Do we face inflation or deflation, and what can you do either way? Merryn Somerset Webb chairs our panel of experts and asks where they stand in the debate, and why.
Our Roundtable panel this week: James Ferguson, head of strategy, Arbuthnot Securities; Liam Halligan, chief economist, Prosperity Capital Management; Peter Warburton, director, Economic Perspectives Ltd; and Thomas Wittenborg, partner, Wittenborg Capital Management.
Merryn Somerset Webb: Liam, would you like to lay out the case for inflation?
Liam Halligan: In practically every month for the last two years consumer price index (CPI) inflation has been above consensus estimates. That must tell you that consensus estimates are dodgy.
The idea that we should be frightened of deflation has served a lot of banks and their chief economists very well; this myth has driven the expansion of our money supply – tripling it in a year, something which would obviously be massively inflationary. Sterling has also depreciated 30% in the last few years – that is massively inflationary. We have had expansionary fiscal and monetary policy and that’s usually inflationary; government debt is rocketing which is hugely inflationary.
And then on top of all that, contrary to the expectations of all the deflationists, oil prices are very firm and looking firmer all the time, even as the Western world teeters on the brink of a double dip. We face an inflation tsunami, yet we are kidding ourselves it doesn’t exist. The rest of the world knows that the West faces big inflation because big inflation is what Western governments tacitly want, to undermine the weight of their huge historic liabilities.
Merryn: Peter, you would roughly agree with that summary?
Head of strategy, Arbuthnot Securities
Deflation: Banks are crippled by the bad debts still on their balance sheets. So they won’t lend, certainly not at anywhere near the base rate. In the absence of credit, the ‘recovery’ can’t be self-sustaining. Consumers can’t spend so firms have no reason to invest. If rates rise to tackle perceived inflation, the economy will slump.
Peter Warburton: Yes, I agree with a lot of that. I’m thinking about global inflation – which is the only credible resolution of a global credit crisis. It’s possible to have phases where inflation is more or less than expected in the short term, and obviously in places like the UK where you’ve got recent currency depreciation, you are going to get a bigger dose.
What I don’t buy into is the double-dip scenario, at least not yet. The medicine has been so strong, I think it would be remarkable if we didn’t have 6-8% nominal growth in the global economy this year. I don’t think we do have an output gap. But even if we did, it would be closing far more quickly than people imagine. This tightness doesn’t express itself in an even way across everything. It is accentuated in the context of food, drinking water, minerals, energy; all the things that the poorest countries in the world spend more on.
My key argument is that we already have global inflation – look at inflation in population-weighted terms and it hit its low in 2000. It’s now 6%. The fact is that we have been on a rising global inflation trend, on that definition, for ten years. It’s just that for a variety of reasons rich countries have been protected from it.
Merryn: So there is no point in arguing about this – it’s already happened.
Peter: The fuel for inflation in the West is just sitting there. Up until now, thanks to globalisation, specialisation and increased productivity, we have been importing a very diluted version of global inflation. But I think those are mature trends and we are likely to import more of their inflation.
Merryn: OK. Who wants to take that up?
James Ferguson: Well, I’ll have a stab. The first thing I would like to say is that this is a much more complicated story than most people make out. I totally understand the inflationary case. We’ve got massive money printing and negative real [adjusted for inflation] interest rates and the authorities really need inflation to get them out of the debt hole. There is also, of course, a risk that if all this plays out really badly, and the guys who are running the printing presses get out of control, we could see a total loss of confidence in fiat currencies. But all that is just too obvious. You need to look for the dog that didn’t bark in the night to see what’s really happening. And that is the fact that despite the massive currency devaluation we have already seen in the UK – 28% – we have very little inflation.
Partner, Wittenborg Capital Management
Deflation: The economy has plenty of spare capacity. Factories have been shut; unemployment is high. That will keep wages from rising, and keep consumer demand low. This means that companies will have no pricing power. There’s plenty of oil too – as soon as investors run out of tankers to store it on, the price will fall.
