Trying to avoiding the icy wastes of the 1930s will lead us straight into the searing desert of the '70s instead...
IN OUR SCROLLING-HEADLINE world of impatience, where every thought has to fit into an SMS text message, one of the hardest things to accomplish in any debate is not getting people to listen to an opinion, per se.
Rather, an expositor will struggle to get anyone to pause sufficiently before receiving his opinion, so as to check that interpretation of the terms employed are consistent with those of his audience.
Advertising execs, state propagandists, and special pleaders of all sorts are only too adept at exploiting such weaknesses. Their very art is to use the disjuncture between perceived and intended meaning as a Trojan horse. This enables them to infiltrate all manner of false analogies, straw men, and logical non sequiturs behind the walls of their listeners' citadels of reason.
As a consequence of such – often intentional – confusion, we can even be seduced into working backwards from a received, phoney definition, allowing it to suppress and supplant our own prior and more accurate understanding of a given word or phrase.
As is the malign intent, we find that once we have deceived ourselves in this fashion, we have little hope of working forward again to unpick the tangles of error contained in the many, fair-sounding arguments proffered by those who would unduly influence our actions or sway our thinking.
In our professional life, perhaps the supreme case of the difficulty caused by a regrettable semantic debasement is the way in which the word 'inflation' has come to mean not an excessive supply of money and credit – as it was classically and correctly taken to be – but only the rise in a narrow index of particular prices, as compiled (and subsequently heavily-doctored) by a given group of statistics-sifting bureaucrats.
By relaxing our guard and not insisting that our debating partner fully declare the precise boundaries of meaning when he employs a term, we give him room to construct an entirely bogus view. It implies that the absence of a frequent (though by no means an inevitable) symptom of inflation – whether a rise in the Consumer Price Index itself or in that of its emaciated 'core' version, ex-food and energy costs – conclusively proves the absence of the disease itself.
Inflation proper – an unjustified and initially unwanted increase in the availability of money and credit (which we shall hereafter capitalize) – is dangerous not only because it leads to inequitable transfers of wealth between actors, but because it leads to a needless reduction in the overall stock of that wealth, both potential and realized. Inflation disrupts the economic decision-making of both entrepreneurs and their customers, thus greatly increasing the chances that today's seeming prosperity will be the ruin of tomorrow's hoped-for provision.
Inflation proper is not even a zero-sum game of conman and conned (a violation of property rights risibly known as 'forced saving' to the mainstream economist). Instead it is a fast-spreading pestilence which blights even that portion of the harvest which the Inflators are carrying out of the community silo as part of their ill-gotten booty.
Once we resolve to view the issue of Inflation vs. 'inflation' exclusively in this light, not only does it strip away more veils of obfuscation than Salome doffs during dance practice; it also allows us to make a consistent whole of the opera buffa of easy money which so dominates the modern repertoire.
Inflation, then, is a monetary distemper, pure and simple. As such it tends to manifest itself as a rise in asset prices, a narcosis of risk awareness, and an increase in leverage. These, in turn, lead to the formation of misplaced, overambitious business plans and overstretched budgets, while fostering elevated levels of greed, chicanery, and the abuse of trust.
Thus, the entire hubris and nemesis which characterize both the credit-driven business cycle and its distorted reflection in that Hall of Mirrors known as "high finance" are the real constituents of an Inflation properly defined. In fact, by the time that one is aware of any rise in consumer prices – the 'inflation' (lower case, inverted commas) which often follows from this feverish and disco-ordinated state of affairs – the street-corner card sharp is usually about to tip his hand and reveal to his victim that he's being fleeced.
Rats in the Cellar
Conversely, if we start with the central bankers' conceit that only a certain rate of climb in a clutch of selected consumer prices constitutes 'inflation', we will unfailingly find ourselves in all sorts of trouble. For some of the most perilous of all economic conditions arise exactly when the range of end-goods prices is quiescent in the face of significantly easier monetary conditions – a combination which is typically dismissed, but which may, in fact, occur for any of a variety of reasons.
