I can sense a growing unease as I talk with investors and other friends, from professional market watchers and traders to casual observers. What in the Wide World of Sports is going on? It is not just that markets are behaving in an unusual and volatile manner (see chart below showing multiple double-digit moves in the last few months); it’s that the data seems to be so conflicting. One day we get data that shows the economies of the developed world to be slowing, and the next day we get positive numbers. The ship of the economy seems to be drifting rudderless.
My dad used to say about a situation that just didn’t seem quite right that things were “about a half a bubble off dead center.” (This was back in the days when we used bubble levels to determine whether something was level or plumb – before today’s fancy digital gadgets.)
There is a reason, I think, that everything seems just a little out of kilter. I believe that central banks, in their valiant, unceasing efforts to restore liquidity and growth, have unleashed numerous unintended consequences that are beginning to show up in earnest. Today we are going to review the well-meaning behavior of central banks for clues about our near future.
Now let’s look at what central banks are doing to us.
Stuck in a liquidity trap?
A few years ago, Jonathan Tepper and I wrote a book called Endgame, in which we talked about liquidity traps developing at the end of debt supercycles. And we certainly did have a liquidity trap, all over the world. The major central banks came up with rather radical policies to deal with it, and those were necessary at the time. But then, like the proverbial Energizer Bunny, they just kept going and going and going.
Central banks have proven that they can make money cheap and plentiful, but the money they’ve created isn’t moving around the economy or stimulating demand. It’s like a car. Our central banker can put the pedal to the metal and flood the engine with gas; but because the transmission is busted, it’s hard to shift gears, and power isn’t delivered to the wheels. Without a transmission mechanism, monetary policy is ineffective. Study after study has shown that quantitative easing didn’t produce the “bang for the buck” that central bankers hoped it would. After a credit crisis like last decade’s, central bankers can cut the nominal interest rate all the way to zero and still not be able to get their economies in gear. Some economists call that a “liquidity trap” (although that usage of the term differs somewhat from Lord Keynes’ original meaning).
The Great Recession plunged us into a liquidity trap the likes of which the world hadn’t seen since the Great Depression, although Japan has been more or less mired in a liquidity trap since its bubble burst in 1989.
Economists who study liquidity traps know that some of the usual rules of economics don’t apply when an economy is stuck in one. Large budget deficits don’t drive up interest rates; printing money isn’t inflationary; and cutting government spending has an exaggerated impact on the economy.
In fact, if you look at recessions that followed on the heels of debt crises, growth was almost always very slow. For example, a study by Oscar Jorda, Moritz Schularick and Alan Taylor found that recessions that occurred after years of rapid credit growth were almost always worse than garden-variety recessions. One of the key findings of their study is that it is very difficult to restore growth after a debt bubble.
Yet Paul Krugman took a victory lap this week on behalf of the reigning economic paradigm and its role in the U.S. recovery. While he was at it, he chided Europe for not pursuing the same policies:
It’s true that few economists predicted the crisis. The clean little secret of economics since then, however, is that basic textbook models, reflecting an approach to recessions and recoveries that would have seemed familiar to students half a century ago, have performed very well. The trouble is that policymakers in Europe decided to reject those basic models in favor of alternative approaches that were innovative, exciting and completely wrong.
Actually the difference in the performance of the U.S. and European economies was almost all attributable to our shale oil revolution. Without it, U.S. growth would have been closer to 1% than our recent anemic 2% average (and likely to be 1% for the recent quarter).
Was it really central bank policy that made the difference? Let’s examine.
Central banks in the U.S., Europe and Japan want to create modest inflation and thereby reduce the real value of debt, but they’re having trouble doing it. Creating inflation isn’t quite as simple as printing money or keeping interest rates very low. Most Western central banks have built up a very large store of credibility over the past few decades. The high inflation of the 1970s is a very distant memory to most investors nowadays, and almost no one seriously believes in hyperinflation. The UK has never experienced hyperinflation, and you’d have to go back to the 1770s to find hyperinflation in the U.S. – when the Continental Congress printed a boatload of money to pay for the Revolutionary War. (That’s why the framers of the Constitution introduced Article 1, Section 10: “No state shall … coin money; emit bills of credit; make anything but gold and silver coin a tender in payment of debts ….”) Japan and Germany have not had hyperinflation for over 60 years.
Today’s central bankers want what they consider mild inflation (~2%) but only in the short run. (They would probably tolerate 3-4% before they leaned heavily against it in today’s economic environment.)
As Janet Yellen has recognized, central banks with established reputations have a credibility problem when it comes to committing to future inflation. If people believe deep down that central banks will try to kill inflation if it ever gets out of hand, then it becomes very hard for those central banks to generate inflation. And the answer to that problem from many economists is that central bankers should be even bolder and crazier – sort of like everyone’s mad uncle – or, to put it more politely, they should be “responsibly irresponsible,” as Paul McCulley has quipped. And yet there is a growing chorus of serious economists beginning to suggest that keeping rates at 0% for six years is just about irresponsible enough.
