Inflation and Deflation revisited

In December 2008 I came off the fence and plumped for deflation as inevitable. Mostly I reasoned that debasement of accounting practice, mismanagement of financial intermediaries, captured regulators that collaborated in perpetuating failure, and extremely poor market pricing of risks and fundamentals meant that there was litte incentive to save and no place safe to invest. I predicted that when the last great bubble in sovereign debt popped, deflation would work its cleansing power to restore fundamentals.

It is now clear to me that policy makers in the West are determined to apply every available resource to underpinning failure, misallocation and executive excess. As this discourages the honest saver from parting with cash, policy makers are ensuring that deflation will wreak its havoc on the financial and real economies of the world. Only when that deflation has played out and rational policies that reward market-based management and returns are restored will it be worthwhile to invest again.

The Fed permitting dividend hikes at bailed out banks only deepens my cynicism about the poor quality of regulation and the inadequacy of management controls.

Obviously, I was premature about deflation as events in 2009 and 2010 proved, but I am not convinced I was wrong in the longer term. Events this week in Japan, and political upheavals this year elsewhere, have me thinking that we are at a turning point in many ways. When the numbness that follows such a mammoth series of tragedies wears off, the public in Japan is going to be very angry. They have suffered three great catastrophes in one week: the 8.9 earthquake, the tsunami that swiftly followed, and the failure of safety controls at six nuclear reactors. We still don't know the scale of the final disaster, or what it will mean for the country or the world.

The Japanese state is to be congratulated that strict building codes preserved much of the physical infrastructure from the earthquake, and regular tsunami drills doubtless saved tens of thousands of lives during the tsunami. The most serious failure was in management, risk assessment and regulation of the nuclear industry. The anger will be that an industry critical to the economy, with powerful lobbyists close to government, was able to capture its regulators and erode safety standards until a crisis revealed the tragic short-termism. The anger will increase when the Japanese come to appreciate that the serial depredations of the banking industry have left them over-exposed with few fiscal policy options to meet the financial challenge of rebuilding and resettlement of refugees.

If the government and institutions of Japan are forced to liquidate and repatriate foreign assets, then fears of rising Yen and destabilisation of G7 economies are well founded. I believe it was the collective self-interest in preserving stability that motivated today's central bank interventions. The Yen appreciated 20 percent in the three months following the Kobi earthquake, and the scale of the current disaster - particularly with the risk of nuclear contamination of some part of the country - is likely to dwarf the Kobi effect.

As radiation reaches California from Fukushima today, we might all consider that regulatory capture places us all at some degree of risk. The crisis in California sub-prime real estate was borne by the currents of international finance to the pension funds of Norway and the savings banks of Germany. Both the nuclear energy industry and the banking industry had parallel patterns of political influence leading to regulatory capture and debasement of best practice, and ultimately ruination for a suffering public. It will be interesting to see how much accountability is demanded of management and regulators in the nuclear industry in Japan, and compare this with the lack of accountabiity for serial financial failures and bailouts.

Japan has 20 years more experience of financial sector accounting abuse and bailouts than the rest of us. And the result has been almost continuous deflation - even in the face of mounting deficits, ZIRP and quantitative easing.

Another factor that leads me to fear deflation over inflation is the risk of popping of the great China bubble. My view is that the Chinese economy slowed markedly in Q4 2010 as monetary tightening and administrative regulation of bank lending began to bite, and that the slowing has accelerated in 2011. This view has been confirmed by Gavyn Davies on his FT blog. With another rate rise today by the PBOC, and the supply chain shock of Japan's industrial disruption and power shortages, we could be in for a sharp, deflationary global contraction in the next few months.

UPDATE 20/03/11: Days before quake, plant operator admitted oversight

Days before Japan plunged into an atomic crisis after a giant earthquake and tsunami knocked out power at the ageing Fukushima nuclear plant, its operator had admitted faking repair records.

The revelation raises fresh questions about both Tokyo Electric Power Co (TEPCO)'s scandal-tainted past and the government's perceived soft regulation of a key industry.

The operator of the Fukushima No. 1 plant submitted a report to the country's nuclear watchdog ten days before the quake hit on March 11, admitting it had failed to inspect 33 pieces of equipment in its six reactors there.

