Euthanasia of the Lender

Stocks have benefited mightily from falling interest rates and the support they provide for rising earnings multiples, both over the last decade, and during the last year in particular. One pillar underlying the revaluation is the somnolence of inflation. It has defied many forecasts and failed to rise as many expected. The reasons for that are debated, and the causes are not as well understood as we might have expected, given its importance.

A recent book attempts to do so. The Great Demographic Reversal, by Charles Goodhart and Manoj Pradhan, ventures onto ground that is usually avoided because its conclusions are subject to so much uncertainty.

Inflation, once thought to be well understood in the days of Milton Friedman as “always and everywhere a monetary phenomenon,” is in fact not that at all. To Goodhart and Pradhan it is a demographic question, the key to which is the remarkable emergence of China as the factory to the world. The demographics, due in part to the sheer size of the population, produced a positive shock to the supply side of the world economy that depressed the relative prices of tradable goods. Its effect has been, in their view, the primary cause of the decline in inflation that has confounded so many predictions:

For most of the history of the last two millennia, China was a dominant force in the world in both innovation and growth. Its workforce has been trained in efficiency through guilds and the absorption of innovation that initially came mostly from within China’s own borders. That culture of training and organisation allowed China to absorb technology from outside its border with a discipline that few advanced economies could match, aided by an administration that remains more single-minded and unencumbered than any other.

If there is a case to be made for China driving globalisation, its demography would be a key foundation. The ratio of China’s population to the world’s has actually fallen since 1955. Thus, it is not the relative size of China’s population, but the accelerated rate at which its labour force integrated into the global economy that has mattered. (p. 41)

Three events that were more or less coincident with these demographics were Deng Xiaoping’s “socialism with Chinese characteristics” beginning in 1992, China’s membership in the World Trade Organization, and its aggressive response to the Global Financial Crisis in 2008-09. But the latter of these three combined with the aging of China’s population to create another transition:

The year 2012, however, marked the beginning of the end of China’s demographic contribution to the world. Unsustainable credit growth is usually seen as borrowing from the future. The prior surge of credit in China then brought forward a slowdown that would otherwise have been a few years further into the future. Over 2014-15, China’s manufacturing and property sectors saw a major slowdown. Along with the coincident slowdown in emerging markets and global manufacturing, China’s slowdown contributed to the dramatic fall in oil prices from nearly $150 a barrel to $27 in 2015 and a collapse in global trade. (p. 48)

Demographics are not typically the key independent variable in economic analyses. But it is hard to deny their importance. It may be, in fact, that their exclusion from typical forecasts helps to explain why so many of them go awry. Most forecasts are relatively short-term in scope, and demographics are too glacial in speed to qualify for inclusion.

It is therefore worth considering what Goodhart and Pradhan describe as their most important conclusion. That is that inflation is set to rise at a rate that is not even close to being priced into financial markets:

The re-birth of inflation is our highest conviction view among the effects of demographics, and it is one that both financial markets and policy-makers are dismissing at their own peril. (p.101)

The aging of many countries’ populations is a primary component of the change they anticipate. The demand for, and supply of, labor along with the balance of savings and investment contribute also. But the logic of demographic effects is simple:

Dependents (the young and the old) are purely consumers and hence generate an inflationary impulse through production, whereas workers can offset this inflationary impulse through production. If the growth rate of workers in the economy outweighs that of dependents (as was the case during the demographic sweet spot), the world will go through a period of disinflation as it has for the last few decades. Over the next few decades, the rate of the growth of dependents will outstrip that of workers. (p. 102)

Such a forecast cuts against the grain of prevailing opinion. Chart 1 shows the inflation rate that is priced into financial markets in the U.S., based upon the difference in yield between fixed rate nominal Treasury bonds and Treasury Inflation Protected Securities (TIPS), which is often known as the breakeven rate:

Graph showing inflation rate priced into TIPS versus nominal treasuries

The stakes are higher than that series would imply, however, since TIPS were only issued for the first time in 1997. The second chart looks instead at inflation since 1950:

Graph showing inflation from 1950 to 2020

Optimists would claim that the darker days of the 1970s were before the Federal Reserve officially adopted an inflation target of 2% in 2012. But the question remains whether that is a hard target, or a softer one. In August of last year, the Fed softened the target by allowing inflation to run higher than their target for a period of time, the duration of whichis now unspecified.

So perhaps the case for higher inflation is building. There are two related issues that will contribute to framing the financial markets over the coming couple of decades. The first is debt, and the second is interest rates—particularly real interest rates.

Debt is a problem. In Chart 3 we show U.S. nonfinancial debt to GDP:

Graph showing percent of U.S. nonfinancial debt to GDP

High debt loads are deflationary at ever-higher levels. Loans or bonds are enforceable claims—if the borrower fails to pay, the lender can foreclose, one way or another. Ultimately, the answer to debt levels such as this is inflation. That was how the U.S. effectively delevered after World War II, with the inflation of the 1970s contributing materially to reducing the burden.

Goodhart and Pradhan acknowledge the likely answer to the debt issue:

But what will then happen as the lock-down gets lifted and recovery ensues, following a period of massive fiscal and monetary expansion? The answer, as in the aftermaths of many wars, will be a surge in inflation, quite likely more than 5%, or even on the order of 10% in 2021, (assuming that the pandemic gets tamed by the end of [2020]—the longer the outbreak takes to tame, the weaker will be the ensuing surge in real activity and then inflation). (p.278)

It is too early to quantify an increase in inflation. Higher inflation would keep real interest rates low. But financial asset valuations are set over time by real rates plus an inflation premium. If the latter is set to rise, it may jeopardize current elevated financial asset levels. In the end, the most probable outcome to the debt problem is covert euthanasia of the lender—inflation.

Reference: Charles Goodhart and Manoj Pradhan, The Great Demographic Reversal, Palgrave Macmillan, 2020.

John R. Gilbert

John is a Senior Research Consultant and whose primary responsibilities include contributing differentiated macroeconomic perspectives as well as providing industry and company research.

In addition, he writes investment commentary, which is published on our website.

John has worked in the investment industry for over 45 years. He was formerly our Director of Research. Prior to joining BFS, he was the Chief Investment Officer at New England Asset Management, Inc.

John has achieved the designations of Chartered Financial Analyst® and Certified Public Accountant.


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