After the recent sharp rally, October finds financial markets stuck in something of a pause now that the buy-the-rumour-sell-the-fact nature of the FOMC’s decision has become evident (even though the decision was, apparently, all part of an ‘optimal’ process—a ’singular achievement of recent monetary policy’—according to the vainglorious words of St Louis Fed chief James Bullard).
Adding to the sense of hiatus has been the absence of hard news from a China off on its autumn Golden Week holidays, coupled with the uneasy entr’acte being endured in Europe while we wait for the crying of Hosannas from this week’s big EU summit and fidget through the daily will-they-won’t-they of Spain’s agonising bail-out decision.
So, while we wait to see whether the Herd can indeed summon the energy to bootstrap itself up to a gratifying, bogey-making series of year-end highs, it might be germane to offer a brief synopsis of the analysis we apply to the system as a whole.
The core principle is that the credit cycle IS the business cycle. Once introduced, easy money starts by stimulating growth, then moves to distorting prices which misleads entrepreneurs (and those who invest in them!) about both the availability of resources at the prices foreseen in the business plan and the long-term financeable appetite for their product and thus leads a good number of them into a misery of capital misallocation.
Thus it is that we actually lose our money by making mistakes during the Boom and merely recognise these – and, ideally, realise them and rectify them – during the Bust.
Should, however, we try to subvert this cleansing process by attempting to inflate a new bubble on the ruins of the old, the chances are that we will accelerate a series of stop-go impulses, bringing about an increasingly costly hysteresis.
It should be apparent then that the short-term stimulative, but long-term disco-ordinating effects of easy money are the key variables to watch, but if we are the last to misled into disregarding the effects of money and credit (as do users of most standard macro ‘models’), nor must we fall into the trap of treating them either too mechanically (by applying, for example, a crude version of the quantity theory), or too aggregatively (as do those who want to lump every single financial contract into some homogenous, overarching credit aggregate, no matter what its components’ true economic function).
Thus it is that variations in the form of the money-proper being provided (whether this originates ‘inside’ or ‘outside’ the depository institutions); in the volume of and constitution of the credit pyramided on it (whether public or private); and in the willingness of that money’s recipients to hold onto it, are each crucial both to the progression of the business cycle and to the asset pricing it generates.
It is not hard to show that oscillations in the rate of monetary change, especially in real terms, are intimately related to swings in economic activity as well as to the ‘Risk On’/’Risk Off’ schizophrenia of today’s increasingly cross-correlated and barely discriminating financial markets.
As each successive crescendo and decrescendo is experienced, adaptive learning in response to this – however poorly articulated by the profusion of commentators and ‘cranks’ who all feel they have some new insight to add to its description – slowly, but surely accelerates the process of anticipation, financial commitment, over-exposure, and mass disappointment . That exactly such a Wheel of Fortune has characterised markets since the Crisis, should hardly be a matter of contention.
As each cycle unfolds, however, the problem facing the policymaker, in his desire to act as the Grand Puppetmaster of the economy, becomes one of constantly trying to overmatch the market’s own ever rising sense of expectation. As more and more ’unorthodox’ means are deployed with less and less patience being exhibited in waiting to see if they will take effect, two principal—and somewhat divergent—sets of risk will gradually mount.
This bifurcation comes about whenever it so happens that one of these acts of desperate, Rooseveltian ’experimentation’ serves to swamp the economy’s own in-built stabilizers and exhaust its negative feedback loops, so driving it outside Axel Leijonhufvud’s archetypal ‘corridor’. On one side, this may unleash the Austro-liberal’s ’secondary depression’: on the other, it may provoke a rush for the wheelbarrows. Either way, we are cast headlong into a hell of self-reinforcing decline.
Looming larger and larger in the collective unconscious at present is the worry that unprecedented levels of central bank intervention, coupled with what are still extraordinarily lax fiscal settings around the world can only lead to higher and higher levels of ‘inflation’. This angst stems in part from the grim suspicion that if debt levels are too high in relation to the income streams generated by the debtors, it is seems much easier to push the nominal value of the latter up than to undergo the pain of trying to negotiate the value of the former down. Ditto for wages and the marginal return expected to attach to the re-employment of the average, would-be wage earner.
Typically, this overlooks the trivial issue of trying to ensure that the extra income gets into the right hands in the first place; that the creditor does not seek recompense the next time he lends; that every employer’s selling price rises faster than his input costs (which, of course, are the rising selling prices of his suppliers in their turn); and that wage-earners are happy to acquiesce to the detrimental loss of their labour’s real worth.
But, if the central bank really wants to pursue this à outrance, the delivery of sustained price rises has historically required an aggressive monetization of debt; therefore, its occurrence has usually been a reflection of poor fiscal policy, to boot, with the central bank helping the exchequer plug its otherwise unbridgeable budget gaps by means of the printing press.
