Debt: The 4 Tools that Central Banks Use to Reduce It
Inflation is getting to all of us, but bigger problems are ahead. Do you know what those are and what the central bankers will do to solve them? We are not in their mind, and we can’t predict what they will do. But we can take a look at the options available and estimate what will be the most probable scenario. Whatever that may be, it will affect all of us, so we better get to it, and let’s prepare accordingly.
High debt levels are the problem
That’s right; inflation is the issue at present. Although looking further into the future, debt will be the next problem. If it remains out of control, it could bankrupt the government.
That is the reason why it is important that the debt levels get addressed, so governments don’t go bust. And we, citizens, can enjoy the benefits of living in a well-run developed economy, such as public health care system, job security, etc.
According to Brian Hirschman: Since 1800, 51 out of 52 countries that have crossed the 130% debt to GDP threshold, couldn’t meet their obligations. With this in mind, think that the US, Japan, and half of the EU have already crossed that threshold. Clearly, the odds are not in our favor, so what will policymakers do about it?
The 4 Tools that Policymakers Use to Reduce Debt
As individuals, we should aim to understand the actions of the central banks. Those have a direct impact on our lives. So if we can estimate what is coming, we might be able to take measures that would benefit us.
So what are the tools central banks can adopt to reduce debt? Ray Dalio, the famous investor, has the answer for us:
- Austerity: Central banks would cut spending. That means less money available in the system.
Imagine that you and that annoying neighbor of yours need a mortgage. There is little money available, so the bank can only lend to one of you. Both of you guys would compete against each other, offering the highest possible interest to the bank in order to get the money. Your cost of capital just increased.
Your neighbor didn’t get the mortgage and couldn’t fix his kitchen. That means less money for the repair guy that would have been hired. You got the mortgage, but since your cost of capital is very high, you don’t have enough to go to the restaurant around the corner. That means less money for the restaurant guy.
As you see, economic activity slows down. In real life, the central bank is the bank from our example and the annoying neighbor is the government. This last has to compete against you, the private sector, to finance itself, elevating interest rates and slowing down economic activity in the process.
That means pain for the citizens because companies would close, people would get fired and public services would be reduced. In summary, this would be highly unpopular.
- Debt defaults and restructuring: This would mean that the government would stop paying its obligations. It would be like, “Hey guys, do you know all that money I owe you? So forget about it. Byeeee”.
This would be an extremely politically unpopular measure. The market would lose confidence in the government, and they would not be able to borrow money. And, international pressure from other countries would increase because they would want to get paid.
In the end, the government would have to continue applying other tools. Because after defaulting, no one would want to lend them money. So they would have to go into full austerity mode, or they would just take the money from you via taxation or inflation. - Wealth redistribution: The infamous “Tax the rich”. This is about taking wealth from those that have more and redistributing it through those that have less. Some of the problems with this are:
Wealthy individuals would move their assets elsewhere. This would be bad for the value of the currency. Wealthy individuals also have the most influence. They could trigger a political backlash that would go against the government’s interests.
Or to make up for the tax loss, some companies would lay off people or pass the tax to the consumer. In any case, it sucks for the citizens. - Printing money: Ultimately, governments could print more money to pay their obligation. This has the risk of affecting the value of the currency and definitely, would keep the inflation rate at high levels. In the end, this is just a sneaky way of taxing citizens, not only on what they consume but also on what they have saved.
These would be the least unpopular choice. Wealthy individuals know how to protect themselves so there wouldn’t be a political backlash. At the same time, most people don’t understand well what inflation means, thinking in some cases that they are getting richer instead of poorer.
What can we conclude based on this?
We can take two ideas:
The first is that sometimes, we distance ourselves from government affairs and think that the government debt is not ours, so we don’t hold the government accountable. Now that the debt bubble is about to burst, we can see that all possible tools policymakers can use will affect us. And in the end, it will be us, the citizens, who pay for it via taxes, inflation, or with our jobs.
The government’s budget is our budget.
The second idea is that from all the possible available tools, printing money is the less politically costly one. Therefore, the most probable scenario is that the policymakers will go for that. If so, we will have elevated inflation levels in the following years, allowing us to start preparing now.
So what to do then?
Your savings need protection. You have to figure out what is the best way for you to protect them. You can get some inspiration from my previous post.
Consider that if prices continue to rise in the upcoming years, cash will decrease its purchasing power. So, allocating part of your savings to some real tangible assets might be a good idea. Examples of that would be precious metals, land, real estate, commodities, bitcoin, etc.
Just bear in mind to research and understand what you are getting yourself into. Everything involves risk, but don’t get discouraged by that. Think that doing nothing is the riskiest of the choices.
What we are experiencing right now in the economic/political space has happened before in history. So for more academic information, you can get for free Ray Dalio’s books by signing up on his website principles.com
If you want an educational video talking about more in detail of the same issue described in this post, you can check Mark Moss’s channel.
And last but not least, share this post on your social media to raise awareness and support my blog 😉