Liam: We have above consensus inflation. At the height of the deflationary mania [Bank of England governor] Mervyn King was writing letters as to why inflation was so high. That’s been the case, even when – as every economist, if they are being really honest, would admit – almost every published measure of inflation that we have, certainly headline measures of inflation, are underestimates. So actual inflation – at a time when we keep being told we are to be engulfed by a deflationary tsunami – has probably been 4-5%.
James: We’ve just had a year where it’s been negative.
Liam: Only if you include mortgage payments – as you know.
Merryn: We haven’t really heard the deflation argument set out yet.
James: Think about it like this. If you were going to have a tick list about inflation, you are going to say things like “interest rates are low”. But they are not. “They have been printing money”. But they haven’t. “Money supply has gone through the roof”. But it hasn’t.
Liam: You just said interest rates in real terms are negative.
James: Policy rates in real terms are negative. But interest rates for ordinary borrowers are not. This is exactly what happened in Japan.
Outsiders thought that interest rates were super low; they thought that credit was available but no one wanted to borrow. It was preposterous nonsense. After a banking crisis, the resolution of the banking crisis is what really matters. The banks rebuild their balance sheets and the normal monetary policy transmission mechanism breaks down [see: The G20’s plans for banks would be a disaster for the real economy]. So the base rate is no longer a shortcut for cost of credit in the economy. In normal times you take the base rate and add 2% to give you the mortgage rate. But right now the banks don’t want to lend, so they add 4%. And they won’t lend at all to anyone wanting more than 75% loan-to-value. That’s why net new mortgage lending is at record lows now. And if you think interest rates are 0.5%, check out overdraft rates – now on average nearly 19%.
Merryn: So real interest rates for ordinary people are extremely high.
James: Super high with record high spreads. That means that we have effectively had no real monetary stimulation despite the very deep recession. Not even from quantitative easing. QE was designed to offset the fact that you usually grow money supply via bank lending – and that’s not happening. But even with QE, properly measured M4 is currently growing at only around about 1% in nominal terms. It’s shrinking in real terms – which is an absolute disaster.
Peter: Hang on, it’s actually been growing at 10% per annum since the crisis began. You are completely ignoring the huge surge in money growth in the first year of the crisis.
Director, Economic Perspectives
Inflation: The credit crisis caused global supply to shrink by more then global demand, due to the disruption to trade and commerce. Many small firms are gone for good. The ‘output gap’ gives false comfort. Demand is rising faster than supply can recover. Big firms are the winners, profiting from the demise of smaller rivals.
James: No. This is very important. It isn’t the case that money supply is growing. Base money is irrelevant when the money multiplier collapses, i.e. after a banking crisis.
What is relevant is broad money. Normally you look at narrow money supply. But you do that on the basis that the money multiplier is consistent so it is a handy sort cut to seeing what’s going on in the money supply. But if the money multiplier is not consistent – like now – then you are only interested in broad money.
Keynes was only interested in broad money; Freidman was only interested in broad money. And do you know something else about narrow money?
Merryn: No, no, not something else – just stick with the point.
James: Broad money growth in the eurozone has gone negative. In the US they have stopped publishing M3, their version of broad money. But as far as we can tell it has gone negative too. And in the UK properly measured M4 has too.
Merryn: What do you mean properly measured?
James: When the Bank of England was expecting credit to collapse, they looked at M4 and found it was growing at 18%.
Liam: So they rigged it.
James: No, no they didn’t rig it. No – this is very important – they realised that accidentally they had been rigging it.
Liam: How convenient for them. I last saw that in Zimbabwe.
James: Don’t be cynical. This is very important. They made a mistake.
Liam: I’m not being cynical at all. I am being strictly factual.
James: They have made a genuine mistake and they realised that they were mis-measuring. So it is important to look at their new measure, which they are temporarily, to cover their embarrassment, calling M4-ex intermediate OFCs. Now this is actually growing by only 1%. This is the worst level we have seen since the Second World War.
