Fixed Income

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The London Real Estate Bubble

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In October, London real estate asking prices jumped 10%. In my view is kind of parabolic-looking jump has developed out of quite a silly situation, and one I think is a good exhibit of just how irrational and weird markets can sometimes be.  London real estate prices have been rising strongly for a long while, and a large quantity — over half for houses above £1 million — of the demand for London real estate is coming from overseas buyers most of whom are buying for investment purposes. It is comprehensible that London is a desirable place to live, and that demand for housing in London might be higher than elsewhere in the UK. It is a diverse and rich place culturally and socially, boasting a huge variety of shopping, parks, art galleries, creative communities, restaurants, monuments and landmarks, theatres and venues, financial service providers, lawyers, think tanks, technology startups, universities, scientific institutions, sports clubs and infrastructure. Britain’s legal framework and its straightforward tax structure for wealthy foreign residents has proven highly attractive to the global super rich. With London real estate proving perennially popular, and with the global low-interest rate environment that has made borrowing for speculation cheap and easy, it is highly unsurprising that prices and rents have pushed upward and upward as the global super rich — alongside pension funds and hedge funds — sitting on large piles of cash have sought to achieve higher yields than cash or bonds by speculating in real estate. In some senses, London real estate (and real estate in other globally-desirable cities) has become a new reserve currency. And while this has occurred, price rises have proven increasingly cyclical as both London residents and speculators have sought to buy. The higher prices go, the more London residents become desperate to get their feet on the property ladder in fear they won’t ever be able to do so, and the more speculators are drawn in, seeing London real estate as an asset that just keeps going up and up.

Yet the bigger the bubble, the bigger the bust. And I think what we are seeing in London is a large psychological bubble, a mass delusion built on other delusions. Chief among these delusions is that real estate should be seen as a productive investment, as an implicit pension fund, or as a guaranteed source of real yield. While investors can look at real estate however they like, there is no getting away from the fact that real estate is a deteriorating asset. Sitting on a deteriorating asset and hoping for a real price gain — or even to preserve your purchasing power — is a speculation, not a productive investment. For commercial enterprises buying as a premises for business, or for residents buying as a place to live this is not in itself problematic. But as an investment this can be hugely problematic. It is just gambling on a deteriorating asset under the guise of buying a “safe” asset.

Of course, in the UK where housing has been treated by many successive governments as an investment, and as a haven for savings and pensions, real estate owners have done particularly well. Governments have been willing to prop up the market with liquidity via schemes like Help To Buy and via restrictive planning laws to rig the market to restrict supply. This may make investors feel particularly secure, but governments can be forced — not least by demographics — to swing in another direction. An important side-effect of continually rising prices and a restricted supply of housing is that many people will not be able to afford to buy a home. With the house prices-to-wages ratio sitting far above the long-term average, the next UK government will come under severe pressure within the next few years to allow — and probably subsidise — much more housebuilding to bring down housing costs for the population. The past-trend of government-protected gains may have inspired a false sense of security in investors.

But such a reversal of policy would not in itself crash the London real estate market. After all, London is a unique place in Britain, and the majority of the new housebuilding may take place away from London. More likely, the bubble will simply collapse under the weight of its own growth. Sooner or later, even with liquidity cheap and plentiful, the number of speculators seeking to cash out will exceed the number of speculators seeking to cash in, and confidence will dip. Sometimes, this simply equates to a small correction in the context of a large upward trend, but sometimes — especially when it can be negatively rationalised — it manifests into a deeper malaise.

When this occurs, one probable rationalisation is as follows.  Domestically, many of the relatively low-income artists, designers, technologists, musicians, students, artisans, academics, service workers and professionals (etc) who make London London are priced out, then they will go and contribute to communities elsewhere where rents and housing costs are lower — Birmingham, Manchester, Glasgow, Paris, Berlin, out into the sprawl of the home counties, and deeper into the English countryside, to places where a four bedroom house costs the same as a studio apartment in central London. Where once this would have been culturally, professionally and socially prohibitive, fast, ubiquitous internet allows for people to live a culturally and socially connected life without necessarily living in a big city like London. Internationally, other cheaper cities and jurisdictions will simply catch up with London in terms of amenities and desirability to the global super class. Competition for global capital  is huge, and while London as an Old World metropolis has done well since 2008, it may suffer in the wake of renewed competition from newer, cheaper, faster-growing Eastern metropolises.

