Lords of Misrule

Smash ! The son of a Parisian shopkeeper accidentally breaks a pane of glass. A crowd gathers at the scene. The shopkeeper is annoyed, being out of pocket by the cost of a window. But the glazier summoned to replace it will benefit, by the same margin. The crowd starts to jump to conclusions. Where would poor glaziers be in a world of pristine windows ? Imagine all the good uses to which the glazier can direct his new-found windfall. Think what he could buy ! All that new money coursing through the economy. Might it not be better if we broke a few more windows ?

Probably the most famous story in the history of economics is a parable by a Frenchman, Frédéric Bastiat, in his 1850 fable of the broken window. The crowd stirs, anticipating a wave of window-breaking across Paris leading, in turn, to an infrastructure boom..

“Stop there !” cries Bastiat, confronting the mob directly.

“Your theory is confined to that which is seen; it takes no account of that which is not seen.”

Hence the title of what is likely to be the most influential essay ever in economics, That which is seen, and that which is not seen.

The handful of francs paid to the glazier for making his repairs are what is seen. Those francs are visible and tangible and their effect as new money and new spending can be anticipated. What is not seen is what the shopkeeper might have done with those francs instead. He might, perhaps, have bought some new shoes, or a book for his library.

“To break, to spoil, to waste, is not to encourage national labour; or, more briefly, destruction is not profit.”

It’s sometimes said that your home is the biggest investment you will ever make in your life. That is incorrect. As the author and comic Dominic Frisby points out, the cost of government is the biggest expenditure you will ever face.

In the UK, public sector net borrowing in the financial year ending March 2021 was estimated to have been £299.2 billion, the highest borrowing since financial year records began in March 1946. Public sector net debt was over £2.1 trillion at the end of May 2021 or around 99.2% of GDP, the highest ratio since the 99.5% recorded in March 1962.

Government clearly plays a dominant role in the modern economy. While it doesn’t create wealth – only honest entrepreneurial activity can do that – government redistributes it. But this can only ever be a zero sum game. The process of capital redistribution involves winners and losers. Government projects may appear to create work for some, but that takes no account of those who must pay for this work. That someone is normally the taxpayer. And if the capital involved is not raised through general taxation but raised via the bond market, then that someone is not today’s taxpayer but tomorrow’s – perhaps someone as yet unborn.

Such government projects also have a high likelihood of diverting resources away from a more deserving group. Capital is finite. Some government spending might even involve the outright destruction of wealth. There are, after all, only three ways in which money can be spent. You can spend your own money on yourself. You can spend your own money on other people. Or you can spend other people’s money on other people. Which is likely to be most efficiently deployed ?

As the world economy gets ever more financialized, and as ever more capital starts flowing in ways that can be best described as less than wholly transparent, Bastiat’s metaphor only gets more and more powerful. In the words of the American business journalist Henry Hazlitt,

“..the broken window fallacy, under a hundred disguises, is the most persistent in the history of economics.”

Ironically, those best placed to advance the message of the broken windows fallacy – professional economists – are often those who least understand it. Paul Krugman, for example, laughably the recipient of a Nobel Memorial Prize in Economics (not a Nobel Prize for Economics, which does not exist), wrote in the aftermath of the Japanese earthquake and tsunami of 2011, and the resultant meltdown at the Fukushima power plant, that

“..the nuclear catastrophe could end up being expansionary.. remember, World War II ended the Great Depression.”

Krugman has also claimed that the threat of an invasion by aliens from outer space could bring the US economy out of recession within 18 months.

If the ‘visible’ finance of government spending (and its ‘invisible’ impacts on other parts of the economy) is dangerous, how on earth to describe the influence of Quantitative Easing and Zero (or Negative) Interest Rates ?

“Favourable global economic prospects, particularly strong momentum in the euro area and in emerging markets led by China and India, continue to serve as a strong foundation for global financial stability.”

So began the assessment of the International Monetary Fund’s (IMF’s) Global Financial Stability Report. Not in 2021, however, but in April 2007. This cheerful global macro-economic summary was published on the eve of the most devastating financial and economic crisis since the 1930s.

