The Deflation/Inflation DebateApr 12, 2018·Alasdair Macleod
“Naïve inflationism demands an increase in the quantity of money without suspecting that this will diminish the purchasing power of the money.” ― Ludwig von mises, The Theory of Money and Credit
It is hardly surprising that with equity indices stalling, the financial community is increasingly worried that the long, steady bull market is coming to an end. Naturally, this makes investors look for reasons to worry, and it turns out that there are indeed many things to worry about.
In fact, there are always things to worry about. Ever since the Lehman crisis, the Four Horsemen of the Apocalypse have been casting long shadows across the financial stage. But as financial assets have continued to rise in value over the last nine years, bearish fund managers, spooked by systemic risks of one sort or another and the perennial threat of a renewed slump, have been forced to discard their ursine views.
As often as not, it is not much more than a question of emphasis. There is always good news and bad news. As an investor, you semi-consciously choose what to believe.
There are causes for concern, of that there is no doubt. Mostly, they arise from the consequences of earlier state interventions on the money side. Governments are slowly strangling private sector production with increasingly rapacious demands on taxpayers and have been resorting to the printing press to finance the shortfalls. In reality, there is a finite limit to government spending, because it impoverishes the tax base. Yet governments, with very few exceptions, seek to conceal this truism by increasing spending and budget deficits even more. In this, President Trump is not alone.
Bankruptcy is the end result. And don’t believe the old saw about how governments can’t go bust. They can, and they do by destroying their currencies, as von Mises implied in the quote above. The naïve inflationists referred to by von Mises justify their stance by believing that inflation is invigorating, and deflation is devastating. Any and all statistics pointing to a slowdown in the growth of money supply or in the economy is therefore taken to be a forewarning of deflation.
Inflationists are simply recycling Irving Fisher’s debt-deflation theory, which is no longer relevant. Fisher held that in an economic crisis, bad debts forced banks to liquidate collateral, pushing down collateral values. And as previously sound loans lose their collateral cover, banks are forced to liquidate those as well.
But it is no longer the case. Central banks have removed the discipline of gold, so they can intervene to prevent financial and economic crises, rather than let them run their destructive courses. They have fully embraced inflationism, giving them the excuse for monetary and credit expansion as a cure-all.
Therefore, when the next crisis occurs, central banks will take steps to ensure that in aggregate the quantity of money does not contract. It is the one forecast we can make with absolute certainty. And every time a crisis happens it takes more monetary heft to get out of it. But that’s not an issue for a central bank with two overriding objectives, not the targeting of inflation and unemployment as such, but to ensure a recession never happens, and to finance, through money-printing if necessary, escalating government spending.
Minor wobbles are not the credit crisis
We must discriminate between the momentary problems faced by central banks and the inevitable crisis at the end of the credit cycle. Dealing with problems as they arise has become routine, the justification for continual inflationism. The credit crisis is a different matter. Central bankers do not seem to realise it, but the credit crisis is their own creation, the way markets eventually unwind the distortions created by earlier monetary policy. So long as central banks suppress interest rates and expand money and credit, there will be periodic credit crises to follow.
The trigger for the credit crisis is always the same. The general price level threatens to rise uncontrollably, reflecting the loss of the currency’s purchasing power. This forces the central bank to reluctantly raise interest rates to the point where business assumptions about the returns on capital, based on borrowing costs, turn from profit-making to loss-making. At that point, if not before, the accumulated mountain of debt becomes fatally undermined.
The timing of the rise and level of interest rates that triggers the crisis is set by the speed with which monetary inflation feeds into prices. And the severity of the crisis depends upon the size of the debt mountain being liquidated.
This has nothing to do with the minor wobbles along the way. Ahead of a cyclical credit crisis, central banks routinely deal with the fires breaking out in an increasingly desolate economic landscape. They are very good at it. The share prices of European banks, such as Deutsche Bank and Credit Suisse raise concerns over systemic risk, but the ECB and SNB will always ensure credit is available to them. And if we are worried about systemic risk in key European financial behemoths, why is it that stock prices for major US banks such as JPMorgan, Goldman Sachs and Bank of America are so strong?