Merryn: Thomas, are you with James on this?
Thomas Wittenborg: I am. Look at a chart not of M4 but of M3 on a seasonally adjusted basis in 2007 and you see it’s been collapsing ever since. But looking beyond the UK and ignoring the monetary arguments for a bit, and the deflationary forces are clear. In the US, foreclosures are up by a record amount. 13% of all households are now basically either delinquent or in foreclosure. Before we fix that and the job market, there isn’t going to be any demand pressure, there isn’t going to be any inflation. There is no pricing power of anything. I recently saw an estimate of the number of factories that have closed in China – 70,000. There are 350,000 factories in the US. It all suggests the output gap is just enormous and it is going to continue to be enormous for quite a while.
Merryn: You don’t think that productive capacity is being so destroyed by the recession that the output gap is …
Liam: Meaningless.
Chief economist, Prosperity Capital Management
Inflation: Inflation is here. In the UK, it will only get worse due to the debasement of sterling caused by soaring government debt and money printing. The output gap is overstated. Meanwhile, Asian demand is driving up commodity prices, which will push up inflation, particularly as Asia swaps Western debt for real assets.
Thomas: No. All those people are waiting to be hired again.
Merryn: So the fact that there are unemployed people knocking around means that there is an output gap.
Thomas: These aren’t high skilled jobs. We are talking factory jobs.
Merryn: Peter, you don’t believe in the output gap.
Peter: The idea of the output gap can be a useful tool in a normal, kind of cyclical, deviation around a continuous trend of growth. But this is not what we have now. This has been a generational destruction of capacity – the destruction of the viability of activities that were based on mispriced credit and obviously hugely exaggerated leverage of the banking system. So we have to say goodbye to huge swathes of economic capacity.
Thomas: But also to domestic consumption capacity. Without houses as cash machines, consumption can’t continue.
Peter: What I am saying is that this is a supply shock more than it’s a demand shock.
The consumer has been relatively protected in all of this. The epicentre of the crisis has been in the global trading economy – in businesses. We are now putting the global supply chain back together again, but absent massive numbers of companies and businesses. Restaurant closures, pub closures, petrol station closures, leisure club closures. They won’t be opening again because the finance isn’t there.
Liam: Capital goods are being exported from this country on a massive scale. A story I am hearing constantly is of manufacturing entities in the UK, as a last desperate measure, unscrewing their capital goods from the floor and exporting them to emerging markets.
Merryn: Selling their factories wholesale.
Liam: Selling their factories wholesale. That is a very stark illustration of the point that Peter is making. The deflation myth isn’t credible but the output gap idea is being used an intellectual conceit; a way of saying, “don’t worry that we’ve tripled the money supply, even though it took us 55 years and two World Wars to triple it last time, the output gap means it’s not inflationary, it’s fine”. Well, the rest of the world is laughing at that position.
James: Why do you think money supply is tripling?
Liam: Because money supply now is 19.5% of current GDP – base money. And in February 2009 it was 6% of GDP. Now I completely accept your point that there are many different measures of money supply. But you can’t just ex-OFCs.
James: Ex intermediate OFCs.
Liam: The money is still there. The money is sitting on the balance sheets, the off-balance sheet vehicles of many of the financial institutions who are desperate to try and float themselves off the sub-prime rocks, and that money will eventually enter circulation and it will be leveraged and the credit creation multiplier will be invoked again
Merryn: But how will this money eventually get into circulation?
Peter: Governments are making sequential decisions to monetise past credit creation because that’s the politically easy path to take. They think they have a free pass on inflation – it cannot possibly appear because of the output gap – so they can monetise anything. Any group of people who are disadvantaged by anything, OK let’s monetise it. So one step at a time we are just going down the monetary road. We gave up on macro-monetary discipline in the mid-1990s and we are only just now exploring the consequences of the mismatch between the inflation target and the fact that it is no longer connected to an underlying monetary discipline. Look at China. Inflation there could easily go to 10%. And we want the Chinese to revalue their currency so we can import more of their inflation.
