The Bear’s Lair: Deflation is the market’s response to QE

Both stock and commodity markets have been stunned in the first couple of weeks of the New Year by a sharp decline in prices, which has surprised investors. However, with Fed policies since 2008 unprecedented, investors get surprised by a lot these days. We’re in uncharted waters, but there are reasons for thinking that the latest blow to investors’ wallets may well turn into a general deflation.

Monetary policy has had one objective since 2008: to produce more output. The financial crisis is thought to have depressed output of goods and services artificially, so “stimulus” has been used to boost output – and of course the prices of assets and commodities. Until the early part of 2012, this appeared to work as suggested in the textbooks – asset and commodity prices recovered, output increased, and inflation trended gently upwards suggesting a tightening would soon be necessary.

Since 2012, we appear to have been in uncharted territory. Inflation has trended downward, suggesting that Irving Fisher’s theory might have merit: that inflation would come to equal the risk free interest rate minus real economic growth. While housing and real estate prices have continued to increase, commodity prices and after mid-2014 energy prices, have gone into an accelerating decline. That suggests that a new paradigm may be needed to explain what has happened, to predict what may happen next, and to design a policy to correct any trends that may prove unpleasant.

Let’s start from economic first principles. Funny money policies were instituted to goose the economies of the world artificially, in other words to ensure production of more goods and services than a free market would have demanded.

So why should funny money, if carried on for the long run, as it has been, make the price of goods and services rise? Surely, by creating a glut of them, it should have pushed their price down, not up.

This effect should be more noticeable in areas where monetary policy is most effective. We would not expect to see a glut of capital to produce food or consumer goods price declines, because food and consumer goods don’t require much capital to produce or to purchase. Hence the cost of money does not have much effect on those markets.

Conversely, we should expect to see a massive glut of items that are especially capital intensive, where capital is the major input into their value.

• We should expect to see a glut of new mines and oil wells, producing a sharp decline in the prices of metals and oil. Check.
• We should expect to see a glut of office buildings and hotels, because those items are almost entirely driven by cheap capital. That will eventually produce sharp declines in office space rentals and a huge surplus of empty hotels. Check. Anecdotally, China’s surplus capital has gone very largely into real estate, and there is a worldwide hotel surplus, since hotel building has been running at record levels. There would probably have been a surplus of homebuilding, except we already had that; even the doziest U.S. homebuilder is still licking his wounds, having been unexpectedly rescued from well-deserved bankruptcy in 2009-10. The buy to let sectors in both the U.S. and the UK have attracted far too much money, and are due for a deep downturn.
• There should be a glut of leveraged buyouts and mergers/acquisitions, which will inevitably lead to a sharp decline in junk bond prices going forward, as the deals prove to have been done at overinflated prices. Check.
• Although the price of U.S. farmland has spiraled ad infinitum, its supply is very inelastic, so there will be only a modest surplus of farm products, whose price is in any case governed by witless government programs and will of course tend to be pushed upwards by farmland price rises. Check.
• Tech companies. Funny money has produced an incredible tsunami of private equity money, which has funded everything that moves in the tech sector. Prices of tech goods and services can be expected to fall sharply, but not as catastrophically as tech company valuations. This hasn’t happened yet, but we should look out for it. Everything from iPhone prices to Uber prices to Facebook advertising rates should fall sharply, or in some cases collapse.
• Profits. Funny money has produced a surge in company profits to record levels, which has fueled record levels of share buybacks (thus preventing share prices from collapsing.) Profits above the market’s natural level themselves attract new capital to businesses that are not intrinsically especially profitable. At some point the house of cards collapses taking both the stock market and the junk bond market with it, the latter more violently. This looks like it may be happening now, although this could still be a foreshock rather than the main quake.
• Financial services. This sector had already become oversized before 2008. Its profits have already begun to deflate, and are now well below the level needed to service capital. Overall profitability will deflate further, but losses from bad debts will in any case overwhelm the feeble remaining profitability.