The reason this state of affairs is so treacherous is because we then tend to disregard the counterfactual possibility that such prices, absent monetary Inflation, would actually be falling outright: that they are therefore being artificially propped up by a surfeit of the means of payment, and that this hidden frustration of the free market is every bit as unwholesome as the one which occurs when final goods prices are rising faster and in a more widespread fashion than one otherwise supposes they would (the only case which the mainstream will admit to as constituting 'inflation' in any form whatsoever).
Indeed, Albert Hahn once remarked that "Inflation without 'inflation'" – i.e., a properly understood episode of monetary excess which does not immediately translate into broadly dearer consumer goods – posed a much greater threat to material well-being than the more usual case. Why? Precisely because the damage was therefore being done so insidiously, like a ship whose timbers are rotting below the waterline, that we still get to pride ourselves on the gleaming state of the paintwork up on deck.
It does to remember that neither the Boom of the late 1920s in the US, nor that in Japan in the 1980s, would have caused today's central bankers much lack of sleep over what they insist upon misperceiving as 'inflation', despite the undeniable evidence of Inflation posed by the frenzied chase for assets – typically channelled, then as now, into a very familiar mix of foreign bonds, real estate, IPOs, M&A.
Those Inflations were also pyramided by means of overlaid, successively-leveraged holding operations in speculative stocks.
And again, with an ominous feeling of déja vu, each of these episodes was accompanied by the complete abandonment of prudence and thrift, follies which were justified by the thrilling delusion that participants were all engaged in breaking the bounds of the possible and in forging boldly ahead into a bright new tomorrow.
For our Inflation's notable absence of their 'inflation', we can thank not just the Boskin commission (which sanctioned politicized changes to the CPI measure), nor 'hedonics' (which equate increased computing power, for example, with a fall in prices), nor the flawed concept of 'Owner's Equivalent Rent'. We can also express our gratitude to the supply side effects of a process of 'globalization' which was accelerated in the wash-out of the previous Inflationary (but barely 'inflationary') booms of the Asian Contagion and the Tech Mania. (That inflation in turn was painlessly financed by the 'childish game of marbles' some commentators have dubbed 'Bretton Woods II'.)
The Wall Street Shuffle
Thus, for a good, long while, this latest recovery saw little upward movement in a broad range of traded, end-goods prices. Indeed, as we have argued elsewhere, the Inflation may even have contributed to the lack of 'inflation'; for Corporate Anglo-America could keep labor costs down by moving production offshore, while lending its income-deprived employee-customers back home the wherewithal to buy its goods in place of paying cash for them.
Inflation as a stimulus mechanism moved from being income-based to asset-based, and so it dropped off central bank radar screens.
It was primarily thanks to Inflation's direct role in triggering the 'search for yield' (and its ancillary role in promoting prime brokerage to its apotheosis as the chief divinity of modern-day bankers), that the GMACs and GEs of this world were well able to securitize the resulting obligations at a lower rate of discount than that being offered to their own customers. So 'profits' could thus be made, and balance sheets ostensibly enhanced, not by raising notional selling prices, but simply by round-tripping what would otherwise have been a mundane and unimpressive form of vendor finance through increasing levels of complex, financially-engineered leverage.
(One stops to wonder here how many of those newly-enlightened corporate treasurers, virtuously eschewing all others' Asset-Backed Commercial Paper (ABCP) and flooding into zero real-return T-bills in their place, realize they may be killing their own golden goose, as they do).
In addition to this, Inflation also enabled the riches of Croesus to be showered upon the Pooh Bahs of the boardroom via a prodigious watering of share options granted into a steadily rising market. The ensuing dilution could then be Miller-Modiglianied away – assuming as those economic worthies did that equity and debt are equally valid and valuable ways of financing business – and earnings per share were duly bolstered with the lower denominator delivered by means of vast equity buybacks, worth some $0.5 trillion for non-financial America alone in the year to September.
All this was funded at ever lower spreads and rates, and Inflation thus kept eye-wateringly high executive salaries from impacting the bottom line, completing yet another virtuous-looking circle for the stock bulls.
