More on US Inflation

Economist's Buttonwood column published an article exploring the future of US treasuries. Here is a small excerpt:

America does not formally need to default to penalise its creditors; it can simply let its currency decline. Short-dated Treasury bonds (those with a maturity of one-to-three years) have returned a healthy 18% in dollar terms over the last three years. But when translated into Chinese yuan that return dwindles to just 0.3%.

History is full of examples of sovereign nations failing to pay their overseas creditors in full. When push comes to shove, governments are unwilling to impose the required level of austerity on their voters. This happened in the 1920s Weimar Republic, which opted for hyperinflation rather than paying the reparations bill, and in 1930s Britain, which abandoned the gold standard in the face of the Depression. (Note the results of the recent referendums in California, where voters rejected all budget-balancing proposals.)

In countries that are frequent offenders, including those in Latin America, foreign creditors have in the past demanded that government debt be denominated in a foreign currency. America has been able to borrow in dollars. However, for foreign investors, that means Treasury bonds are not risk-free at all.

Even domestic investors might reflect on the potential for inflation to erode the real value of their holdings. Inflation-adjusted, the capital value of Treasury bonds fell by more than five-sixths between 1962 and 1981.

Inflation-linked government bonds ought thus to be a more appropriate risk-free asset than conventional bonds. Foreign investors might calculate that, over the long run, a dollar decline would be matched by higher inflation, for which they would be compensated. However, the index-linked market is a lot less liquid than that for conventional debt. And cynics might wonder whether governments will really meet their obligations when faced with runaway inflation, rather than finding a way to “redefine” the statistics.

So what might replace Treasury bonds as the global risk-free asset? Some would opt for gold, although it pays no yield and its nominal value is highly volatile. China has no asset that seems appropriate. What about German government bonds? Fiscal policy is relatively prudent and the European Central Bank seems far more committed to fighting inflation and maintaining a stable currency than other monetary authorities.