terça-feira, 16 de dezembro de 2008



The world seems to be heading for a deflationary abyss with governments around the world flinging money at the problem with no worries about sowing the seeds of inflation later. The entire process is totally out of control, like an airplane spiraling towards the ground, the pilot desperately applying countermeasures. Zero short term interest rates incentivize investors to reach out for higher yields. But the huge growth in money supplies flash a warning signal that hyperinflation could come later and obliterate the value of all fixed income investments.
I subscribe to a number of investment letters. I have never seen such confusion. Some are predicting continued massive deflation. Others massive inflation. Some are urging Buy, Buy, Buy for the stock market. Others are suggesting the worst is yet to come. Stay in cash or buy gold.
Economic recovery, Great Depression style deflation or Weimar Republic hyperinflation? Take your choice.
So how did we get in this fix? Under the free market/monetarist/efficient market framework that accompanied the rise of Reagan, Thatcher and Deng Xiaoping, markets were assumed to be efficient. Financial innovation and leverage were good things. So long as money supply (however defined) grew at a steady, non-inflationary pace, markets would correctly price assets. The system was supposed to have a tendency to return to equilibrium on its own, and economic cycles would be manageable.
But in fact an economic cycle has come that seems to be out of control.
The Malfunctioning International Financial System Explanation
The Dismal Optimist has been arguing that a malfunctioning international monetary system is one cause of the current problems. Countries with surplus dollars have held down the value of their currencies, have bought dollars and inflated global money supply. In my opinion, China has been the biggest offender here and China is now paying the price. A bubble in manufacturing facilities oriented towards exports has grown up on the China coast. Reportedly thousands of these manufacturing firms are going bankrupt and China may be headed for its own hard landing.
I just attended the Fourth Annual Asia Economic Summit in Hong Kong. It was very interesting meeting for what was said and what was not said. Speaker after speaker called for a restructured international monetary system, one that reflected the new economic power of Asia. But nobody talked much about how to do that. People sense there is a problem, but perhaps the arcane nature of international finance makes it difficult to pinpoint what that problem is. Or perhaps some of the speakers shied away from the politics that is implied in any restructuring of the global finance system. In my opinion the restructured system has to start with a revaluation of the renminbi and elimination of Chinese capital controls. China has to stop buying US dollars, thereby holding down the value of the renminbi and adding to the global money supply. China has to allow its citizens to invest in the global equity markets including Hong Kong. (It is interesting that Hong Kong went back to Chinese sovereignty in 1997. But Chinese citizens cannot buy Chinese stocks in Hong Kong. It is as if the Handover never happened! )