When the bubble begins to burst — something that I think could occur endogenously within the next five years, especially if the fast increases continue — speculators, and especially speculators who are heavily leveraged may face severe problems, resulting in a worsened liquidation and contraction, and possibly threatening the liquidity of heavily-invested lenders. As many people at the table are sitting on big gains, they may prove desperate to cash out. Just as many presently feel pressured to get in to avoid being priced out of London forever, a downward turn could be severely worsened as many who are heavily invested in the bubble and scared of losing gains on which they hoped to fund retirements (etc) feel pressured to get out. Such an accelerated liquidation could easily lead to another recession. While I doubt that London prices will fall below the UK average, prices may see a very sharp correction. The psychological bubble is composed of multiple fallacies — that housing is a safe place to put savings and not a speculation, that deteriorating real estate should yield higher returns than productive business investments, that the UK government will continue to protect real estate speculators, that large flows of capital from overseas speculators will continue into London. A bursting of any of these fallacies could begin to bring the whole thing into question, even in the context of continued provision of liquidity from the Bank of England.

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On the Breakdown in the Correlation Between Gold Price And The Federal Reserve’s Balance Sheet

Once upon a time there was a strong correlation. Then it broke:

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Of course, we know that correlation is not and does not imply causation. But I think there was an underlying causation to the relationship that we saw, but it was not a superficial relationship of more asset purchases, higher gold prices. I think the causation arose out of self-confirmation; people noticed that the Fed was printing money, and believed that expansion of the Fed’s balance sheet would lead to price inflation (in ignorance of the fact that the broadest measure of the money supply was still shrinking in spite of all the new money the Fed was injecting into the economy, and the fact that elevated unemployment, weak demand, and plentiful cheap goods make it very hard for strong inflation to emerge). Many others believed that in the wake of 2008 and the shadow banking collapse, the financial system was fundamentally broken, and that the world might have to return to the gold standard. I myself believed that at the very least the West was in a prolonged Japanese style deflationary depression that in the absence of a return to strong growth might only be broken by very high inflation or a liquidationary crash.

Neither of these predictions — of imminent elevated inflation (or hyperinflation), and of imminent catastrophic financial system breakdown — have come to pass. Core inflation is close to its lowest year-on-year rate in history, and further financial system failures have mostly been prevented. So expectations have been shaken and are adjusting. Gold doesn’t produce any yield other than speculative price gains, but when gold is going up in price by around 20% a year it is still an attractive thing to hold to many, especially in an environment where its year-on-year speculative yield vastly outstrips bond yields and rates on savings. Once gold stopped going up by such a margin, investors had to sell their gold to lock in any speculative gain they might be holding onto, resulting in selling. And once gold started to fall, investors faced negative yields on gold, further spurring selling. This has meant gold has faced strong headwinds, and that is why its price has dropped by over 30% since its all-time high in September 2011, even while the Federal Reserve balance sheet continued to soar. Correlation broken. And in a market where the only yields are speculative gains, lost momentum can spell long-term depression as we saw for almost 20 years between 1980 and 2000.

Where gold goes from here is an interesting question. The main spur that pushes gold as an asset is goldbug ideology — the notions that it is the only real money, that it has intrinsic value, that fiat financial systems — and even modern civilisation in general — are fundamentally unmanageable and unsustainable and prone to collapse. As the technologies of capitalism, energy and production improve and advance, these goldbug views have been allayed and pushed to the margins as occurred in the 1980s and 1990s. In my view, their resurgence in the early 21st century stems almost entirely from the fact that real energy prices were rising, and real incomes falling. These two phenomena and their causes are complex and interconnective but essentially the energy infrastructure that brought the world spectacular growth and pushed all boats higher on a rising tide from the early 20th century to the 1990s began to come under strain — cutting into firms’ incomes, and individuals’ living expenses — and it has taken a long while for the market to even begin to equilibriate away from the increasingly-expensive old energy infrastructure and toward new infrastructures (initially increased U.S. production of shale, but going forward renewables especially solar). And while through financialisation and utilising insider-advantage much of the economic and financial elite managed to keep growing their incomes strongly, the vast majority came under stronger financial pressures and were only capable of sustaining their standard of living through debt-acquisition, which itself became a strain due to debt service costs.