So much for the value of “experts”.

Equity markets are, by and large, close to or at all-time highs throughout the world.

Bond prices are in precisely the same territory, leaving bond yields at close to all-time lows (bond yields move inversely to bond prices, so higher bond prices send the yields on bonds inexorably lower).

Asset valuations are vulnerable to any correction.

Any shocks to either bond or stock markets could have large negative consequences for the world economy. In the IMF’s words,

“A sudden uncoiling of compressed risk premiums [an acknowledgment that Quantitative Easing and Zero Interest Rates have inflated asset prices, perhaps to unsustainable levels], declines in asset prices, and rises in volatility would lead to a global financial downturn.”

To put it more prosaically, look out below.

Assessing a recent IMF overview of global economic prospects, Martin Wolf, the chief economics correspondent for the Financial Times, and probably Europe’s highest profile advocate of Quantitative Easing and other unorthodox forms of central banking monetary policy, wrote as follows:

“Criticising the success of our central banks in reflating our crisis-hit economies, because this created today’s financial risks, is not a valid reaction to their actions. It is, however, an extremely valid criticism of finance. It is also a valid criticism of the failure of governments to address the many frailties that still lead to financial excess. The central banks did their job. Unfortunately, almost nobody else has done theirs.”

I bow to no man in my disrespect for Martin Wolf, but even by his standards of economic bewilderment and his highly partial advocacy on behalf of the world’s central banks, this is a disgrace.

Central banks did not solve anything – they were in fact the proximate cause of most of the problems that Martin Wolf highlights. It is central bank control of interest rates that has led to the boom and bust cycles of the last several decades. Central banks, in other words, caused the asset bubbles in the first place – through overgenerous monetary policy and overly low interest rates – and then mysteriously “solved” the crises they themselves provoked (bursting asset bubbles) with more of the same medicine – overgenerous monetary policy and overly low interest rates. A strange thing, easy credit – at one and the same time both the cause of our economic problems, and mysteriously their solution.

Or perhaps Martin Wolf is just dead wrong.

As soon as the Global Financial Crisis hit, the US Federal Reserve, and the rest of the world’s major central banks, moved heaven and earth to ensure that deflation did not set in.

Like generals fighting the last war, the one historical episode they were determined not to repeat was the deflationary experience of the Great Depression.

The American economist Irving Fisher is well known today for his ill-judged remark of mid-October 1929, when he stated his view that US stock prices have reached “what looks like a permanently high plateau”. This was two weeks before the Great Crash.

This is a shame, because Fisher also contributed greatly to our understanding of the deflationary process, especially the interconnections between debt and deflation.

In The Debt Deflation-Theory of Great Depressions (published 1933), Fisher posited the following scenario, which accurately reflected the macro-economic dilemma of 1930s America:

“Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”

In a debt deflation, panic selling of overleveraged assets leads inevitably to a contraction in the money supply and to a slowdown in the turnover of money throughout the economy. This leads, in turn, to a generalised fall in prices. Absent intervention in the free market process, businesses sicken and fail, profits collapse, and trade collapses with it. This leads, in turn, to a rise in unemployment and the whole grisly cycle repeats itself.

Which is why central banks acted as they did in the immediate aftermath of the collapse of the US property market in 2007/8 and the resultant run on the international banking system. They did not want the history of the 1930s to repeat itself.

But just as Bastiat’s original broken window begat all sorts of foolish speculation about money flows, central bank market intervention came with all sorts of unintended consequences.

Bernanke at the Fed, Carney at the Bank of England, Draghi at the European Central Bank all thought that by slashing interest rates and pumping money into the bond market (thus reducing bond yields across the board), they could encourage consumers to rush out to borrow and spend, and thus reflate the economy.

Theory is one thing; reality is another.

What actually happened, as we have learnt to our cost (but that central bankers have yet to), is that consumers refused to go out and buy products and services they didn’t need with money they didn’t have.

Business people, similarly, watched interest rates slide down towards zero with grave misgivings. They could recognise what central bankers could not – that an economy where the cost of money is zero is not healthy but rather sick, and wholly artificial. So instead of investing in things like research and development and hiring, they concentrated – where they could – simply on buying back their own stock, which has the happy side-effect of boosting earnings per share, on which many of them are remunerated by way of options programs.

