding exactly the type of real GDP growth necessary to reduce debt.
As a thought experiment it could appear quite alluring. After all, in the U.S. the central bank is part of the Federal government, so on a consolidated basis debt issued by the U.S. Treasury and held by the Federal Reserve simply nets out. The Wallace Neutrality Theory holds that because the public recognizes that this debt will ultimately find its way back into the private sector, its temporary residence at the Federal Reserve doesn’t alter behavior, similar to the way tax cuts funded by deficits don’t promote growth because households save more in anticipation of higher taxes later (Ricardian equivalence). Gavyn Davies is not a believer in the Wallace Theory, but rather than get into the theoretical difficulties instead consider the consequences of debt forgiveness.
The most compelling feature is that there is no obvious injured party. Putting aside for a moment the likely adverse market reaction of such a move, if the Federal Reserve did agree to a modification of terms on the debt it holds, there would be no direct private sector losses as a result. It could be done in many ways more subtle than a complete write-off, which might include taxing interest income to the Fed, extending maturities or even rolling over maturing debt at favorable rates. Carried out in small, incremental steps that sought to minimize any negative market reaction such an approach could be politically very appealing. At a time when Congress will be wrestling with a set of highly unpalatable choices involving spending cuts and tax increases, a modification in debt terms that was part of a wholesale improved fiscal outlook could gather populist support at a minimum. After all, if we owe the money to ourselves, which in effect we do for that component of the debt held by the Federal Reserve, why shouldn’t we be free to alter its terms.
All this of course creates the risk of increased inflation expectations and perhaps higher actual inflation down the road. The point of the thought experiment though is to highlight how politically such a course of action, in conjunction with other fiscally prudent moves, could happen. There’s no directly injured third party. If such a subject was broached without triggering a spike in bond yields (an important IF no doubt) it might gain support. Gavyn Davies notes in his article that one possible future Bank of England governor privately considers such a step worthy of serious consideration.
The fact that the steps outlined above are plausible albeit clearly not imminent supports the case for an investor to own assets that provide some type of inflation protection and to shun fixed income risk entirely. Companies with strong franchises and a history of earnings growth should represent an important part of any investor’s portfolio. For example, we like Microsoft (MSFT) which currently trades at less than 7 times 2013 earnings ex-cash on balance sheet and possesses two powerfully cash generative businesses in Windows and Office. We like owning the Gold Miners ETF (GDX) –although we don’t think gold is a good long term investment, the balance of risks and potential return as described above argue in favor of exposure to bullion. And Japan, with its lost two decades and periodic bouts of deflation, may be a candidate for the debt modification described above. We are long $/Yen through owning the ProShares Ultra Short Yen ETF (YCS).