Who really understood the forces of destruction building up in the global economy?
(This Post is longer than usual but doesn’t lend itself to being divided into multiple Posts – trust it is worth the read.)
Part One – How investing in the 80s was so hit and miss.
My education with respect to the sound management of one’s wealth came from a propitious mistake by a global insurance company, one of Britain’s largest insurance companies as it happens. Here’s the story.
In 1986, aged 42 and having sold what had been a successful company, I decided to put the sum of £250,000 ($400,000) into a personal pension to provide for a decent retirement. I was recommended by the large insurance company that I had chosen, to put it into a ‘with profits’ fund and several market sectors were recommended. I remember asking for a low risk portfolio.
I then disappeared, for what became many years, sailing a yacht around the Mediterranean and further afield. My quarterly reports on my pension fund were being sent to my mother’s address. From time to time I would call my mother and try and make sense of these reports.
Eventually, in 1993, I returned back to England and found, to my acute discomfort, that my pension fund was worth approximately half what it had been in 1986! I was told by the insurance company, “You have been invested in the wrong funds!” Ergo, this was made out to feel like my mistake! Clearly over the preceding years I should have played a much more active role in managing this fund but, of course, the critical importance of such a role had missed me. I was not, after all, either familiar or expert when it came to pension fund investments. I am certain that I was not alone in finding this out the hard way!
Withdrawing my funds introduced another interesting aspect of this insurance company, there was an early withdrawal penalty. Thus after much argument and anger, I ended up banking a little over £94,000 ($150,000), a pale shadow of the original £250,000. It was by now 1994.
Part Two – Luck plays an important role.
Then followed a rather strange period in which I attempted to find another company that might provide me with greater confidence in their investment strategy of my funds. All of them failed on two counts: One, to explain the underlying economic situation and, Two, to predict what economic risks might be ahead and how they could be spotted in advance. The years ticked by.
In exasperation, I was complaining to a good friend, who is no fool when it comes to investing, and he suggested I might contact David Kauders of Kauders Portfolio Management. Thus it came about that I found myself in David’s office listening to his thoughts about my two fundamental needs; what’s happening to the economy now and where is it heading. I think the year was late 2000 or, possibly, early 2001.
David spoke about the long-term trends that were driving the Western world towards a major economic crisis.
Part Three – how it looked in 1999.
Those trends were deeply deflationary, a view that flew in the face of every other commentator. To better understand what David was talking about let me quote, with David’s permission, from his client’s lecture given in 1999. (A modified transcript is available free from the Kauder’s web site.)
To obtain value from long-range thinking, it is essential to detach ourselves from day to day news stories. Much of what we read, see and hear, even when labelled “long term” gives little insight. The current obsession is with inflation and interest rates, and this obsession can be expected to fade in the next few months. What we have to do is to two make TWO mental leaps: first to the deflation that still lies ahead, and then to what lies beyond it.
We have no doubt that the next ten to twenty years will be characterised by a severe deflation, and we will briefly review the evidence and the possible impact on society in a few moments. Beyond that deflation, there will be a new expansionary cycle in a world that looks rather different.
For at least 10 years, we shall be investing for deflation and gradually most of the rest of the population will come to recognise our viewpoint. The deflationary cycle will end when everyone knows that deflation has replaced inflation. That is the point at which equity investment will become viable once more.
At this stage, we can only estimate the scale of deflation that lies ahead. A complete reversal of those price trends, as has happened in past deflations, would involve a fall in asset prices of roughly 90%. A return to the 1930s would involve a 50% to 90% fall in asset prices according to which assets and which country you choose for comparison.
The essay then spent some time examining a series of paradoxes as to how society at large may move forward and a discussion about the industries of the future. It closed with the following,
If we summarise the big picture, then, deflation will continue to be the driving force of the global economy for at least another ten years and possibly as long as twenty years. There are now severe dangers to those asset prices that depend on credit supply, and there are lower yields ahead. As debt deflation becomes more prominent, so it is likely that there will be a resurgence in communism allied with Islam, changing capitalism as we now know it. Eventually, equity investment will become viable but in new industries and in a rather different world environment.
Part Four – How it looks in late 2009
There is very little to disagree with in David’s views held so reliably a decade ago. Much of what he predicted has now come about. We are going to finish 1999 with significant weaknesses in many western economies and increasing odds that government policies have and are continuing to make things worse. The next few years will be very bleak indeed. Yes, we are still in the dark.
