God is a Capitalist

Tuesday, April 14, 2015

Central banks as vestigial organs

In his early years Hayek anticipated that the monetary theory of trade cycles, now known as the Austrian business-cycle theory (ABCT) would become widely known by business people who would refuse to borrow when the central bank reduced interest rates to an artificially low level. That would dampen booms caused by money created ex nihilo and reduce the severity of recessions.

Hayek was wrong because the Keynesian tsunami pushed the ABCT into a tiny corner so that few business people learned it. However, we may have reached a similar dampening of economic cycles by another route, that is, by central bankers making central banking irrelevant. Glimpses of this can be seen in Japan, as I wrote in this posting.

Chris Mayer of Daily Reckoning recently traveled to Japan and confirmed the thesis. Japan has enjoyed near zero interest rate (ZIRP) policies for over 25 years. Most economists consider the Japanese economy during that period to have been an unmitigated disaster because nominal GDP has stagnated. In spite of massive money printing by the Bank of Japan and fiscal spending by the government, both intended to generate price inflation, Japan has “suffered” from deflation. Mayer wrote, 
Japan is ground zero for studying how a deflation upsets all the normal economic assumptions we have. 
And Mayer quotes from David Pilling’s book Bending Adversity: Japan and the Art of Survival who wrote that Japanese have been hoarding yen in their freezers:
Because of the deflation that had been gnawing at prices since the mid-1990s, the crisp notes could acquire more goods the longer they remained in their frozen vault. If, for example, someone had stashed 100,000 yen in the fridge in 1995, by 2012, its purchasing power would have risen to 112,000 yen.
One economist in Pilling’s book estimated that as much as $300 billion worth of yen notes, the GDP of Denmark, has been similarly frozen or stuffed under mattresses. Mayer commented that,
There is no feeling of entitlement about getting an annual raise in Japan. In fact, as Pilling writes, “a worker’s wages might fall, but he or she could still feel better off ... Japanese incomes may have been falling, but the price of everything from newspapers to haircuts to housing and sushi have been stuck at 1981 levels.”
But the people aren’t “feeling” better off; they really are better off when prices fall faster than wages. Japanese citizens have done well under Japan’s 0% regime. Now the whole developed world is doing it. Central bankers want inflation more than life, but they can’t get no satisfaction. Inflation like they want can happen only when states borrow and spend, but most states in the developed world are tapped out. They have maxed out their credit cards. Without inflation, or with mild deflation, state debt continues to rise. 

Without increased state spending, mild deflation sets in and businesses that depend on rising prices refuse to borrow and invest. Mild deflation and the danger of causing the domestic currency to rise blocks central banks from raising rates.  In a nutshell, central banks and state spending have become irrelevant.

Will we do as well as the Japanese because the Fed has lost its ability to manipulate the money supply so much? Without being able to create artificial booms, the busts tend to be much milder. Uncertainty falls. The real economy becomes much more important. Instead of hedging and speculating people go back to actually making things of value.

In addition to the Japanese experiment, we can look to the US from about 1875 to 1918 during which the economy experienced mild deflation. That period produced some of the US’s greatest growth in standards of living in its history. Investment was high and technological progress was explosive. For a detailed look at this period, check out Robert Higg's book The Transformation of the American Economy, 1865-1914.

Under inflationary regimes, we buy stocks for their price increases. Most investments are financed by debt, even a lot of stock market purchases. Inflation artificially boosts profits and therefore stock prices while reducing the real value of debt. It only hurts old retired folk on pensions, the working poor and middle classes because wages don’t keep up with price inflation.

The world in mild deflation would seem upside down to most investors who would borrow to invest only if they have found technology for reducing production costs. Interest rates would remain low, or even negative, 1) because there is no inflation to melt away debt over time and 2) demand for debt will be much lower. Most investment would come from savings instead of money created ex nihilo. But the increased real wages of workers will make saving much more attractive and, as a result, abundant.

Workers won’t look for annual cost of living increases; they won’t even get raises because deflation makes their pay worth more each year. New workers would be hired at lower wages each year to reduce producdion costs.

Under inflation, real estate and government debt are the safest investments and the Basel Accords reward banks for lending to them. Under deflation they would be the worst investments. Housing prices would fall. As poor investments, housing would become very cheap and easy for most workers to buy.

We may be living in a parallel universe to that of 1875 – 1918 because that period of deflation began with a major international real estate crisis followed by a banking crisis and deep, but short, recession.
Among mainstream economists, deflation is like the name in Harry Potter that shall never be mentioned. The thought of deflation causes central bankers and mainstream economists to wet their pants. But as the US experience and the Japanese experience show, mild deflation is good for the middle class and poor. 

The Bank for International Settlements confirmed that with a paper in 2004, Back to the future? Assessing the deflation record. The report concluded,
One feature of the deflation record stands clear. During the 19th century and early 20th century, deflation was not generally associated with persistent and deep economic malaise...there is in fact no reason to expect that deflations should necessarily be associated with economic weakness... “Good” deflations would be those reflecting productivity improvements against the background of underlying or secular restraints on the growth of nominal demand.28 These might occur alongside higher growth, buoyant asset prices and a healthy rate of expansion of monetary and credit aggregates, reflecting the fact that lower prices would not impair profitability and cash flows.  
What does that mean for investors? We can look to the electronics industry for guidance. The industry has enjoyed rapidly falling prices since the 1950’s, yet has managed to make good profits and find investors by innovating ruthlessly and vigorously. As a result, costs of production fall faster than prices. Investors will want to find businesses that do the same.
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