Thomas: But we’re not importing their inflation, are we?
Peter: Well, increasingly we are, yes. If you look at the US import prices of goods from China, there is positive inflation.
Merryn: If inflation is high and rising in Asia and we import the majority of our manufactured goods, particularly low-grade manufactured goods, from Asia, how could we not be importing that inflation?
Thomas: It is all about who takes the hit. Wal-Mart has announced that it is to cut 10,000 prices so it isn’t consumers. It is all the people between the manufacturer and the end consumer getting squeezed.
Merryn: So it’s profits that will be squeezed, not the consumer?
Thomas: There is no pricing power.
Peter: But if you look at corporate free cash flow ratios to GDP, they are at 40-year highs. Corporate profit margins were briefly under great pressure – they are now rebounding. If you look, the corporate share of income has risen in the past year because the economic risk has been transferred from the corporate sector to the government and the government doesn’t really have a clue how to transfer it back.
Thomas: But the margins are being driven by unit labour costs that have collapsed in the US to levels we haven’t seen in 40 years. That’s not an inflationary situation.
James: And Peter, how sustainable is the situation you describe?
Peter: What we have is a global corporate sector that is reinstating capital expenditure; we are on the verge of a global IT boom because the return on capital of the quick payback of global IT expenditure is extremely attractive. The global corporate sector is going to get us out of this mess for the next six months, taking on a lot more labour as they do. As the global corporate surplus pays down then it allows budget deficits to fall in the household sector.
James: It seems to me that the corporates have no real reason to spend money on the likes of IT at the moment. They may have wide spreads now but that’s down to the huge drop in global trade and industrial production – the biggest we’ve seen since the 1930s. Things dropped so fast there was suddenly no point in competing on price, so production just got shut down. In the US, car production literally halved for six months, because GM and Chrysler went into Chapter 11.
Honda closed down its Swindon plant for five months. So now, as demand comes back a little, we are seeing better margins. But, as Thomas says, at the expense of the labour market. So where is consumption demand going to come from now? Sure you usually have a round of corporate capex when demand picks up after an ordinary recession. But this is different – a classic post-bank crisis position where there is nothing to feed sustainable recovery.
Peter: But I’m saying this is not like your typical downturn. The spasm in the global traded goods economy meant that global industrial production fell about twice as far as it would have needed to do, to match the fall in final demand. So at the moment we are trying to recalibrate global industrial production to global final sales. OK, at a lower level than they were. However, as we are trying to do that we are finding that demand is picking up a little bit too, despite everything. So there is a long way to go now to get inventory to meet final demand. There is a V-shaped recovery in terms of the growth rate in the traded goods economy.
And on capex, the point is that businesses didn’t stop believing in the capex that they were planning to do in September 2008. What they did was, they acted in an emergency way to conserve cash. They no longer need to do that. Now the crisis has stripped out a lot of the smaller/medium sized businesses that were the active competitive force in the market. So we have stronger global oligopolies able to exploit their position. The other point is that these companies don’t need to operate at full capacity (hence producing deflation in times of low demand). They can make a profit at 75% capacity utilisation.
Liam: Globally it’s not a V-shaped recovery – it’s more like a K. The big emerging markets, where 4/5 of the global population live, are almost back to their former growth rates while the Western world is not.
James: But four-fifths of the world’s economic activity GDP is in the West.
Liam: That is a staggeringly parochial…
James: It’s mathematical rather than parochial.
Liam: OK look at the UK. Output price inflation this month is at 10%. Part of that is the oil price – we are importing inflation from China via commodity prices too – but part of it is the destruction of the supply chain.
Thomas: But look at core inflation [stripping out food and oil]. That’s not high at all. Really it is the high oil price that, near term, almost entirely explains high CPI and RPI [Retail Price Index].