As energy prices begin to fall (in what future economists may call a series of technology shocks), as private deleveraging proceeds strongly (with or without higher inflation) and as new cost-cutting technologies such as 3-D printing become more widespread real incomes will probably begin to rise again for the masses indicating a new supercycle of growth and pushing goldbug and other scarcity-concerned views to the fringes once more. We are, I think, moving inexorably to a world of superabundance, whether we like it or not. (Of course, in such a world assets like gold may still have a popular following to some degree, but that is another story for another day).

So even while the Federal Reserve continues to expand its balance sheet into the future in an effort to keep the US financial system liquid and further lubricate private deleveraging (and simultaneously chasing the elusive unemployment-reducing properties of Okun’s Law), the broken gold-Fed correlation is likely to break down even more.

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What Are Interest Rates And Can They Be Artificially Low Or High?

Many economic commentators believe that interest rates in America and around the world are “artificially low”. Indeed, I too have used the term in the past to refer to the condition in Europe that saw interest rates across the member states converge to a uniformly low level at the introduction of the Euro, only to diverge and soar in the periphery during the ongoing crisis.

So what is an interest rate? An interest rate is the cost of money now. As Eugen von Böhm-Bawerk noted, interest rates result from people valuing money in the present more highly than money in the future. If a business is starting out, and has insufficient capital to carry out its plans it will seek investment, either through selling equity in the ownership of the business, or through credit from lenders. For a lender, an interest rate is their profit for giving up the spending power of their capital to another who desires it now, attached to the risk that the borrower will default.

In monetary economies, money tends to be distributed relatively scarcely. In a commodity-based monetary system, the level of scarcity is determined by the physical limits of how much of a commodity can be pulled out of the ground. In a fiat-based monetary system, there is no such natural scarcity, but money’s relative scarcity is controlled by the banking system and central bank that lends it into the economy. If money was distributed infinitely widely and freely, there would be no such thing as an interest rate as there would be no cost to obtaining money now, just as there is no cost to obtaining a widely-distributed and freely-available commodity like air (at least on the face of the Earth!). Without scarcity money would lose its usability as a currency, as there is no incentive to trade for a substance which is uniformly and effectively infinitely available to everyone. So an interest rate is not only the cost of money, but also a symptom of its scarcity (and, as Keynes pointed out, a key mechanism through which rentiers profit).

So, where does the idea that interest rates can be made artificially low or artificially high arise from?

The notion of an artificially low or high interest rate implies the existence of a natural interest rate, from which the market rate diverges. It is a widely-held notion, and indeed, Ron Paul made reference to the notion of a natural rate of interest in his debate with Paul Krugman last year. A widely-used definition of the “natural rate of interest” appears in Wicksell (1898):

There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them.

This is easy to define and hard to calculate. It is whatever interest rate yields a zero-percent inflationary level. Because interest rates have a nonlinear relationship with inflation, it is difficult to say precisely what the natural interest rate is at any given time, but Wicksell’s definition specifies that a positive inflation rate means the market rate is above the natural rate, and a negative inflation rate means the market is below the natural rate. (Interestingly, it should be noted that the historical Federal Funds Rate comes pretty close to loosely approximating the historical difference between 0 and the CPI rate, despite questions of whether the CPI really reflects the true price level due to not including housing and equity markets which often record much greater gains or greater losses than consumer prices).

The notion of a natural rate of interest is interesting and helpful — certainly, high levels of inflation can be challenged through decreasing interest rates (or more generally increasing credit-availability), and deflation can be challenged by decreasing interest rates (or more generally increasing credit availability). If the goal of monetary policy is price stability, then the notion of a “natural interest rate” as a guide for monetary policy is useful.

But policies of macrostabilisation have been strongly questioned by the work of Hyman Minsky, which posited the idea that stability is itself destabilising, because it leads to overconfidence which itself results in malinvestment and credit and price bubbles.

Austrian Business Cycle Theory (ABCT) developed by Ludwig von Mises and Friedrich Hayek, most influentially in Mises’ 1912 work The Theory of Money and Credit, theorises that the business cycle is caused by credit expansion (often fuelled by excessively low interest rates) which pours into unsustainable projects. The end of this credit expansion (as a result of a collapse resulting from excessive leverage, or from the failure of unsustainable projects, or from general overproduction, or for some other reason) results in a panic and bust. According to ABCT, the underlying issue is that the banking system made money cheaply available, and the market rate of interest falls beneath the natural rate of interest, manifesting as price inflation.

