"The definition of insanity is doing the same thing over and over again and
expecting different results" - Albert Einstein
The Law of Unintended Consequences (LOUC) has now fully taken hold of the
global economy, thanks primarily to the efforts of Keynesian economists and
their more recent apologists occupying prestigious posts in the corridors of
central banks globally. Stagflation beckons around the corner, and that
actually counts as the better of the two possible outcomes at this stage.
The notion that governments are inefficient allocators of capital has been
underlined once again by the United States non-farm payroll report for July,
published last Friday. The number for July (131,000 jobs lost) was bad enough;
but the downward revision for
June (from -125,000 initially estimated to -221,000 revised) must have stung
particularly. In that context, the relatively marginal decline in US stocks on
Friday stands testament to the sheer, incredible stupidity of the average stock
market investor.
There is a sense of deja-vu here that is particularly unshakeable: last
October, I wrote an article that took issue with the further quantitative
easing ideas of neo-Keynesians; pronouncing the need for a change of tack. (See
Double or quits, Asia Times Online, October 6, 2009). Stock markets
have done almost nothing for the intervening 11 months or so; even as bond
yields (for 10-years for example) fell from 3.5% to 2.8% - the importance of
this will become apparent in following paragraphs.
People getting kicked out of the workforce numbered some 280,000 in September
2009 and 225,000 in June 2010. The deceleration (not reversal, mind you) of job
losses is pretty much the only "achievement" that Keynesians have to show for
the few hundred billions of dollars thrown around by governments and central
banks. If these folks worked in the private sector, they would have been fired
for incompetence three years ago. Hang on, that IS the point isn't it?
Financial media channels led the positive spin on events by focusing not so
much on the poor jobs report but by claiming that the report would "force the
Federal Reserve to forget about exit strategies and focus instead on further
quantitative easing". This is akin to stating quite flatly that the discount
rate for stocks would decline massively in coming months; this would in turn
increase the value of stocks. That at least is the theory. Financial media
would obviously not focus too much on critically analyzing the problem here.
To explain - there are two moving components for stock valuations (in reality
there are many more, but let's keep things simple here). First is the expected
stream of future earnings, and the second is the discount rate (ie to arrive at
the present value of those future earnings). When the Fed moves the discount
rate down, it stands to reason that the present value will increase - that is,
that you would argue for stock prices to increase. All fair and logical (as the
channels would claim). However, this isn't the full story.
The basic question to address here is - why is the Fed looking at cutting rates
in the first place? That would be the weaker-than-expected recovery in the
economy. In other words, remember those earnings that constitute the first
variable above? A weaker economy would mean that these earnings would decline
massively, which is another way of stating the improvements arising from
changing the denominator (interest rate) would be more than wiped out by
changing the numerator (earnings).
Look at the quality of first half earnings. Companies that beat Wall Street
estimates have generally done so by relying on one-off items (for example the
technology replacement cycle that has helped software and hardware companies;
the release of past reserves for banks that more than offset the decline in
recurring earnings) and so on.
An objective analysis of pump-priming and stimulus programs would easily
conclude not just that the ideas have been ineffectual but also more
specifically that they have been counter-productive. What governments and
central banks need to do now is to engage in fiscal and monetary tightening
rather than the opposite.
The case for tightening
The redoubtable Tim Price, writing on August 2 in an article called "Tales of
the Unexpected", writes as follows:
... that free market capitalism
worked. Some, if not all, of those assumptions have not survived their first
serious contact with the enemy. We are increasingly accused of labouring what
we perceive as the unusual if not unique "riskiness" of the current situation,
as if we weren't already aware that sounding a continual note of extreme
caution is not exactly conducive to encouraging new investment business. At the
risk of appearing either trite or inadvertently offensive:
First the sub-prime assets sold off,
And I wasn't much bothered because I didn't own sub-prime assets.
Then the bank stocks sold off,
And I wasn't much bothered because I didn't own bank stocks.
Then the equity markets sold off,
And I wasn't much bothered because I have a diversified portfolio.
Then Big Government stepped in and bailed out everybody,
And I got a little bothered because I believe in free markets and not the
socialisation of banking losses.
Then government finances became imperiled,
And I got a little more bothered because there are only so many safe havens.
Then neo-Keynesian economists were allowed to dominate the debate,
And they shouted louder than everybody else for the creation of yet more debt.
Then quantitative easing threatened to go 24/7,
And I got a little more bothered because there are no good historical examples
of unrestrained money-printing or currency debauchery that ended well.
Then the wheels well and truly fell off,
And by that time there was nowhere left to go.
Recent history, as in within the lifetime of anyone engaging with this
commentary, is not necessarily up to the task of assessing the risks facing the
modern investor, anywhere except Japan over the last two decades, the example
of which does not exactly lend itself to any market view that could be
described as bullish.
This is the core of the market's fears
today. Capitalists and individuals fear government expansionary policies
precisely because they know (or recognize) that a big, fat bill is slowly
making its way through the sclerotic bureaucracies but is nevertheless headed
towards them.
Governments being unable to eventually repay the mountains of debt being piled
on today stood at the core of the European sovereign crisis earlier this year.
I have written too many articles on this subject to repeat arguments here.
