• Inflation is a policy with a purpose
  • Financial repression requires low interest rates and inflation
  • The inflation may be back soon

It may sound like some sort of conspiracy theory to argue that central bankers and politicians deliberately engineered the inflation we experienced. But, if we allow that they overdid it a little by even their own measure, this argument has plenty of evidence…

As the economist Ludwig von Mises explained, inflation is by definition a government policy:

The most important thing to remember is that inflation is not an act of God; inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy — a deliberate policy of people who resort to inflation because they consider it to be a lesser evil than unemployment. But the fact is that, in the not very long run, inflation does not cure unemployment.

Inflation is a policy. And a policy can be changed. Therefore, there is no reason to give in to inflation. If one regards inflation as an evil, then one has to stop inflating. One has to balance the budget of the government.

If only Labour’s James Callaghan had listened to that lecture 18 years before he famously told his party in Blackpool that they’d learned the same thing the hard way:

We used to think that you could spend your way out of a recession, and increase employ­ment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of infla­tion into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment. We have just escaped from the highest rate of inflation this country has known; we have not yet escaped from the consequences: high unemployment.

That is the history of the last 20 years.

Who could’ve seen it coming…?

But unemployment is only one malady that inflation appears to fix. Some of those who predicted our inflation today based their argument on the need to use it to reduce the government’s debt burden. And, just as Callaghan should’ve listened to von Mises in the 1950s, we should listen to those who foresaw today’s inflation coming in 2021.

So, let me put their argument together for you in simple terms – a narrative that you can easily follow… having experienced it already.

In the aftermath of the pandemic, governments around the world faced troubling debt-to-GDP ratios. They borrowed too much money to pay for lockdowns – a policy that also hammered GDP, worsening the debt-to-GDP ratio on both ends of the ratio.

There are three ways to deal with too much government debt, presuming you exclude default…

The first is what Liz Truss attempted – grow GDP faster than debt. Over time, your larger economy can carry the burden of the government’s debt by paying more in taxes.

The second option is austerity – less government spending. The trouble with this option is obvious. The way we measure GDP includes government spending in it. In fact, it’s the biggest part of GDP, by some categorisations. And so cutting one part of GDP in order to reduce your debt-to-GDP ratio looks counterproductive at first.

The third option is to inflate away the debt by devaluing the money it is measured in. If you promised your daughters a biscuit each if they finish their dinner, what stops you from splitting one cookie into two pieces to cut costs…?

Just as people’s mortgages half a century ago seem tiny by today’s standards, so too does government debt after a few decades of inflation have eaten away at it. Devaluing the pound devalues all debt denominated in pounds.

The trouble with this option is that daughters and lenders eventually wise up and don’t like it very much when you scam them. Investors aren’t willing to lend money to the government at 2% when inflation is 5% because they’re losing 3% once they head to the shops with their supposed profits.

Instead of putting up with this quietly, investors begin to demand ever higher interest rates to lend the government money. And those interest rates cost the government interest, defeating the purpose of the inflationary policy in the first place.

Similarly, if central banks foresee inflation and react to it by raising their interest rates, the ploy fails too.

The scheme only works if interest rates are kept low somehow. And so we have the second ingredient needed to cook up the stew known as “financial repression”: low interest rates.

For the government to pay off debt by way of inflation, it needs the central bank and investors to keep interest rates low. Preferably below inflation, so that lenders are outright dispossessed by their lack of returns relative to rising prices.

Here’s how Russell Napier explained all this to the Swiss website The Market in 2021, before inflation took off to the levels he predicted:

The most important part of my forecast is not the inflation rate per se. It’s that interest rates will not be allowed to reflect that rate of inflation. That is what changes the entire structure of finance. This is the key question: Will interest rates, short and long, be allowed to reflect 4% inflation? My answer is No. This is because we will be entering a period of financial repression, where governments keep interest rates below the rate of inflation, just like after World War II.

How do you trick central bankers and investors into ignoring inflation, so that they don’t raise interest rates and demand higher returns on the money lent to the government?

There are several ways. They might sound familiar.

First, the inflation comes as a surprise – some sort of shock. This allows the government to get as much debt financing as possible at the low interest rate that precedes inflation. Even if interest rates rise in the future to reflect inflation, the government’s interest bill on those bonds remains fixed until they mature and must be refinanced. Inflation eats away at their value in the meantime.

Second, inflation must be ascribed to some temporary act of God, as von Mises put it. By saying the cause and thereby the inflationary effect will be “transitory”, interest rates won’t rise. This also has the benefit of allowing the government to issue lots of debt at very low interest rates while investors presume inflation will come back down again once the “act of God” is passed.

The third option is to include central bankers in your cabal of financial repression. A government that is struggling financially is bad news for a central bank for a long list of reasons. And so, if you can convince central bankers that a period of financial repression is just what the country needs, then they will keep rates low for you, despite the inflation they’re supposed to prevent.

Of course, central bankers can’t be seen to be doing this publicly or the public will lose confidence in their inflation mandate and demand higher interest rates to lend to the government.

This explains why central bankers were so extraordinarily slow to react to inflation in 2022. They needed it to get out of control – that was their deliberate policy to help the government inflate away its debt.

Another way to keep rates low is to mandate the purchase of government bonds. By declaring them to be “risk free” under banking and insurance company regulations, as well as encouraging all pension funds to have bond allocations, the government can find willing buyers of bonds regardless of the interest they pay. They’re buyers of no other resort, blind assets allocators or bond funds.

All this combines to explain why and how inflation was let out of its box, if not propelled, by governments and central banks.

Why, then, do I say they’ve overdone it? Didn’t governments and central bankers get precisely what they wanted when inflation kicked off?

Maybe, but I suspect they overdid it given what has happened since.

The sudden need to raise interest rates, and the crash we saw in the bond market, suggest that governments and central bankers were surprised by just how much inflation we got. They were probably hoping for a few years of inflation slightly above interest rates, allowing a vast stock of government debt to be inflated away slowly. Boil the frog, and all that…

Instead, the inflationary burst they unleashed woke investors up to the threat of inflation and the absurdity of negative bond yields. Investors sold out, causing interest rates to spike in a panic.

In the end, central bankers could no longer pretend to be asleep at the wheel, with even their own staff protesting about inflation in some cases.

The reason I bring all this up is that it suggests the inflationary policy may not be over yet. The policy failed. Debt-to-GDP ratios are still too high. Governments and central banks may be planning a few more years of having inflation above interest rates in order to devalue the debt even further. There will be a few more inflation “whoopsies” yet.

You watch, before long, we’ll be back to quantitative easing and rate cuts to “stabilise the market”.

It’s important to note that such a devaluation via inflation can take place at many different levels of inflation and interest rates. If inflation is 2% and interest rates are 1%, that’s much the same effect as inflation at 5% and interest rates at 4%.

But, whatever the combination of inflation and interest rates ahead of us, do not forget the lessons we already learned the hard way in the 1970s. Inflation is a deliberate tool of government policy… that doesn’t work.

But it does have the power to dispossess you of your wealth, as President Reagan warned, “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” No wonder politicians use it on their citizens.

Until next time,

Nick Hubble
Editor, Fortune & Freedom