Dueling Ghosts of Past Economic Calamities
The IMF is clearly not satisfied with the current state of affairs in Europe. Not only has the global "agency" reduced growth forecasts across the board, it is predicting a global contraction absent comprehensive solutions to the PIIGS problems. Setting aside the obtuse idea that the world's economic problems only reside within the PIIGS, the stakes are very high in the manner and method that Greece pioneers before its March zero hour. The entire banking structure awaits some kind of agreement, knowing full well that this is the test case that decides how the multi-trillion euro/dollar sovereign problem will likely be decided.
Germany, for the most part, wants restraint, a position not hard to understand given that it is still living with the legacy and remnants of its hyperinflationary episode of the early 1920's. The global establishment, on the other hand, is fixated on the decade after, the 1930's. We have dueling ghosts of past economic calamities.
Germany views unbridled money printing as the ultimate monetary mistake, no matter how challenging the economic environment or how rotten the banking system. The global establishment, including the IMF, sees deflation as the primary danger, the doomsday machine that will be unleashed absent sufficient "resources". With that in mind, Christine Lagarde, the head of the IMF, earlier this week warned the world, but aimed squarely at Germany, that:
"The global economy faces a depression-era collapse in demand if Europe doesn't quickly act to dramatically boost the size of its debt-crisis firewall, implement pro-growth policies and further integrate the euro zone. It is about avoiding a 1930s moment, in which inaction, insularity, and rigid ideology combine to cause a collapse in global demand."
If we analyze the chain of events leading to a 1930's-style collapse, what Ms. Lagarde is warning us as the likely path of "inaction" and adhering to "rigid ideology", I believe it goes like this: bank losses lead to firesales of assets in liquid markets leading to widespread price declines, depressed market prices then force losses into a wider subset of banks within the global system (especially a forced reprice of the entire "risk-free" sovereign class) leading to a further collapse in credit availability that intersects with the real economy by creating a shortage of usable currency, leading directly to the dreaded currency "disease" (Irving Fisher's word) of deflation.
That last step of real deflation and currency disease, however, is not complete without a widespread malaise where the demand for currency is near exponential, meaning that individuals value "liquidity" over real economic items. The scale of collapse in the early 1930's, transmitted as a monetary shock through the banking system, followed exactly this path.
Losses in a few banks led to firesales in bond markets that transmitted "contagion" to other banks, leading to further bank runs, collapsing the stock of money, creating a shortage of currency that forced a large proportion of the general population to sell personal possessions (real, not financial) to gain exposure to some manner of liquidity. In other words, the collapsing pyramid of fractional reserve lending made it all the way to the public-at-large. Firesales of real assets is the stain and strain of deflation, depressing the value of real production (including raising the cost of a rigid labor force that demands "sticky wages"), enforcing a feedback loop of financial and real economy destruction.
The question I have today, and one that I have been asking since 2008, is whether or not the final step in the deflationary collapse is even possible in a modern system. There is no doubt that there were deflationary "pressures" building up in 2008 and 2009, but there is no evidence those pressures were going to be exhausted into the general population's general usage of currency. There was, indeed, a desperate shortage of dollars, but that shortage only existed in the eurodollar and Fed funds wholesale marketplaces, the balance sheet world of interbank finance. In other words, the only place the currency disease existed was within the banking system itself. It was the world's first banking panic that consisted entirely of only banks panicking.
Money market funds were the only sector that came close to public panic. But the potential for "breaking the buck" in several money market funds does not/would not lead to a general shortage of currency. The wider population of consumers and households had been effectively insulated by perceptions of the FDIC's guarantee of deposits (especially once that guarantee became unlimited), meaning that money market investors had a viable banking-system alternative to park balances.
There was no shortage of real currency, physical cash or digital deposit balances, that would have forced consumers to begin selling their furniture, clothing or automobiles to raise cash for the very basic necessities of buying food and shelter. Even in Europe and Britain, where deposit insurance imposed some losses at lower levels, there were no runs on physical currency stock or deposit conversions (outside of a few exceptions like Northern Rock). Without a real and widespread currency shortage, true deflation is simply not possible.
The major intersection of the real-world economy with the banking system's shortage (which has been chronic) of dollars was credit to businesses. Yes, credit availability dropped amongst consumers and homeowners, but the scale of the economic decline in the fourth quarter of 2008 and first quarter of 2009 was paced by business "investment". Without working capital financing, inventory levels, and thus production, nearly ceased, especially in automobiles. Business equipment spending (capex), again without access to credit, also collapsed.
