Damien Grant: Borrowers win if inflation used to cut debt

Imagine owning the National Mint. If you needed something you'd simply print cash. No need to work, borrow or trade.

Many governments have done exactly that and the result is well known: inflation.

To resist temptation governments placed the National Mint, now known as a central bank, in the hands of inflation-obsessed, flinty-eyed economists. New Zealand did this in 1989 with the Reserve Bank Act, freeing the Reserve Bank from political control.

We have enjoyed low inflation ever since.

One advantage of this arrangement is a willingness of lenders to buy New Zealand government bonds, believing that the government cannot print money to repay the debt.

This has allowed the current Government to run a deficit expected to be 9 per cent of our gross domestic product with borrowed money.

The current plan is for a return to surplus in five years. Government debt will still be less that 60 per cent of GDP and sustained economic growth will lift us out of the mire. It's possible.

An alternative narrative is that no government in an MMP environment will have the political courage to deal with the structural deficit in the Crown accounts, the debt mountain will continue to escalate and lenders will become nervous about advancing further funds.

The easiest way to resolve the dilemma of an unstoppable deficit train and an immovable debt mountain would be to print New Zealand dollars, letting inflation reduce the real value of government debt.

The Reserve Bank Act won't prevent this. The act merely forces the Reserve Bank Governor and the Minister of Finance to explicitly agree on central bank priorities.

Those priorities can include 6 per cent inflation and it is not uncommon for central banks to miss targets. The Bank of England enjoys a similar degree of independence yet has been helpless as inflation runs at twice its 2 per cent mark.

Politically, printing money is attractive. Less than 5 per cent of our debt is denominated in foreign currency and 57 per cent of government debt is owed to foreigners. In times of inflation, real assets such as gold, property and equities have appeal. But real wealth is gained by those with leveraged positions.

They borrow cash, preferably from people confident inflation will stay low, to buy tangible assets. Inflation will erode the value of the debt, resulting in a wealth transfer from the lender to the borrower.

Investing is about taking a bet on the future. If you believe in the second narrative, invest accordingly. Buy shares in firms with good cash flow but high debt. Take fixed-interest loans and buy property or invest in your business.

In an inflationary environment, savers are punished and borrowers rewarded; the young win at the expense of the old and the profligate prosper while the prudent are penalised. If you cannot be young, you can still borrow and be profligate.