There is also a narrative being promoted which posits that a slowdown in broad money supply is giving an advance warning of recession. The chart below, of US M2 plotted weekly, puts it into context.
Yes, there has been a recent slowdown in the rate at which M2 is growing. But it has hardly diverged much from the average rate of increase, shown by the black line, for the last five years. And it’s not worth repeating the chart for M1 Money Stock, which is remarkably similar, despite the Fed reducing the size of its balance sheet.
How bank credit is used is rarely questioned
What charts of money supply do not tell us is where money is deployed between two groups of borrowers. Newly created money, mainly bank credit, is allocated either into the financial sector, which is not included in GDP excepting fees and commissions, or into non-financial activities, where goods and services are included. Furthermore, missing from GDP is all the intermediate business-to-business activity that goes towards manufacturing and delivering the goods and services included in GDP. And it is B2B which borrows to invest.
It is only when extra money is allocated through the markets to the production of items in the consumer price index that price inflation is recorded. However, we cannot know how new money is allocated and reallocated between the arbitrary divisions set by statisticians. Attempts to marry up changes in broad money with demand for it are never convincing.
But as proxy for non-financial business activity away from the world of big corporates, the following chart appears to confirm that ordinary businesses are just getting on with commercial life and have been for the last six years, though you wouldn’t know it from the financial headlines.
Again, we see that following the great financial crisis, ordinary businesses making and doing things for ordinary people, just get on with investing in production. But there is an interesting observation here, highlighted on the chart: in the first few months of every year, almost no extra loans and leases are taken out, so the sideways trend in M2 from early-January may be nothing to worry about. Furthermore, taking this seasonality into account, it appears that demand for loans and leases so far this year is stronger than in any of the previous five years.
Investment strategists examine statistical trends to discern turning points in stocks and bonds, when the wealth creation and destruction from bull and bear markets could be the driving force for these statistical trends, having little to do with the economy itself. In this context, our next chart shows the build-up of margin debt in the financial sector, and how it has become sufficiently large to be potentially destabilising.
The point at which a fall in outstanding margin debt flashes warning signals for the equity market is one thing, but it is unlikely to destabilise the non-financial economy on its own. It is worth noting that it fell $21bn in February, and presumably more in March, yet to be reported. While some of this finance is by brokers acting as shadow banks, reductions in loans on securities are bound to be reflected in a slowdown in the rate of growth of bank lending. But no such distinction is made by financial scribblers, attributing all changes in money supply to demand in the non-financial economy.
Another statistic worrying the scribblers is the LIBOR-OIS spread, which has suddenly increased. This is the difference between the unsecured wholesale money market lending rate in London and the overnight index swap rate, which is a derivative that is effectively tied to the risk-free interest rate. The spread is therefore normally taken as an indication of bank lending risks.
The explanation for this spread increasing is unknown, with few signs of lending stress apparent. One could point to the share price performance of systemically important European banks, such as Deutsche Bank and Credit Suisse, which suggests there is greater counterparty risk in London’s money markets than in New York. But if that’s the case, central banks will be monitoring the position closely and ready to intervene if required.
It is perhaps more likely that tax changes in the US are encouraging US corporations to transfer dollar funds from banks in London to New York, which is bound to increase dollar rates in London, where LIBOR is set, compared with New York.
How the credit cycle progresses
Investors trying to understand the financial markets’ major trends should keep an eye on the credit cycle. The first point to note is that it is now nine years since the last credit crisis ended, and there are, as yet, no signs economic growth is over. However, as the cycle progresses, history and monetary theory tell us that interest rates begin to rise from the artificially suppressed levels set by central banks. That is now happening, leading us into the final phase of the credit cycle before the credit crisis finally ends it.