No marvel, then, that reported profits seemed to make up a record share of GDP when Inflation was keeping a lid on payrolls and salaries. It simultaneously boosted dollar revenues, so it's also no surprise that personal consumption rates have miraculously outpaced reported compensation. Inflation was both boosting the prices of the assets used as collateral (mainly stocks, options, and property) and depressing the cost of borrowing against them in a benign double whammy for their owners' net worth calculations.
Meanwhile, a similar scheme was being run on a pan-continental scale as the West's main suppliers automatically recycled their US Dollar (and Pound Sterling) receipts in a bid to prevent their own currencies from appreciating along with their trade surpluses.
At first, the monies were parked in the bonds issued by the debtor nations' governments – contributing to a 'conundrum' of falling yields at the long end for those who deliberately chose not to notice what was actually plain for all to see. Soon, however, the same yield hunger infected the exporter-creditors, to the point that they came to provide a ready market for the toxic credits being concocted by the uniquely fertile financial minds of the West.
From this witches' brew arose the poison of sub-prime as a means of underpinning the robust securitization 'profits' being made in the West by bankers and builders alike.
This attempt to stop the so-called 'price-specie' mechanism from performing its proper regulatory function retarded the 'inflation' which should have resulted in from higher import prices. Notably, the Fed, the very institution which could have done much to halt the build up of the ensuing 'imbalances' any time it chose, fatuously called the phenomenon a 'saving glut' instead, implying that its own, sustainedly lax policies played no role in the alarming widening of America's trade gap.
It all came down to semantics, again, for the use of this harmless seeming phrase meant that rather than admitting the US (among others) had become a serial overspender and that, conversely, its partners were aiding and abetting Occidental excesses by succumbing to the age-old fallacy of mercantilism, America's strip malls were only buzzing and its Stakhanovite builders heroically throwing up a metropolis of McMansions in the selfless quest to provide needy Asians with a secure outlet for their otherwise homeless retirement savings.
We wish them well of the fruits of this Reverse Marshall Plan for we suspect the harvest is likely to be a bitter one for all concerned!
Domestically, too, the Inflation among the urbanisers has been largely predicated upon this influx of foreign currency. Initially, it helped suppress 'inflation' there (as recognized by the macromancers) by holding down, or even - in the case of the dominant state-owned lenders and borrowers in China – effectively eliminating, the cost of access to the tidal surge of financial capital sloshing around inside a closed network of piping. Along the way, it unleashed an investment boom, the likes of which the world had never before seen in peacetime.
Incidentally, such is the maths of GDP accounting that this orgy of investment is also likely to be flattering the true degree of profitability at the macro level while, at the micro level, we should ask whether anyone worries about fully covering costs when capital accounting is largely absent; when much factory land is grabbed from its existing owners without paying them any compensation; when dividend distributions are a rarity; and when loans never need to be repaid?
The problem faced by those importing their Inflation in this manner becomes one of what to do with all the extra product which results from the crash program of industrialization and urbanization? They send it abroad, of course, often with the aid of a little export subsidy built into the taxation system - throwing their goods into the sea, as Bastiat might remark.
Input prices (oil, steel, copper) may rise worldwide as this goes on and on in ever-mounting volumes, but we shouldn't quibble. Final goods prices are the only ones that matter for 'inflation', remember, and these are being held down along the way.
Thus, the urbanisers face something of a margin squeeze when they come to swap their paper dollars for the natural resources required in their products' fabrication, This has lead to the kind of barely-concealed accounting loss which Asia's price-capped petrol refiners and cooking oil suppliers are most visibly suffering today. But don't fret that this represents a gross misuse of capital. The fruits of Inflation can be readily used to cover this gap, if only at the expense of a burgeoning central government budget deficit.
Moving on to the next link in the chain, the recipients of such an embarrassment of resource dollars – especially those among the energy-rich – mainly run greenback-linked currencies. So they have imported their own Inflation too, leading to a series of construction, real estate, and equity bubbles in their generally underdeveloped home markets.
