This article was written by Nicholas Mitsakos : Chairman and CEO at Arcadia Capital Group.
Nothing to See Here
We’ve got nothing to worry about. Inflation won’t be an issue, unless…
Central bank independence and fiscal responsibility matter, even though the Western world is acting as if these rules no longer apply. Well, perhaps. But the world has given us three examples where the consequences are extreme when these basic foundations of economic policy are ignored or violated.
Expectations Matter
Ultimately, if markets lose confidence in a central bank’s independence and thoughtfulness (yes, thinking really matters), or a sovereign government’s fiscal responsibility (where thoughtfulness is never taken for granted), inflation expectations will undermine an economy and make recovery almost hopeless.
The impact of inflation in the developed world has interesting case studies in the developing world. While some of the emerging market’s politics and economic circumstances may not apply to the developed world, the world is coming out of an unprecedented convergence of events, including a global pandemic, spectacular supply chain interruptions, and fiscal budget experiments with unknown long-term consequences.
For now, in spite of high inflation in the developed world, with soaring food and energy prices, these advanced economies remain stable because central banks are assumed to be credible and independent. The assumption is that a thoughtful hand is on the tiller, and if things look to be getting out of control, appropriate actions will be taken to reduce inflationary pressure. However, this sanguine state can be disturbed, perhaps irreparably, if the assumption regarding central bank independence and ultimate fiscal responsibility is undermined and violated.
Specifically, while inflation in developed economies may or may not be under control, there are lessons to be learned from other economies about the consequences of interfering with central bank independence and fiscally irresponsible policies. Turkey, Brazil, and Argentina represent these potential consequences.
Turkey
Recep Erdogan, Turkey’s president, has taken central bank interference to an art form. While declaring himself an “enemy of interest earnings” he has pressured the central bank to lower interest rates in the misguided belief that that will bring down inflation. Of course, economics 101 tells us that the opposite is true, but since Turkey’s president is essentially an authoritarian dictator, these absurd antics are tolerated and have contributed to a spectacular capital outflow and a tumbling currency. Because Turkey’s lira has fallen so significantly, the rising cost of imports and the government’s control over economic activity has caused a combination of plummeting economic activity and extreme inflation, undermining the value of the lira even more, and placing what was otherwise a very promising economy 10 years ago into another emerging market basket case.
The sad case of Turkey is that prior to this authoritarian meddling, the economy was robust and even more promising, attracting sophisticated foreign capital and business discipline. Most of this has been undermined, eroded, or eliminated. The sad consequences are the destruction of wealth and economic prospects for the Turkish people.
Brazil
Brazil is a scary demonstration of how inflation can spiral out of control in spite of a reasonable and hard-working (and mostly) independent central bank. Fiscal irresponsibility on a profound scale drives this horror show. Brazil is no stranger to hyperinflation, with rates over 3,000% in the 1990s. While the country tried to place itself on a firmer foundation by adopting reasonable budget reforms and even enhancing the central bank’s independence, those reforms and that responsibility seem to be long forgotten.
In spite of a reasonable central bank, it is overwhelmed by a tidal wave of fiscal irresponsibility that even the best dams cannot withstand. Inflation is roaring again, and there is significant doubt as to whether or not Brazil’s sovereign debt levels are sustainable. Reduction in investor confidence and the downward spiral of both asset prices and currency values will undermine any economy. Combined with profound fiscal irresponsibility, and disaster looms. Brazil continues to be a case study of what not to do.
Brazil is rich in commodities and natural resources and therefore should have a foundation for stable economic growth. But its economy is undermined by the central government’s incompetency and corruption, weakening the currency, and driving interest rates skyward while undermining its currency. All this creates a toxic mix generating stubbornly high inflation. Import prices are up, prices earned on exports (in real terms) are down substantially, and interest rates are rising – making the debt sustainability worries for Brazil’s sovereign debt worse. All this weakens the currency further, and the central bank is left unprotected on the battlefield with no ammunition left. Brazil’s currency, the real, has dropped almost 3% in one month alone even though the central bank raised interest rates that same month by almost 2%.
Brazil’s economy goes against all economic theories and continues to prove the point that it is confidence and expectation that drive outcomes more than any specific actions. There really is no such thing as a “near-term fix.” We know what the long-term will bring, and the market simply cannot be fooled with sleight-of-hand.
Argentina
What happens when a central bank lacks independence and a central government lacks fiscal discipline? Welcome to Argentina.
This country is a perfect storm of central bank interference and fiscal irresponsibility. The government has long relied on printing currency to cover budget deficits. Attempts at reasonable monetary policy, which take years to develop effectiveness and stability, are consistently cut short by populist regimes. The central bank’s till is constantly under pressure to be pilfered by the central government declaring them to be “the people’s money” to be doled out irresponsibly and corruptly.
The market knows this and reacts appropriately giving Argentina’s government almost no confidence or benefit of the doubt to get its act together. While it can tell a compelling story on occasion, and the IMF is more than willing to underwrite incompetence and willful disregard for reasonableness, the markets are less patient. It does not take much to see the effect of increasing the money in circulation by over 50% while the value of the peso, Argentina’s currency, has fallen over 60% against the dollar this year alone. It is a train wreck that gets an occasional reprieve, but incompetence ultimately prevails in Argentina.
The market’s expectation drives Argentina’s access to debt markets, and without the IMF, the country’s fiscal irresponsibility and central bank meddling would cause its people to pay a draconian price of economic misery and little hope of recovery.
When any government claims to run the economy “for the people” cover your wallet, as financial markets and investors always do, because what it really means is profound corruption, inefficient policy, central bank interference, and ultimately, unavoidable disaster.
What About Us?
While Turkey, Brazil, and Argentina represent global basket cases, perhaps because of the underlying strength and resilience of its people, its economic circumstances may yet be salvaged. But there are valuable lessons here.
Policymakers in rich developed countries seem to be ignoring the lessons of central bank interference and irresponsible fiscal policy. There are enormous economic and budgetary costs associated with this kind of irresponsibility, and when combined with the convergence of the pandemic’s impact, supply chain disruption, uncertain economic recovery, and instability, we are seeing policy in the developed world suggesting a departure from well-established standards for monetary and fiscal policy.
The consequences are obvious when we look at the disastrous examples of Turkey, Brazil, and Argentina, among others. Western governments are not immune to fundamental economics and the impact of irresponsible management.
Where are You from Again?
Inflation does not discriminate when it is given the fuel to burn brightly. The US, UK, and Western Europe are blessed with an underlying confidence that the market trusts they will stay within reasonable bounds and continue to keep their act together. These governments are dangerously close to crossing a line that markets will find unforgivable, and the inflationary Kraken may ultimately be released.