A power board distributing electricity to a reactor's temperature control valves was not examined for 11 years, and inspectors faked records, pretending to make thorough inspections when in fact they were only cursory, TEPCO said.

It also said that inspections, which are voluntary, did not cover other devices related to cooling systems including water pump motors and diesel generators.

The report was submitted after the regulator ordered operators to examine whether inspections were suitably thorough.

Snake Oil and Deflation

First, an apology for neglecting the blog this past week as I enjoyed the damp, cold, rainy discomfort of an English seaside resort in August. As a European, I make no apologies for taking my full entitlement to holiday each year, but should have provided warning of my impending leave as I posted last Friday. I regret not being active in the discussion which the Fisher Debt-Deflation Theory prompted, and will follow up with a further post taking up some of the many substantive comments when I’ve returned to my office and can organise myself again.

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We are likely in future to have great debates on the who, how, why and wherefore of the coming recession/depression, particularly if it leads to global conflict and currency realignments that mark the end of Bretton Woods II and US economic hegemony. At base we have the quote I opened with last week:

“Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.”
- Mr John Mills, Article read before the Manchester Statistical Society, December 11, 1867, on Credit Cycles and the Origin of Commercial Panics as quoted in Financial crises and periods of industrial and commercial depression, Burton, T. E. (1931, first published 1902). New York and London: D. Appleton & Co

The difficulty is that the policies which financed highly leveraged unproductive works are extremely popular to the extent of representing the culture of at least two generations. While a deflationary recession/depression will make such policies even more costly and destructive than they have been in getting us to the critical point of failure, the same policies are such basic political drivers that without a culture change political and economic change become almost impossible.

It should be obvious that borrowing short through commercial paper to lend long on mortgages and credit cards to bad credits with inadequate collateral is not a sound business model. And yet somehow the alchemy of securitisation with a sprinkling of AAA pixie dust was widely accepted as turning financial lead into gold. It should be obvious that a house, once built, is not a productive asset as it produces no revenue but instead absorbs a high proportion of its owner’s income on mortgage interest, property taxes, maintenance and utilities. It should be obvious that credit card debt, once consumption goods are purchased, produces no productive income stream for repayment of the debt but instead becomes an obstacle to future consumption as debt service eats up a rising proportion of stagnant wages. It should be obvious that a car that weighs twice as much and uses twice as much fuel is not as productive as a car that is small and fuel efficient, and costing twice as much will harm more productive savings and investment with the excess debt borrowed for its purchase. It should be obvious that the financial sector, as intermediaries between savers and productive ventures requiring capital, should never rise to the point where it alone represents over thirty percent of economic activity. Nonetheless, markets all over the world carelessly followed the path of under-production, dis-savings and over-consumption as the path to prosperity rather than a betrayal of capital into hopelessly unproductive works.

It will be a very brave politician indeed that says that young people should save twenty percent cash for a downpayment on their first home (as is the rule generally in countries that never experience boom/bust property cycles like Germany and Switzerland). It will be a very brave politician indeed that says that consumers should save cash to purchase electronic goods and cars. It will be a very brave politician indeed that raises taxes on single family housing and privately owned cars in the face of a sustained housing market crash and sustained high oil prices. It will be a very brave politican indeed that says that the financial sector should not be government subsidised with tax breaks on interest, tax breaks on unproductive speculation, tax avoidance through off-shore registration of hedge funds and private equity, and other magnanimous means of raising election year contributions.

In short, the system which has for sixty years precipitated the greatest debt cycle in history may be inadequate to address the greatest deflationary cycle in history if it chooses to prescribe the same snake oil which sickened the economy in the first place rather than the balanced (fiscal) diet and (strict economy) excercise we all know would be better for us.

Even bank supervisors, who should know better than others that rapid asset growth is the surest indicator of bank failure, chose instead to believe the hype and ignore the reality. Instead of intervening to curb credit excess, regulators congratulated themselves on overseeing a robust and innovative financial sector while rewriting their rulebooks to embrace the market’s delusional ratings-based models for undercapitalising greater and less transparent risks.

