What High Inflation Will Do To Your Bonds And Your Bank Stocks

Renowned economist Charles Calomiris highlights a troubling scenario where the budget deficit could have dire consequences for savers. His insights shed light on the potential challenges that lie ahead for depositors and banks alike.

Calomiris introduces the theory of fiscal dominance, which explains how a budget deficit can overpower the Federal Reserve’s efforts to combat inflation. This phenomenon could lead to persistently high inflation rates and compel the government to rely on an “inflation tax” on currency and bank deposits to meet its expenses.

Implications for Depositors and Banks: Concerns and Consequences

Calomiris emphasizes that large banks should not be considered immune to the impact of fiscal dominance. Depositors may seek to evade the inflation tax by withdrawing their funds from the banking system, resulting in reduced bank profitability. This scenario has occurred in the past, during the inflationary period of the 1970s, and may likely repeat itself, potentially leading to chronic 8% inflation.

Investor Anxiety and Government’s Limited Options

While Calomiris cannot accurately predict when this dire situation will materialize, he asserts that there will come a time when investors will be wary of U.S. Treasury bonds. As the government struggles to finance itself with increasing levels of debt relative to GDP, it will face limited choices: raising taxes, cutting entitlements, or resorting to the inflation tax. Political constraints make the first two options nearly impossible, leaving the inflation tax as a feasible alternative that can be implemented by the Federal Reserve independently.

Charles Calomiris: Economist and Expert in the Financial Sector

Calomiris, a prominent economist, and professor at the University of Austin, brings a wealth of knowledge and experience to his analysis. With a background in academia and as the former chief economist at the Office of the Comptroller of the Currency, he offers insights into the potential implications of fiscal dominance on the financial sector.

Dual Crisis: Banks Grapple with Bond Losses and Commercial Real Estate Risks

Banks are currently facing a challenging environment as they contend with two additional crises. They are experiencing losses on their long-term bond holdings, and there is a risk of further losses due to loans for commercial real estate. Calomiris himself is personally affected by this predicament, owning commercial property that has been negatively impacted by closures and economic disruptions.

Understanding the Inflation Tax: Impact on Currency and Bank Reserves

The inflation tax, as described by Calomiris, is presently imposed solely on the currency. With inflation at around 5%, the value of stored currency depreciates by $5 annually for every $100. The government seizes this $5, effectively using it to fund Social Security, Medicare, and other expenses. However, Calomiris explains that the inflation tax could also extend to bank reserves, significantly increasing the virtual income accrued by the government.

Potential Shift in Government Policy: Reserves, Deposits, and Inflation Tax Base

Currently, banks hold approximately $3.2 trillion in deposits within the Federal Reserve system, which is used for various banking operations. Although the Federal Reserve pays banks 5.15% interest on these balances, it has the authority to eliminate interest payments and mandate a certain reserve percentage on banks’ deposits. This adjustment would subject bank deposits to erosion similar to that faced by currency, reducing the interest earned by depositors.