I do not dispute the idea that bubbles tend to coincide with credit expansion and easy lending. But it is tough to say whether credit expansion is a consequence or a cause of the bubble. What is the necessary precursor of an unsustainable credit expansion? Overconfidence, and the idea that prices will just keep going up when sooner or later the credit expansion will run out steam. This could be the overconfidence of central bankers, who believe that macrostabilisation policies have produced a “Great Moderation”, or the overconfidence of traders who hope to get rich quick, or the overconfidence of homeowners who see rising home prices as an easy opportunity to remortgage and consume more, or the overconfidence of private banks who hope to make bumper gains on loans or loan-related securities (Carl Menger noted that fractional reserve banking and credit-fuelled bubbles originated in economies with no central bank, in contradiction of those ABCT-advocates who go so far as to say that without central banking there would be no business cycle at all).

And is price stability really “natural”? Wicksell (and other advocates of a “natural rate of interest” like RBCT and certain Austrians) seem to imply so. But why should it be the norm that prices are stable? In competitive markets — like modern day high-tech markets — the tendency may be toward deflation rather than stability, as improving technology lowers manufacturing costs, and firms lower prices to stay competitive with each other. Or in markets for scarce goods — like commodities of which there exists a limited quantity — the tendency may be toward inflation, as producers may have to spend more to extract difficult-to-extract resources form the ground. Ultimately, human action in market activity is unpredictable and determined by the subjective preferences of all market participants, and this applies as much to the market for money as it does for any market. There is no reason to believe that prices tend toward stability, and the empirical record shows a significant level of variation in price levels under both the gold standard and the modern fiat system.

Ultimately, if interest rates are the cost of money, and in a fiat monetary system the quantity and availability of money is determined by lending institutions and the central bank, how can any interest rate not be artificial (i.e. an expression of the subjective opinions, forecasts and plans of those involved in determining the availability of credit and money including governments and central bankers)? Even under a commodity-money system, the availability of money is still determined by the lending system, as well as the miners who pull the monetary commodity or commodities out of the ground (and any legal tender laws that define money, for example monetising gold and demonetising silver).

And if all interest rates in contemporary markets are to some degree artificial this raises some difficult questions, because it means that the availability of capital, and thus the profitability (or unprofitability) of rentiers are effectively policy choices of the state (or the central bank).

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Of Krugman & Minsky

Paul Krugman just did something mind-bending.

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In a recent column, he cited Minsky ostensibly to defend Alan Greenspan’s loose monetary policies:

Business Insider reports on a Bloomberg TV interview with hedge fund legend Stan Druckenmiller that helped crystallize in my mind what, exactly, I find so appalling about people who say that we must tighten monetary policy to avoid bubbles — even in the face of high unemployment and low inflation.

Druckenmiller blames Alan Greenspan’s loose-money policies for the whole disaster; that’s a highly dubious proposition, in fact rejected by all the serious studies I’ve seen. (Remember, the ECB was much less expansionary, but Europe had just as big a housing bubble; I vote for Minsky’s notion that financial systems run amok when people forget about risk, not because central bankers are a bit too liberal)

Krugman correctly identifies the mechanism here — prior to 2008, people forgot about risk. But why did people forget about risk, if not for the Greenspan put? Central bankers were perfectly happy to take credit for the prolonged growth and stability while the good times lasted.

Greenspan put the pedal to the metal each time the US hit a recession and flooded markets with liquidity. He was prepared to create bubbles to replace old bubbles, just as Krugman’s friend Paul McCulley once put it. Bernanke called it the Great Moderation; that through monetary policy, the Fed had effectively smoothed the business cycle to the extent that the old days of boom and bust were gone. It was boom and boom and boom.

So, people forgot about risk. Macroeconomic stability bred complacency. And the longer the perceived good times last, the more fragile the economy becomes, as more and more risky behaviour becomes the norm.

Stability is destabilising. The Great Moderation was intimately connected to markets becoming forgetful of risk. And bubbles formed. Not just housing, not just stocks. The truly unsustainable bubble underlying all the others was debt. This is the Federal Funds rate — rate cuts were Greenspan’s main tool — versus total debt as a percentage of GDP:

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More damningly, as Matthew C. Klein notes, the outgrowth in debt very clearly coincided with an outgrowth in risk taking:

To any competent central banker, it should have been obvious that the debt load was becoming unsustainable and that dropping interest rates while the debt load soared was irresponsible and dangerous. Unfortunately Greenspan didn’t see it. And now, we’re in the long, slow deleveraging part of the business cycle. We’re in a depression.

