Inflationary Depression — Causes & Cures

Key takeaways

• Inflation is a measure of the rate of rising prices of goods and services in an economy.
• Currency depreciation is a fall in the value of a currency in terms of its exchange rate versus other currencies.
• Inflationary depression is a period of severe economic depression characterized by high inflation rates.

Causes of Inflation

• Cost-push inflation occurs when prices increase due to increases in production costs, such as raw materials and wages. The demand for goods is unchanged while the supply of goods declines due to the higher costs of production. As a result, the added costs of production are passed onto consumers in the form of higher prices for the finished goods.
• Demand-pull inflation can be caused by strong consumer demand for a product or service. When there’s a surge in demand for goods across an economy, prices increase, and the result is demand-pull inflation. Consumer confidence tends to be high when unemployment is low, and wages are rising — leading to more spending.

Figure 1: What is Inflation

• Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs/wages to maintain their standard of living.

Expansionary Fiscal Policy & Debt

• Expansionary fiscal policy by governments can increase the amount of discretionary income for both businesses and consumers. If a government cuts taxes, businesses may spend it on capital improvements, employee compensation, or new hiring. The government could also stimulate the economy by increasing spending on infrastructure projects. The result could be an increase in demand for goods and services, leading to price increases. This leads to inflation rates becoming higher than interest rates which is bad for bondholders since they aren’t compensated for their investments.
• The government expands the money supply in the economy. It uses budgetary tools to either increase spending or cut taxes. That provides consumers and businesses with more money to spend. It boosts economic growth over the short-term.

Figure 2: How did US debt get so big?

Currency Depreciation

• Currency depreciation can occur due to factors such as economic fundamentals, interest rate differentials, political instability, or risk aversion among investors.
• Countries with weak economic fundamentals, such as chronic current account deficits and high rates of inflation, generally have depreciating currencies. Currency depreciation, if orderly and gradual, improves a nation’s export competitiveness and may improve its trade deficit over time. But an abrupt and sizable currency depreciation may scare foreign investors who fear the currency may fall further, leading them to pull portfolio investments out of the country. These actions will put further downward pressure on the currency.
• Easy monetary policy and high inflation are two of the leading causes of currency depreciation. When interest rates are low, hundreds of billions of dollars chase the highest yield. Expected interest rate differentials can trigger a bout of currency depreciation. Central banks will increase interest rates to combat inflation as too much inflation can lead to currency depreciation.
• Additionally, inflation can lead to higher input costs for exports, which then makes a nation’s exports less competitive in the global markets. This will widen the trade deficit and cause the currency to depreciate.

Political factors

• While economic fundamentals for the most part determine the value of a currency, political rhetoric can cause a currency to fall as well. Between 2015 and 2016, the U.S. and China were repeatedly in a battle of words with regards to each other’s currency value. In August 2015, the People’s Bank of China (PBOC) devalued the country’s currency, the yuan, by roughly 2% against the U.S. dollar. Chinese officials said the move was required to prevent a further slide in exports.
• In 2019, the Trump administration labeled China a currency manipulator, saying Chinese officials were purposely devaluing its currency, leading to unfair advantages on trade. In 2018, U.S.-China political rhetoric turned toward protectionism that resulted in a long-term trade dispute between the world’s two largest economies.

Effects of high debt

• When the national debt is below the tipping point, it improves your life. Government spending contributes to a growing economy. When the debt is moderate, it can boost GDP enough to reduce the debt-to-GDP ratio.
• When the debt exceeds the tipping point, your standard of living will slowly deteriorate. It’s like driving with the emergency brake on. Debt holders demand larger interest payments. They want compensation for an increasing risk they won’t be repaid. That increases interest rates and slows the economy.
• It puts downward pressure on a country’s currency. Its value is tied to the value of the country’s bonds. As the currency’s value declines, foreign holders’ repayments are worth less. That further decreases demand and drives up interest rates. As the currency declines, imports become more expensive. All these factors coupled together contribute to an inflationary depression.

Lebanon’s Financial Crisis

Lebanon has a long history of high public debt and imbalances. Remittances started slowing from 2011 as Lebanon’s sectarian issue led to more political chaos. The budget deficit rocketed and in 2016 and banks began offering remarkable interest rates for new deposits of dollars. Lebanon’s central bank introduced “financial engineering”, a range of mechanisms that amounted to offering banks lavish returns for new dollars. What was less obvious — and is now a point of contention — was a rise in liabilities so it was going through big losses. The government’s failure to deliver reforms after the 2018 election meant foreign donors held back billions of dollars in aid they had pledged. The final spark for unrest came in October 2019 with a plan to tax WhatsApp calls causing mass protests. Foreign exchange inflows dried up and dollars exited Lebanon. Banks no longer had enough dollars to pay depositors queuing outside, so they shut their doors. The currency collapsed, sliding from 1,500 to the dollar to a street rate of as much as 8,000.

How to solve the issue of rising debt?

• Issue debt with bonds.
• Interest rate manipulation.
• Cut government spending.
• Raise taxes.
• Shift spending to more promising areas.

Figure 3: 4 ways the United States can pay off Its debt

How can investors hedge its portfolio against such events?

• Diversify portfolio across global markets to capitalize on emerging market trends.
• Closely watch leading catalysts like GDP, currency valuations and real estate market and reallocate accordingly.
• Avoid holding cash or cash like instruments because they lose value during inflation.
• Avoid investing in bonds because they lose value when inflation rate is higher than interest rates.
• Explore safe asset classes for store of value e.g., gold and crypto currency.

References

1. https://www.reuters.com/article/uk-lebanon-crisis-financial-explainer- idUKKBN268223

2. https://www.investopedia.com