James: Basically, there’s been enormous stimulation and pretty much nothing has happened.
Peter: I disagree. Stimulation has had an enormous effect.
Thomas: It has in that it prevented total collapse. But a degree of stabilisation isn’t the same as a bounce. And it isn’t self-sustaining. So we are bound to see a double dip when we take away the stimulation.
Liam: Are you suggesting that we should carry on borrowing at the current rate?
James: Fiscal stimulation doesn’t work. Only monetary stimulation does – everyone should have learnt that from the Swedish and Japanese crises. And, as I have said, we haven’t done much of that – interest rates aren’t low and money supply is not growing.
Liam: Printing money isn’t a solution. It is just easier than restructuring the banks. The banks have effectively taken over our political classes. If the weather were better here we would call it a kleptocracy. Many of our banks shouldn’t exist any more but they do because they get huge subsidies from the implicit guarantee from government.
James: One thing we can be sure of is that the markets think we are in an inflationary environment.
Liam: Ordinary people know we are. Look at the way middle England is desperately working to pay down mortgages before rates rise –which they will. The hoi polloi see through the nonsense most City economists are spouting about low inflation. It’s almost undeniable now, to anyone who is willing to look at this objectively, that with the money supply increase and with the massive expansion in government debt, we are facing inflation. I think the great British public is canny enough to know that that rings true. History is littered with examples of people waking up to reality a long time before the ruling elite does. And now the markets are starting to wake up to the enormity of the situation. Despite all the vested interests, they are beginning to price it in.
James: Irving Fisher pointed out that a fair representation of inflationary expectations is the difference between a ten-year bond yield and the real base rate. On that basis we have the highest inflation expectations that we’ve had for maybe two decades.
Liam: And they are going to go a lot higher when reality bursts through.
James: We have to go back to the money multiplier. Narrow money is up but the money multiplier has broken down. This is crucial.
Peter: But the money multiplier isn’t worth talking about any more. It belongs in a world where banks’ only source of funding was deposits. It isn’t any more. Now they can borrow in the markets and have done so hugely. They are no longer constrained by reserve ratios. So any ratios like this that we draw on over long periods of time just don’t have the significance now that they might have had before.
James: Three points, very quickly.
1) Money supply is growing at the slowest rate since the ’30s.
2) The size of public sector debt, which I agree is large and which is always and everywhere inflationary, is being swamped by the elephant in the room which is the size of the private sector debt; and
3) private sector debts are always and everywhere deflationary. So where you’ve got inflationary pressures you must also bear in mind you’ve got deflationary pressures.
But what if there really was inflation about and policy makers acted accordingly? Normally the base rate is 2% over inflation. So it should be 6% now (if we use RPIX [RPI excluding mortgage interest costs]). Then add a 4% margin for the banks to use to repair balance sheets, and we’ve got mortgage rates over 10%. But we don’t have that because you aren’t right and the central banks are still desperately working to bail us out. That is the real elephant in the room: there may be an inflationary overlay here, but it is on top of a deeply deflationary situation.
Liam: The inflationary implications of it are still there. Let’s not forget that this time last year Mervyn King said we could expect inflation at 1%. And here we are with RPIX at 4.5%. The RPI might have been negative for a bit, but you can add up as well as me. We all know that’s only down to low interest rates and low mortgage payments and the VAT cut. At no point did the CPI go even below target.
Peter: The real question we have to ask is what is the resolution of this? I don’t think you can overlay the Japanese experience on the UK and say we have embarked on a seven-year boot camp of debt repayment and hence a deflationary world. Anglo-Saxons are already back out there borrowing and spending again if they can. The savings rate in America went up to 7%, yes. But it’s gone back to 3%. Same in the UK. Up to 8% now back to 4% or 5%. We want to normalise. So what is going to finance these high budget deficits if not inflation? The only reason we haven’t got higher nominal bond yields is down to lot of clever footwork by investment banks.
