By John Mauldin
I fully intended to write today about a recently released academic paper that illustrates nearly every bad idea currently being bandied about in the field of economics. The insidious part is that the paper is considered mainstream and noncontroversial. Simply reading it required me to up my blood pressure medicine dosage. It is going to take me a little longer to finish that letter, and I realized that it needs a certain setup – one that coauthor Jonathan Tepper and I conveniently wrote a few months ago and included in the book Code Red.
So next week we’ll take a deep dive into the most dangerous economics paper written in a long time (that is perhaps only minor hyperbole on my part); but today, by way of setup, let’s think about central banks and liquidity traps and see if we agree that central bankers are driving the car from the back seat based upon a fundamentally flawed theory of how the world works. That theory helped produce the wreck that was the Great Recession and will have its fingerprints all over the next one. So this week we’ll have a preliminary round before putting on the sparring gloves next week.
Here is a part of chapter 7 from Code Red. By the way, the book has done very well and is getting great reviews, with 49 readers giving us five stars. And three people who apparently didn’t read the book gave it one star anyway. Check out the reviews on Amazon.
But before we turn to the chapter, I want to note that this year for the first time we are not requiring Strategic Investment Conference attendees to be accredited investors. A change of venue that gives us a little more room and a shuffling of the speaking schedule allow us to open the event to everyone. If you are from outside the United States, you will not have as much trouble getting accepted into the conference as you may have encountered in the past. I am really excited about this change and hope that we have a significant contingent of non-US citizens at the conference. The speaker lineup is certainly international in breadth.
We sent out a note earlier this week encouraging you to register for the Strategic Investment Conference, which is coming up in mid-May. This is our 11th conference (cosponsored by Altegris Investments), and it will be our biggest and most comprehensive yet. Our attendees regularly say it is the best investment conference they attend anywhere. Click on this link to learn more. Rather than simply listing the names as we normally do, I have provided a little color about who the speakers are and what we can expect to hear. Register now to get the early-bird discount, which lasts for only a few more days.
From Code Red, by John Mauldin and Jonathan Tepper
Like a car, an economy has lots of moving parts; everyone thinks they know how to drive it when they’re in the back seat; and it crashes too often. But on a more serious note, the analogy of a car works especially well when you think of where large parts of the global economy are.
Today central banks can make money cheap and plentiful, but the money that is created isn’t moving around the economy or stimulating demand. They can step on the accelerator and flood the engine with gas, but the transmission is broken, and the wheels don’t turn. Without a transmission mechanism, monetary policy has no effect.
This has not always been the case, but it is today. After some credit crises, central banks can cut the nominal interest rate all the way to zero and still be unable to stimulate their economies sufficiently. Some economists call that a “liquidity trap” (although that usage of the term differs somewhat from Lord Keynes’s original meaning). The Great Financial Crisis plunged us into a liquidity trap, a situation in which many people figure they might just as well sit on cash. Many parts of the world found themselves in a liquidity trap during the Great Depression, and Japan has been stuck in a liquidity trap for most of the time since their bubble burst in 1989.
Economists who have studied 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 recessions that have happened after 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 from their study is that it is very difficult to restore growth after a debt bubble. Central banks 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 United Kingdom has never experienced hyperinflation, and you’d have to go back to the 1770s to find hyperinflation in the United States – when the Continental Congress printed money to pay for the Revolutionary War and so started a period of extremely high inflation. (That’s why the framers of the Constitution introduced Article 1, Section 10: “No state shall … coin money; emit bills of credit; make any thing but gold and silver coin a tender in payment of debts….”)
Japan and Germany have not had hyperinflation for over sixty years. Today’s central bankers want inflation only in the short run, not in the long run. As Janet Yellen 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 today. And the answer from many economists is that central bankers should be even bolder and crazier, sort of like everyone’s mad uncle or, more politely, to be “responsibly irresponsible,” as Paul McCulley has quipped.
In a liquidity trap the rules of economics change. Things that worked in the past don’t work in the present. The models of economies that we mentioned above become even less reliable. In fact they sometimes suggest actions that are in fact actually 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, today we will look at what we can call 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 spacetime, a point where 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 spacetime 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 spacetime.
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 a 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 us, please.) An economic bubble of any type, but especially a debt bubble, can be thought of as an incipient black hole. When the bubble 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.
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 was 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. Thus, 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 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.”
In our previous book, Endgame, we explore the idea of a Debt Supercycle, the culmination of decades of borrowing that finally ends in a dramatic bust. Unfortunately, much of the developed world is at the end of a 60-year-long Debt Supercycle. It creates our economic singularity. A business-cycle recession is a fundamentally different thing than the end of a Debt Supercycle, such as much of Europe is tangling with, Japan will soon face, and the United States can only avoid with concerted action in the next few years.
A business-cycle recession can respond to monetary and fiscal policy in a more or less normal fashion; but if you are at the event horizon of a collapsing debt black hole, monetary and fiscal policy will no longer work the way they have in the past, or in a manner that the models would predict.
There are two contradictory forces battling in a debt black hole: expanding debt and collapsing growth. Raising taxes or cutting spending to reduce debt will have an almost immediate impact on economic growth. But there is a limit to how much money a government can borrow. That limit clearly can vary significantly from country to country, but to suggest there is no limit puts you clearly in the camp of the delusional.
To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.
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