For a while now I have been on the fence on the inflation/deflation issue – whether the massive monetisation of bad debts by central banks and governments will lead to rapidly escalating inflation as currencies are debased or, alternatively, lead to deflation as bad debts and illiquidity undermine all commercial and financial activity in the economy. I’m now coming down on the side of deflation for a very simple reason: there is no longer any incentive to save or invest, and so debt and investment cannot increase much beyond current bloated levels.
In Lombard Street, Bagehot’s seminal tome on fractional reserve central banking, Bagehot advises any central bank facing a simultaneous credit crisis and currency crisis to raise interest rates. By raising rates they will ensure that foreign creditors remain incentivised to maintain the general level of credit available while the central bank resolves the local liquidity crisis through liquidation of failed banks and temporary liquidity support of stressed banks.
The very opposite policies have been pursued by central banks in the US, Europe and UK since the beginning of the sub-prime crisis in August 2007. They have cut policy rates drastically, and as the crisis escalated and spread, the yield on government debt has dropped to negative territory. Meanwhile they have shielded those responsible for the creation of record levels of bad debt from any regulatory accountability, relaxed transparency of accounts, and provided massive taxpayer-funded financial infusions to prevent failure and liquidation.
While in the short term these policies have expediency and the maintenance of market “confidence” on their side, in the longer term these policies must undermine any confidence a rational and objective saver or investor might have that savings or investment in the US, EU or UK will be fairly remunerated at an above-inflation rate, or that savings and investments will be protected by effective oversight and regulation from the sorts of executive debasement and outright misappropriation and fraud that are beginning to colour our perceptions of the past decade.
Anyone sitting on a pile of cash now is unlikely to want to either (a) place it in a bank, or (b) invest it in the stock market. As a result, the implosion of the financial and real economy must continue no matter how big the central bank’s aspirations for its balance sheet or the treasury’s aspirations for its deficit.
If US, EU and UK had substantial domestic savings to fund their banks (as in Japan in 1990), then perhaps the consequences would not be so imminently disastrous. Lacking sufficient domestic savings, however, their actions will likely make foreign creditors in Japan, China, the Gulf and elsewhere question whether it is worthwhile to keep pumping scarce savings into such flawed and reckless economies.
During the reckless boom years, savings collapsed in bubble economies as retail and commercial and financial actors alike chased speculative yields with greater and greater leverage. During the reckless bust years, savings will collapse further as retail and commercial and financial actors chase safety by hoarding their meagre remaining assets from further erosion by refusing to lend at negative returns and refusing to finance failed corporate and investment models that only enrich poltically-connected management and intermediaries.
The determination to avoid any accountability for failed banks, failed business models, failed regulatory systems and failed academic rationales for all the above invites anyone with spare cash – an increasingly select crowd – to withhold it from further depredations. It is this instinct, more than confidence in the government, which is driving so many to seek the temporary safety of short-dated government securities.
The result of discouraging domestic and foreign creditors and investors must be inevitable deflation as debt levels become increasingly hard to finance and ultimately contract. Irresponsible central banks and governments can try to bail out the failed banks, businesses and municipalities at the centre of every popped bubble, but the bubble economies are ever more certain to deflate with each bailout. Each bailout further undermines the market discipline which is bedrock to a saver or investor’s decision to part with hard-earned cash by trusting it to the intermediation of the management of a bank or business.
It’s this simple: I won’t invest in a country that bails out failure and punishes savers. I won’t invest in the US or UK until they change course and protect savers and investors, ensuring a reasonably predictable positive return. In the EU, I will be very selective, preferring those conservative states like Germany that never embraced the worst excesses, although sadly still have fall out from individual banks' stupidity in buying into foreign excess. I will know when it is safe to reinvest when policy interest rates, bank/intermediary oversight and accounting standards give me confidence I am better protected than the corporate or financial elite.
While it may take the Asian and the Gulf State investors longer to embrace my analysis, I have no doubt that they too will eventually conclude that parting with their savings under the terms now on offer will only deepen their losses. They would be better off keeping the money at home, investing locally under local laws and vigilance, and letting the US and UK implode.
The argument against this has always been that with trillions already invested in the US during the deficit years, the Chinese and Gulf States would suffer even more horrible losses from a collapse of the western economies. This is accurate, but not complete, as it ignores the relative value of cash investment at the top and bottom of a bursting bubble. Once the collapse has bottomed out, so long as a globalised economy survives, there will be even better opportunities for those with savings to invest selectively in businesses with clearer prospects and more certain profitability under regulatory frameworks which have been restored to a proper balance of investor protection and intermediary oversight.
