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Why the Fed will failRobert Wutscher The set-up for a deflationary collapse - December 2009 Most investors are positioning themselves for an expected up-tick in inflation driven mainly by "quantitative easing" and the expectation that the Fed will not be able to withdraw liquidity later on. Inflation assets are currently being bid up while deflation assets are being bid down. What are deflation assets? These would include shorts, bonds and cash. The covering of shorts only adds to the upward thrust of inflation assets. The effect on price of a sell off in bonds is fairly straight forward (price is bid down and yields go up). In the case of cash/deposits at banks you have to ask yourself, if people are exchanging cash for inflation assets, what is being done with the cash by the sellers? Unless one believes that it is just going round in circles driving up price (i.e. sellers soon change their minds and buy again, leading to the next round of sellers regretting their decisions, only to find themselves on the buy again in an everlasting price chasing and supposed profit-booking frenzy), the only other alternative is that cash goes into circulation of consumption activities and drives up consumer goods prices. For as long as inflation is not actually increasing, the money has to be going elsewhere. As we are ruling out an increase in cash holdings (as this would negate the positioning for inflation) and consumer goods prices are not yet increasing, it must be going towards debt reduction. This would also be the ultimate reason for there still being willing sellers - net of those selling for consumption requirements - of inflation assets. An increase in inflation hedge positioning by most investors is therefore beginning to trigger a liquidity crisis as bank deposits start to contract. Higher commodity prices, driven by the speculative positioning as opposed to real demand, place pressure on business margins. In the beginning business activity may even show signs of recovery as businesses too partake in the positioning for inflation by buying inventories while these are perceived to be cheap relative to the future (and thanking their lucky stars that they bought cheaper the week before, regardless of the fact that their current margins continue to fall under pressure). Thus you have the combination of a liquidity contraction as well as an eventual business contraction: the perfect set-up for a deflationary collapse. One possible missing ingredient: the waiting for the inflation that does not arrive. Why should it not arrive?: too much private debt relative to net private income. Why inflation will have no traction in 2010 It has all to do with the level of PRIVATE debt, not public debt, Stupid! I think that this is the differentiation that the inflationists fail to make. Inflationists assume hyperinflation on the basis of the unsustainability of the public debt. When considered, private debt is merely added on to strengthen their case, without considering that its dynamics in human decision making could be very different. If the level of private debt was sustainable, and the public debt exploded to extremes, then I would concur with the inflationists that hyperinflation is indeed the path of least resistance. Where may the tipping point towards a possible deflationary outcome lie. Pyramid schemes are sustained until there are not enough new people joining the scheme. Where this involves money, the pyramid scheme can carry on for longer until the point is reached where not enough new money is entering to meet withdrawals from the scheme. If you regard fractional reserve banking as a form of pyramid scheme, you would almost be correct to assume that because the amount of fiat money is infinite, there is no tipping point. But because we are dealing with the real world, where money is sometimes exchanged for real goods, there is a limit to be found after which money, instead of continuing to expand, starts turning upon itself (in the form of cancelling credit from which money was created in the fractional reserve banking system). This point has all to do with the level of private debt, as private debt forms the underpinnings of the productive sector of the economy. If the level of private debt is sustainable, then the printing of new money can be accommodated in the form of higher prices for output covering higher nominal interest rates that will be demanded. If, however, private debt is unsustainable, then policies of inflation lose their traction on the real economy. This is because the interest payments on overextended debt, which will also be reflected in overinflated asset values, far exceeds the net national income that can be produced by an increase in money. Money instead finds it easier to repay debt, than remain in circulation. Higher nominal interest payments necessitated by a policy of higher inflation would kill off the economy before higher nominal prices would have a chance to take effect. For example, imagine private debt as 150% of net national income (roughly defined as company net profits plus private net earnings - salaries minus living expenses including what some may classify as net capital gains for themselves. Note: this figure may be significantly lower than GDP). A 1% increase in nominal interest rates will then eat into productive earnings by an additional 0.5% for every anticipated increase in the rate of price inflation, i.e., a 2% nominal increase takes out 1% of productive earnings, etc. If the real rate of interest is say 4% in the aggregate economy, then it only takes an 8% increase in nominal interest rates before aggregate productive earnings are absorbed by third party financiers. At some point, businessmen will just consider it not viable to expand/even continue production and consider a much better use of additional money for the repayment of debt. This last sentence should be qualified as it is a rather complex process, not just involving the decisions of businessmen, but also that of consumers (unwilling borrowers), financiers (unwilling lenders), etc. The main point I am trying to make is that the economy falters on the weight of its interest burden. On the basis of basic supply and demand economics, you could argue that the reduced output/supply of goods provides an impetus for higher prices. But I think that it is possible that the weight of private debt can attract a greater pull on additional money than remaining in circulation. If such is the case, you will also see declining demand (manifested in the rise of unemployment/increased saving) meeting the decline in supply until we are back to sustainable levels of private debt (at which point productive returns for entrepreneurs again exceed interest to third parties at the aggregate level). The 1970s could have led to hyperinflation if Paul Volker had not raised interest rates when he did. The raising of rates did not kill the economy and I think this proves that the level of private debt was still sustainable back then. I would not bet the same today! The implication of all this for policy purposes is that if the Fed wanted to create high inflation in order to reduce the public debt burden, it should have done so before private debt had reached its present levels. Also, once on a hyper-inflationary path that started off with a sustainable level of private debt, there is little danger that private debt levels should become unsustainable thereafter (as prices can keep moving up faster than the level of real debt). This is not to deny an eventual collapse of the economy from following a hyper-inflationary path, but the collapse would be of a different dynamic. It would seem that the best conditions for creating an unsustainable level of private debt is a prolonged period of low monetary and/or price inflation, just as we have experienced up until about 2007. Conclusion The path to inflation is by no means a straight one as we have already witnessed in 2008. Whereas questions are raised regarding the ability of the Fed to withdraw liquidity at the appropriate time later on, very few seem to be questioning the potency of the Fed in its stated objective of being able to inflate away the economic problems for which it has been largely, but not wholly, responsible. Just because it has been able to create “benign” inflation for so long on the back of record credit creation, does not mean that it will be able to continue this path into the ground. As investment analysts the world over are apt to state: "past performance is not necessarily a guide to future performance" – the “not necessarily” providing a shadow of hope that it is. The same should apply to the Fed with regard to its stated objectives. ### Robert Wutscher The shadow economist, Robert Wutscher, is a retired financial due diligence specialist who has taken up the study of economics. His study has turned to the shadow side of economics: what most economists ignore, suppress or fail to account for in their models under the light of mainstream economic consensus methodology. A rich resource exists in many old economists who have passed away with insights that do not sit comfortably in today's quantitative models and with warnings/lessons of the past going unheeded. The modern consensus methodology is primarily based on quantitative methods and generally considers only economic aspects and assumptions that are amenable to quantitative analysis, even if this can only be done with abstraction of reality or of the mathematics itself. It ignores other concepts essential to human decision making, that may be too hard to quantify and that may be hidden in the shadows of the aggregates and averages that form the edifice of macroeconomics and econometrics. The shadow economist is new on the block and will generally challenge the conventionally held wisdom even that of the gold bugs. He welcomes constructive criticism. He can be reached at rwutscher@telkomsa.net 321gold Ltd |