Bond markets have all peaked, and their yields are rising, and not only at the short end where prices are corelated with interest rates. The 10-year US Treasury yield bottomed at 1.46% in June 2016, since when it has increased to 2.79% currently. The 30-year UST yield bottomed at the same time at 2.182%, and now yields 3.02%. The bond bear market is firmly established.
Generally, the rise in medium and long-term bond yields anticipates increasing prices for commodities, goods and services, the consequence of earlier monetary expansion. Business conditions then appear to be improving, and equity markets have reflected this benign environment.
It is becoming clear that a further jump in bond yields will confirm the end of an equity bull market, and the beginning of a bear market. But that will not mark the end of the current phase of the credit cycle and the onset of the crisis. Even if equities have a 1987-type crash, the credit cycle will continue, rather than enter the crisis phase.
The concluding phase of credit expansion before the credit crisis is now about to begin. Demand will appear to be picking up while prices are rising and interest rates still low. It will be characterised by a growing belief among businessmen that they must borrow to invest. We can already anticipate the factors leading up to this happy but brief state.
President Trump has cut taxes and increased spending. The result is there will be a substantial injection into the US economy late in the business cycle, mostly financed by monetary inflation. It is bound to create short-term optimism but being based on money created out of thin air it will be an illusion. The consequence will be an acceleration of price inflation, as the extra money is absorbed into the non-financial economy. Bond markets will anticipate higher interest rates, so banks, losing money on their bond investments, will then compete for loan business in the non-financial economy. For a brief period, buoyed up by a business-friendly fiscal policy, the economy will appear to grow more rapidly.
The rise in prices, initially seen by business as a stimulant to production while borrowing costs remain suppressed by the Fed, will accelerate fuelled by too much money chasing too few goods. However, the business environment will only appear to be improved during the time period taken for the economy to absorb monetary inflation and reflect it in higher prices. When it dawns on markets that next year’s prices will be significantly higher than today’s the time-preference value on loans will be increasing, irrespective of the Fed’s monetary policy.
The crisis will then be upon us. The switch from stimulative fiscal policies to sharply escalating interest rates and bond yields could be sudden. At the worst possible time, the Fed will be forced to raise the Fed Funds Rate to protect a declining dollar. If they haven’t begun to do so already, financial assets will be crashing, along with physical assets whose values are set by interest rates, such as residential property.
America is not alone in its stimulation of markets. Interest rates are also suppressed in the Eurozone, Japan, Britain and Switzerland, all of which stand to benefit from China’s economic evolution. Those economists who in recent weeks have proclaimed that at last synchronised growth is here do not realise that the inflationary consequences for prices brings the global credit crisis forward in time.
So, that’s the sequence. Bonds top out, followed by equities, followed by a credit crisis. We have had the first, perhaps entered the second, and have the third event still ahead of us. And if the evidence before our eyes is not enough, we have proof of central bankers’ ignorance in these matters from Janet Yellen, who in her swansong said, “Would I say there will never, ever be another financial crisis? You know, probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.”
Hubris indeed, reminding us of Greenspan’s “Irrational exuberance” in December 1996, before the Dow nearly doubled, and his conversion to the New Paradigm of Larry Summers et al in 2000, just before the dot-com bubble burst. It is proof that those who have taken it upon themselves to protect us from our own financial indiscretions are clueless about the credit cycle, and their role in its creation. But will it result in a massive deflation?
If by deflation is meant an increase in the dollar’s purchasing power, the answer must be an emphatic No. As well as the views of central bankers, that deflation must be avoided at all costs, even a mild recession plays havoc with government finances. This is why the Fed and other central banks will do everything in their power to stop it. But their power is confined to the cure-alls of reducing interest rates and throwing yet more money at the economy.
Far from deflation, the Fed’s only response to the next credit crisis will be to take measures that will lead to the final destruction of the dollar. Other central banks are set to follow. Deflationists don’t have a leg to stand on, and unknowingly conform with von Mises’s description of naïve inflationists.
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