Despite the widespread use of subsidies on politically sensitive goods to deaden the impact of all this new money, their thrumming container ports have also been discharging a significant consignment of central-bank-variant 'inflation', along with the asset booms.
Additionally, since the Gulf States, in particular, are incapable of fully absorbing the torrents of petrodollars flooding their system, they participate in a $600-700 billion a year vendor finance scheme of their own with their customers, the major oil and gas burners – a policy which, in turn, helps reduce the ability of higher fuel prices to ration demand effectively, even in those parts of the world where relatively free pricing of the product still exists.
At this juncture, however, with Western credit markets in disarray and with the dollar at hazard of wearing out the well-tried patience of its main sponsors, we have to worry whether the unimaginable non-linearities which comprise this system are about to rip apart at the seams.
If so, what we are arguing implies that our apparently effortless Golden Age of corporate profitability may very well be coming to a juddering end and, further, that many of those already-booked 'profits' will prove to have been utterly insubstantial in sober retrospect. If that happens, the Bull's oft-repeated mantra that - at a forward multiple of 15-16 – the market is 'cheap' enough to support present prices, might ring very hollow, indeed.
Taken in isolation, it is true, as some have argued in our hearing, that the US housing market is not the be-all-and-end-all of the nation's economic capabilities. We have always been at pains to emphasise the towering scale and predominant role of overall business spending in comparison to this and, as but one specific example, we have spent a good eighteen months showing charts of the concomitant rise in non-residential construction outlays and payrolls as a case of a reallocation of a fairly interchangeable group of 'factors', as the impetus of Inflation has switched between the two sectors.
Alas, that counterpoise may now be swinging to the same, lowered side of the balance arm. The sorry state of Commercial Mortgage-Bond Security spreads (CMBS) bodes ill for future construction finance while commercial property prices seem to be flagging after an impressive bull run in both the US and the UK.
Not only are the newspapers beginning to report rumblings in the market of project cancellations and repricings, but the unease can only deepen if we take the latest, far more stringent Fed Loan Officers survey at face value; if we pay heed to the unusually rapid deterioration in state and municipal finances (and hence the reduction likely to follow in their building budgets); if we note the sharp loss of confidence among NFIB small business members; and if we realize that the bio-ethanol racket is in imminent danger of becoming yet another New Deal program gone spectacularly awry.
But, beyond this, what we have repeatedly cautioned is that the real danger inherent in housing is exactly the one which is now unfolding – namely, that it represents nothing more than the ragged edge of an vast, hemispheric storm system of horribly malinvested capital and negligently granted credit which has quietly been brewing far out over the steamy, tropical ocean of Inflation, but which is now rushing terrifyingly shorewards.
Turning to the semantics again, we are beginning to find the term 'sub-prime' not only annoyingly clichéd, but actually of as little worth as are the loans so-designated, for, in order that this characterization should have any meaning at all, there must be a 'prime' in relation to which the offending category is 'sub' and that, in itself, is becoming a premise of increasing doubtfulness.
What, after all, is 'prime' in a world when the biggest and brightest banks have so patently Chuck Prince'd themselves to exhaustion by polka'ing too hard?
What is 'prime' in a world where default spreads are going stratospheric for the very companies whose financial integrity is supposed to insure the credit worthiness of a multi-trillion tranche of debt?
What is 'prime' when the shares of the GSEs, the main guarantors of the ostensibly better class of mortgage credit, are in freefall, having already squandered all credibility with a series of accounting scandals during the boom years and thus having no reserves of trust upon which to draw in their present difficulties?
What is 'prime' in a world where the very money market funds to which the Forgotten Man turns when he seeks a safe haven are chock full of the same poisonous garbage causing problems elsewhere – a sorry state of affairs brought about by a deplorable lack of stewardship on the part of managers either running unacceptable risks for the most trifling of extra rewards or culpable of an outright conflict of interest in passively accepting such credits straight from the sausage factories of their firms' origination departments?
