Bryan Caplan, favorably citing Sumner, tells us “stop worrying about inflationâ€
Supposedly we should stop worrying about inflation, because the bond markets predict only moderate levels of inflation. Supposedly we can determine future inflation by looking at the difference between Treasury Securities, and Treasury Inflation Protected Securities. Supposedly, this tells us what the people investing in securities think that inflation will be, and they are pretty good at predicting inflation.
However, this tells us only what people who are confident that inflation will be moderate think inflation will be, because if you are worried about immoderate levels of inflation, you do not diversify into long term Treasury Inflation Protected Securities, you diversify into gold, silver, guns, ammunition, rice and beans, which is roughly what the Chinese are doing, except that they are also diversifying into copper and iron, and private Chinese are not allowed to diversify into guns and ammo.
The bond market does not tell us what the smart money people think inflation will be. It tells us what those among the smart money people who do not expect very high levels of inflation think inflation will be.
What are the Chinese worried about?
They are not worried about the possibility four percent inflation in 2011. They are worried about the possibility of four hundred percent inflation in 2020. And so they are not buying Treasury Inflation Protected Securities. And so the difference between Treasury Securities and Treasury Inflation Protected Securities fails to reflect their concerns. And so, if we look at the bond market, what it tells us is that the Chinese think inflation may well hit four percent in 2011, but does not tell us what they think inflation will be in 2020. But if you listen to what they are saying, what they are saying is that they think there is a substantial risk of very high levels of inflation in eight years or so.
Governments tend to go down the tubes when total public debt is around two hundred percent of GDP or so. Thus a deficit of ten percent of GDP or so is sustainable for ten or twenty years or so. Trouble is that in addition to an on budget deficit of ten percent or so, there is also a much larger off budget deficit, in the form of an ever growing pile of government guarantees, which there is no will to restrain. Put the two deficits together, crisis looms.
Trees do not grow to the sky. That which cannot continue, must stop.
This is kind of cryptic although probably right. If you thought that there was likely to be high inflation and nothing else then diversifying into TIPS would be a fine plan. TIPS pay inflation rate + real return, where real return is fixed in advance, and so guarantee against capital loss via inflation. The reason buying TIPS is a loony strategy if you expect hyperinflation is that the conditional probability of a bunch of other bad stuff (depression, civil unrest, political instability, trade break-downs, etc) is so high conditional on US hyperinflation.
It is these other things which TIPS do not hedge against but which rice, beans, and guns do. Moving to Switzerland (or obtaining or maintaining the ability rapidly to do so) would probably be a better hedge, however.
If lots of the big money people come to expect hyperinflation, we should see interest rates on both TIPS and regular treasury securities rising a lot, with the TIPS rising only somewhat less.