Of the nearly 9% annual rate of decline in Q4 2008 GDP, 47% was due to inventory contraction and lower business spending on equipment. Of the nearly 7% annual rate of decline in Q1 2009 GDP, inventory and business equipment was responsible for 76% of it.
Real currency was not in short supply in 2008 and 2009, credit money was. That is a vital distinction in the context of why and how the economy has failed to recover, and why the banking system exists in this chronic state of malady.
The funny thing is that the economy did recover (to some small degree) without ever reconciling this credit shortage. Within the three most robust (if they can be called such in the context of both the scale of contraction and historical recoveries in general) quarters of economic growth, according to GDP calculations, inventory and business equipment spending accounted for nearly all of the recovery. Of the 3.8% annualized rate of GDP growth in Q4 2009, 123% was due to those two segments (meaning inventories and equipment more than offset declines elsewhere). The next quarter, Q1 2010, saw 3.9% growth, 113% from our two segments. Finally, Q2 2010 registered 3.8% growth, this time 59% due to inventories and equipment spending.
Bank credit, to the contrary, continued to contract at the same time as this turnaround in the worst hit portions of the real economy. Commercial and industrial loans from commercial banks operating in the United States (including branches of foreign banks) contracted a further 10.6% during those three quarters, on top of the 9.2% decline during the crisis' worst days. The inventory and equipment revival was accomplished through other means: corporate bond debt.
In response to the credit money shortage, large businesses able to float bonds directly to investors, bypassing the intermediation system completely, issued any and all bonds they could. The real economy was able to at least begin to heal itself without having to solve the credit money problem at all. Of course this has been extremely uneven to say the least, forcing most small and mid-sized businesses into a lower tier recovery where self-financing has become more the norm, but the point here is that a credit money shortage is not at all the same as a currency shortage. Once large businesses figured out they could no longer count on banks for financing, they went elsewhere because there was still someplace else to go - there would not have been in a real currency shortage situation like that of the 1930's. Money found a way to close the loop of economic circulation because there was more than enough money available.
For all the commotion about deflation, it has largely been constrained to asset prices. Even here there is no mystery to it. The valuations of so many assets, especially credit assets, were set far too high in the confines of the last asset bubble. The ability to repay borrowed credit money was assumed to be far too vigorous given the level of artificial stimulation through real estate prices and extremely low credit standards (especially the costs of money and risk). Once the U.S. housing bubble collapsed, the global ability to repay has dropped with asset prices, meaning so many credit assets have had to be reduced in true value (while central banks try to prop up transactional prices). This was done to some extent in the mortgage bond arena, but government debt was largely unscathed.
It has been assumed that a robust recovery would solve this repayment impairment, meaning the realization that there is no robust recovery around the corner has given impetus to the attempt to revalue sovereign issues. Whatever deflationary pressures exist today are a direct function of the lack of recovery running through bare tax coffers. The level of credit money borrowed during the height of the artificial economic period cannot be repaid absent another artificial economic period.
This has produced the dual challenge of ensuring enough credit still flows to sovereigns weighed down by those bare tax coffers that will continue to get even more bare, while also managing the valuation hit to the banking system that ended up buying most of those bonds. Forcing banks to revalue these multiple trillion euros of bonds will necessarily lead to another round of credit contraction (in the U.S. as well as Europe, since European banks are a large source of U.S. credit through the eurodollar market, and U.S. banks hold more than trivial amounts of European sovereign debt - MF Global is not the only Wall Street bank that bet on exactly what Ms. Lagarde is pitching).
Will another credit contraction lead to devastating deflation, the currency disease of 1930's lore? Nothing is impossible, but I find it very unlikely. Again, bank losses would have to endanger the real currency stock of the general population, meaning deposit guarantees would have to be overridden, fail or be perceived as totally inadequate. Real currency would have to be destroyed right alongside financial asset values, despite the immense firewalls (to borrow a term) that have been erected as far back as the 1930's to ring fence (to borrow another) the general population from the banking system.
This is not to say another credit crunch would be a non-event. To the contrary, another credit crunch would likely lead to another recession and contraction, probably with inventory erosion leading the way. Any kind of interruption is always likely to produce a dislocation while the real economy sorts out the type and magnitude of a changed input. I think the IMF has it right in that regard, but none of this is the same as devastating deflation. Again, deflation is, and has been, contained today wholly within the realm of the financial economy. As the financial economy recedes, it produces imbalances that imperil the banks that made bad choices (which seems to be nearly all of the large ones), but not the general population's access to real currency.
