What does an economist think…when he adjourns to the local bar…or is hauled away to the asylum? In the dead of night or the quiet of a confessional, does he laugh sourly at having fooled most of the people most of the time? Or does he curse his trade and feel like hanging himself?
The thing economists said was nearly impossible actually happened last week. Yields on 2-year US debt hit a record low just as the Treasury prepares for another record-setting deficit. The supply of Treasury debt and the demand for it hit new highs – together. Stranger things have happened. But the strangeness of this event has caused a furor loquendi amongst economists. Usually, there are only two major ways of misunderstanding current events. Now there are at least four of them.
Party economists take the party line; whenever the party flags, get out more gin. Now, they say the recovery is proceeding, thanks to adroit demand management. Unsurprisingly, since they are the authorities, they claim that record low Treasury yields mean investors have confidence in the authorities. Deficits don’t matter, they add.
Another group – the Paul Krugman, Martin Wolf, Joseph Stiglitz wing of the neo-Keynesian faction – fear the recovery may stall, as it did in America in the ’30s and Japan in the ’90s. They say deficits do matter; they wish there were more of them. Low bond yields are cheap gin to them.
In opposition is a large group of “inflationistas.” (Marc Faber, Jim Rogers…). They believe the authorities have already added too much monetary juice. And now they’re afraid the feds will run bigger deficits and add even more monetary inflation. Along with tightened supplies and demand pressure from the emerging markets, this will cause consumer prices to rise more than expected. The dollar and bonds will be crushed.
A small group of ‘hardcore deflationists,’ meanwhile, believes falling yields prove the economy is sinking into a deep hole of debt destruction and depression. (Robert Prechter, Gary Shilling) These Jeremiahs expect the main US stock index – the Dow – to lose 95% of its value and the bond market to continue to rise.
Yet another school of thought confines itself to this Markets and Money. It acknowledges that nobody knows anything, but it doesn’t mind taking a guess. Herewith is its view, beginning with a critique of its opponents. Fair-minded reader, you be the judge.
Mainstream opinion is contradicted by the facts. Fewer people are employed today in the US than when the stimulus program began. Sales are down. Growth is falling. Credit is contracting. Even hairstylists and cab drivers know something is wrong.
As for the ‘inflationistas’ view, it makes sense. The feds add money. Prices should rise. But in Europe and America, the rate of consumer price inflation is generally ebbing. That’s what low bond yields are really telling us; they signal deflation, not inflation. Maybe the inflationistas will be proven right, eventually. But for the moment, prices in the developed world are going down; they should remain weak until this phase of debt reduction is largely complete.
Meanwhile, ‘hard-core’ deflationists could be right too. A big credit expansion typically gives way to a big credit contraction. The past is not prologue, it is an account payable. Now it’s due. But there’s room for negotiation. If the ‘hard-core deflationists’ are right, credit will contract back to ’70s levels and asset prices will correct as much. But a lot has happened since the Carter era. There’s much more demand, for example, coming from all over the world. China is now a bigger energy consumer than the US, and a bigger auto buyer too. Demand for just about everything is growing. This new demand is bound to boost prices.
The supply side, too, puts a brake on deflation. The easy, cheap oil has already been pumped. Other resources – including food and water – require huge new capital investments before supplies will increase. Domestic inflation rates in China and India are already increasing. It’s just a matter of time before the exporters put inflation in a shipping container and send it west.
But we don’t need to rely purely on guesswork. We have an example right in front of us – Japan. The island has been de-leveraging its private sector since 1990 – complete with ultra-low bond yields. Consumer prices fell. Between real estate and stocks, investors lost an amount equal to three years’ total output.
Economists misunderstood it completely and gave consistently bad advice. And the authorities took the advice and squandered a whole generation’s savings. But the world did not come to an end. Japan de- leveraged while the rest of the world went on a buying spree. Now, the entire developed world de-leverages, while the emerging world continues to shop.
Nobody knows anything. But readers should expect a long, soft correction just the same.
for Markets and Money