Liam: And the fact that 98% of the QE is used to buy bonds.
Peter: These bonds have not found willing long-term holders in the savings system. It’s all clogged up.
James: That’s not true. The QE of £200bn was used by the Bank of England to buy outstanding gilts at the long end. They bought at the long end because there is already a massive new buyer of gilts at the short end – the banks. The banks buy government bonds after every single banking crisis. It is a normal part of the process of de-risking their balance sheets. In the last five quarters, the banks have bought £280bn-worth of short-dated gilts. Much more than we have spent on QE. Long-term buyer of short-term gilts.
Peter: So you’re saying that long-term bank monetisation of government debt is not inflationary?
James: Historically it’s not been inflationary ever. Even when they did it in a really big way in the US in the ’30s.
Liam: They had a war to soak up the demand.
James: Yes, but short-term interest rates stayed below 2.5% for 25 years, even though we had the fiscal stimulation of the New Deal and the Second World War. In Japan we are now 20 years in, and we’ve still got interest rates well below the 2% mark. The evidence is that if you’ve got a big one, this stuff stays deflationary for quite some time. The game – if you are a central banker – is to try and make it inflationary. I do not disagree with you guys that they want to make it inflationary; they need to make it inflationary. I’m just debating whether they can.
Peter: I think there are two issues here. One is whether you think that the huge public sector intervention is being effective, and I think it is. And the second one is, do you think that private sector responses to this intervention are entrepreneurial? Now I can well see, in other times, that private sector response was not there. But I don’t think you can impute that to the current situation. Basically, what I’m hearing about the way that global corporations are behaving, they are excited about the prospect. They can see huge potential gains from the investments they are about to make.
Thomas: But aren’t they being overly optimistic about the outcome?
Peter: I think they realise that for once the boot is not on the state to allocate resources. They can get on and do what is beneficial for their business.
James: My concern with this is still the shortage of credit. Big listed companies can get finance. But they will find that their clients don’t have that luxury. So we are back to the fact that there isn’t any self-sustaining return to the aggregate recovery. You were saying, Peter, that the important thing is whether the economy can respond to the fiscal and monetary stimulation. The monetary stimulation, if you are not a corporate, is non-existent and the fiscal stimulation is unfortunately unsustainable. And this is our Catch-22. All we can do is to try and deliver monetary policy along fiscal channels – i.e. have the state continue to lend very cheaply to the banks until the balance sheet repair process is complete.
Liam: What you really have to do to stimulate the economy, to get bank lending going again, in my view is to do what Roosevelt eventually did. Send people with clipboards into every single bank and under force of law make banks completely disclose their liabilities.
James: That doesn’t solve it – that reveals the size of it.
Liam: Which is the crucial prerequisite for solving it. The only way to rebuild proper trust within the interbank market, is to lower fear of counterparty risk. When every bank knows that they are hiding junk on their off-balance sheet vehicles then of course they are going to be worried about lending to other banks. That gums up the wheels of finance and means that creditworthy firms and creditworthy households can’t get access to finance. Yet we are failing to do this. Our politicians don’t know enough and the banks have captured them. We need full disclosure of legal liabilities.
James: The main reason we’re not doing it is not that. It is because if you did do it, you would discover that the banks’ losses are way bigger than their capital.
Liam: Maybe we need to ‘fess up these losses. In Ireland it’s been awful; it’s been two years of collapse. But now finally Ireland is the only country in the Western world whose spread over the Bund is comparable to its pre-Lehman spread, because it is making these sacrifices and having a real conversation. The British elite is not yet having a real conversation.
James: Anglo-Irish has so far admitted over €20bn of losses on a loan book that peaks out at €73bn. And Brian Lenihan says there is another €10bn of state support liable to be needed [see: Should Britain set up a ‘bad bank’? ]. All the evidence says you are not finished with your banking crisis until the banks’ balance sheets are fixed. And their balance sheets are not fixed until they have crystallised all the losses.
