Waiting for ‘the big one’

If any country in the world is prepared for earthquakes, it’s Japan. The country sits on the Pacific edge of the Ring of Fire: a seismically active zone that experiences roughly 90% of the world’s earthquakes and over 80% of the largest. That’s why Japan has the world’s most sophisticated early warning systems against earthquakes.

But on 11 March 2011, a magnitude nine earthquake off north-eastern Japan took the country completely by surprise.

Scientists had prepared for earthquake forecasting and response using data and observations drawn from the previous 120 years. But as seismologist Fumiko Tajima points out, the history of plate tectonics is over four billion years old. A hundred and twenty years of data was just not sufficient.

In many ways, our economists are making the same mistake. Consider what we’ve lived through. I don’t just mean the financial crisis that erupted in 2007/8. I mean a 40-year sequence of uncontrolled credit expansion fuelled in large part by dishonest money.

It’s not enough to only consider the past six years. We’ve been ignoring the signals for more than four decades and a financial earthquake is now on its way.

This conflict defines investing

The fund manager Incrementum has compared the interplay between deflation and inflation to the permanent pressure of two opposing tectonic plates: currency is being created (monetary inflation) by central banks; currency is also being effectively destroyed (monetary deflation) by deleveraging banks within the commercial banking system.

We have a debt-based monetary system, so every time a bank calls in a loan or a borrower pays back a loan, money disappears from the financial system. Balancing these opposing forces, the task of every central bank, is going to become increasingly difficult.

In many respects, central banks are just like the great and powerful Wizard of Oz, pulling levers and throwing switches and claiming control over the economy. “Pay no attention to the man behind the curtain.” Monetary policy is a confidence trick. “The Fed can change how things look,” said the famed financial commentator, Jim Grant, in an interview recently, “but it cannot change what things are.”

Inflation versus deflation? All bets are off, but whichever policy wins the confidence trick, there will be no happy conclusion.

Who benefits from QE?

Before I start speculating about the outcome, it’s important to consider who has really benefited from quantitative easing (QE) and who benefits from inflationary policies. Not prudent savers and pensioners – their prospects have been severely impeded by artificially low interest rates.

The prime beneficiaries of QE, other than the banks, have been ‘the 1%’ – the very wealthiest in society, who own the lion’s share of the financial assets whose values have been boosted by monetary stimulus.

And of course QE, by artificially suppressing the prevailing interest rate on government debt, has made life – in the short term, at least – much easier for hopelessly indebted Western governments.

This is a highly visible example of Mises’ redistribution: “a shift in income and wealth from some groups to other groups”. Individual savers and creditors lose, to the benefit of government, shareholders, bondholders and debtors. Homeowners benefit, at the expense of younger workers who may never be able to get onto the property ladder without help from the bank of Mum and Dad.

And there is no shortage of inflation in the prices of financial assets. Those who have benefited from this shift in income and wealth won’t want to give it up easily. And in the case of our indebted governments, they don’t have the means to.

The nightmare scenario of price deflation

In a highly leveraged world, price deflation is, from a political perspective, a nightmare scenario that must be avoided at all costs. Deleveraging – paying down existing debts – leads to consumer price deflation and asset price deflation. Tax revenues desperately needed by overleveraged governments decline precipitously. Asset price inflation can be taxed, but asset price deflation cannot.

In an environment of falling prices, the burden of debt gets heavier in real terms. It becomes increasingly difficult to service debts until it becomes impossible. The journey between ‘difficult’ and ‘impossible’ is not a smooth one and its duration cannot be forecast with any precision. As Hemingway observed, you go bankrupt in two ways: gradually, and then all at once.

Debt liquidation and price deflation also have fatal consequences for an overleveraged banking system. It all ultimately comes back to the banks.

The interests of the banking system and the interests of Western governments have now become fused. And governments have given the banks an impossible task: shrink their balance sheets, but keep lending, to individuals and small businesses.

They can do one or the other. They cannot do both. In the meantime, financial institutions – AKA, the bond market – are the lender of last resort to governments, for as long as confidence in the system can be maintained.

So, central banks are now the prime movers in the financial system, tasked with a mandate to ensure that deflation, in the words of former Fed chairman Ben Bernanke, “doesn’t happen here”.

Pre-crisis, the US monetary base stood at around $800bn. After the most recent iteration of QE, it now stands at around $4trn. There is no historical precedent.

They are now reducing the rate at which they pump further liquidity into the markets – the infamous ‘taper’. But extricating themselves from such a dominant position in the marketplace, as prime mover behind both bond markets and stock markets, is not going to be easy.

• Tim Price writes the Price Report newsletter. He has built an investment strategy around preparing for “the big one”. To find out more, click here.

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Category: Market updates