By Paul Handover
Disclosure: I am currently a client of KPM and invested in long-dated US Treasuries. David Kauders has had no part in this Post and I do not benefit in any way whatsoever by any other person becoming a client of Kauders Portfolio Management.
Learning from Dogs 
I have to say I do not understand how deflation can happen at a time when government is pumping tons of money into the system (not an economist! But trying to learn more in that area.)
I do know that the under- and unemployment issue is significant and will be impacting the consumer’s ability to spend for a very long time to come.
Political and business leaders seem fairly cool to doing anything to change the situation on the job front. Not sure why the paralysis in that area, and if I’m wrong, please set me straight….
And as I understand it, we’re still sitting on that toxic dump of miserable assets collected by banks in the last few years. Not sure how that will all get cleaned up, but am pretty sure the taxpayers, not the banks, will pay the price for that bit of effort. In this modern age, we seem seriously unwilling to hold those whose decisions led to the failure of our financial system in any way accountable for their actions.
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Anne, I’m not an economist either – but I know a person who is! So will ask Sherry to comment more specifically. As I understand it (health warning here!) inflation/deflation are the outcomes of demand and that, as we all know, is slumping. Society has reached the limits of the amount of debt that it can manage, in fact we have way overshot that.
Anyway, see what Sherry says.
Paul
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Hi Anne and Paul,
Sorry for the delay. Was away from my computer yesterday.
How can we have deflation when the Fed is purchasing assets? Anne is right to ask….typically, the Fed would pay for these assets by creating deposits, which leads to an increase in the monetary base which, given lending by banks which begets further deposits, would lead to a 3-4 multiple increase in the final money supply. This increase in the money supply would lead to an increase in aggregate demand which, given supply, would increase the U.S. price level.
But these are not ordinary times. For one, I believe the money multiplier is suppressed by a lack of lending and borrowing in the private economy, in part driven by the Fed paying interest (for the first time in my memory) on the banks’ excess reserves.
Second, it is unclear how much of the Fed’s purchases have been paid for with net new reserves. To the extent the Fed uses any other asset to pay for the toxic assets, money is not created, and demand is not increased.
In addition, business and consumer demand are down, which have a significant negative effect on aggregate demand.
If supply were falling faster than demand, prices would rise. But private industry is hanging in there, doing what they do best: hiring labor and capital to creating products and services that a competitive market values.
Sherry Jarrell
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Invested in long dated US securities?
You could have inflation … then interests go up, international confidence downs and many other nasty things can happen which can make public debt unserviceable; or you can have deflation where tax revenues and assets values go down while liabilities remain the same and again makes public debt unserviceable, either way, if I was essentially invested in long dated US securities and depended on it, I would not be sleeping like a baby… Welcome to the club of the boomers not sleeping like babies.
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Per,
Firstly, an honour to have your comment in this Blog!
But out of town at present so not a good opportunity to respond, as much as I would like to.
Paul
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Per, an opportunity to reply to your comment. You say “make public debt unserviceable” but that isn’t clear to me as to what exactly you mean. Do you mean that the US Government would default on either Treasury interest payments or, even more unlikely, a refund of capital payments? That seems an almost impossible likelihood.
Paul
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Thanks so much for your comment. You really hit a core issue. I’ve been teaching macroeconomics and finance a long time, and up until about 2 years ago, your question would have been unthinkable: could the U.S. actually default on its debt (I assume you single out long-term debt because there is a higher probability of something bad happening “in the future sometime” than in the very near term)? Assuming no coupons, this means that when the naturity date comes, the U.S. is unable to raise the funds necessary to pay the principal, either through taxation or selling assets, like issuing new debt? And, as implied by your question, this development would be driven by either inflation or deflation, which means we have a real problem unless the U.S. price level (or our price level relative to other economies, since if everyone’s inflation rate is the same, there is no real impact from inflation alone) remains flat? Firstly, I think you are referring to unexpected inflation or deflation, since expected price changes are already priced into the yields on debt. If price changes are greater than expected, the borrowers gain at the lenders expense, or vice versa. Secondly, we may be ignoring the fundamental driver of the U.S. interest rate, and that is the level of real productivity in private industry, which is sound, though challenged by the uncertainty surrounding government policies, particularly the spectre of higher taxes and higher costs of doing business. And thirdly, the U.S. economy, given that it can create money and has taxing authority, does not have the budget limitations of, say, a household or the rising costs of equity of a leveraged corporation.
