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Master Shake
03-24-10, 10:42 PM
Since the last serious outbreak of inflation in the 70s, central banks have conquered this pestilence and have practiced a responsible stewardship over national monetary systems ever since. Due in no small part to the benign inflationary environment that has followed their victory, stocks and bonds have outperformed historical averages. This reflects a high degree of confidence in future monetary stability and prosperity.

Or so we are constantly told.

That this consensus view is a twisted mirror of reality is the theme of an undeservedly obscure work of financial economics, Peter Warburton’s Debt and Delusion: Central Bank Follies that Threaten Economic Disaster (http://www.amazon.com/exec/obidos/tg/detail/-/0713992727). Published in 1999, the work rapidly went out of print but has since become a cult classic among financial contrarians.[1] (http://mises.org/daily/1579#_ftn1)<SUP>,</SUP>[2] (http://mises.org/daily/1579#_ftn2) Although not written from an Austrian point of view, the argument parallels an Austrian view of money and banking in many aspects. My purpose in writing this article is to present Warburton’s main argument and to interpret it through an Austrian lens.

[snip]

Warburton’s story begins in the aftermath of Volker’s triumph. The conundrum facing governments at the time was: how to enable governments to continue to live beyond their means, without suffering inflationary consequences? In this climate, a new outbreak of inflation would have contained the seeds of its own demise, for the following reason. Lenders require a positive real return in order to lend; interest rates must then exceed the rate at which the currency is losing value, by some margin. Having recently been burned by inflation, bond buyers would have resisted any signs of rising prices by insisting on higher bond yields. Such a market-driven rise of interest rates would have given the central bank little choice but to follow with rate increases of its own to slow down money growth, or else risk a total destruction of the currency through accelerating inflation.

Central bankers offered a program to solve this dilemma, the centerpiece of which was a change in the method of financing government debt. Deficit finance bonds would be sold to private investors through existing financial markets. This would place the bonds in the hands of investment funds, rather than on the books of commercial banks as would have been the case had they returned to the old style of monetization. The subsequent explosion in the size and breadth of bond markets is illustrated by a few snapshots of gross issuances: less than $1 trillion in 1970; $23 trillion by 1997[4] (http://mises.org/daily/1579#_ftn4) and nearly $43 trillion by 2002.[5] (http://mises.org/daily/1579#_ftn5)

A second part of the central bankers’ program was to reign in government deficits so as to reduce the need for borrowing. This advice has been mostly ignored. Borrowing to fund government deficits exploded under Reagan, continued to soar in spite of the phony "surpluses" of the <?XML:NAMESPACE PREFIX = ST1 /><ST1:CITY><ST1:PLACE>Clinton</ST1:PLACE></ST1:CITY> years, and has reached stupefying levels under George W. Bush.[6] (http://mises.org/daily/1579#_ftn6) It is the interaction between this explosion of debt and what Warburton calls "the capital markets revolution" that has produced a new and deceptive form of inflation.

The Interest Rate Anomaly

Scarcity requires that when a good is demanded in increasing quantity, the price paid by the buyers will be successively higher. This must happen because the sellers who value a good the least are the first in line to sell. As buyers continue to search out a greater quantity of the good, potential sellers who place an increasingly greater valuation on the good must be recruited to supply it. Buyers then bid up the price of a good up by demanding more of it.

Under a sound monetary system where credit cannot be created out of nothing, credit can only be the supply of savings by a lender. If credit is demanded in increasing quantities, borrowing must take place at ever-higher interest rates because savings are necessarily scarce; a higher interest rate is necessary to draw more marginal savers into parting with their cash. There is an inherent limit to the amount of borrowing that can occur: the point where savers cannot be enticed to part with any more present goods at any rate of interest. The reason that the pool of savings cannot expand indefinitely is because people only have so many assets that they can save, and everyone must engage in some consumption in the present.[7] (http://mises.org/daily/1579#_ftn7)

Yet, as the fire hose of government bond issuances has flooded international capital markets with debt issues, interest rates have not risen much, are now lower than in the 70s (a time of less borrowing), and for the last year have been at or near generational lows. It is dubious to maintain that the gargantuan volumes of bond purchases in recent years could have been funded out of savings when the <ST1:COUNTRY-REGION><ST1:PLACE>US</ST1:PLACE></ST1:COUNTRY-REGION> personal savings rate has also dropped to long-term lows.