Thus, galloping inflation is usually a crisis of the State, even if a more widespread monetization of claims cannot be ruled out in these days of ever more orthodox unorthodoxy. Bill Gross’ ‘Ring of Fire’ is usually kindled at the Treasury, but that pecuniary pyromaniac, Burn’em Ben might well start striking matches over some other pile of tinder, if need be.
Conversely, crises which originate in the private sector typically see debt extinguished via paydown, revaluation, or default. Such mass dislocations are almost exclusively the result of a prior credit inflation which has encouraged too much capital to be fixed into places where it cannot be both serviced and amortized. Often this misuse may be all the more insidious by remaining well hidden from the mainstream’s purview through simultaneous increases in industrial technique or sheer, brute output; by the feeding in of savings ‘forced’ from within, via the Cantillon effect of differential access to credit; or from monies sourced externally by means of ‘deficits without tears’ – usually in the context of a currency union, whether formal (as in the Eurozone), or informal (as in what some have termed ‘Bretton Woods II’).
To the extent any of these temporarily caps the rise in the prices of end-consumption goods, there will be all too few to question the growing cancer of ‘fictitious capital’ and the widespread incompatibility of aspirations which it will foster.
When such a Ponzi scheme implodes, credit loses its unquestioned, boom-time negotiability and so arises a sudden rush for a money which, having not been so prized, may be relatively under-supplied and which, in any case, can only be created within the market by a banking sector which will hardly be disposed—and may well not be capable—of extending its tally of demand liabilities.
This will be even more of a constraint to the extent such banks had been playing pass-the-parcel with each other in the upswing and so have loan-deposit funding gaps which have only been plugged by borrowing wholesale from one another, much like their wildcat predecessors used to pass the same, small carpet-bag of gold and the same scant bundle of state bonds through each others’ back windows, just ahead of the scheduled visit of the banking inspector.
Thus, deflation is usually a crisis of a previously credit-inflated private sector, but, naturally, matters cannot be allowed to rest here for the modern response to such straits is for the State to summon up the full force of its power to spend beyond its means in order to counteract the struggles of its citizens to reduce their now-insupportable burden of leverage.
This Leviathan does, not least because of the perils being posed to its main legally-privileged clients, those co-conspirators against the accountable and truly representative republic of law whose ideal the ruling class so disdains; the typically over-extended, scantily-reserved, thinly-capitalised banks which implicitly rely on the guarantees of their Master in order to maximise their rents.
The State – helped by its willing patsies at the Central Bank – all too frequently overplays its hand, not least because its interference prevents the economy from properly ‘resetting’ itself and so renders too much of what subsequently passes for growth both weak and overly stimulus-dependent. In turn, this almost guarantees that the timely adoption of an ‘exit strategy’ is not to be expected: the ghost of 1937 features no less large in the folklore of Depression than does the spectre of 1931
Thus, renewed inflation is the frequent result of the State’s attempt to override the purgative effects of the private sector deflation. That this is not necessarily the demon it is cracked up to be can be seen from the startling reinvigoration of much of war-raddled Europe in the late 1940s, when a severe, imposed deflation combined with widespread disintervention to unshackle its citizens’ native spirit of enterprise and self-reliance: far-reaching ‘Auflockerung’ being far more potent than faux austerity.
Though, as we have noted, a growing body of opinion sees this scenario as an almost inevitable consequence of the ongoing, ham-fisted attempts to avoid hacking a way through the Gordian tangle of unfulfillable obligations which were knotted together by that pervasive misapplication of effort which the LEH-AIG crisis finally revealed as a folly, there is another possibility, no less bleak perhaps for being less dramatic in its unfolding.
This alternative consist in the notion that the quickening pace of policy changes, price suppressions, and signal falsifications can easily induce a creeping sense of enervation, if not absolute paralysis, in the entrepreneurial classes upon whom our material well-being ultimately depends.
This latter is a realisation sadly lacking among our simian troupe of ‘throw it at the wall and see if it sticks’ central bankers. Not actually having held down a genuine, private sector job; being entirely unversed in the matter of having to deliver on time, to a tight budget, in a competitive marketplace; and having little concept of how razor sharp is the boundary between taxable success and tort-wracked failure, few of these idiot savants seem to be able to grasp the fact that it does little good to act to lower the cost of financial capital if, at the same time, the risk adjustments being applied to project IRRs are screaming higher by several multiples of that reduction, thanks to the complete unpredictability of the policy regime, coupled with the increased rapaciousness typically displayed in the crisis to any so-called ‘economic royalist’ who still happens to have two pennies to rub together.
Thus, a wilfully capricious approach to policy which positively results in its own avant garde irresponsibility can easily extinguish the smouldering embers of productive risk-taking.
Aggravating that absence – as well as seeming to confirm the premise on which this unnatural and stultifying, sense of caution is adopted – the growing population of zombies which the state will now be nurturing will slowly impair the health of all those around them; whether, like GM-Solyndra, they are directly latched to the public teat, or, as seems to be true of most of China, they are being indirectly suckled at the tender bosom of the dole-dependent banks. The zombies spread their poison by denying scarce resources to their unsupported competitors and so needlessly increasing the latter’s cost-base, even as they unfairly clutter up the latter’s marketplace.