Savers, meanwhile, and those on fixed incomes (such as pensioners) watched interest rates burn away towards nothing with horror. Rather than going out and spending money on trivialities, they (sensibly) concluded that with the economy and financial markets effectively showing signs of crisis as opposed to rude health, they would save even more – even at derisory deposit rates.

And banks, who can make effortless profits simply by front-running central banks (i.e. by buying government bonds just ahead of central banks who will buy the same bonds at even higher prices), or who could park their capital back with those central banks and earn interest on it, saw little urgency in providing loans to the diminishing number of small businesses who still displayed an interest in expanding.

Result: not inflation but rather deflation, economic stasis, and confusion.

In short, just about everything you are told about the economy and the supposed “health” of the financial system is a gigantic lie. When it comes to stock and bond prices, the free market has already gone into hibernation, replaced by the arbitrary flows of newly minted money, printed out of thin air by central banks, and directed into this or that asset class according to the whims of state-appointed bureaucrats propping up a Potemkin village depiction of a robust market.

Company executives see the reality. They are reluctant to hire staff when the future is so uncertain. They would rather buy back their own stock than put their capital to work to more productive ends.

Consumers see the reality. They recognise shrinkflation when they see it – when companies that are loath to hike prices explicitly do so by stealth by shrinking the amount of product in the boxes they ship instead – but keep the headline prices unchanged.

Savers see the reality. In recognition of the extreme economic uncertainty they double down on their savings even if those savings deliver nothing by way of real returns.

The famously miserabilist Leonard Cohen nicely articulated our current predicament in his song Everybody Knows. Amongst its lyrics:

Everybody knows that the dice are loaded
Everybody rolls with their fingers crossed
Everybody knows the war is over
Everybody knows the good guys lost
Everybody knows the fight was fixed
The poor stay poor, the rich get rich
That’s how it goes..

Everybody knows that the boat is leaking
Everybody knows that the captain lied
Everybody got this broken feeling
Like their father or their dog just died
Everybody talking to their pockets
Everybody wants a box of chocolates
And a long-stem rose
Everybody knows..

And everybody knows that the Plague is coming
Everybody knows that it’s moving fast
Everybody knows that the naked man and woman
Are just a shining artifact of the past
Everybody knows the scene is dead
But there’s gonna be a meter on your bed
That will disclose
What everybody knows..

And everybody knows that you’re in trouble
Everybody knows what you’ve been through
From the bloody cross on top of Calvary
To the beach of Malibu
Everybody knows it’s coming apart
Take one last look at this Sacred Heart
Before it blows
And everybody knows..

We are not in a recovery, we are in a depression. Keynes defined a depression as a prolonged period of sub-par growth. Couched in those terms it almost sounds peachy. The one question, perhaps the only one that really matters to investors, is when ? When does reality impose itself on the façade of our financial markets ? When does the mask slip ? When does the central banking emperor of Oz reveal himself behind the curtain ?

That, sadly, is the one question that none of us can answer, definitively. But it is surely sensible to be prepared for the rearrival of reality, or the reappearance of those famed bond market vigilantes, those agents of true and free markets that will wipe away all those manipulations arising from the biggest misallocation of capital in the history of finance.

One last suggestion: the causes and consequences of the next big market dislocation will not be discussed by the mainstream media, because, like Martin Wolf and the supporting cast of the Financial Times, they have become cheerleaders for the central banks and their dangerously counterproductive monetary experiments.

If you want to understand what is really going on in the economy and financial markets, you will need to keep an open mind and ignore most of the conventional commentary, which sees nothing wrong in the first place when we know there are reasons to have grave misgivings about the apparent solidity of a market whose prospects are built mostly on sand, free money and wishful thinking. Own defensive assets and inflation protection. (The threat of inflation is widely understated, not least by central banks who laughably pretend that the threat is merely transitory). And as we now know from the Convid debacle, trust no-one from the world of conventional media. Challenge everything you see. Distrust, and verify.

Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.

Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.