I’m reproducing the bulk of a very good (and possibly final) post by London Banker, a former central banker and securities regulator, that takes issue with some of the conventional wisdom surrounding the efforts to remedy our economic crisis via liberal applications of monetary easing and fiscal stimulus.
I happen in general to be sympathetic to minority views (conventional wisdom is generally wrong). And in this case, as I discuss below, I am worried that conventional wisdom rests on a thin and dubious set of data and assumptions.
London Banker’s arguments are two-fold: first, deflation is more likely than inflation because the underlying messes have not been cleaned up. Therefore investors will be leery of putting funds into risky investments. Note this differs from the commonly-held view that deflation can be cured without addressing institutional arrangements. Second, he argues that punitively low yields will lead foreign investors eventually to retreat even from government debt. He argues that they will tire at throwing good money after bad, and will prefer to seek returns closer to home.
This claim is hard to prove (one can argue that the high risk spreads are due to deleveraging, not distrust) but it is a serious issue if true. One of the things that worked for years in favor of the US is that it had the most liquid, deepest capital markets, That was due not just to the size of its economy, but also the fact that it had high standards for financial disclosure and generally strong investor protection. If investors come to doubt the fairness of the markets, or think that the rot in its economy is not being cleared out and will undermine growth, that will hold investment back. As Brad Setser has pointed out, foreign capital flows have consisted almost entirely of central bank purchases of Treasuries and Agencies for quite some time, hardly a vote of confidence.
We also have the question of how long the high dollar/low Treasury interest game can go on. Bernanke wants rates low to try to stimulate economic activity and has even broached the idea of long bond purchases to keep yields on the long end of the curve down. But the poster child of deflation and low interest rates is Japan, which due to its high savings rate, was not dependent on external funding. The US should want the dollar cheaper to boost exports, but that risks the ire of our creditors, who would take big losses on their FX reserves (many economists argue this idea is specious, but try explaining the loss in paper wealth to a populace not schooled in such niceties. FX losses, when the dollar was weakening earlier in the year, produced a lot of ire in China, including among bureaucrats). Similarly, even if you subscribe to the deflation outlook, 3%ish 30 year bonds is a pretty risky bet independent of the currency risk. So it looks like our friendly funding sources are likely to get burned one way or another, perhaps both. There is a real risk of a disorderly fall of the dollar, and it is hard to tell what the collateral damage would be.
Now to my doubts about the proposed remedies, namely monster stimulus and monetary easing. First, as mentioned before, the analogy is to the US in the Depression, which we have said repeatedly before is questionable. The US in the 1920s was the world’s biggest creditor, exporter, and manufacturer. Our position then is analogous to China’s now. Indeed, Keynes in the 1930s urged America to take even more aggressive measures, and argued that it was not reasonable for the US to expect over-consuming, debt-burdened countries like the UK and France to take up the demand slack. So even though most economists are invoking Keynes, it isn’t clear he’s prescribe such aggressive stimulus for the US and UK now.
Second, the argument is that the US in the 1930s and Japan in its post bubble era failed to engage in sufficiently large stimulus. That is mere conjecture; there is no way to prove that argument (we cannot go back in a time machine and test different remedies in both economies).
In the US, the claim generally made is that the US did not emerge conclusively from the Depression until it engaged in massive wartime spending starting in 1939-40, and therefore a stimulus of perhaps that large a magnitude is required. However, quite a lot happened between 1930 and 1939, including going off the gold standard, the securities law reforms of 1933 and 1934, the creation of the FDIC, refinancing homeowner debt to longer-term mortgages via the Homeowner’s Loan Corporation, and the closure of a lot of business, some of which were probably victims of circumstance, but others probably deserved to be put out of their misery.
There is another huge extenuating circumstance with the war spending that observers choose to forget. The US’s problem in 1929, like China’s appeared to be (at least in part) overproduction, that there might be too much global capacity relative to consumer demand (that is certainly true for the auto industry now, which had managed to forestall the day of reckoning by converting consumers to leases that had them trading in cars after 3 years, when buyers generally keep them longer, Decreasing the effective life of cars was tantamount to increasing demand). In addition, the US suffered a fall in GDP of 11% in 1946 and 1% in 1947 in transitioning off a wartime economy.
But perhaps more important, at the end of WWII, productive capacity in the next two biggest industrialized nations, Germany and Japan, had been destroyed. The US had effectively no competition for its bulked up industrial capacity.
Had the US in 1930 tried monster stimulus, without the painful adjustments of the 1930s, would it have worked? Probably narrowly, in keeping unemployment from rising to horrific levels and containing the fall in GDP. But I question whether it would have been a panacea. The New Deal, contrary to popular opinion, did produce a lot of good results with its workfare, such as the building of parks and roads, the electrification of rural America. if the US had attempted something at twice that scale, would it have been productive? Some argue that it didn’t matter, the important thing is to get money into the economy, but I wonder. Japan did engage in pretty heavy infrastructure spending (a lot of bridges to nowhere) and it does not seem to have done them much good.
Note my sophisticated investor buddies disagree, saying this is backwards looking, confident that a US budget deficit of 10% of GDP next year will do the trick, and think inflation/hyperinflation is the bigger risk (note some consider hyperinflation to be operative at 20% per annum; you do not need to get to Weimar scenarios for inflation to start distorting economic decisions in a very serious way).
From London Banker:
For a while now I have been on the fence on the inflation/deflation issue …. 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.
Yves here. For the UK, the currency crisis issue is a real concern. Recall that the pound has taken a huge dive in recent months, and Willem Buiter has taken to comparing Britain to Iceland. Back to the post:
The very opposite policies have been pursued by central banks in the US, Europe and UK …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…
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…
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…
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…
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.