baby boomers, banks, Bernanke, budget deficit, capital ratios, de-leveraging, debt monetization, Debt/GDP Ratio, ECB, Europe, European sovereign debt crisis, Fed, financial crisis, fiscal deficits, Flub-Med, GDP growth, Hunt brothers, income/dividend bubble, inflation, Japan, multiplier effect, Occupy Wall Street, politicians, quantitative easing, real assets, risk aversion, savings rate, stagflation, US, Volcker
I was beginning a new post in my recent Hitting the Century series (and here), and realized my next 3 investment allocations were to real assets – Natural Resources, Agri & Property. This v quickly got me thinking about inflation, enough to devote myself to this post instead:
Along the way, dear reader, you may have noticed my pronounced distaste for fiscal & monetary policy in the developed world. Particularly in the US... That’s not intended to be a US slap-down…and certainly not praise for Europe either! It’s simply a pretty inescapable conclusion if you compare the US & (the hard-core of) Europe over the past 4 decades. Jesus, I struggle to think of somebody with any real power in the US who truly gives a flying f**k about their accelerating debt burden, debt monetization, or the long-term external value of the dollar. In contrast, the ECB & certain Eurozone countries still actually exhibit a painful reluctance to take that road to monetary & fiscal oblivion – even in the face of a European sovereign debt crisis!
Of course, this crisis simply illustrates European politicians are just as poor as their US counterparts in facing up to a problem. Their bumbling & procrastination over the past 2 years is the primary reason for the crisis, with bond investors’ sheep-like behaviour a close second, as far as I’m concerned. Don’t believe me? Well, look at greater Europe: The overall EU budget deficit’s around 4% of GDP, whereas a 7-10% deficit in the US now appears simply run-of-the-mill. The total US Debt/GDP ratio’s now at 102%, compared to the EU at 83%! [Sure, US Public Debt's only at 72%, but seriously...how long before that also exceeds the EU figure?!]. C’mon, do these EU numbers really look like a crisis to you (at this point), on a relative or an absolute basis?!
But somehow the hand-wringing, idiocy & sheer tomf**kery of EU politicians has now transformed this into a real crisis. I’m amazed to see European sovereign debt mutualization (whether total, or above a certain Debt/GDP threshold) still being offered up as a solution. Rather pointlessly, as it’s immediately rejected each time – understandably, as the hard-core would pay for it, while Flub-Med would presumably lose all control of their bowels, financially & literally… This song & dance is pretty mystifying to me. The obvious & low-risk solution is to mutualize debt only up to a certain Debt/GBP limit, as I spell out here. It would also represent a v significant step towards the greater fiscal union that’s needed to support the Euro.
Now it’s obvious a European ‘solution‘ is desperately required, and it’s going to cost vastly more pain & money than it would have cost two to three years ago. When it comes to politics, or finance, never has a proverb been more true than: ‘A stitch in time saves nine.‘ This means Europe is now contemplating a capitulation to the profligate American approach… Which is also a moving target to keep up with, as the latest Fed QE kabuki now indicates an open-ended bond purchase strategy.
This, of course, will quickly & inevitably lead to currency debasement and/or inflation. [Or maybe I should stagflation - I'm none too hopeful for GDP growth prospects in the developed world.] If you’re in the same camp, this isn’t a major mental leap to make – if you’re not, I probably won’t be changing your mind. But I do have a mea culpa that might prompt you to think twice: I screwed up, this ‘default’ inflation assumption is far too simplistic. It’s not that I believe I’m wrong about inflation to come, but my timing’s completely off..!
Remember, the 2008 crisis & the ongoing European sovereign debt crisis are financial/leverage induced crises, not a regular economic contraction. A regular recession generally takes 1-2 years to recover from, but (if I remember my Reinhart & Rogoff properly) recovery from a financial crisis takes far longer – say 3-7 years, and sometimes much much longer… Yes, of course – I’m thinking of Japan! In fact, I’m amazed how little serious commentary/study there has been about this since 2008, particularly when it seems like an extraordinarily instructive comparison to make. It’s like there’s an unspoken childish conspiracy afoot – shhh, if we don’t mention it, perhaps it won’t come true… However, I do think Japan has also had some unique problems of its own in the past two decades, so let me sidestep that comparison! Don’t take it as a hopeful sign though, there are still numerous similarities.