It is true that the points I raise merely mitigate the degree of concern about the viability of U.S. debt, but that’s all we need, for as concerns of the sort you raise develop, the market simply demands a higher yield to compensate them for the higher perceived credit risk. There are always two sides to a trade, and both sides are looking out for themselves. Both the lenders and the borrowers include all available information about forecasts of risk and inflation and productivity and the strength of the dollar and politics and so on….into the expected yield on debt before they transact. And they transact voluntarily. We never have guaranteed real returns, even from the government, even with inflation-adjusted t-bills. We just get lower returns, the more certain we are of receiving the principal at the maturity date, and vice versa: we demand higher returns the less certain we are of that payoff.
Just my base-case thoughts on a very complex and interesting and ever-evolving topic! Thank you!
Sherry Jarrell
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No, the US does not run the risk to default the normal way since being all its debt denominated in dollars and having the right to print they can always pay back. The question is whether they will they service the debt with dollars worth something or dollars worth nothing.
Now in order to service the debt with real money, the government has to be able to raise taxes, and let me be honest about it, I seriously doubt that the USA, at this particular juncture, would pass with flying colours any willingness-to-pay-tax stress test
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Well, I don’t know about “Who saw it coming?”, but if we apply a bit of good old-fashioned commonsense to this then it seems to me that the idea that you could have a “new paradigm” (Gordon Brown “I have ended BOOM and BUST”) based on endless growth, borrowing, debt and rise in house-prices was stupid. This, to emphasize once more, is not a slick, vastly-overpaid corporate economist’s point of view but the sort of thing my nightwatchman Granddad would have been likely to say 60 years ago – and he would have been RIGHT. The crisis was caused by GREED and ARROGANCE. Unfortunately, I can’t see much sign of either diminishing.
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GREED and ARROGANCE have always been around. What is new in this crisis is the utterly destructive role played by some gullible and truly naive regulators.
In reference to “very few saw this crisis coming” I am one of the very few. I knew we were doomed to have this crisis… I warned about what was going to happen… even as an Executive Director at the World Bank (2002-2004)… unfortunately to no avail.
Just as an example January 2003 published in the Financial Times a letter I wrote that said “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”
What worse though is that we are still not facing up to the real problems present in our current regulatory paradigm, because we find ourselves in the hands of what I now almost classify as a sect of regulators who give cult to the idea that they really know what risk is.
http://www.subprimeregulations.blogspot.com/
http://teawithft.blogspot.com/search/label/subprime%20banking%20regulations
http://www.theaaa-bomb.blogspot.com/
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I have a question for my economist colleagues! Currently, the euro is weakening against the dollar because people have less faith in the long-term reliability of the euro ….. what happens if ALL currencies weaken? How far can a generalised collapse go? To put it another way, does the ABSOLUTE value of a currency matter or ONLY its value RELATIVE to OTHER currencies?
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I have to say I do not understand how deflation can happen at a time when government is pumping tons of money into the system (not an economist! But trying to learn more in that area.)
Is this REAL money or just stuff printed on paper? One is almost reduced to going back to basics (We are not all trained economists!!) and asking: (What exactly IS “money”).
As for myself, I am preparing for an economy based on barter ……
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Last one – promise!!! I share Paul’s gloom …… if governments start to RAISE taxes to pay for their deficts this will further DEPRESS economic activity and we are into a perfect and stormy vicious circle. At the root of this – IMHO!! – is COWARDICE by governments. They simply CANNOT bring themselves to reduce their bloated budgets because this means some PAIN …. And PAIN today we don’t do; we prefer to dump that onto future generations, and in any case till after the next elections ….
This utter contempt for the cowardice and competence of current governments is very dangerous for democracy, that fragile flower we have fought and died to nurture …..
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You are right… and on December 31, 2009 the Financial Times published the following letter I wrote.
The monsters that thrive on hardship haunt my dreams
Sir, As a son of a Polish soldier who had to endure more than five years in a German concentration camp, I also connect to Martin Wolf’s feeling that the civilisation we pray survives for our descendants is indeed at stake (“The challenges of managing our post-crisis world”, December 30).