In a liquidity trap, the rules of economics change. Things that worked in the past don’t work in the present. Central bankers’ economic models, iffy in the best of times, become even less reliable. In fact they sometimes suggest actions that are quite destructive. So why aren’t the models working?
Sometimes the best way to understand a complex subject is to draw an analogy. So with an apology to all the true mathematicians among our readers, I want to revisit what I call the Economic Singularity. I must confess that when I coined the term in 2012 I had no idea how accurate the description would become in the past few quarters.
The economic singularity
Singularity was originally a mathematical term for a point at which an equation has no solution. In physics, it was proven that a large enough collapsing star would eventually become a black hole so dense that its own gravity would cause a singularity in the fabric of space-time, a point at which many standard physics equations suddenly have no solution.
Beyond the “event horizon” of the black hole, the models no longer work. In general relativity, an event horizon is the boundary in space-time beyond which events cannot affect an outside observer. In a black hole, it is “the point of no return,” i.e., the point at which the gravitational pull becomes so great that nothing can escape.
This theme is an old friend to readers of science fiction. Everyone knows that you can’t get too close to a black hole or you will get sucked in; but if you can get just close enough, you can use the powerful and deadly gravity to slingshot you across the vast reaches of space-time.
One way that a black hole can (theoretically) be created is for a star to collapse in upon itself. The larger the mass of the star, the greater the gravity of the black hole and the more surrounding space-stuff that will get sucked down its gravity well. The center of our galaxy is thought to be a black hole with the mass of 4.3 million suns.
We can draw a rough parallel between a black hole and our current global economic situation. (For physicists this will be a very rough parallel indeed, but work with me, please.) An economic bubble of any type, but especially a debt bubble, can be thought of as an emergent black hole. When the bubble gets too big and then collapses in upon itself, it creates its own black hole with an event horizon beyond which all traditional economic modeling breaks down. Any economic theory that does not attempt to transcend the event horizon associated with excessive debt will be incapable of offering a viable solution to an economic crisis. Even worse, it is likely that any proposed solution will make the crisis more severe.
We are fast reaching the point where markets are crossing the event horizon, where mathematical investment analysis no longer makes sense. We read that some 25% of bonds in Europe now offer negative interest rates. How do your value equations work in an environment of negative yields? It becomes mathematically impossible for pensions and insurance companies to meet their goals, given their investment mandates, in a world of negative interest rates. While economists may applaud negative rates, those who will need their annuities and pensions are probably not yet aware that their futures have been mortgaged for a set of narrow economic goals, which look as though they are not being fulfilled at any rate. When the bill comes due in 10 years, those in charge today will have moved on to other more lucrative opportunities, and pensioners will realize how screwed they have been.
German bonds have negative yields out to the eight-year mark, as yields have steadily dropped for the last three years:
Switzerland is now issuing 10-year bonds at negative rates. Has lending returned to Europe? If you squint real hard, you might be able to detect an uptick in the next chart.
However, when you take a closer look, you find that the recent uptick is almost all in finance (in just two financial corporations, to be specific) and not in the household and business sectors, which are seeing credit lines being close to them. (Hat tip Alhambra Partners.)
I believe the world will soon find out that by holding interest rates down and allowing sovereign debts to accumulate past the point of rational expectation for being paid, in one country in Europe after another (Greece is just the first), central banks have pushed us past the event horizon, believing they have supernatural powers that will let the global economy escape the debt black hole that has been created by and for governments.
The Minsky moment
Debt (leverage) can be a very good thing when used properly. For instance, if debt is used to purchase an income-producing asset, whether a new machine tool for a factory or a bridge to increase commerce, then debt can be net-productive.
Hyman Minsky, one of the greatest economists of the last century, saw debt in three forms: hedge, speculative, and Ponzi. Roughly speaking, to Minsky, hedge financing occurred when the profits from purchased assets were used to pay back the loan; speculative finance occurred when profits from the asset simply maintained the debt service and the loan had to be rolled over; and Ponzi finance required the selling of the asset at an ever higher price in order to make a profit.
Minsky maintained that if hedge financing dominated, then the economy might well be an equilibrium-seeking, well-contained system. On the other hand, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy would be what he called a deviation-amplifying system. Minsky’s Financial Instability Hypothesis suggests that over periods of prolonged prosperity, capitalist economies tend to move from a financial structure dominated by (stable) hedge finance to a structure that increasingly emphasizes (unstable) speculative and Ponzi finance.
Minsky proposed theories linking financial market fragility in the normal life cycle of an economy with speculative investment bubbles that are seemingly an inescapable part of financial markets. He claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops; and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As the climax of such a speculative borrowing bubble nears, banks and other lenders tighten credit availability, even to companies that can afford loans, and the economy then contracts.
“A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”
continue reading: http://www.mauldineconomics.com/frontlinethoughts/half-a-bubble-off-dead-center