The problem with financial crises is that their lead-up can take years, or even decades. It’s absurd to think such built-up excesses, and then the resulting collapse, can be offset and growth rates restored in a mere year or two. De-leveraging is much slower & more painful than that..!
Don’t tell the politicians though – they’d puke up a goddamn kidney at the thought. After all, they have to ensure GDP growth at all costs… But why? What on earth is so wrong about a static GDP in real terms? And it seems like everybody’s bought into this obsession – search online for say ‘US GDP‘, what do you bloody get? Virtually every single search result is a f**king GDP % growth rate… That’s not what I searched for! I wanted to find a US GDP figure or, even better, a US GDP per capita figure – far more meaningful.
To put it into personal terms, if you told me my income wouldn’t change in real terms for the next decade or two, I wouldn’t be that perturbed at the idea. My needs are pretty simple, they don’t really change, and I’ve absolutely no desire to impress anybody. [Notice too that we're now usually labeled as consumers, rather than citizens, fer Chrissake?!). How about you? Perhaps I'm just in the minority..?!
Actually, no! Hasn't that been the dire lot (unwillingly) of the US middle class for the past few decades? They just didn't realize it - instead they fell hook, line & sinker for the politicians' lies, the illusion cast by inflation and the availability of easy credit. The virtual abandonment of a national savings rate also helped Americans to keep up with the Joneses, and ahead of the rest of the world. And to think some said voters for Obama were embracing socialism... Tsk, that conversion already happened en-masse when Americans decided not to save any longer. Despite the utter incoherence of Occupy Wall Street, I suspect the heart of the movement is Baby Boomer offspring beginning to realize that maybe, just maybe, their parents were sold a crock of shit..?
But politicians would never dare contemplate denying/jumping off this merry-go-round. Money absolutely has to be pumped into the economy to restore growth and (oh so fortunately for them) their ability to do that is, to a greater or lesser degree, virtually unlimited... To 'treat' a regular recession, this can be done in a relatively controlled manner & any serious inflationary impact can hopefully be avoided. But this time is different - it's a financial/leverage induced crisis, and it prompted the worst recession since the Great Depression. This has demanded an unprecedented monetary & fiscal stimulus in response - so why has unemployment remained so stubbornly high, growth so low, and inflation bizarrely absent?
Well, actually, that's easy enough to answer...
Most consumers have no home equity to tap any longer, and they're fearful about the economy, their jobs & their retirement. Whether they like it or not, this forces them to think twice/pull back on their spending, and it puts them in de-leveraging mode. That's just the tip of the iceberg though - look at the bloody banks! Their (un)-recognized bad debts, their risk aversion, their need for higher capital ratios, and their increased regulatory burden have all pushed them inevitably into de-leveraging mode also. And this is where the really savage deflationary impact shows up. Politicians love to boast about multiplier effects - but ever notice they're always talking about positive multipliers?! Of course that's rubbish, by definition a positive multiplier is simply a promise that a negative multiplier may be lying in wait just around the corner.
And that's what we're seeing here - when banks need to raise their ratios, it's no coincidence to note that's usually an incredibly expensive & dilutive time to raise equity. Clearly, that's been necessary to survive in all too many instances, but the more palatable alternative is to shrink their balance sheets. For example, if a bank could magically shrink its balance sheet by half overnight, its capital ratios would double, and shareholders would be untouched. Sure, return on equity would suffer (and the bank may have just doubled down on its bad loans...) - but all things being equal, this seems a far better option than massive dilution, or a possible shareholder wipe-out.
But this is where the negative multiplier sinks its fangs in - for every 1 million of extra equity a bank wants to 'produce/free up' for capital ratio purposes, it's forced to shrink its balance sheet by 10-20 million. Multiply (!) that across the industry, across the US, and across Europe, and you're talking about numbers even more unprecedented than the stimulus we've seen to date. There have been numerous recent forecasts that European banks will shrink their balance sheets by at least EUR 2-3 trillion, for example, in the next few years.