In endorsing Minsky’s view, Krugman is coming closer to the truth. But he is still one crucial step away. If stability is destabilising, we must embrace the business cycle. Smaller cyclical booms, and smaller cyclical busts. Not boom, boom, boom and then a grand mal seizure.

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The Unsustainable US Financial Sector

According to Bloomberg, the vast majority of the Big Five banks’ profits consisted of a taxpayer subsidy — the Too Big To Fail guarantee. If the Too Big To Fail banks had to lend at the rates offered to their non-Too Big to Fail competitors, their profits would be severely shrunk (in some cases, to a net loss):

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What does that mean?

That means that the American financial sector is a zombie, existing on the teat of the taxpayer.

It means the huge swathes of liquidity spent on saving the financial sector are ultimately good money chasing after bad.

As Bloomberg notes:

The U.S. financial industry — with almost $9 trillion in assets, more than half the size of the U.S. economy — would just about break even in the absence of corporate welfare. In large part, the profits they report are essentially transfers from taxpayers to their shareholders.

Neither bank executives nor shareholders have much incentive to change the situation. On the contrary, the financial industry spends hundreds of millions of dollars every election cycle on campaign donations and lobbying, much of which is aimed at maintaining the subsidy. The result is a bloated financial sector and recurring credit gluts.

This is extremely prescient stuff. The Fed since 2008 has reinflated the old bubbles, while allowing the same loot-and-pillage disaster-corporatist financial model to continue.

It is insane to repeat the same methods and expect different results. This credit glut, this new boom that has seen stocks rise closer and closer to their pre-crisis high (which may soon be exceeded) will just lead to another big 2008-style slump, just as the Fed’s reinflation of the burst tech bubble led to 2008 itself. This time the spark won’t be housing, it will be something else like an energy shock, or a war. Something that the Federal Reserve cannot directly control or fix by throwing money at it.

America (and the Western world in general) post-2008 needed real organic domestic growth built on real economic activity, not a reinflated bubble that let the TBTF financial sector continue to gorge itself into oblivion. 

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The Interconnective Web of Global Debt

It’s very big:

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Andrew Haldane:

Interconnected networks exhibit a knife-edge, or tipping point, property. Within a certain range, connections serve as a shock-absorber. The system acts as a mutual insurance device with disturbances dispersed and dissipated. But beyond a certain range, the system can tip the wrong side of the knife-edge. Interconnections serve as shock-ampli ers, not dampeners, as losses cascade.The system acts not as a mutual insurance device but as a mutual incendiary device.

A mutual incendiary device sounds about right.

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When Currency Wars Become Trade Wars…

Beggaring thy neighbour has consequences. Neighbours might turn around and bite back.

China and the United States are already locked in an intractable and multilayered currency war. That has not escalated much yet beyond a little barbed rhetoric (although if China want to get a meaningful return on the trillions of dollars of American paper they are holding, one can only suspect that there will be some serious escalation as the United States continues to print, print, print, a behaviour that China and China’s allies are deeply uncomfortable with).

But Brazil are already escalating.

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The Washington Post notes:

When the Brazilian economy began to stall last year, officials in Latin America’s largest country started pulling pages from the playbook of another major developing nation: China.

They hiked tariffs on dozens of industrial products, limited imports of auto parts, and capped how many automobiles could come into the country from Mexico — an indirect slap at the U.S. companies that assemble many vehicles there.

The country’s slowdown and the government’s response to it is a growing concern among U.S. officials worried that Brazil may be charting an aggressive new course — away from the globalized, open path that the United States has advocated successfully in Mexico, Colombia and some other Latin American nations, and toward the state-guided capitalism that the United States has been battling to change in China. As the world economy struggles for common policies that could bolster a still tentative recovery, the push toward protectionism by an influential developing country is seen in Washington as a step backward.

“These are unhelpful and concerning developments which are contrary to our mutual attempts” to strengthen the world economy, outgoing U.S. Trade Representative Ron Kirk wrote in a strongly worded letter to Brazilian officials that criticized recent tariff hikes as “clearly protectionist.”