This anomaly has not attracted much attention or investigation. Instead, most analysts now find this state of affairs to be utterly normal. An alleged quote attributed to Vice President Dick Cheney that "deficits don’t matter" perfectly summarizes the prevailing attitude.[8] (http://mises.org/daily/1579#_ftn8) Notes Warburton, "the incongruity of the massive accumulation of government and corporate debt with a low inflation environment no longer provokes much curiosity, even among professionals."[9] (http://mises.org/daily/1579#_ftn9); and, "a stratospheric stock market has become accepted as the normal state of affairs, requiring no special explanation."[10] (http://mises.org/daily/1579#_ftn10)

As he wryly noted:

Periodic bouts of price inflation, the tell-tale signs of a long-standing debt addiction, have all but vanished. The central banks, as financial physicians, seem to have effected a cure. . . . Few have bothered to ask how the central banks have accomplished this feat, one which has proved elusive for more than 20 years. As long as inflation is absent, who really cares exactly what the central banks have been up to.[11] (http://mises.org/daily/1579#_ftn11)
The solution to this puzzling anomaly is to identify the source of demand for government bonds. For this, we must examine "what the central banks have been up to."

Financial Assets and Price Inflation


Economists have long known of a general correspondence between changes in the quantity of money and its purchasing power. A naïve quantity theory of money (http://mises.org/easier/Q.asp)would have all prices moving by the same proportion in response to a change in the quantity of money. According to the quantity theory, if apples cost $1 and bananas $2 today, then after an increase in the quantity of money, their new prices should still be in the ratio 1:2, perhaps $2 and $4.

Debt and Delusion argues that the institutional changes described above have confined the price adjustments resulting from monetary expansion to the financial system. The character of the 80s and 90s inflation differed from that of the 70s. In recent decades, price changes following money quantity changes have been in stocks and bond prices, rather than wages and consumption goods prices.

[snip]

But what does it matter if stock and bond prices rise relative to consumption goods? As economist Paul Krugman once wrote (http://www.pkarchive.org/economy/stockbub.html), "It's paper gains today, paper losses tomorrow; who cares?" The problem with financial inflation is that investment decisions by entrepreneurs are based on relative prices. When relative prices are disrupted, as by financial inflation, the entire productive structure of the economy is distorted. The movement of real savings into real investment is stymied. As Mises wrote, "The endeavors to expand the quantity of money in circulation either in order to increase the government's capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation."[31] (http://mises.org/daily/1579#_ftn31)

The "financialization" of the economy—the expansion of the financial sector relative to mining, agriculture, manufacturing, transportation, energy, transportation, and retail—is but one example of these distortions. Various measures of the size of financial assets, such as the stock market capitalization to GDP ratio, and Tobin’s "Q" ratio (which measure total stock market capitalization to replacement cost) reached all-time highs in the late 90s and are still above long-term average values.
The increasing domination of the stock market capitalization and economic activity by financial institutions is noted by the New York Times (http://www.nytimes.com/2004/06/20/business/yourmoney/20watch.html):

. . . in recent years, financial services companies have quietly come to dominate the S&P 500.
Right now, these companies make up 20.4 percent of the index, up from 12.8 percent 10 years ago. The current weight of financial services is almost double that of industrial company stocks and more than triple that of energy shares.
… It is also worth noting that the current weight of financial services companies in the S&P is significantly understated because the 82 financial stocks in the index do not include General Electric, General Motors or Ford Motor. All of these companies have big financial operations that have contributed significantly to their earnings in recent years.
… Financial companies now generate about 30 percent of the profits, after taxes, of <ST1:COUNTRY-REGION><ST1:PLACE>United States</ST1:PLACE></ST1:COUNTRY-REGION>’ companies, [financial economist Andrew] Smithers said. That is up from 7 percent in 1982. In addition, profit margins at financial companies in the first quarter of 2004 stood at 32.6 percent of all corporate output, around 11 percent higher than their average since 1929 [Smithers] said.
The economic purpose of capital markets is to provide a nexus between savers and borrowers for the financing of productive investment. Financial entrepreneurs, such as venture capitalists, traders, and speculators, are essential in forecasting the best uses of available savings and bearing the risk in an uncertain world. But a society cannot prosper by printing ever-increasing quantities of paper tickets representing claims for real goods and drawing more of the population into trading these tickets back and forth among themselves. We cannot all be day traders: someone must produce the goods that are consumed.

Warburton calls the recent period "an excursion into the realm of financial fantasy." The fantasy is that central bankers have found a way to inflate without any negative consequences. While the effects of money supply growth can be confined to stocks and bonds, inflation is hidden in plain sight. The adjustment of relative prices between financial assets and consumption goods cannot be postponed indefinitely. The unwinding will not be easy or painless. Surely central bank follies now threaten economic disaster.


http://mises.org/daily/1579

Good read.

FRED
03-24-10, 10:49 PM
Good article but not news. We interviewed Warburton 10 years ago and forecast this outcome. Moving thread.