The way forward, which I have referenced in the article "Double or Quits", is
simply to engage in monetary tightening, as follows: If governments in these
countries had simply allowed many of the banks to fail, while protecting retail
deposits, the capitalist solution would have worked out perfectly well:
1. Balance sheets of banks would have shrunk;
2. Borrowers would have been forced to cut their debts;
3. Worldwide deflation;
4. Unprofitable and overleveraged companies would have been closed down;
5. Economies would have contracted to the point where (some) capacity became
profitable again;
6. Higher returns from such activity would have prompted new investments from
surviving capitalists;
7. Economies would have resumed profitable growth, albeit in the lower
trajectory.
It is obviously impossible to reverse the bank rescues of two years ago.
However, it is still time for solvent countries in Europe (namely Germany,
France, the Netherlands and a couple of others) and for the US government to
avoid rescuing bankrupt countries and states (Greece, California et al). The
effect on balance sheets would be similar to the situation with banks above.
What's with the panic? Quietly and almost unobserved in the corridors of power
in the Western world, there has been a rise of inflation in the developing
world. That's not a typo - inflation, not deflation. In this regards, Russia's
ban on the exports of wheat last week in response to falling harvests and
rising prices (and widely circulated reports of wheat rust in Africa and parts
of Asia) further accelerates the problem; creating at its core an echo of the
agricultural inflation that shocked global markets in 2008 (even if that
episode was led by rice rather than wheat).
Ambrose Evans-Pritchard writes in the Daily Telegraph:
It is
deflationary, acting as a transfer tax to petro-powers and the agro-bloc. It
saps demand from the rest of the economy. If recovery is already losing steam
in the US, Japan, Italy, and France as the OECD's [Organization for Economic
Cooperation and Development] leading indicators suggest - or stalling
altogether as some fear - the Eurasian wheat crisis will merely give them an
extra shove over the edge. Agflation may indeed be a headache for China and
India, where economies have over-heated and food is a big part of the inflation
index. But the West is another story.
... "Unprecedented monetary and fiscal stimulus has produced unprecedentedly
weak recovery," said Albert Edwards from Societe Generale said in his latest
"Ice Age" missive. That stimulus is now fading fast before the private economy
has clasped the baton.
After digesting Friday's jobs report, Goldman Sachs' chief economist, Jan
Hatzius, thinks the Fed will abandon its exit strategy and relaunch QE
[quantitative easing] this week, taking the first "baby step" of rolling over
mortgage securities. Future asset purchases may be "at least $1 trillion". He
is not alone. Every bank seems to be gearing up for QE2, even the inflation
bulls at Barclays. The unthinkable is becoming consensus.
Last
week, both the European Central Bank (ECB) and Bank of England kept rates
steady as nerves increased on the quality and state of the economic recovery.
As the Financial Times reported on August 5:
Economists must now await
next Wednesday's quarterly inflation report and forecasts to discover the
detail behind the Bank [of England]'s thinking. It is expected that the Bank
will be forced to revise its optimistic growth projections lower and to
forecast higher inflation in 2011 to reflect the coming rise in value added tax
to 20 per cent in January.
These uncomfortable forecast revisions highlight the dilemma that the MPC
[monetary policy committee] is facing, but business groups called for restraint
before interest rates are raised.
Lee Hopley, chief economist at EEF, the manufacturers' organisation, said:
"Growth prospects in the medium term at home and overseas suggest continued
caution before policy begins to tighten."
David Kern, chief economist of the British Chamber of Commerce, said:
"Businesses cannot properly plan for recovery without clear knowledge that rate
rises will be off the agenda for an extended period."
Meanwhile,
Jean-Claude Trichet, the president of the ECB, had an altogether more scary
assessment of the situation as outlined in an article written for the Financial
Times on July 22 aptly entitled "Stimulate no more - It is now time for all to
tighten"
Taking account of these facts, there is a strong unity of
purpose among the world's policymakers to address our fiscal fragilities. It is
reassuring that the consensus on the need for credible fiscal exit strategies,
along with profound financial sector reform, is very broad. But the timing
remains disputed. In the waiting camp, some argue that it would be desirable to
maintain or even increase the fiscal stimulus to avoid jeopardising the
economic recovery. Others claim that fiscal consolidation will have a negative
systemic impact on the global economy by damping the growth environment. I
disagree with both these views. We have to avoid an asymmetry between bold, if
justified, loosening and unduly hesitant retrenchment. There are three main
reasons for starting well-designed fiscal consolidation strategies in the
industrial countries now, precisely to consolidate the present recovery.
... With hindsight, we see how unfortunate was the oversimplified message of
fiscal stimulus given to all industrial economies under the motto: "stimulate",
"activate", "spend"! A large number fortunately had room for manoeuvre; others
had little room; and some had no room at all and should have already started to
consolidate. Specific strategies should always be tailored to individual
economies. But there is little doubt that the need to implement a credible
medium-term fiscal consolidation strategy is valid for all countries now.
Trichet was roundly criticized for tightening in 2008 after the first bout of
agricultural inflation; he may yet repeat his action simply to be consistent.
That would send the US dollar plummeting to new depths to the benefit of gold,
the yen and perhaps the euro (I say perhaps because the resulting "default"
from higher interest rates of various European states would be a severe drag on
the currency).
Conclusion
I started this article with Einstein's famous remark about insanity because it
is worth reading for all of today's Keynesians; but also for the people who
have allowed them to get away with the monetarist nonsense for a little too
long.
You might give a policy a little longer than say a physics theorem to observe
results, but when a policy produces the exact opposite results of what was
expected for two years running, persisting with this policy is a simple case of
insanity.
It is time for governments and central banks to tighten.
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