The Financial Instability Explanation
There is another explanation for the current boom/bust which lies outside the free market/monetarist/ efficient market framework and which until recently has gotten very little attention. And one we can’t blame the Chinese for. This explanation is laid out rather skillfully in a new book by George Cooper called The Origin of Financial Crises. Cooper concedes that central bank money creation as described above “creates one-way irreversible positive inflation” and that excess money growth is one cause of inflation.
But Cooper describes another type of inflation that is derived from what he calls “private sector credit creation.” Unlike public sector central bank money creation which creates high powered money out of thin air and does not produce additional debt, private sector money creation involves the simultaneous creation of offsetting debt. People borrow for new projects and for new consumption. Positive feedback loops and natural human tendencies toward herd behavior keep the process going until a point of excess is reached and the debt becomes a major problem. Once that point of excess is reached there is very little the central banks can do. Deleveraging and asset price deflation become unstoppable.
According to Cooper, equilibrium, as defined in the efficient market hypothesis, does not exist. The economy oscillates between private sector credit booms and busts. It is the job of central banks to moderate these booms and busts. Asset price movements rather than consumer price inflation should be what central banks should moderate. The monetarist prescription of keeping the money supply growing at a constant, non-inflationary rate – whether this is achieved by deliberate central bank policy or by some type of gold standard – will not fix the problem. Credit driven asset price booms and busts will arise regardless of whether central banks are creating money in excess or not.
Cooper’s work is based upon the work of the late Hyman Minsky who developed the Financial Instability Hypothesis. Minsky thought financial markets were inherently unstable, given to credit-driven booms and busts. Until recently, Minsky has been generally ignored by the economics profession.
A Glance at the History of Prior Booms and Busts
For the graduate course in valuation that I developed, I spent quite a bit of time researching prior booms and busts. I discovered something that puzzled me. With my monetarist training, I always looked for a monetarist explanation for prior booms and busts. Somewhere there had to be an excess growth of money to explain each cycle. But in fact I couldn’t find monetarist explanations for all the bubbles. For some yes but clearly there were others where the monetarist explanation seemed to be deficient.
For starters for most of its history prior to 1913 when the Federal Reserve was created, the US didn’t have a central bank. So who was creating the high powered money out of thin air? With the exception of French reparations to Germany after the Franco Prussian War in 1871, at least for the major countries I have found no explanations based on gold movements, at least for the boom part of the cycle. Of course, for gold enthusiasts such a finding would be embarrassing. If rapid increases in high powered money and resulting boom bust cycles were due to an influx of gold, this would undermine gold’s reputation for promoting financial stability.
Prior to 1913 US certainly had its share of asset boom/busts that were accompanied by bank panics and economic setbacks. In 1873 for example the US along with a number of other countries experienced a significant stock market and economic downturn. Global overinvestment in railroads was a driving factor.
1. Exhange Alley, England -1696
2. South Sea Company/Mississippi Scheme 1720
3. Briitsh Canal Mania –1793
4. Crash of 1825- United Kingdom
5. Crash of 1837
6. Crash of 1893
7. Crash of 1929
8. Japanese Bubble -1989
9. Internet Bubble - 2000
The literature describing these earlier boom/bust cycles is filled with descriptions of what could be called positive feedback loops – i.e. mechanisms that promoted the boom independent of any changes in high powered money—and an investor class susceptible to over enthusiasm and herd behavior. All of this fits the Minsky view of the world.
The first mechanism that turned up in every boom was abuses and excesses of credit creation. Prominent in contemporary accounts are all kinds of what now would be called margin schemes for buying IPOs. Financial systems, especially those with fractional reserve banking, are ingenious in coming up with new ways to leverage new business opportunities. The credit was always forthcoming. The busts always involved leveraged overinvestment in favored asset classes, accompanied by frauds and followed by bankruptcies and deflation. As day follows night, deleveraging followed overleveraging. In the contemporary literature central banks are not blamed for this. They are usually not even mentioned. According to Cooper, financial instability “caused central banking, not the other way around (at least not originally).”
A second positive feedback loop is innovations in communications. Today it is CNBC and Bloomberg and the internet. You can watch a giant Bloomberg screen in the main subway station in Hong Kong if you want. Or sit almost anywhere in the world in Starbucks and wifi your way into the markets. In the England of the 1690s stocks were traded in the coffeehouses. Presumably the coffee wasn’t up to today’s caffe latte standards. Nevertheless, the infant newspaper industry helped generate enthusiasm in the coffee houses for the purchase of securities. The introduction of new communications devices and systems– financial newspapers, the telegraph, the telephone, the stock ticker, radio, television, the internet — all in their time served to generate interest in the bubble phase of the credit cycle. In his now classic book, Irrational Exuberance, Robert Shiller asserted that no bubbles occurred until the introduction of newspapers.
In theory, communications improvements make markets more efficient. But especially when they are first introduced to the investing public, excitement is generated. In most cases such as the internet, the new means of communication was itself the object of speculation and overinvestment.
A third positive feedback mechanism was the fact that new, perhaps therefore less sophisticated investors, historically have constantly joined the investing universe. Today it is Chinese and Indian investors.
The Bottom Line
The two explanations for the current global boom bust —excess internationally derived high powered money creation and Minsky private sector credit creation– are not incompatible and are unfortunately additive. As a result the world is in a perfect storm of boom bust. Governments today have no choice but to throw money at the current deleveraging. But we have no assurance that these efforts will work, or that if they do, that they will not bring about hyperinflation. Because of past misguided policies, our governments must now take a huge gamble with our currencies and by implication with our investment portfolios.
Finally, we have no assurance that the infamous anti-deflation policy response of the Great Depression – protectionism—will not raise its ugly head, perhaps disguised this time in “green” or a anti-outsourcing cloaks. Intellectually, if governments take the view that they must do whatever it takes to avoid deflation and that this end justifies whatever the means, then the populist temptation of protectionism becomes more difficult to resist. However much they really didn’t mean what they said, the Democratic candidates did publicly embrace protectionism in their primaries. Sincere or not, they may find it to be an irresistible temptation when they take power and the unemployment numbers are rising.
My own view is that for the near term further deleveraging and deflation will prevail globally. Yes the markets look ahead and they are currently rallying from an oversold condition. But the markets may not fully appreciate how bad things can get. What’s happening today has not happened before, at least not on this scale. On anything but a trading basis, I think it’s too early to buy stocks or real estate or art despite the apparent values that now exist.

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