So, will we get deflation, as measured by the consumer price index? Possibly not. The “core” U.S. Consumer Price Index, excluding food and energy, was up 2.1% in the year to December 2015, above the Fed’s target inflation rate, largely reflecting a 3.7% rise in rents and a 3.1% price rise in “owners’ equivalent rent” the fudge factor used by the BLS to suppress house price inflation (it rises especially slowly when interest rates are declining, but rates have been flat to trending slightly upwards over the past year.) Since these two items represent over 40% of the “core” consumer price index, their relatively robust rise in the past year has caused the core index to be strong.

Deflation of consumer prices would in any case not be a bad thing. The 1880s were a period of deflation, with prices declining 25% between 1873 and 1895, according to Federal Reserve data. However it was also an era of massive technological advance, possibly the most fundamental we have ever enjoyed, with refrigeration and transportation globalizing the agricultural markets of the world, while electricity began to revolutionize our lifestyles. Productivity rose quite rapidly, as did living standards – if you could keep your job, and the salary attached, your standard of living rose by 33% in those 22 years without your having to get promoted or learn new skills. Overall, Ben Bernanke’s fear of deflation is nonsense, just one of several Bernanke errors that have bedeviled the last decade’s monetary policy.

The 1880s were however a hard decade for those living on farms, which in the United States had expanded too far, into areas without sufficient rainfall, and which suffered a steady decline in the returns available from their crops – and, unless they owned their farms outright, debt burdens that increased steadily in real terms. In Britain also the agricultural sector, which had been kept going on smoke and mirrors since the foolish 1846 Repeal of the Corn Laws, fell into terminal collapse, from which it was not to recover until after World War II. Thus although the overall deflation of the 1880s was benign, it was malign “bad deflation” for the agriculture sector.

This time around, whether or not we get overall deflation as we did in the 1880s, there will be many sectors with “bad” deflation, if only because of the massive over-leverage caused by foolish Fed policies. Commodities and energy price declines are clearly going to cause a mass of bankruptcies, indeed they are already beginning to do so. Chinese real estate generally and global hotels seem all too likely to cause further huge losses to the owners of their debt as prices collapse. Shoddily put together LBO and merger empires, for example in the pharmaceutical sector, will collapse in a mountain of bad debt. Farmland prices will collapse, causing further bankruptcies for those who have borrowed against their rising value. The tech company meltdown will affect primarily equity values, although of course individual tech entrepreneurs have borrowed far too much against the fictitious value of their holdings. Stock market and bond market collapses and the financial sector’s troubles will wipe out further values. Each debt liquidation causes a further decline in prices, a further shove in the direction of deflation.

On past form, the Fed and its sister central banks will make matters worse. Once the liquidations and value declines begin, they will print more money, forcing down interest rates further in a desperate attempt to prop the system up. However money is already in massive global glut while inflation is being driven down in a Fisherian fashion by ultra-low interest rates. Hence the most likely effect of Fed money printing will be to force prices in general into massive deflation as the glut of goods and services is further increased. Meanwhile, the collapse in debt values will begin to affect government debt, of which there is also a gigantic global glut, so you will find countries defaulting on their debts, beginning almost certainly with Japan.

In the final stage of debt deflation, it will no longer be reflected in prices measured in the currencies the world’s central banks are so busily turning into confetti. The world’s currency system will then collapse, and only in genuine stores of value (such as gold, but not apparently Bitcoin – bad luck, techie Millennial nerds!) will the further deflation of values be apparent. By this stage we will have to pick the world’s economy back up again, essentially starting from 1694, or if the world’s governments have defaulted, from about 1250. Needless to say our living standards, by then probably measured in beads, will have catastrophically fallen.

The solution? Restore positive real interest rates, with a Federal Funds rate of 2-3%, balance the Federal, Japanese, UK and EU budgets, and massively deregulate to produce a surge in newly available output. We’d still have a massive deflation, but it would quickly come to resemble the 1880s, rather than the 1280s. That’s what governments should do, but the chances of them doing it are infinitesimal.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)