The response of authorities to financial deflation has been very telling in this regard. Using narratives of a rerun of the 1930's, authorities have been allowed to pass along massive bank losses (diffusing these so-called deflationary pressures) to the wider population through taxpayer-funded bailouts and intentional inflation. In the toolkit of central banks, inflation is believed to be a lot like duct tape - it is useful in so many applications. For central banks, inflation not only counteracts and defends against deflation (including potential deflationary "pressures" that have yet to manifest anywhere in the real economy), it also reduces and socializes financial losses (if a bank made really bad lending choices to the tune of $50 billion, then a 50% increase in base money theoretically reduces that loss-load by a proportional amount).
The IMF clearly would like to try to increase base money by as much as possible to reduce and diffuse to you and me the banking system's very real losses. But if deflationary pressures only exist, as I contend, within the financial economy (having no direct, available channel to the real economy), then why would it not be better to focus their efforts on managing that imbalance where it already exists? In other words, rather than socializing everything in an attempt to disperse deflationary pressures among a broad base of real economy participants that are largely innocent and coincidental to all this, shouldn't policymakers focus on marshalling all their resources to manage the banking system's decline, with particular emphasis on insulating it completely from the real economy? To date, central banks have done the opposite.
Without making the case that the real economy does indeed have real deflationary pressures that go beyond financial asset prices, there is little argument for socializing losses and/or printing money. I suspect that the current policy regime knows that, thus the emotional appeal to the Great Depression in the hopes that the public fails to see the distinction between a credit money shortage and a real currency shortage. Preserving the current system in largely its current form is evidently the prime motive for every monetary action around the globe. The use of a deflation scare is just a rationalization; and in light of the rebound in inventories and equipment investment, it is not even a good one.
Because of the outsized role the financial economy has played in creating artificial levels of economic activity, a managed decline of that financial economy should actually be desirable. That necessarily means a system more in tune with the real economy, further meaning the financial system would be relegated to a support role in economic matters, not a prime one (where the IMF itself would be either an afterthought or did not exist at all). It would also mean that intermediation returns to more boring and traditional notions of actually intermediating credit, making the easy money, high flying returns of the current system the anachronism. Nothing marks this imbalance of the financial economy so much as how speculation has overwhelmed true productive investment.
However, none of that appeals to the IMF, ECB or Federal Reserve. A more traditional system of real economy over financial means less direct ability to control and manage. It would be an economy less likely to follow centrally manipulated inputs, impervious to the mathematical designs of 21st century central planning. Less financial economy means a dispersal not of losses, but of power and decision-making. It is a bottom-up system, not the top-down malfunctioning mess we currently exist with.
Ms. Lagarde, in her statement at the outset of this piece, referenced something far truer than she probably realizes. In terms of the current recovery, "rigid ideology" is probably the single largest reason for the inability of the economy to move beyond the 2008/09 dislocation. In every policy decision and program, the banking system has received the highest priority no matter what circumstances or conditions might otherwise dictate. The devotion of the financial policymakers and authorities has been unconditional, regardless of any sizable impositions upon the larger population. Not only have we withstood the intentional stoking of inflationary expectations through determined dollar debasement, savers have been taxed to nothingness through ZIRP (which will reach a very Japan-like six years if allowed to run all the way to its scheduled conclusion - though I have little doubt that next January the Fed will be renewing its commitment to ZIRP through 2015 or 2016).
We are supposed to believe that the banking system and the economy are one in the same. That if one fails, they both fail. Yet, in late 2009 and early 2010, the real economy decoupled (to use a word currently en vogue) to a large degree from the financial. That leaves the financial economy in a very precarious position where asset deflation is the rightful and proper course. It is attempting, through a measure of what I have called financial gravity, to revert back to something more balanced. But that means financial pain is still in the future, an unavoidable outcome of so many years (decades) of unrequited and unrelenting financial dominion.
While the real economy continues to suffer the very real effects of this artificial decay, it can function on its own as the corporate bond market amply demonstrated for anyone paying attention. If anything, peeling the real economy away from the financial economy's artificial façade is a positive sign of progress. The one constant about artificial, asset inflation-driven growth is that it is utterly unsustainable, unsuitable for long-term economic health. Yet until policymakers are forced to admit as much, they will continue to push for the artificial over productive, the financial over the real. The status quo is to be maintained no matter how much sense the opposite position makes. Rigid ideological adherence to ghosts of the 1930's is the order of the day, whether or not it is ever really appropriate.
