WHY THE MONETARY LIFEBOAT WON’T FLOAT
The global financial system has come to rest on a single complacent assumption, one which is seldom put explicitly into words, but is remarkably implicit in actions.
This assumption is that the authorities have, and are willing to deploy, a monetary ‘fix’ for all ills.
Accordingly, the system has come to be seen as a bizarre casino, in which winning punters keep their gains, but losers are sure that they’ll be reimbursed at the exit-door.
So ingrained has this assumption become that it’s almost heresy to denounce it for the falsity that it is.
The theme of this discussion is simply stated. It is that the complacent assumption of a monetary fix is misplaced. The authorities, faced with a crash, might very well try something along these lines, and might even adopt one or more of its most outlandish variants.
But it won’t work.
The reason why no monetary expedient can provide a “get out of gaol free” card is that the economy and the financial system are quite different things.
The complacent rush in
You can see financial manifestations of mistaken complacency wherever you look.
It emboldens those who have lent most of the $2.9 trillion that, over the last five years, American companies have ploughed into the insane elimination of flexible equity in favour of inflexible debt.
It informs those who pile into the shares of cash-burners, or queue up to buy into overpriced IPOs.
It reassures those long of JPY, despite the monetization of more than half of all outstanding JGBs by the BoJ.
It tranquilizes those who, unable to see the contradiction between gigantic financial exposure and a stumbling economy, remain long of GBP.
It blinds those to whom the Chinese economic narrative remains a miracle, not a credit-fueled bubble.
The aim here is a simple one. It is to counter this complacency by explaining why economic problems cannot be solved with monetary tools, and to warn that efforts to do so risk, instead, the undermining of the credibility of currencies.
A casino which hands back losers’ money belongs in the realm of pure myth.
The secondary status of money
Money has no intrinsic worth. Someone adrift in a lifeboat in mid-Atlantic, or stranded in the Sahara, would benefit from an air-drop of food or water, but even a gigantic amount of money descending on a parachute would do nothing more than allowing him or her to die rich.
Conventionally, money has three roles, but only one of these is relevant. Fiat money has been an atrociously bad ‘store of value’, and money is a very flawed ‘unit of account’. Money’s only relevant role is as a ‘medium of exchange’.
For this to work, there has to be something for which money can be exchanged.
This means that money has no intrinsic worth, but commands value only as a claim on the products of the economy. If you build up a structure of claims that the economy cannot honour, then that structure must – eventually, and in one way or another – collapse.
Conceptually, it’s useful to think in terms of ‘two economies’. One of these is the ‘real’ economy of goods and services, its operation characterised by the use of labour and resources, but its performance ultimately driven by energy.
The other is the ‘financial’ economy of money and credit, a parallel or shadow of the ‘real’ economy, useful for managing the real economy, but wholly lacking in stand-alone substance.
To be sure, the early monetarists oversimplified things with the assertion that inflation could be explained in wholly quantitative monetary terms. The price interface between money and the real economy isn’t determined by the simple division of the quantity of economic goods into the quantity of money.
Rather, it’s the movement or use of money that matters. The quantitative recklessness of Weimar would not have triggered hyperinflation had the excess been locked up in a vault, or in some other way not put to use. It’s not hair-splitting, but an important distinction, that Weimar’s true downfall was not that excess money was created, but that it was created and spent.
The process of exchange, which really defines the role of money, makes the interface dynamic, and, as such, introduces behavioural considerations. The creation of very large amounts of new money needn’t destabilize the price equilibrium if people hoard it, but a lesser increment can be extremely destabilizing if is spent with exceptional rapidity. This is why the simple quantitative interpretation needs to be modified by the inclusion of velocity, making Q x V a much more useful monetary determinant.
Behaviourally, velocity falls when people turn cautious – they did this during and after the 2008 global financial crisis (GFC), a tendency which reduced the inflationary risk of the loose money responses deployed at that time.
Even so, claims that the monetary adventurism unleashed at that time did not trigger inflation are simply untrue, unless you accept a narrow definition of inflation. To be sure, retail prices haven’t surged since 2008, but asset prices most certainly have, the truism being that the inflationary effects of the injection of money turn up at the point at which the money is injected.
Additionally, inflation is influenced by expectations – which have been low in an era of ’austerity’ – and by the performance of the economy. An economy which is performing weakly puts downwards pressure on inflation.