The second, and third problem, is risk aversion. Duh! If the authorities are spewing money into the economy, that's exactly when the banks are at their most risk averse - of course! This provides another compelling reason for them to further shrink their balance sheets, and to have a distinct preference for less risky lending. Next, who provides the conduit, and the hoped for multiplier, for the majority of all monetary & fiscal stimulus? Yes, again it comes back to the banks! Who have no desire to lend out these funds either, so they simply recycle them into 'safe-haven' government debt. This type of debt monetization's a neat trick (and sure to prove v handy, and necessary, in years to come), but a far cry from the hoped for stimulative/multiplier effect...
Put all this together, and it's no wonder the stimulus appears to have had very little real impact to date, and it certainly accounts for the absence of inflation. So, should we even worry about inflation? Yes, we should. But for the foreseeable future it's suppressed under an ocean of
shit de-leveraging. But I think we'll ultimately see a different path for Europe & the US vs. Japan (which is a whole other ball-game in terms of its Debt/GDP ratio..!).
Banks can never reach a happy equilibrium. This is due partly to the on/off-balance sheet leverage that's inherent in their business, but we can mostly ascribe it to the sheer idiocy & insanity of the average banker. Eventually, banks will have raised capital, shrunk their balance sheets, and regained a reasonable risk appetite. This transports them to a pleasant lower risk/lower reward place which they could (notionally) dwell in forever... But of course they won't, that's worse than purgatory for them - it's simply a tipping point.
And not just for the banks, for the authorities too - they'll be only too happy to loose the reins at that point, just wait & see! The bankers will immediately dive into riskier loans, and look to work that amazing multiplier effect as quickly as their greedy little paws can robo-sign loan docs. And can you blame them?! After all, they've been forced to survive the lean times on a paltry few million a year in salary/bonuses - but they know the real money's to be made from share/option price appreciation, and that requires sustained credit growth!
OK, but Bernanke has calmly reassured us - as only an academic can (he really should take up pipe-smoking). This eventual & massive new stimulatory impact (and its inflationary consequences) can be offset, for example, by a steady withdrawal of the Fed's quantitative easing. But alas, that's a real f**king pipe-dream... Instead, we've three likely outcomes to choose from here:
i) Like politicians have discovered with entitlements, central banks will also realize how incredibly difficult it is to reverse course, their promises & most of all the flow of money, or ii) they go ahead and withdraw the monetary, and even fiscal (?!), stimulus...and growth/the economy promptly collapses again, or iii) the economy begins to enjoy such a renewed boom that it actually proves possible to withdraw the stimulus without significant damage - yeah great, but doesn't that pretty much imply it's far too late, the inflation genie's already out of the bottle..?
Looks like no way out - but does this really surprise you? I'm always bemused by politicians/central bankers' insane confidence - they can intervene purposefully & positively, but think any reversal of that intervention will magically have no impact?! Just like fool traders who think they can corner/run up a price based on their aggressive buying. Their next step is to then somehow dump their investment without causing a ripple, let alone a complete retracement of their price run-up... The fate of the Hunt brothers is pretty instructive in this regard.
Investors will play their part too. Currently, it seems fairly obvious an income/dividend bubble is being blown... This could go on for a couple more years yet, particularly with short/long term interest rate repression looking set to continue. Eventually investors will reach a point though where they seek out riskier investments/real assets/capital gains, because they've a) regained their confidence, b) become so desperate in response to continued yield compression, and/or c) become sufficiently fearful of actual/anticipated inflation.
I also have to wonder if current/future politicians would ever have the guts to appoint a new Volcker, if inflation did get out of control..? ['Cos Bernanke sure as hell ain't going to be the one to win that fight...] I’m pessimistic on that score. In fact, upon re-examination, I recently learned the pols. may not even have had the gumption back then – even after the inflationary hell of the ’70s! At the time, it actually appears that there was no (widespread) political expectation that Volcker would act so independently, or embark on a crushing multi-year anti-inflation crusade!
So, piecing all of this together, we may still see a prolonged period of low inflation, despite the odds. But only to be followed by a scenario where, almost at the snap of a finger, economic growth, risk appetite and especially inflation will start firing monstrously on all cylinders… Therefore, there seems to be plenty of time to kill before you really need to jump into those real asset/inflation pure plays. It also suggests certain real asset investment preferences may prove superior. I will return to the topic in my next Hitting the Century post.