If the core problem leading to the current seizure of the credit markets is the misallocation of credit into unproductive works during the boom years, then no amount of new credit will solve the problem unless the distortions promoting misallocation are redressed through fiscal and regulatory policy changes. Bailouts and recapitalisation of failed policies of the past are only digging a deeper hole, betraying more capital of younger generations into the unproductive works financed by the current generation.

Correcting the bias toward betrayal of capital will not be popular or easy. Correcting the bias toward unproductive investments will require a massive change of political structures, financial intermediation channels, savings and consumption habits, and economic incentives which challenge virtually every assumption made by at least two generations of American businessmen and consumers and exported globally.

Regulatory policies promoting misallocation of capital included elimination of restrictions on bank dealing and brokerage of securities and derivatives, self-determined models-based capital adequacy calculation, ratings-based weightings of capital assets, accounting reforms that permitted off-balance sheet financings and acceptance of ill-transparent corporate structures. Re-knitting that sweater/jumper, however ill-fitting and itchy, won’t be easy either.

Consumer credit is viewed as a fundamental necessity by virtually all classes of the workforce. Weaning the populace from borrowing to saving would require a huge shift of policy and popular culture. Few of the generations raised on instant gratification of desire will gracefully or voluntarily shift to living within their means and saving for their future requirements.

In short, there are no easy answers. We have hypothecated our future prosperity to repayment of our current debts. We will live less well in future, as will our children for a time. Whether by inflation or deflation our debts must be extinguished. Savings must be encouraged and must be allocated to productive investments that will yield not just future prosperity but social equity to minimise political conflicts.

Those who sold us or imposed on us the current set of policies and practices will be re-bottling their snake oil under new labels. We must be wary before buying bulk lots in the tens of billions of dollars worth of the same old snake oil that has sickened our economies and political processes already. In the US, I class the bailouts of Bear Stearns/JPM and Freddie/Fannie as snake oil, that perpetuates the subsidies to speculation and unproductive housing markets. In the UK, I class the talk of a cut in stamp duty (a transfer tax on house sales) as similar snake oil. Snake oil, unfortunately, wins elections because it appeals to constituencies that are politically important. As a result, we may be entering a dangerous phase where the democratic structures are biased to economically damaging policies that further harm future growth and prosperity because investment in unproductive works is so widespread as to form part of the popular culture.

Deflation challenges many of the assumptions that work in an inflationary context: “Property is a safe investment.” and “You’ll be fine in equities in the long term.” and “Governments don’t default.” When people are forced to reconsider these cherished touchstones of their financial beliefs, they will also reconsider the cherished notions of their political beliefs. It was under similar conditions that nations in the past embraced racial hatred, ethnic divisions, discrimination against gender/sexual preference, economic imperialism and war as a means of directing public discontent away from threatened elites.

Just bear in mind who sold you the snake oil that sickened you, and be wary of new bottles of whatever shape or size from the same salesmen.

Hattip: Steve Phillips who traced the Mills quote back to the original and corrected my attribution.

Credit Cards Contracting

From Javelin Strategy and Research:

“The sharp decline in credit card spending challenges the popular belief that more Americans are charging basic goods in order to sustain their quality of life,” said Jim Van Dyke, president of Javelin Strategy & Research. “Consumers are making deliberate cutbacks like shopping at superstores, eating out less and watching what they charge. We believe this is because most people have already been impacted by the downturn or they’re anticipating that we haven’t seen the worst of it. It’s very cautious behavior.”

Javelin analysts also found significant cutbacks among credit card issuers. Seven out of ten issuers have reduced efforts to solicit new customers and 62% have cut back the lines of credit they make available to consumers.

“From declining consumer use, rising risk levels, and possible new merchant fee legislation, the credit card industry is taking several hits right now, which could have unintended consequences on Americans,” said Bruce Cundiff, director of payments research and consulting at Javelin Strategy & Research. “If the economy continues to decline, consumers will likely be forced to turn to credit, but find it unavailable when they need it most.”

Tomorrow I'll be writing about debt deflation and how contractions in credit intensify into a deflationary spiral. Hint: It starts when the middle class gets squeezed so hard by wage stagnation that it can't support any more debt.