What is 'prime' in a world where record share of a record volume of debt issuance has been conducted at record low spreads, with record loose covenants, and at multi-decade low real rates – a self-fuelling process which has helped deliver extraordinarily low corporate default rates by enabling sub-marginal businesses to postpone the day of reckoning by means of a succession of judicious refinancings, exactly like an overburdened homeowner rolling up his P&I payments each and every month?
Such a lowly level of defaults may well have seemed to endorse the low risk premia being demanded as recently as this summer, but this same feedback is likely to show an equalling self-exacerbating (but inevitably more vertiginous) reversal now that the fat lady has, at last, begun to warble.
Yesterday Once More
As we have repeatedly warned, the credit cycle IS the business cycle and with the first having ploughed so disastrously through the crash barrier it is inconceivable that the second can stay on the track. An Austrian economics maxim is that a treatment of the cycle may well start as a monetary problem, but that it always ends up as a real one.
Here we would note some uncomfortable parallels with the late 1920s/early 1930s. Though history often forgets this, Jazz Age exuberance did not just express itself in the steep rise on Wall St, but also in the granting of copious loans by creditor America to debtor Europe and Latin America where it was used in a highly unproductive fashion to build apartment blocks and municipal swimming pools, as well as to support ailing industries and stabilize commodity prices.
When this flood was suddenly staunched as the Young negotiations became bogged down in 1928, it caused the hot money to rush back home where it boosted the Dow to the unsustainable heights of 1929, in outright defiance of contemporaneous moves by the central bank to reduce the liquidity pouring into stocks.
As the credit-starved foreigner consumers were forced to draw in their horns, however, US exports started to fall off and domestic output started to cool, driving a fatal wedge between soaring stock prices and faltering business performance. Furthermore, as the indebted were severely restricted in the volume of trade goods they could remit in payment of their debts – thanks to a spectacularly ill-advised tariff policy – they began to bleed gold as a consequence, tightening the monetary vice further.
At last, the strain became too much and their banks began to freeze up, culminating in the devastating 1931 collapse of Austria's giant Creditanstalt, itself mortally weakened through having been used previously as a rescue vehicle by the government of the day. In the upheaval which followed, the UK reneged on its adherence to gold, causing incalculable losses to holders of sterling reserves and provoking a further credit squeeze. The attempt to alleviate this ushered in a disruptive round of competing currency devaluations around the globe and turned the stock market crash into a deep, worldwide depression.
If we reverse the positions of the US and Eurasia and think of a gold drain then as a rush from the dollar today (conflating the current US administration's malign neglect of the world's reserve currency with the then-British government's pusillanimity in cutting sterling loose), we can get all the way to the Creditanstalt episode – for whose present analogue we are not lacking in likely candidates from which to choose.
Knowing this, however, and being aware that the Fed is currently headed by a Depression Era buff (if one whose Neo-Keynesian orthodoxy has led him to derive all the wrong conclusions from his studies), we can fully expect that these resonances will be all too apparent to policy makers and that they will be ready to take drastic and pre-emptive action at a moment's notice in order to avoid a full re-run of the scenario they all dread so much.
Right Back Where I Started From
Therefore, with the scale of the credit disaster potentially so enormous, there would seem to be only one course of action open to the authorities, however misguided this will be in terms of perpetuating the cause of our woes, not expunging them.
Firstly, we should expect short term rates to be slashed in order to steepen the yield curve and ease banks' financing costs, while simultaneously tempting Dollar-shy foreigners to buy currency-hedged US assets by means of cheap, short-dated loans.
Secondly, a sizeable slug of the sour credit will have to be repackaged and co-opted by a government which will promptly run much larger budget deficits (perhaps compounding this fiscal loosening with the electorally attractive expedient of greater tax breaks for property owners).
When seeking to issue more Treasury notes against the junk, the Federal government will find it convenient that the Fed (and the Basel rules) will have already made them into a suitably rich, capital requirement-lite, income stream for the ailing commercial banks, thus helping them rebuild their battered balance sheets.
No doubt this process will be augmented by an upsurge in the mutual back scratching whereby one bank subscribes to a 'capital'-raising issue from a peer in the full expectation of receiving both a larger credit line and a swift quid pro quo when it comes to the market on its own account.
