Monetary faultlines

“I had $600.00 in gold under my pillow. I awoke as I was thrown out of bed. Attempting to talk, the floor shook so that I fell. I grabbed my clothing and rushed down into the office, where dozens were already congregated. Suddenly the lights went out, and everyone rushed for the door.

Outside I witness a sight I never want to see again. It was dawn and light. I looked up. The air was filled with falling stones. People around me were crushed to death on all sides. All around the huge buildings were shaking and waving. Every moment there were reports like 100 cannons going off at one time.”

That’s how the American G.A Raymond described the morning of 18^th April, 1906.

Raymond happened to be in San Francisco. The events he was describing were caused by the worst natural disaster in American history: an 8.2 earthquake that tore the city apart.

It’s not the only time San Francisco has been hit by an earthquake. You may well remember a quake in 1989 (which was slightly smaller, and didn’t cause anywhere near as much damage).

It’s not by chance, either

Like much of the California, San Francisco sits on the San Andreas Fault – the point where the North American and Pacific tectonic plates meet.

It’s a faultline. It’s the divide between two hugely powerful geological forces which are moving in opposite directions. For the most part, the two forces cancel each other out. But the faultline is where all the friction is.

Occasionally, you reach a point where the friction is too much and the plates snap into a new position in an earthquake. You don’t want to be around when that happens.

There’s a parallel to be drawn here, of course. The financial and economic world finds itself in just such a situation right now.

We have two hugely powerful forces acting on the economy, pulling in entirely separate directions. The forces of inflation and the forces of deflation. And the balance of power between the two forces is probably the single most important economic dynamic in the world today.

Let’s call it monetary tectonics

OK, so let’s just make sure we’re all on the same page here. Most people know what inflation is. It’s rising prices. Sometimes prices rise moderately – at, say, 2% per year. Other times, for instance during the 1970s, inflation can be as high as 15% or 16%.

People are familiar with inflation. It’s become a fact of life.

Deflation is less well known and understood. This is essentially where prices fall across the economy. For example if prices were deflating at 2% something that cost £100 last year would cost £98 this year.

Central planners (mostly bankers, governments and academics) generally want mild inflation. In the UK, they ‘target’ 2%. I’m not entirely sure how (and no explanation has ever really cut it for me), but they seem to have decided that 2% is the ‘right’ level of inflation.

But what they do not want is deflation

If you’re in a lot of debt, as most of the Western world is, deflation is a death sentence. As prices and incomes fall and your debts remain constant, it becomes increasingly hard to keep your head above the water.

Imagine you have a debt of £100,000. Your income is enough to allow you to just about meet the repayments.

Then your income drops 5%. You still owe £100,000. But it’s harder to pay now. Then your income drops again. You still owe £100,000, but you’re even further in the hole.

Etc, etc. You get the picture.

Fear of this is what’s keeping pretty much every central banker and government official up at night right now. MarketWatch had the story last month:

“One can easily imagine that, absent quantitative easing in the United States, Europe, and Japan, those economies would have been mired in a deflationary post-crisis landscape akin to that of the 1930s. Early in that terrible decade, deflation became a reality for nearly all countries and for all of the advanced economies. In the last two years, at least six of the advanced economies — and as many as eight — have been coping with deflation.

“Falling prices mean a rise in the real value of existing debts and an increase in the debt-service burden, owing to higher real interest rates. As a result, defaults, bankruptcies, and economic decline become more likely, putting further downward pressures on prices.”

Let’s get back to our monetary tectonics analogy

You have the forces of deflation (huge national and private debts, falling commodity prices and a rush to ‘safe haven’ assets like the dollar) pulling prices in one direction – down.

Then you have the world’s monetary authorities desperately trying to drag prices in the opposite direction – back towards their 2% target – by dropping rates to near zero and printing money left right and centre.

For most of the last six years, the two forces have been finely balanced. They’ve been like two tectonic plates grinding against each other and cancelling each other out.

We’ve been living and investing on the faultline for half a decade. Just like with an earthquake, it’s almost impossible to know when the dynamic will change and the plates will snap into a new positon. But we know the longer the wait… the more chance the ‘Big One’ is due.

Yesterday, the story moved on a little

The UK inflation rate dropped beneath 0% again in September (to -0.1%). That isn’t full blown deflation. And it’s not enough to send Britain into a deflationary debt spiral just yet. But it’s an important psychological barrier. It’s a signal. It’s a twitching seismograph.

What comes next?

Well, if the dynamic continues as it has done since the financial crisis, don’t expect the authorities to give up the fight just yet. They know they have to do all they can to ward off deflation and stoke up inflation. It could be a losing battle, but that won’t stop them.

Expect more talk stimulus… more talk of negative interest rates… and more talk of abolishing cash.

One way or the other, the ‘Big One’ is coming.

Category: Geopolitics