In this respect my worst nightmare is that unmanageable Versailles-type public debts will become fertile ground for those monsters that thrive on hardships, and that is why I often wake up wishing that the US, instead of taxing and inflating itself out of an almost impossible problem, would simply do an Argentine form of restructuring such as offering 10 cents of the new dollar for each 100 cents of old dollar debt, hand out some Dollar II to its citizens and then take it from there. I believe not only that the world would still accept Dollar II as it has little other choice but also that China would then wake up and adjust … you see, governments can’t stop dancing either while the music plays.
Once the air is cleared then we might have a better chance of tackling other challenges to civilisation like the climate change threat. As to the banking system, there is nothing that could not be solved by asking ourselves the simple question about what our banks are supposed to do for us, because, unfortunately, that is the question our current very poor set of regulators have never asked themselves.
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My understanding of deflation is that it can be caused either by a contraction in credit/supply of money OR by a general contraction in demand and spending. If the latter, which is the great force now pressing down on ‘Main Street’, then extra money or credit doesn’t make a difference.
See if Per and/or Sherry want to add to my amateur view!
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There´s a tug of war between slowing of demand, available production capacity and unemployment on one hand; and the increased public spending that could lead to unsustainable public debt on the other.
If the first side wins we will have deflation, if the second wins inflation. My bet is on the second… because the willingness of taxpayer to pay up for the costs of the crisis and what is needed to get us out of it is totally absent.
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Per, Useful clarification – we shall see. Must admit that the bond markets seem more inclined to support the inflation outcome side of the tug of war.
By the way, that was one powerful letter that you wrote to the FT. My fear also is that some very grim outcomes await us when the music eventually stops!
Appreciate your contribution to the Blog.
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Paul,
Re Kauders: Does David Kauders have much to say on the prospects for goverment bonds given the growing fiscal crisis in the UK and elsewhere. Also, I was wondering why you chose US bonds rather than gilts (or a mixture).
Kauders sounds interesting (I like contrarians) but his charges are quite high I think.
BP
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Bill, appreciate the comment and many thanks for visiting the Blog. Happy to respond but better via email than in this rather more public place! Paul
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OK, to add to the ‘flation debate: Is it De. or In.?
It’s an issue I have researched and pondered for about 10 years since starting to manage my own investments. I did get a degree in Economics but later worked in IT, but followed this sort of debate closely as it is the No. 1 investment issue for the next 1 or 2 generations.
I came down on the DEflation side of the fence. I’m in a rush – pls excuse typos – so won’t waffle too long (hopefully) but simply write that the main issue which gets overlooked again and again by inflationistas (who think governments can print their way out of the current mess) is that the present currency system is very different from that of Weimar and Zimbabwe, which had paper systems. We have a CREDIT system. Most of what we call money is just double-entry bookkeeping entries or IOUs which are calls on future cash. There were no credit cards in Weimar, nor mortgage banks generating credit with a fractional reserve lending system in Zimbabwe.
The bond markets are central to the functioning and trust in the system. As such the litereal ‘printing’ of money or its electronic equivalent cannot be done without a collapse of the bond markets, a spike in interest rates then an economic collapse which itself would be deflationary.
Should a government try to pay its debt principal or interest (or even pay its wage bills) with new digits, the initial recipients would benefit (as in Weimar) but the sytem would deflate, not inflate as the bond market got wind of what was happening and collapsed and interest rates on mortages and other loans soared.
There is just too much debt to inflate in this manner. Certainly governments have inflated their way out of post-WWII recessions, but did this by encouraging the creation of more credit by lax lending standards, low interest rates and other incentives (MIRAS for eg.). This new credit behaves like money in the macro aggregates, but is phenomenologically very different in the way it affects market dynamics. This trick doesn’t work any more as we’ve reached the limit of debt that parties can assume and credit is contracting.
There are other aspects I could discuss: why asset bubbles are not necessarily concommitant with, nor automatically cause systemic inflation. (Eg current gold price). Or the psychological aspect of inflation. Or the demographic changes and how they relate to inflation cycles. Etc.
IMHO we are witnessing the slow turn of the post-war credit bubble into a long deflation. No amount of QE, OMOs or other liquidity injections as such will cause systemic inflation in the real economy, only asset bubbles as banks play hedge funds with the money and impoverish the real economy more by higher oil prices!
Here are some interesting links:
http://www.hoisingtonmgt.com/hoisington_economic_overview.html (the 2 most recent issues suffice)
http://globaleconomicanalysis.blogspot.com/ (search blog for very colourful debating of this question over the last few years).
Cheers
Bill
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