Debt Reduction the Post-War Way

In the 35 years following the end of WWII, the rate of inflation exceeded the interest rate on our government’s debt about a quarter of the time. The so-called “real rate” of interest was negative, and materially so. In the estimation of Carmen Reinhart and Belen Sbrancia, in a paper published in March of this year, a negative real rate of interest resulted in America’s goverment debt, as a percentage of GDP, to be reduced by more than half in the decade following WWII. Without politically painful cuts to programs or large tax increases, the nation’s public debt burden was less than half of what it would have been otherwise (66% of GDP versus 141%) by 1955.We at Creekside have felt for some time that any solution to our national debt problem will involve extended periods of low, but grinding, inflation. Reinhart/Sbrancia have provided the depth and rigor to support what we have long suspected. The Federal Reserve and US Treasury Department have combined interests in past eras to simultaneously keep interest rates low, and inflation up in the mild single digits. Low interest rates are easy to support. What voter (and member of Congress) doesn’t like low interest rates? As for the low inflation (3-4%), we as a people tolerate it. Mild inflation is usually accompanied by some economic growth — and we tolerate mild inflation in exchange.

We will provide an in-depth analysis of how this outlook affects the expected return on a range of asset classes in our July newsletter. In light of this week’s 300 point drop in the Dow, we can remind clients and readers that we have had in place a strategy that anticipates the Reinhart/Sbrancia analysis for nearly two years. We are underweight stocks — holding about half of our normal allocation.

We do not own long-term bonds or US Treasury bonds. Those securities fail to compensate investors for what we believe to be the inevitable return of grinding mild inflation. After taxes, a ten-year Treasury bond provides a negative return 1.5 to 2.5 percent below the inflation rate that we expect. In contrast, we have bought extremely secure municipal bonds that provide an after-tax return of 1.5 to 2.5 percent above the rate of inflation.

This week’s market correction was, like all short-term movements, triggered by the current news cycle. And the news cycle has turned negative. That could turn in the other direction next week, and the market would head higher. No one can predict such things. We believe that stocks have little room to go higher since they are priced today in the top four market peaks of the past 100 years. Such pricing levels have universally led to corrections in the past, and we expect this time to be no different.

Watch for our July newsletter and a detailed treatment of what Reinhart/Sbrancia call the age of “Financial Repression.”