Right now survival of businesses in the West depends largely on political pull and access to regulatory forbearance and central bank or treasury finance. The market has failed, and officialdom is collaborating in perpetuating that failure.
Should the western economies implode in deflation, however, there will be new opportunities to return to market-based policies that reward effective, efficient management and punish corrupt, debased management. Until that happens, those that invest will continue to lose money. Once deflation is exhausted, then those that invest can expect to make and retain profits again.
I think it took me so long to feel confident about predicting deflation because the floating currency system under dollar hegemony and Bretton Woods II distorts the workings of both inflation and deflation. Despite the US being the epicentre of all the failed debts, failed securitisations, failed credit derivatives, failed rating agencies, failed banking businesses, failed corporate governance, failed accounting standards, failed capital adequacy models, and failed regulatory forbearance, the US dollar has recently strengthened as deflation globalised. The US exported inflation in the boom years, and now exports deflation in the bust years.
Since spring 2008, as US investment banks sold off assets, imposed margin calls, and used access to unsegregated wholesale assets in custody in the rest of the world to upstream liquidity to their US-based parents and affiliates, the dollar has strengthened relative to other currencies. The media reports this as a “flight to quality”, but it is more like a last looting of the surrounding countryside before dangerous brigands hole up in their hilltop fortress. The brigands appear temporarily wealthy compared to the peons left stripped and penniless and facing winter. When the brigands have eaten all the stolen grain and livestock, however, they will have no means to replenish except to use force to raid the countryside again. The peons can always hunt, forage, farm and carefully husband a surplus to gradually increase their wealth. If the brigands raid too thoroughly or too regularly, the peons have no incentive to grow crops or keep herds (negative savings returns) and everyone starves (deflation).
In the meanwhile, the peons just might wise up, hide any surplus more securely and organise mutual defense against further attacks to ensure that their peon children prosper and the brigands die off. That would be the end of Bretton Woods II, and the rise of China, India, the Gulf and other productive and/or resource rich states which invest surplus in domestic productivity and regional growth.
I reread my piece on Fisher’s Theory of Debt Deflation in Great Depressions the other day. One of the more confusing aspects is his assertion that the dollar “swells” as debt deflation takes hold. What he meant, of course, is that deflation increases the quantity of assets and the likely investment return each dollar purchases as deflation wrings debt and misallocation of capital out of the economy.
It is now clear to me that policy makers in the West are determined to apply every available resource to underpinning failure, misallocation and executive excess. As this discourages the honest saver from parting with cash, policy makers are ensuring that deflation will wreak its havoc on the financial and real economies of the world. Only when that deflation has played out and rational policies that reward market-based management and returns are restored will it be worthwhile to invest again. In the meanwhile, any wealth saved securely from state seizure will "swell" to buy more assets in future - a key aspect of deflation and a key means of restoring the control of the economy into the hands of more farsighted savers and investors.
I have quoted Mr John Mill before, but it bears repeating: ““Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.” The extent to which capital has been betrayed in the past quarter century under Bretton Woods II, bank deregulation and the Basle Capital Adequacy Accords is unrivalled in the history of fiat banking. The bankers, lawmakers, regulators and academics who collaborated in the betrayal still hold power, like the well-armed brigands in the fortress, and their continued collaboration to prevent accountability must inevitably discourage honest savers from risking further loss. Even so, it is the savers/peons who hold the ultimate power as they can starve the brigands.
Some day soon savers will revolt at financing further depredations. They will refuse to buy even government securities, gagging at the quantities of issue forced upon them under terms of only negative return. When that final massive bubble bursts, deflation will follow its harsh corrective course and clean out deficit-financed “unproductive works”.
When that happens, if reason is restored in markets with effective oversight, I might consider investing again, very selectively, in whatever productive works might then be on offer and only when secure in realising - and retaining - a positive yield.
Apologies for not posting last Friday.
Writing for this blog has been a great experience, forcing me to refine my views about current events and the principles which should underpin financial market interactions and supervision. In parallel, I have been forced to re-evaluate whether I should commit to sorting out some of the practical aspects of the future of banking in the global economy. Writing takes a lot of time and passion, and these are limited commodities for any of us.
I have accepted a full time executive position which will take all of my time and passion going forward in 2009, so the blogging has to be suspended at year end. The job will enable me to put into practice the principles I’ve illuminated here, hopefully mitigating some of the impacts of financial instability. I’ll still lurk, and maybe comment on Professor Roubini’s thread from time to time.
Wish me luck!