The Great Reflation: How Investors Can Profit from the New World of Money

Chapter 4. Government Deficits and the Great Reflation

When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having being fairly and completely paid. The liberation of the public revenue, if it has ever been brought about at all, has always been brought about by bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment.

—Adam Smith^[26]

The crash, panic, and Great Reflation have unleashed an explosion in public debt that will last for years. This will have a profound effect on investors' portfolios and their ability to protect, and it is hoped, expand their wealth in the future. Like all experiments, the Great Reflation will have an uncertain outcome and investors owe it to themselves to understand how the financial world will be transformed by unprecedented peacetime fiscal deficits.

Chapters 2 and 3 discussed the debt supercycle and its role in the asset inflations of the past 25 years. Burst bubbles created by too much debt destroy balance sheets by causing asset prices to fall sharply. Liabilities, which are on the other side of the balance sheet, are fixed at any point in time. The difference between the two is net worth, or equity. The bigger the actual or expected fall in asset prices, the greater the risk that lenders won't get their money back. Their fear sets in motion a process called balance sheet recession, a term coined by Richard Koo,^[27] a recognized ...