I began this series of posts with the observation that inflation and deflation benefit (and harm) different economic actors. Inflation benefits people who spend more and save less, who place their capital at risk by investing, and who in general feel comfortable taking risks. Deflation benefits people who save more and spend less, who prefer not to place their capital at risk, and who in general prefer to avoid risk.(1)
A society that favors inflation is a society that is signifying its preference for what I’ll call “hubristic” folks, those comfortable with risk, those who like to live on the edge, those who – let’s call a spade a spade – can’t be trusted not to blow up the economy. A society that favors deflation is signifying its preference for what I’ll call “prudential” folks, those who prefer to avoid risk and who, left to their own devices over a long period of time, would cheerfully convert a vibrant economy into a moribund one.
Since 1990, we have had a more or less laboratory-condition example of these two societies, namely Japan and the US. Japan has experienced almost consistent deflation since 1990 and the US has experienced almost consistent inflation. Advertently or not, Japan chose to favor prudential actors, while the US chose to favor hubristic ones. How have the outcomes differed?
Initially, the outcome in Japan was terrific – prices declined across the economy, vastly improving the lives of the people. But Japan allowed deflation to persist for too long.(2) Today, an entire generation of adult Japanese (i.e., those under age forty) has never experienced inflation. And these people have, over time, internalized the lessons of deflation: don’t spend now because prices will be lower next year; don’t invest in the stock market because you could lose your capital; avoid risk.
As a result, the Japanese economy very slowly lost its vitality. Matters were papered over by huge borrowings at the national level,(3) but the day will come when even the patient Japanese will wake up and realize there is no way in hell all that debt can be paid back. When that day comes matters will get ugly very quickly. Prime Minister Abe recognizes this and is at least trying to do something about it, but he will fail for the reasons I’ve expressed in an earlier post.(4)
Meanwhile, back in the US, the Fed made the opposite mistake: it ensured that the US would experience inflation every year. To the surprise of no thoughtful person, this led to a vast rise in risk-taking pretty much across the board. In the late 1990s, we saw “irrational exuberance” in the stock market. This was followed in short order by the Tech Bubble and the Tech Bust, when many tech managers lost nearly 90%. (Some large tech names, like Hewlett Packard, are still selling for well below their 2000 peak.) The Tech Bust was followed by the Housing Bubble and Credit Crisis in 2007, which was followed by the stock market crash and Global Financial Crisis of 2008.
Like prolonged deflation, prolonged inflation matters. Imagine that you run a big bank or I-bank.(5) You can pretty safely achieve about a 6% return on your capital. Unfortunately for you, your cost of money is somewhere between 3% and 6% and inflation is running at 3%. A 6% nominal return is a disaster. You need to take on more risk to boost your return, and the easiest way to do this is to lever up your balance sheet.
So you do, say 3X. You’re now getting a reasonable net return, but you notice that the guy across the street is getting a much better return. Obviously, the SOB is leveraging up even more than you! Not to be outdone – your stock price is crumbling, after all – you lever up even more than the competition, which then levers up even more than you, and soon you are all levered up 30X, 40X, 80X.(6) Sure, you could refuse to play this game, but you would soon arrive at your office to find the locks changed and your desk cleaned out. As Chuck Prince, then Citi’s CEO, so memorably put it, when the music plays, you have to dance.
The reason the banks kept dancing was because the Fed kept playing the music. The Fed had the backs of the lunatic risk-takers, all of whom were enjoying the “Greenspan put” that persisted from 1987 to 2000, and again after 9/11. The “put” meant that, if things got really difficult, the Fed would flood the market with liquidity, bailing everybody out. The put removed moral hazard from the stock markets and, indeed, from the entire financial system: profits had been privatized while losses were socialized.(7)
Note that the “sweet spot” for encouraging outrageous risk-taking isn’t higher and higher inflation, it’s modest inflation maintained for far too long. Risk takers come to believe, unfortunately correctly, that their upside is spectacular while their downside is a nice soft bailout.
Is this any way to run a railroad? What sense does it make for the Fed to set the stage for rampant risk-taking by insisting on endless inflation? What sense does it make for the Fed to watch calmly as bubble after bubble swells and explodes, then do it all over again? Could any sane person prefer this outcome even to the relatively dismal one in Japan?
Maybe we ought to revisit our knee-jerk preference for Inflation Forever.
(1) It may not have escaped your notice that this second group, those capable of postponing gratification, are pretty much the definition of emotionally mature adults. Hal Hershfield, a professor at the NYU Stern Business School, has pointed out that people with strong connections to their future selves are willing to save more, spend less, and forego immediate cash rewards in exchange for what they believe will be greater future cash rewards. See Hal E. Hershfield, et al., “Increasing Saving Behavior Through Age-Progressed Renderings of the Future Self,” Journal of Marketing Research, Vol. XLVIII (November 2011), S23–S37. In other words, these are the people central bankers hate.
(2) It’s beyond the topic of this series of posts to delve into the question of why Japan failed to halt deflation. In brief, however, the problem had much less to do with monetary policy in Japan than with the extreme political difficulty of making the needed structural changes in the Japanese economy. In other words, Japan has the same problem with its insular economy that America has with its ballooning entitlements.
(3) At last count, even under the proposed budget of Prime Minister Abe, fully 43% of Japan’s central government revenue will come from bond sales. Total government debt in Japan is now about 240% of GDP. Even in the profligate US, the figure is around 135%, including GSEs.
(4) See “From Hot Wars to Cold Wars to Currency Wars,” posted July 2, 2013. Abe has implemented the first two of his famous “three arrows,” but the third arrow – fundamental structural reform of the economy – simply won’t happen because if Abe actually tries to do it he will quickly be voted out of office.
(5) Banks and investment banks are now pretty much the same. At the height (depth?) of the financial crisis in 2008, I-banks like Goldman had to quickly convert themselves into banks so they could be bailed out by the Fed. Otherwise, they would have failed. Talk about wasting a good crisis.
(6), Ah, you are thinking, there goes Curtis, off on some ridiculous rant trying to prove his point. But I am merely reciting history here, as these were exactly the leverage ratios financial institutions were using just before the collapse. Indeed, in-between having to mark their books to market at the end of quarters, leverage was even higher.
(7) Then, from 2006 until recently, we had the Bernanke put, and now we have the Yellen put. True, post-2008 the economy won’t support the old kind of risk-taking (leveraged loans, subprime mortgages, Structured Investment Vehicles, etc.) But don’t imagine risk isn’t already being ratcheted up. Traditional leverage has moved to the corporate sector (where debt has rocketed far beyond its 2008 peak) and the government sector (135% of GDP, as noted above). And since the banks can’t load up on traditional leverage, they’ve loaded up on non-traditional leverage: derivatives, which now stand at a notional level of nearly $250 trillion(!) True this is the notional figure, but the trouble is that no one knows what the net figure is. $10 trillion? $50 trillion? $100 trillion? These numbers matter because derivatives have figured prominently in virtually every financial crisis starting with 1987. No wonder Warren Buffet calls them “financial weapons of mass destruction.”
Next up: Time to Junk Junk? (Again)
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