Posted by: Dirk | April 19, 2013

Dark clouds on the horizon

The Wile E. Coyote moment is when you realized that there is nothing below you and that a free fall seems inevitable. I think that many investors are slowly realizing that this is what happens. At the New York Times, quantitative easing is declared a failure:

The effect the central bank hopes to produce hasn’t materialized. Despite modest growth, the economy remains a wellspring of misery, with mass unemployment, wage stagnation and factories going unused. In March, a smaller percentage of working-age people were actually working than at any other time since 1979.

All that quantitative easing did was to give more money to those whose speculations brought about the last bubble:

The Fed is engaged in “trickle-down monetary policy,” said Daniel Alpert, managing partner of Westwood Capital, an investment bank. “This type of monetary policy is making the wealthy wealthier and hoping that it trickles down to the shop floor.”

But “trickle down has never worked,” he said. “The wealthy don’t need to consume. And when there is oversupply of capacity, the wealthy don’t need to invest in new capacity.”

Honestly, I have never heard that view being expressed by somebody from an investment bank (maybe these views did not get reported by the financial press before?). If the investors think like this, we have to come up with something else. Here is a quick reminder of how Keynesian economics can be applied. It is all based on the idea that income (Y) can be spent on consumption (C), investment (I), government spending (G) and, in an open economy, net exports:

Y = C + I + G + NX

Let’s leave out net exports (and other open economy implications) for the sake of clarity. America’s trade with the rest of the world is not very large. In the long-run this has to change, but in the short run not much will happen. A demand problem arises when one of the variables on the right hand side (RHS) of the equation is falling. Say, households start repaying debt. That should lower consumption because households spend income on consumption and savings (Y=C+S). So, since the accounting identity up there says that supply (income) is equal to demand (RHS), a fall in demand will cause income and thus supply to shrink.

The central banks job is to make sure that this doesn’t happen. It puts the interest rate down during a recession, which should spur investment. This investment if financed by loans – this is why it is influenced by the interest rate – and therefore has an influence on the financial sphere. Lately, it seems that monetary policy is stuck: investment does not rise even though rates are at historical lows in many countries. That is because a large part of investment consists of real estate, and with prices expected to fall some more nobody wants to build or buy houses. That’s many jobs not there right now. One condition for construction to restart seems to be expectations of rising prices. So, that is why cheap money is supposed to help. However, if wages do not increase, nobody will be able to afford those houses and the prices will come down to the point where they can afford them or wages come up. However, with inflation at below two percent and unemployment high a rise in wages is unlikely.

cpifredgraphThe recent fall in the gold price and other primary goods might have been just a part of one of those up and downs. If it is the realization of investors that with economies not moving much, and China engaged in rebalancing which will lead to lower investment and hence less consumption of raw materials, primary goods prices are probably on their way down, then deflation rears its ugly head. This would lead to wins and losses in the derivative market, but more importantly, to less collateral available. As we learnt in the Great Financial Crisis, this can harm the repo market. The resulting fall out might be large, and with public debt significantly higher in most places as a result of the last bail-outs, this time the financial sector will not be saved, it seems save to say. That is the situation that Axel Leijonhufvud has been warning about for years.

To repay debt, incomes are needed. Now that it seems clear that monetary policy, including QE, does not work anywhere there are not that many options left. Economists might have to think the impossible.


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