Liam: And we are in denial.
James: You have to be in denial. Unless you are willing to stump up all the capital needed, the only way is to let the banks trade their way through it with cheap loans.
Liam: Or creative destruction. Here we are not using the state to cleanse, we are using the state to cover up. That’s the difference. NAMA [Ireland’s ‘bad’ bank – see Should Britain set up a ‘bad bank’? ] allows at least a ‘fessing up of the losses. That will begin the long process of cleansing the interbank market, so allowing credit markets to work to get their economy going again. The Irish have grasped the nettle, I’m afraid the British have not.
James: Nominal GDP is down 19%.
Liam: Of course. And it hurts.
James: But this is my point. My point is, you guys are talking about how this is inflationary. It’s not inflationary. We are hiding the fact that it’s incredibly deflationary. If we did a British NAMA, we would reveal it all.
Peter: Ireland is a an outlier in all of this
Liam: It’s an honest player, that’s all.
Peter: The thing is that nominal GDP around the world, from the middle of last year, is up in all but about four of the largest 50 countries. Basically, the reflation of nominal GDP is underway: the velocity of money is rising in most countries around the world
Merryn: But isn’t it possible for us to have deflation in some countries in the West and to have inflation elsewhere? Why does everyone have to inflate at once? Why can’t we have both?
Peter: There is going to be a diversity of experience with some countries currently in deflation and remaining in it for some time. But the key argument I want to make is that we went from having sovereign primary debt issue of about $1 trillion a year on net, to somewhere between $4 and 6 trillion a year, and we have no credible resolution of how that’s going to be absorbed. There’s not a rise in the private savings rate large enough to do this. The banks can do maybe a quarter of it but they can’t do it all.
James: Peter, almost by definition they can do all of it. The reason you need it is because of the damage done to the economy by the contraction of credit into the private sector by the banks. In other words, it is entirely to negate a balance sheet move by the banks. If they can shrink risk assets and do nothing to risk-free assets, or they can shrink risk assets and expand risk free assets at the same time, for the banks it has marginal difference. But for the rest of us it is a huge difference. They can take it all as long as you make it short dated – they don’t want long dated.
Peter: There is a phase of that and then the economy stabilises, non-GDP grows and banks return to lending. Next year banks will be lending again to the private sector.
James: The banks will not return to positive lending next year because they’ve not repaired their balance sheets. We know how long it takes to repair their balance sheets and we know what they have to do to repair the balance sheets. First of all they have to shrink the wholesale funding gap back to zero. Look at the size of the wholesale funding gap in Ireland or the UK. It’s still a massive proportion of GDP – it’s still about 40 or 45% of GDP in the UK and bigger in Ireland [see: Should Britain set up a ‘bad bank’? ]. So there is no way they have repaired their balance sheets, that is the liquidity constraint of the banks. They haven’t repaired or dealt with their capital constraints either, because they haven’t actually crystallised the losses. When they do try to crystallise the losses like Ireland, you discover that the losses are truly, epically horrific.
Thomas: And that’s going to stop the banking system working.
James: You are right. So we are all going for the slow, ‘let’s pretend it’s not happening’, ‘let the banks trade their way out of it’, soft solution. The only way we can tolerate banks recapitalising themselves is doing it through higher profitability. And they are doing that, thanks to trading benefits, particularly through underwriting fees into the capital markets. Their net interest margins are no higher than they were at any stage pre-crisis, so they are not making more money than normal. On top of that, the banks’ profitability on the income statement is completely and utterly negated by their losses on the balance sheet, which they are hiding.
Peter: OK. But the income they are making from trading in the fixed income is massively higher than it was and turnover in fixed income is hugely inflated and will remain so because of the size of the instrument. So basically what they lose in one place they will make up in another.