And Brazilian officials are very, very clear about exactly why they are doing what they are doing:

Brazilian officials insist the measures are a temporary buffer to help their developing country stay on course in a world where they feel under double-barreled assault from cheap labor in China and cheap money from the U.S. Federal Reserve’s policy of quantitative easing.

“We are only defending ourselves to prevent the disorganization, the deterioration of our industry, and prevent our market, which is strong, from being taken by imported products,” Brazil’s outspoken finance minister, Guido Mantega, said in an interview. Mantega popularized use of the term “currency war” to describe the Federal Reserve’s successive rounds of easing, which he likened to a form of protectionism that forced up the relative value of Brazil’s currency and made its products more expensive relative to imports from the United States and also China.

How long until other nations join with Brazil in declaring trade measures against the United States is uncertain, but there may be few other options on the table for creditors wanting to get their pound of flesh, or nations wishing to protect domestic industries. After all, the currency wars won’t just go away; competitive devaluation is like trying to get the last word in an argument. The real question is whether the present argument will lead to a fistfight.

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The Contrarian Indicator of the Decade?

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

Sir John Templeton

Buy the fear, sell the greed. Since bottoming-out in 2009 markets have seen an uptrend in equity prices:

Now it seems like the euphoria is setting in. And in perfectly, deliciously ironic time, as shares of AIG — the behemoth at the heart of the 2008 crash — are returning to the market. Because reintroducing bailed-out companies to the market worked well last time didn’t it?

Joe Weisenthal:

Markets are down a hair today, but the theme of the morning is clear: Uber-bullishness. Everywhere.

This is the most unanimously bullish moment we can recall since the crisis began.

Note that this comes as US indices are all within a hair of multi-year highs, and the NASDAQ returns to levels not seen since late 2000.

Big macro hedge funds, who have been famously flat-footed this year, are now positioned for a continued rally.

Bank of America’s Mary Ann Bartels:

Macros bought the NASDAQ 100 to a net long for the first time since June, continued to buy the S&P 500 and commodities, increased EM & EAFE exposures, sold USD and 10-year Treasuries. In addition, macros reduced large cap preference.

J.P. Morgan’s Jan Loeys:

We think the positive environment for risk assets can and will last over the next 3-6 months. And this is not because of a strong economy, as we foresee below potential global growth over the next year and are below consensus expectations. Overall, we continue to see data that signal that world growth is in a bottoming process.

SocGen’s Sebastian Galy:

The market decided rose tinted glasses were not enough, put on its dark shades and hit the nightlife.

And the uber-bullishness is based on what? Hopium. Hope that the Fed will unleash QE3, or nominal GDP level targeting and buy, buy, buy — because what the market really needs right now is more bond flippers, right? Hope that Europeans have finally gotten their act together in respect to buying up periphery debt to create a ceiling on borrowing costs. Hope that this time is different in China, and that throwing a huge splash of stimulus cash at infrastructure will soften the landing.

But in the midst of all that hopium, let’s consider at least that quantitative easing hasn’t really reduced unemployment — and that Japan is still mired in a liquidity trap even after twenty years of printing. Let’s not forget that there is still a huge crushing weight of old debt weighing down on the world. Let’s not forget that the prospect of war in the middle east still hangs over the world (and oil). Let’s not forget that the iron ore bubble is bursting. Let’s not forget that a severe drought (as well as stupid ethanol subsidies) have raised food prices, and that food price spikes often produce downturns. Let’s not forget the increasing tension in the pacific between the United States and China (because the last time the world was in a global depression, it ended in a global conflict).

It would be unwise for me to predict an imminent severe downturn — after all markets are irrational and can stay irrational far longer than people can often stay solvent. But this could very well be the final blow-out top before the hopium wears off, and reality kicks in. Buying the fear and selling the greed usually works.

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The Shape of 40 Years of Inflation

I have written before that there is no single rate of inflation, and that different individuals experience their own rate dependent on their own individual spending preferences. This — among other reasons — is why I find the notion of single uniform rate of inflation — as central banks attempt to influence via their price stability mandates — problematic.

While many claim that inflation is at historic lows, those who spend a large share of their income on necessities might disagree. Inflation for those who spend a large proportion of their income on things like medical services, food, transport, clothing and energy never really went away. And that was also true during the mid 2000s — while headline inflation levels remained low, these numbers masked significant increases in necessities; certainly never to the extent of the 1970s, but not as slight as the CPI rate — pushed downward by deflation in things like consumer electronics imports from Asia — suggested.

