Can the West inflate away its debt?

The developed world is facing a policy paradox. It needs inflation to rid itself of enormous household and government debt. But it needs deflation to encourage firms to boost production and employment at home rather than transferring production to low-cost emerging economies. So how can central banks deliver moderate inflation and reasonable growth at a time of massive deleveraging?

We are all well aware that the trillion dollar question is who will shoulder the burden of all the debt the West has accumulated? So often in the past, inflation has been the option of choice even though it punishes domestic savers. But even if the intention is there, this assumes developed-world policymakers can choose inflation.

Policymakers in the Western economies still seem confident that they can – that they are entirely in control of their economic destiny. They have argued that the Great Moderation or 'goldilocks' period of strong growth and low inflation during the 1990s and early 2000s was largely attributed to the good policies of independent central banks. But this gives little credit to the idea that it was simply good luck – thanks to a series of positive supply shocks as emerging economies such as China and India boosted global output potential.

Who will shoulder the burden of all the debt the West has accumulated?

Now with the benefit of hindsight we see the goldilocks period wasn't quite so rosy. To absorb the goods produced by the developed and emerging worlds, the monetary authorities in the West had to create unsustainable bubbles – largely in the construction and government sectors. Only now that these bubbles have burst are we seeing the true deflationary force the emerging world is exerting on developed economies.

The developed world thus now faces that policy paradox. It must try to deflate domestic prices to compete with the emerging world but can only ease its debt burden by inflating domestic prices. A selfish solution would be to engineer a sharp decline in the real exchange rate by printing money. It is no surprise central banks haven't emphasised that this is one of the key channels by which quantitative easing is supposed to work.

That's not to say it is costless for those running the printing press, largely because of the impact of rising commodity and import prices. The UK has shown this problem only too clearly with import inflation running well ahead of domestically-generated inflation, resulting in a real wage squeeze and very little real growth. While printing money may solve unemployment in a small section of the population, quantitative easing policies can make the aggregate workforce worse off.

Is quantitative easing in the West simply being sucked into a monetary vortex in the emerging world? In part, yes. The current episode holds alarming parallels with the influx of gold and sterilisation by France and the US in the 1920s which ultimately led to the great depression. But quantitative tightening in the emerging world does have its own problems and limitations. First, an ever increasing amount of foreign assets must be bought to prevent currency appreciation. It is questionable whether this is the best use of the nation's savings. Second, not allowing interest rates to guide the allocation of capital often means a misallocation of funds. China is now dealing with the aftermath of a lending and property mini-boom.

So while inflation may seem the easy way out for over-indebted governments in the West – the West’s inflationary destiny lies in the East.

So while inflation may seem the easy way out for over-indebted governments in the West – the West's inflationary destiny lies in the East. The only way developed world central banks have stopped this goods deflation from becoming a more generalised disinflation in the past has been to create credit bubbles. Now, with the West's appetite for debt exhausted, this is more difficult, so the risk of a prolonged period of disinflation in wages and domestic goods and services is severe. This is a huge problem for the Federal Reserve. To meet its unemployment mandate, the Fed will require significant deflation in wages to compete with the emerging world. But then it will not only miss its inflation mandate, it risks sending the US into a debt-deflation spiral.

This is an unsatisfying and unsustainable situation for the emerging and developed world alike. Resolving it amicably will involve compromise: patience on one side and some real currency appreciation on the other. But politicians tend to be impatient. In 2012, President Barack Obama could be seeking re-election at a time when unemployment has been uncomfortably near 10% for four years. Blaming another part of the world may seem increasingly attractive: there is growing momentum in the US for a trade bill against China.

But what is clear is that despite the extraordinary monetary policy action taken in the developed world in the past few years to help tackle the high debt burden, we shouldn't be too concerned about inflation in the short term. We believe there is no need to run to gold as a safe haven from the end of the fiat money system and hyperinflation. This would still hold true even if the ECB joins the money-printing club.

Any sign of rising inflation should be seen clearly in the emerging markets before it reaches developed world shores. If global inflationary pressures do not pick up, governments in the West are going to find it hard to meet the promises made to their domestic populations and their external creditors. The only solution to this 'collective failure' of the global system that we see today involves a decline of G10 currencies against those of the emerging world. Geopolitical risk will continue to provide volatility, but staying exposed to emerging market assets and cash flows seems the right thing to do over the medium term.

This report must be read with the disclosures, analyst certifications and the disclaimer.