James: There is actually little evidence that they will be able to maintain that one-off spurt in traded income: it comes predominantly from their high quality corporate bank borrowers shifting debt into the capital markets – they are all doing a big one-off trade and want to borrow money in the capital markets.
Peter: Then they will do M&A. They will reinvest the money somewhere else.
Merryn: Any other vital points?
Liam: In my view the fact that global growth is still very low and yet oil prices are extremely firm is a broader expression of the phenomenon that has driven gold above $1,000 an ounce. Do not underestimate the determination of the emerging giants of the East and their sovereigns to diversify out of Western government debt, given the debasement of the currencies in which it is denominated, and diversify into commodities. That will be an inflationary episode on the Western commodity importers of historic proportions.
Merryn: So Liam, what would you recommend an ordinary retail investor to do right now?
Liam: If they can stand the volatility…
Merryn: No they can’t.
Liam: Then I have no advice for them.
Merryn: OK, if they can.
Liam: They should have in their portfolio assets that governments can’t print more of. That means tangible assets.
Peter: My final point would be that inflation targets were a great psychological trick while they lasted. But their credibility is blown. Basically this is the third successive episode of blowing through and just assuming that people will acquiesce to lower wages and all the rest just because the inflation target is 2%. I don’t really think that’s going to happen anymore. Retail investors basically need to be in the income-paying equities of global oligopolists.
Liam: Big oil.
Merryn: Thomas, anything you feel that we’ve all missed out or got wrong?
Thomas: The price of oil can be driven by markets. But when you run out of super tankers to store it in, the price will come down again. In 2008, it went to $147 a barrel and then collapsed. Nothing to do with final demand. The other point about sovereign wealthy funds funding the deficits of large nations like this one or the US, it’s not that important compared to the banking system. China owns $850bn roughly of US treasuries. That’s a fraction of what the US banking system holds. Sure, if they dumped it in one day it wouldn’t be good. But what would they buy instead? You can’t buy $850bn worth of anything apart from treasuries.
Merryn: What would your retail investor do, Thomas?
Thomas: I’m not worried about the inflation at all; I would be in the fixed income paying market. As retail investor, through some sort of bond ETF [exchange-traded fund].
Merryn: James.
James: I can see the inflation argument. But the fact is that if you are right, then the logical consequence of it is that short rates go through the roof. Then you’ve got hugely deflationary monetary policy.
Merryn: So even if they are right, they’re wrong.
James: Yes, that’s the whole point. That’s the whole bloody point. If you are right, you’re wrong and the problem is I don’t think you are right.
Liam: That is the ultimate polemicist’s argument – even if you are right you are still wrong!
Merryn: One final question. Is there any possibility that inflation could knock around 2.5% and there would be no deflation and no proper inflation? That everything could be just fine?
James: Very hard.
Liam: No, no, no, no.
Merryn: So there is no middle way.
James: Not unless you believe that the policy makers are super good at their job.
Jargon-busting
The money supply is the amount of money in an economy. In Britain, narrow money consists of notes and coins in circulation, plus commercial banks’ deposits (reserves) at the Bank of England (BoE). The overall sum of money in the UK (broad money) is known as M4 (M3 in the US). This is narrow money plus the cur-rent and savings accounts of individuals and firms. So it reflects how much the banks are lending.
M4-ex intermediate OFCs strips out specialist financial firms, giving economists a clearer picture of credit creation in the ‘real’ economy.
The relationship between narrow and broad money is the money or credit multiplier. This shows what impact a change in narrow money has on broad money.
Cue Quantitative Easing (QE), in effect, printing money. The BoE buys assets, such as gilts, from investors. This increases those investors’ bank balances, which pushes up commercial banks’ reserves at the BoE, and so boosts narrow money. The aim is for banks to lend this extra cash into the real economy, lifting spending. But if the banks instead hoard the funds, the money multiplier falls. So broad money won’t rise as the BoE hopes.
• This article was originally published in MoneyWeek magazine issue number 483 on 22 April 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don’t miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now
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