This biflationary (or polyflationary?) reality is totally ignored by a single CPI figure. To get a true comprehension of the shape of prices, we must look at a much broader set of data:

Yet the low level of headline inflation has given central banks carte blanche to engage in quantitative easing, and various ultra-loose monetary policies like zero-interest rates — programs that tend to benefit the rich far more than anyone else. Certainly, lots of goods and services — especially things like foreign-made consumer goods and repossessed real estate — are deflating in price. But you can’t eat an iPad or a $1 burnt-out house in Detroit. Any serious discussion of monetary policy must not only consider the effects on creditors and debtors, but also the effects on those who spend a larger-than-average proportion of their income on necessities.

Another issue is that CPI leaves out both house prices as well as equity prices.

Below is CPI contrasted against equities and housing:

It is clear from this record that a central bank focused upon a price index that fails to include important factors like stock prices and house prices can easily let a housing or stocks bubble get out of hand. CPI can — as happened in both the 1990s as well as the early 2000s — remain low, while huge gains are accrued in housing and stocks. Meanwhile, central bankers can use low CPI rates as an excuse to keep interest rates low — keeping the easy money flowing into stocks and housing, and accruing even larger gains. However, because such markets are driven by leverage instead of underlying productivity, eventually the ability to accrue new debt is wiped out by debt costs,  hope turns to panic, and the bubble bursts.

Both of the above examples indicate that the contemporary headline price index measures of inflation are deeply inadequate. Attempts to measure the rate of inflation that ignore data like house or stock prices will lead to flawed conclusions (rendering any such notions of “price stability” as meaningless), which has tended to lead to failed policy decisions such as those which led to the bust of 2008.

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Gold, Price Stability & Credit Bubbles

John Cochrane thinks that central banks can attain the price-stability of the gold standard without actually having a gold standard:

While many people believe the United States should adopt a gold standard to guard against inflation or deflation, and stabilize the economy, there are several reasons why this reform would not work. However, there is a modern adaptation of the gold standard that could achieve a stable price level and avoid the many disruptions brought upon the economy by monetary instability.

The solution is pretty simple. A gold standard is ultimately a commitment to exchange each dollar for something real. An inflation-indexed bond also has a constant, real value. If the Consumer Price Index (CPI) rises to 120 from 100, the bond pays 20% more, so your real purchasing power is protected. CPI futures work in much the same way. In place of gold, the Fed or the Treasury could freely buy and sell such inflation-linked securities at fixed prices. This policy would protect against deflation as well as inflation, automatically providing more money when there is a true demand for it, as in the financial crisis.

The obvious point is that the CPI is a relatively poor indicator of inflation and bubbles. During Greenspan’s tenure in charge of the Federal Reserve, huge quantities of new liquidity were created, much of which poured into housing and stock bubbles. CPI doesn’t include stock prices, and it doesn’t include housing prices; a monetary policy that is fixed to CPI wouldn’t be able to respond to growing bubbles in either sector. Cochrane is not really advocating for anything like the gold standard, just another form of Greenspanesque (mis)management.

Historically, what the gold standard meant was longer-term price stability, punctuated by frequent and wild short-term swings in purchasing power:

In its simplest form (the gold coin standard), gold constrains the monetary base to the amount of gold above ground. The aim is to prevent bubble-formation (in other words, monetary growth beyond the economy’s inherent productivity) because monetary growth would be limited to the amount of gold dug out of the ground, and the amount of gold dug out of the ground is limited to the amount of productivity society can afford to spend on mining gold.

Unfortunately, although gold levels are fixed, levels of credit creation are potentially infinite (and even where levels of credit creation are fixed by reserve requirements, shadow credit creation can still allow for explosive credit growth as happened after the repeal of Glass-Steagall). For example, the 1920s — a period with a gold standard — experienced huge asset bubble formation via huge levels of credit creation.

In any case, I don’t think that the current monetary regimes (or governments — who love to have the power to monetise debt) will ever change their minds. The overwhelming consensus of academic economists is that the gold standard is bad and dangerous.

In a recent survey of academic economists, 93% disagreed or strongly disagreed with this statement:

If the US replaced its discretionary monetary policy regime with a gold standard, defining a “dollar” as a specific number of ounces of gold, the price-stability and employment outcomes would be better for the average American.

