The big (double-)dipper

I concluded my previous article with the observation that

in many regions of the world, the inevitable lag between cause and effect has seen a more slowly growing stock of money meet with a higher basket cost of goods. This is a toxic combination with which to confront such sickly economies, one which is now leading to a diminution of demand and, ipso facto, to a deceleration of the pace of those same price rises, as the inflationary impetus behind them slackens. Far from being an idiosyncrasy, this is no more than a normal, cyclical overlay on what are admittedly very abnormal underlying conditions.

In this, we can see the nucleus of an explanation for the recent downturn in the economic indicators as well as both the current and expected underperformance of many companies. In a world where the job of economic ‘recalculation’ has been falsified by heavy government intervention and where entrepreneurial repair-work has been paralysed by the elevated levels of uncertainty surrounding both the policy outlook and the fundamental soundness of so many customers, suppliers, and even competitors, such recovery as has been achieved, has been rooted in shallow, infertile soil. Thus, the adverse reaction to the diminuendo of many stimulus programmes has been all too predictable.

As such, this rollercoaster of incomplete recuperation, alternating between stimulus-driven boomlets and stimulus-starved mini-busts – with each successive switchback attaining lesser new peaks of output and generating more inflationary friction earlier in the ride – is something we foretold way back at the start of the crisis.

It may seem a long way off at this juncture – and the possible consequences of a Euro break-up or a gross miscalculation on the part of China’s central planners in the interim add an extra seasoning of doubt to the question of timing – but, as we seem otherwise destined to repeat this pattern for the foreseeable future, we can hardly hope to diminish the risk of repeating the mistakes of the 1960s in all their dubious glory.

Unwilling to countenance any increase in unemployment, those in charge of monetary policy will ease the pressure on the gas pedal only grudgingly and will effect the merest feint at the brakes when the bus starts fishtailing too wildly through the esses. The minute, however that any speed is lost or any of the passengers fall out of their seats and into the unemployment queue, the pedal will be planted firmly to the metal once more. And, yes, Mr. El-Erian and all you other naysayers, there is still enough in the tank to get the tyres smoking – as this whole series has been arguing from the start.

Eventually, of course, the passengers will learn to anticipate what the driver is going to do and will start to rush, en masse, to the outside of each approaching curve so as not to be slammed into windows or even thrown out of the open doorway when the driver floors it and wrenches the wheel into the bend. Though perfectly rational behaviour in a highly irrational situation, this will have the doubly detrimental effect of both increasing the instability of the vehicle and impeding its forward progress. In other words, the temporary boost to output and employment which each acceleration hopes to deliver will become more and more short-lived and the rise in prices will come faster and faster while each ascent will start from a higher and higher base until a complete degradation threatens.

The problem with this behaviour is that it is like that of a reforming alcoholic who treats himself to a wee dram every time the shakes get too bad, or a weight-watcher who treats herself to a midnight snack in order to stave off the hunger pangs until the dawn. This will be not just a Red Queen dilemma of running to stand still; not just Ben Bernanke and his clones reprising the role of Keanu Reeves in ‘Speed’, but a game in which it requires not just an acceleration to stay ahead of the self-cancelling change in prices which has been brought about, but a rising third derivative to outrace people’s growing awareness of what is afoot, on top of that.

What we should be concerned about is the sort of spiral which slowly, but progressively emanated from the 1960s Fed’s politically craven, ‘even-keel policy’ of facilitating Washington’s fiscal incontinence and of the one-sided focus it gave then – and is giving again –  to the unemployment side of its infamous ‘dual-mandate’.

Forty years ago, this led to a ratchet effect of higher inflation, higher unemployment, lower (real) equity prices, a massacre for bond holders, and soaring raw materials prices. It also broke up the post-war financial architecture which arrogantly presumed to mimic the eternal constant of scarce gold by linking values to an ephemeral dollar supposedly redeemable in the metal by fallible human diktat. The collapse of this flawed system ushered in the chaos of currencies free to gyrate wildly against one another, to the discomfit of investors and businessmen everywhere and triggering a race to the bottom among those wrongly convinced they could inflate the armies of the displaced back into work.

While it is easy to envisage such a deplorable scenario being re-run in the US, in the UK, in China, and in many of the emerging market economies, the suggestion that Europe might participate is usually treated with scorn, a nasty bout of Continental inflation seeming far too remote to contemplate, what with banks buckling and exchequers exhausted. Even here, however, there are two, admittedly divergent, scenarios which could see the balance shift decisively to the Dark Side.

The first is that Germany – despite its admirable international competitiveness and the fillip of a real-exchange rate touching eight year lows – may finally succumb to the malaise spreading around it in a ‘Zone where it directs almost two-fifths of its exports, or in those parts of Asia for which another one-sixth are destined. Given that it was happy to expand its fiscal deficit by more than 3% of GDP at a clip during the late Crash, one presumes that Frau Merkel’s strictures on good housekeeping might be somewhat less vehement were that to happen.

Once German rectitude gave way to a little Keynesian counter-cyclicality, it might just be that the non-Teutonic majority at the ECB would be able to overcome the now hollow-sounding objections of their Bundesbank colleagues and so could start unreservedly to emulate the Anglo central banks, as some of them have no doubt been itching to do all along.

This possibility does have form, for a great deal of the blame for the Continent’s current ills can be traced back to the fact that Euro-launch only shortly preceded the German weak patch suffered subsequent to the TMT implosion and that this led to a sustained period of monetary accommodation.

Note the stark contrast between the actions of the Bundesbankers then in office and those of their far less pliable predecessors. These latter had been anxious for the outcome when the Berlin Wall came down and Germany thus entered into a currency union with a poorer, less productive nation which had been used to less readily available and more expensive credit. So, they aggressively hiked interest rates while the adjustment went ahead, seeking to buffer the dangerous dilution brought about by the 1:1 conversion of Ostmarks to the real thing and damn the prospect of a recession anywhere in Europe, including in the (enlarged) Heimat itself.

A decade later, however, Germany entered into a wider currency union with several poorer, less productive nations used to less readily available and more expensive credit. This time, after a brief, 15-month, 1.7% real rate hike, its erstwhile guardians became so worried about a recession sullying the early years of the Project that they pushed real rates down, down, down for the next 4 years to the point that they plunged into the here-be-dragons territory of negative values (and that, on an EZ-wide basis which understated the price increases and hence the sub-zero depth, in the periphery). They would stay there all the way to early 2007, fermenting fiscal indiscipline in the public sphere and financial demoralization in the private one – from Countrywide, to RBS, to Amaranth and Sempra, to Michael Lewis’ ‘idiots’ in Dusseldorf.

Given the scale of this temptation, we might well ask: whose Bubble was it that finally burst around the time of the tenth birthday celebrations of the euro? Do the Greeks and Irish actually have a point when they insist they are not solely to blame for the miseries they now must suffer? More to the point, should the whole experience give us pause to wonder how resolute the stand for austerity will remain when it is German jobs – and German votes – which are next at stake and not far away Italian and Spanish ones?

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