Deflation the symptom, Demographics & Debt the disease; Default the cure?


You should fear deflation, or so the story goes, as it puts a brake on the economy: In a deflationary environment, people expect the same amount of money to be worth more tomorrow. There’s then no point spending or even investing it, and borrowing to invest is true folly. The only anti-dote are negative (real) interest rates, so people ‘know’ that parking money without putting it into the economy will cost them. We are even seeing negative nominal rates now, and it’s still not working: bank’s aren’t lending, people are still saving instead of investing, and growth is sluggish.

Deflation can be a vicious cycle, in that the behaviour that it induces (saving instead of investing) can cause further deflation, because when people don’t expect growth, they don’t invest and don’t spend. Deflation is thus also a symptom of people expecting slow growth. Deflation isn’t the only brake on the economy : Others are debt (causing high taxes) and bad demographics, and these two brakes won’t go away, no matter who runs the country(ies) or the central banks.

Just look at the numbers: (1) We have never had such high national debt levels (compared to GDP) other than after major wars, and (2) humankind has never had such a high tax base. [If you want a very neutral, non-alarmist analysis of the state of the world, I recommend Vito Tanzi’s “Government versus Markets: The Changing Economic Role of the State“.] Historically, debt levels often recovered from these highs, but that was at a time of population growth. Today an incredibly high tax base isn’t sufficient to pay off the debt, not even at practically zero interest, because (a) growth is no longer supported by a growing supply of labor (remember: economic growth is the simple arithmetic product of growth of workers and growth of productivity per worker), and (b) the obligations to debtors and non-workers keep going up, not just because the number of non-workers keeps growing, but also because the number is already so large it can single-handedly and decidedly swing elections in its favor. It’s a simple truism that in any sizable western democracy today, no-one is powerful enough to take on the army of dependents of the state and stay in power at the same time.

A central bank, created by political fiat, cannot forever out-spend the real economy.

The increasing tension between very tight fiscal and very loose monetary regimes cannot build up indefinitely.  Fiscal constraints create brakes, which the central banks are already powerless to fight. One thing will snap with central banks: Either their balance sheets, or their social license to operate by simply betting the house again and again. A central bank, created by nothing other than political fiat, cannot forever out-spend the real economy. Switzerland, for entirely different reasons, just gave us a reminder that Greenspan puts (or calls) do expire (and have a negative theta). Politically it may be prudent to pretend otherwise, financially it is folly. The question is not whether central banks will run out of ammo, but how it will unravel when they do.

So first, when loose monetary policy comes to an abrupt end, interest rates immediately threaten to shoot up. There aren’t enough buyers of newly issued debt. From then on, governments either borrow at punitive rates or not at all. The only way out are rapid contraction of spending (which may, however, mortally damage the economy), or debt restructuring (a form of default) which, if done decisively enough, could pull most countries into surplus by taking the debt-servicing out of the balance of payments. To keep such a country in surplus thereafter, the restructuring (a form of default) has to go hand in hand with a devaluation of the currency, but there are plenty of ways (if they were needed) to engineer that outcome.

To avoid immediate damage at that first step of a debt crisis, a domestic investor’s strategy is straightforward: own real assets (land, houses, forest, ships, infrastructure, etc.) instead of financial, nominal ones (bonds, pension plans, insurance policies, cash, IoUs). Get leveraged, but be careful, because two things can kill: (1) the ‘carry’ while you wait for the lid to blow, and (2) interest rates if you get caught having to refinance at the wrong time. The safest way to build leverage is therefore to secure the loans against only a fraction of your assets (be prepared to lose those), and hold the bulk of your other assets as unencumbered, unleveraged. If you have already max-ed out on real assets (oil wells, roads, water pipes, forests), or you are too small an investor, putting some of your wealth in equities may give you just the right mix of exposure: equities give you leverage because as an equity investor you are the last in line for payments, and the leverage you have implicitly in equities is ringfenced: you can’t lose more than the value of those shares. The fact that massive government debt goes hand in hand with a seminal bull-run on equities is rational.

As a government debt crunch then unfolds further, the second step governments, policymakers (or, in their absence, the general public) will take is to re-distribute wealth on a grand scale. The fact that the gains and losses of the winners and losers after the first step (the default) will be measured in astronomical units means that a ‘clean slate’ has to be drawn up. That step is harder to escape if you are asset-rich. If your assets are domestic assets, they’ll get caught up in the great redistribution, and if you are a foreign investor (or invest through an offshore vehicle), you are likely to be even worse off: Firstly, if your off-shore assets end up ‘protected’ from the wealth redistribution by virtue of being off-shore, you are also unlikely to be able to use them. They become nominal wealth of no practical use. The second reason is that an offshore entity is where you book your returns, not where you generate them. The thing that you are ultimately invested in is likely to sit in a big country where the proverbial brown stuff has just hit, and your offshore vehicle, being a ‘foreign investor’, is unlikely to get away lightly, or perhaps even unlikely to be able to defend its rights to ownership (witness Argentina in the last few years).

How do you make personal wealth generally sustainable then, in an environment where there is the risk that public debt may not be repaid, and private wealth may be re-distributed? Only by a strategy that has sustainable advantage for all those around you.

Put simply, you need to own something that, at the depth of the crisis, people want, need, and still can’t take from you. That’s the sphere of human capital and social capital .

Put simply, you need to own something that, at the depth of the crisis, people want, need, and still can’t take from you no matter how bad things get. “Respect”, “reputation”, “skills”, all that soft stuff is the only possible answer to that riddle. Sustainable business, socially responsible business, and a reputation for ethical and compassionate conduct becomes a matter of economic survival, both for the individual, and for society, when things get really tough.

If, in the past, we have borrowed too much from the future, and you are one of the financial beneficiaries of that bought-forward growth, be prepared to pay your share. That’s not a threat, it’s advice for your mental health: It’s your choice whether to stare at the facts with generosity or contritely. The financial results will be the same.

Also, remember that the outcome of a debt crisis, or even of a default, is by no means always bad. It is the over-extended indebtedness that is unhealthy, and not necessarily the unraveling of the leverage that follows it. It is an interesting thought experiment, for example, to guess what would have happened if Greece had deliberately and unilaterally left the Euro and defaulted on its debt back in 2009. It would have had an immediate structural surplus, further supported by a collapsing currency. It would have been extremely stressful in the short term to be sure, but patently financially possible, to adjust to a life without foreign lenders. Perhaps Greece would be further now had it bitten the bullet and defaulted then instead of trying to starve its way to unattainable financial health within the context of its debt. No politician wants a big bang on their watch, but defaulting in any of its many guises can be a rational choice. But popular? Never.

Europe has the highest social spending per capita of any region in the world, and has had one of the lowest birthrates for decades, putting it on an utterly predictable path of sub-par growth. But growth is needed to service the debt. It’s an impossible mix. Deflation may make it worse, as it makes it harder to re-pay debt, but deflation is also a symptom of low expected growth.

The Swiss Nationalbank wasn’t able to depress the Swiss Franc forever. The new ECB actions to be announced this Thursday will also have a (financial and political) theta-cost, which means it’s all just a question of time until they too run out of road. But the type of loose monetary policy that would be needed to effectively offset Europe’s tight fiscal misery isn’t just too costly, it hasn’t even been invented yet. We are also unlikely to witness anyone inventing it between now and this Thursday’s eagerly awaited QE announcement. The ECB’s medicine may sooth the nerves, but it will not be the cure.

One response to “Deflation the symptom, Demographics & Debt the disease; Default the cure?

  1. Pingback: To Whom Tolls the Bell? | The Sustainability Report·

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