What it does not do, though, is to eliminate latent inflation. Any erosion of faith in the reliability of money would cause velocity to spike, as people rush out to spend it whilst it still has value.
One of the analytically adverse side-effects of monetary manipulation is that it inflates apparent activity. Globally, and expressed in constant 2018 PPP dollars, the $34tn increase in recorded GDP since 2008 cannot be unrelated to the $110tn escalation in debt over the same period. According to SEEDS, most (67%) of the “growth” recorded over that period was nothing more than the simple effect of spending borrowed money.
This matters, first because a cessation in credit injection would undermine supposed rates of “growth” and, second, because a reversal would put much prior “growth” into reverse.
By falsifying GDP, this ‘credit effect’ also falsifies any relationships based on it – so the ‘comfortable’ 218% global ratio of debt-to-GDP masks a real ratio which is nearer to 340%, and higher by more than 100% than it was ten years ago (236%). It also distorts the measurement of financial exposure, so lulling us into misplaced insouciance about those countries (such as Ireland and Britain) whose financial assets stand at huge multiples to the real value of their economies.
Behind the mask of ‘the credit effect’, global economic performance is at best lacklustre, growing at about 0-9-1.3% annually whilst population numbers are growing by 1.0%.
Moreover, these numbers disguise regional disparities – whilst the average Chinese or Indian citizen continues to become more prosperous (for now, anyway), the average Westerner has been getting poorer for at least a decade.
Of course, there’s a countervailing ‘wealth effect’, giving false comfort to those whose assets have soared in price – and few, if any, of them appear to wonder what would happen if there was a rush to monetize inflated values.
But the drastic distortion in the relationship between asset values and incomes has real downsides exceeding its (illusory anyway) upside. Policymakers and their advisers may remain ignorant of the deterioration in Western prosperity, but to voters it is all too real, something which has been a major contributor to those changes in voter responses which have informed “Brexit”, Mr Trump’s ascent to the White House, and the rolling repudiation of established political parties across much of Europe.
The decline of “stuff”
The weakness of the underlying picture has now started showing up unmistakeably in weakening in demand for everything from cars, domestic appliances and smartphones to chips and drive-motors. Logically, deterioration in the economy of “stuff” will extend next into commodities because, if you’re making less “stuff”, you need less minerals, less plastics and, critically, less energy with which to make it.
Whilst all of this is going on in plain view, markets and policymakers alike are failing to recognize the risks implicit in the widening gap between a stumbling economy and escalating financial exposure. As well as borrowing an additional $110tn since 2008, we’ve blown a not-dissimilar-sized hole in pension provision, because the same low cost of capital which has incentivized borrowing has also crippled the rates of return on which pension accrual depends.
Additionally, of course, the prices of equities and property have reached heights from which any descent into rationality would have devastating direct and collateral consequences.
When the next crisis (GFC II) shows up, the complacent expectation is that everything can be ‘fixed’ with even looser monetary policy. Some of the more bizarre suggestions aired in 2008 – including ‘helicopter money’, and NIRP (negative interest rate policy, with its implicit need to outlaw cash) – will doubtless come to the fore again, accompanied by a whole crop of new ‘innovations’. The authorities are likely, in the stark despair which follows protracted denial, to act on at least some of these follies.
The trouble is that it won’t work.
You might as well try to rescue an ailing pot-plant with a spanner as try to revive an ailing economy with monetary innovation.
The form that failure takes need not necessarily involve massive inflation, though this is the only non-default route down from the debt mountain. Authorities capable of believing that EVs are “zero emissions”, or that we can overcome the environmental challenge with some form of “sustainable growth” (rather than degrowth), are perfectly capable of also believing that we can fix economic problems with monetary recklessness.
If inflation doesn’t spoil the party, two other factors might. One is credit exhaustion, in which massively indebted borrowers refuse to take on yet more debt, irrespective of how cheap the offer may be.
The other factor might well be a loss of faith in money, which might also be accompanied by a ‘flight to quality’, perhaps favouring the dollar (as ‘the prettiest horse in the knackers’ yard’), whilst hanging weaker currencies out to dry.
However it pans out, though, we know that an economy whose prosperity is faltering cannot indefinitely sustain an ever-growing burden of financial promises. By definition, whatever is unsustainable eventually fails, and this is as true of monetary systems as of anything else.