(NB: We put 'capital' in inverted commas to emphasize just how specious this process really is, consisting, as it does, of little more than a series of offsetting book-entries between failing fractional reserve franchises).
On the face of it, none of this would be of much comfort to a dollar which may presently be heavily oversold, but whose structural weakness is hardly a source of puzzlement. Lower rates and steeper curves would not only draw in new, currency-neutral buyers of US assets, but would also see existing holders heavily incentivised to seek protection by selling forward, at least during the period of overall adjustment.
However, the one thing which might frustrate the bears is that any further upward pressure on the Euro is likely to see to see the ECB capitulate in its own sham combat with 'inflation' (neither must we forget that European banks may need a little yield curve help of their own, as the crisis unfolds).
If this happens, the Asians will be faced with an imminent shrinkage in both their prime export markets – rather than having the one take up the slack provided by the other, as is currently the case. They will doubtless then respond in time-honored fashion by seeking ways of pumping in more of their own currency and pouring prodigious amounts of concrete as a counter.
Thus, as the Inflationary boom rolls over into a credit-led slowdown, we are likely to see a radical shift back to government as the main conduit of a renewed Inflation...an Inflation needed to keep the banking system afloat and to keep individuals from taking to the streets.
This change of emphasis will not be without its frictions, of course. So a period of falling profitability, increased joblessness, and sub-par GDP growth is a distinct possibility (even if this last, flawed measure does not manage to register the two successive quarterly contractions needed to qualify – semantically speaking – as an official 'recession').
However, if the Leviathan of government is to be the main deficit spender in this next round of Inflation, we can clearly expect fewer supply-side wonders to accompany its outlays. Political dole will be directed at buying votes, not enhancing efficiencies, meaning more power will be ceded to domestic labor – especially in the overgrown public sector – allowing it to seize a larger share of the proceeds.
This power will also be backed up with heightened barriers to trade, if necessary, as the backlash against 'globalisation' intensifies.
Such an outcome means that the new Inflation is far more likely to degenerate straight into 'inflation' – rising consumer goods prices – than the old one it replaces, disappointing those who automatically assume that slower growth ensures lower prices, irrespective of the prevailing monetary conditions.
Keynesian economists – being so verbally hung up on their narrow concepts of 'inflation' – never could get their heads around the concept of 'stagflation'. But they'll soon discover what it means. Financial assets could be in for a rough ride if this is the case – that is, if the intent to avoid the icy wastes of the 1930s leads us straight into the searing desert of the 1970s instead.
Conversely, the experience of that latter dark decade (the first dark decade in economics, incidentally, after 1933) suggests that, after a further bout of liquidation by the speculative crowd, commodities might find a second wind, though with a distinct change of dynamic which means investors would be wise to de-emphasize exposures to primary inputs to industrial growth (bulk base metals, iron ore, and coking coal) and re-orient themselves to end-consumables (foods and fuels) and anti-money 'hoardables' (precious metals such as Gold Bullion Investments and diamonds).
There would be a certain grim irony to be had if things do come to this pass for, as the great Richard Cantillon well understood, nearly three hundred years ago, Inflation and 'inflation' are just as often enemies as friends and that paper money is ultimately a poor substitute for hard money, known in the trade as "specie":
"In 1720 the capital of public stock and of Bubbles which were snares and enterprises of private companies at London, rose to the value of 800 millions sterling, yet the purchases and sales of such pestilential stocks were carried on without difficulty through the quantity of notes of all kinds which were issued, while the same paper money was accepted in payment of interest. But as soon as the idea of great fortunes induced many individuals to increase their expenses, to buy carriages, foreign linen and silk, cash was needed for all that, I mean for the expenditure of the interest, and this broke up all the systems.
"This example shews the paper and credit of public and private Banks may cause surprising results in everything which does not concern ordinary expenditure for drink and food, clothing, and other family requirements, but that in the regular course of the circulation the help of Banks and credit of this kind is much smaller and less solid than is generally supposed.
"Silver [and gold] alone is the true sinews of circulation."