That question is skewed. A gold standard can also be a discretionary regime; gold can be devalued, it can be supplemented with silver, and it can be multiplied by credit. And the concept of “price-stability” is hugely subjective; the Fed today defines “price stability” as a consistent 2% inflation (which on an infinite timeline correlates to an infinite level of inflation — the only stable thing being the rate at which the purchasing power of a dollar decreases).

If anything, the events of 2008 — which I interpret as a predictable and preventable housing, securitisation, and debt bubble stemming very much from central bank mismanagement of the money supply under Greenspan — secured the reputation of central banking among academic economists, because the bailouts, low rates and quantitative easing have prevented the feared debt-deflation that Milton Friedman and Ben Bernanke postulated as the thing that prolonged and worsened the Great Depression.

The Japanese example shows that crashed modern economies with excessive debt loads can remain stagnant for long periods of time. My view is that such nations are in a deleveraging trap; Japan (and more recently the Western nations) hit an excessive level of debt relative to GDP and industry at the peak of the bubble. As debt rises, debt servicing costs rise, leaving less income for investment, consumption, etc.

Throughout Japan’s lost decade, and indeed the years that followed, total debt levels (measured in GDP) have remained consistently high. Simply, the central bank did not devalue by anywhere near enough to decrease the real debt load, but nor have they devalued too little to result in a large-scale liquidation episode. They have just kept the economy in stasis, with enough liquidity to keep the debt serviceable, and not enough to really allow for severe reduction. The main change has been a transfer of debt from the private sector, to the public sector (a phenomenon which is also occurring in the United States and United Kingdom).

Eventually — because the costs of the deleveraging trap makes organically growth very difficult — the debt will either be forgiven, inflated or defaulted away. Endless rounds of tepid QE (which is debt additive, and so adds to the debt problem) just postpone that difficult decision. The deleveraging trap preserves the value of past debts at the cost of future growth.

Under the harsh discipline of a gold standard, such prevarication is not possible. Without the ability to inflate, overleveraged banks, individuals and governments would default on their debt. Income would rapidly fall, and economies would likely deflate and become severely depressed.

Yet liquidation is not all bad.  The example of 1907 — prior to the era of central banking — illustrates this.

As the WSJ noted:

The largest economic crisis of the 20th century was the Great Depression, but the second most significant economic upheaval was the panic of 1907. It was from beginning to end a banking and financial crisis. With the failure of the Knickerbocker Trust Company, the stock market collapsed, loan supply vanished and a scramble for liquidity ensued. Banks defaulted on their obligations to redeem deposits in currency or gold.

Milton Friedman and Anna Schwartz, in their classic “A Monetary History of the United States,” found “much similarity in its early phases” between the Panic of 1907 and the Great Depression. So traumatic was the crisis that it gave rise to the National Monetary Commission and the recommendations that led to the creation of the Federal Reserve. The May panic triggered a massive recession that saw real gross national product shrink in the second half of 1907 and plummet by an extraordinary 8.2% in 1908. Yet the economy came roaring back and, in two short years, was 7% bigger than when the panic started.

Although liquidation episodes are painful, the clear benefit is that a big crash and depression clears out old debt. Under the present regimes, the weight of old debt remains a burden to the economy.

But Cochrane talking about imposing a CPI-standard (or Greenspan talking about returning to the gold standard) is irrelevant; the bubble has happened, it burst, and now central banks must try to deal with the fallout. Even after trillions of dollars of reflation, economies remain depressed, unemployment remains elevated and total debt (relative to GDP) remains huge. The Fed — almost 100 years old — is in a fight for its life. Trying to balance the competing interests of creditors — particularly those productive foreign nations like China that produce much of America’s consumption and finance her deficits — against future growth is a hugely challenging task. The dangers to Western economies from creditor nations engaging in punitive trade measures as  a retaliatory measure to central bank debasement remain large (and the rhetoric is growing fiercer). Bernanke is walking a tightrope over alligators.

In any case even if a gold standard were to be reimposed in the future, history shows that it is unlikely to be an effective stop against credit bubbles. Credit bubbles happen because value is subjective and humans are excitable, and no regime has proven itself capable of fully guarding against that. Once a credit bubble forms, the possibilities are the same — liquidation, inflation or debt forgiveness. Today, central banks must eventually make a choice, or the forces of history will decide instead.