This blog post is going to be a rather unusual one for me, the first obvious reason – it’s in English not in Hebrew, the second is that it’s dealing with world macroeconomics which is not a common topic for me to write about and probably is the reason why I chose to write in English.
A little background for those not familiar with the subject, for a long time now, I and many others have been puzzled over the subject of inflation, or the lack of to be exact. Central banks all around the world, led by the American Federal reserve have been busy providing enormous of amounts of liquidity to the markets, lowering interest rates and buying financial assets such as government bonds and mortgage loans.
Traditional Economics teaches us that accommodating monetary policy and inflation are mutually interconnected and that the one leads to the other. indeed From early on concerns have been raised that actions taken by the FED will lead to inflation, These concerns have so far been proven dead wrong. but how can that be? why is it (so far) different this time? This question may prove very important when trying to assess the possible outcome for the ending of the Quantitative easing area, an ending that raised concerns whether it was done prematurely and will impair the economic recovery and even cause a recession, forcing the central bank to lower rates once more and cause continued deflation.
With this background story in mind, a strange question had been bothering me of lately – what if the policy change by the FED at this point in time will cause some unexpected outcome? if easy monetary policy didn’t work as expected and indeed seemed to increase inflation, could a tightening policy do the opposite? To answer this question, we need first to try and understand the reasons for this current economic behavior.
Inflation is happening when too much money chases too few goods available for purchase, so increasing the amount of money in the system should cause inflation. but that assumes that all the excess money flows toward consumption, it is obviously not the case. money flows also toward savings and investments so those two are reasonable places to start looking for answers.
For quite a long time, the only hypothesis I could come up with was that savers, denied of the returns they needed were forced to increase saving rates to support their future financial plans. more saving means less free money for consumption, hence lower inflation. It is a fine theory and probably a justified one, but I doubt if its substantial enough to prevent inflation at a world scale.
Another argument has been made that easy monetary policy inflated asset prices. It’s hard to deny that prices of financial assets all around the world are elevated but that also doesn’t seem to be a convincing enough reason for the lack of inflation in my opinion.
Can there be another explanation? A third channel for money to flow thru? The lead I needed came from an interview by fund manager and financial blogger – Barry Ritholtz with journalist Bethany Mclane, and it gave me some hint of what I was looking for. it came from an unexpected corner of the planets economy – the oil fracking industry.
The main claim made by Mclane was that it is not clear weather this industry is financially sound enough to support itself, meaning that it needs continues external capital to keep its operation and in that sense relays on cheap money to stay alive and profitable. Oil is a major component in the cost of much of what we consume and thus has a profound impact on inflation worldwide. If we are to believe the headlines in financial journals that increased American oil production is the main cause for the oil glut in recent years, and if this over capacity is financed via cheap money then we have here a clear example of how cheap money can actually cause deflation rather than inflation.
But if such a thing can happen in the US why not in other countries, like china for example, the factory of the world. If cheap money is financing overcapacity in china then this also could be a powerful mechanism by which easy money can cause deflation. So, if this little theory of mine is correct, then switching the monetary gears to reverse has the potential to cause the opposite of what is expected from it and actually increase inflation by means of lowering production capacity and the amount of goods supplied to the markets.
It needs to be said that so far, the evidence doesn’t support this theory. in the US where the central bank has started reversing its policy in recent years, inflation is still very much NOT a problem. but in finance there is sometimes a certain elasticity between cause and effect so things may yet change, or not, at least for a substantial amount of time, which is the same as saying I was wrong.
So, what’s the end game here? How can things roll out? well I`m not one of those people who has a functional crystal ball, I believe that forecasting is hard, especially regarding the future, so I will not attempt to do so. What I can and will do is try to assess the risks that are inherent in the system under the assumptions described above.
Overcapacity has the tendency to drop corporate profit margins to minimum, a race to the bottom is formed, prices plummet and the only way to make a decent profit is to sell more, much more. In a low interest environment that can be achieved by debt financing that helps ramp up production. An economic environment like this is a fragile one, any shock to the system can cause a severe chain reaction. Imagine a recession heats and drives demand down. many factories that managed to make a living of a very small profit margin would be forced to close shop, but not before they will drop prices to absurdly low levels in an attempt to sell more and stay afloat. After that a sharp incline in prices is expected as factories close down and capacity drops. Central banks may find themselves in a situation where they have to choose between fighting recession or inflation, in other words – stagflation, a situation where prices rise in spite of an economic slowdown.
Its quite a doom and gloom outlook, I’m well aware of that, but again, this is not a prophecy, it’s just an examination of a plausible scenario that needs to be taken in to account when preparing for the future. I’m not alone in this view point, in an interview that was given by former FED chairman Alan Greenspan late last year he suggested that stagflation is a risk to be aware of.
To close this subject up, I want to discuss another strange impact that the low interest environment may have had on large corporations, that is a lack of Ingenuity. many companies prefer to buy back their own stock rather than invest in their core business. when a company buys back its stock it is declaring that it sees no better use for its capital, this may be untrue in many cases but human psychology should be to blame here. People are inherently lazy and will pick the low hanging fruits when possible. When capital is so cheap it’s easy to generate returns over and above its cost just by adding more debt and increasing capacity. Ingenuity comes from scarcity, from a difficult hurdle that needs overcoming, that hurdle does not really exist in such an environment as the one we have today. On the other hand, abundant venture capital may saw the seeds of tomorrow`s big inventions.
Anyway, that’s my take on this subject, everything in the economy is cyclical, prosperity sows the seeds of tomorrows declines and vice versa, most of the time tomorrow will be same as today, but change is always behind some corner and it helps to try and imagine what it could bring and by doing so be a little bit more prepared.