Moreover, these wraiths of the former boom often have to run only to the point that their variable costs are covered—these themselves being much reduced by the preternaturally low interest rates now being promoted by the open-handedness of the central bank. If they can lumber along in the economic shadows, garnering just sufficient cash flow to maintain the pretence that the credit continually being extended and re-extended to them is soundly based, they can thus afford to operate on the barest of operational surpluses. In this manner, not only does the capital formerly committed to them remain locked inside such pitifully suboptimal entities, but more is progressively bled out of the veins of the Living in order to satisfy the craving of the Undead (strictly that of their equally vampiric lenders).
Coupled with those elevated levels of ‘regime uncertainty’ to which have already alluded, and frightened by the angry populism of those who would confiscate all wealth, the few who do manage to thrive in such an unconducive environment cannot but become unclear as to where best to re-invest their winnings. A similar funk may well descend upon the thrifty wage-earner, in his turn.
Not willing to risk their fortunes by tying it up in an endeavour which may be arbitrarily and perhaps fatally disadvantaged at the whim of some breakfast-egg exchange manipulator, or headline-chasing politico, they may end up piling their surplus unproductively—leaving it to lie idly on deposit at the state-guaranteed banks, or parking it for an ever-extended ’meanwhile’ in the debt of the same state which is plotting to despoil them and all their fellows.
If this is the case and if the authorities do not turn into a blind mob of vengeful Samsons, ready to pull the temple’s fabric down around the ears of the poor Everyman whose only goal is to find some small measure of security, the attempt at stimulus will gel instead into a weary quagmire of long-term stagnation.
The state will continue to spend in excess of its revenues; those in receipt of its poisoned munificence will transfer the cash into the coffers of those they patronise; and these latter, not knowing or not trusting to do anything genuinely productive with it will recycle it passively back to the state. They may do this by amassing a hoard of T-bills or by filling up their accounts at banks who do so in their stead, or else who set these liabilities against the plentiful reserves which have been created (through its own purchases of state debt) by the Central Bank’s unavailing attempts to jump-start a self-sustaining upsurge in activity.
This slough of economic despond—this tedious provision of a monotonous dole of fish, means many will lose both the skill and the incentive to catch their own, so that each day more and more turn up hungry for handouts—is a common blight. Many aspects of this can be read as the cause of what has held back, for twenty long years, the revitalization of a formerly vibrant Japan. A similar fate may yet await the vast, bread-and-circus Provider States of the West, should they resist both the impulse to inflate themselves to a rapid conflagration of values and the necessity to sanitize their finances and to own up to their losses honestly.
By way of illustration, not that, on the eve of that nation’s collapse in 1991, private households and non-financial corporations each held some 7.2% of their financial assets in the form of money-proper, with another 1% or so being devoted to government securities. Pension and insurance companies, for their part, had less than 6% of assets invested in the latter.
Twenty years of sub-par growth later (though admittedly a period when real, per-capita outcomes were nowhere near as bleak as the headline aggregates suggest was the case) and households now hold almost a quarter of their means in the form of money (against which the banks and the BOJ hold mostly JGBs, in their turn). For their part, forget a greater complement of plant and equipment, the NFCs now allocate a hefty 18% of their financial assets to the same, sterile cause.
While these two key sectors have only modestly increased their direct holding of public IOUs in the interim, the pension and insurance funds in which they hold sizeable stakes have not been as restrained, devoting no less than ¥9 out of every ¥10 they have received over the last two decades to buying them on their trustees’ and policyholders’ behalf. This alone is equivalent to 15% of the total assets on the household balance sheet, meaning that a group of people who are arguably the world’s biggest savers have allowed two-fifths of their wealth to leak out of the well-springs of material advance into the stagnant cisterns of the state.
Thus is the business of ‘stimulus’ prevented from becoming outright inflationary and thus can an incontinent and ill-regarded political elite continue, year after year, to buy itself votes with its people’s own funds.
Thus do those lucky enough to be in work and those still running viable companies become mere vendor financiers of welfare, both personal and corporate, and contributors to unproductive, often highly corrupted, political boondoggles. Thus does thrift and enterprise become befuddled into holding a goodly proportion of what it assumes is its net wealth in what can only be described as certificates of deferred capital consumption, as the prepayment of a tax bill which will ultimately be presented, either in the regular form of a greater call on income and property or via the contractual violence of devaluation, debasement, or default.
While Bernanke and Draghi may well be willing to go much, much further along that road of good intentions than Mieno, Matsushita, Hayami, Fukui, and Shirakawa ever did between them, by exciting such a widespread distrust of that same currency with the maintenance of whose value they are charged that everyone into whose hands it comes rushes to dispose of it as rapidly as possible, it would not be wise to assume that the dreaded, funeral pyre of the Western order, the Weimar-like ’flight to real values’, is the only form of Ragnarök we now face: it is merely – given the credentials of those currently in charge of our destiny – the most likely.