EconomicReason

Dyed-in-the wool inflationists and equally convinced deflationists have been arguing for years about the consequences of the inevitable bust of the credit bubble – the former arguing that the only way out is the printing press, the latter pointing to the overwhelming deflationary impact of falling asset prices and falling aggregate demand.

One of the two views will probably eventually turn out to be right. However, most proponents of the correct view, although being right, will be right by accident, and not because of their foresight. The outcome of the current crisis has probably not yet been set in stone, let alone some years ago – the outcome will critically depend on recent, current and future actions by governments and central banks around the world. The outcome is path dependent.

If authorities act too late or too little, deflation will follow. If authorities overreact, excessive inflation will ensue. Obviously, authorities would prefer neither deflation nor excessive inflation, but the middle ground. However, the chances of hitting that middle ground are probably slim. First, it is unknown by how much authorities have to intervene in order to get it “just right”. Second, even if they knew, they are severely hampered by actors with other interests, such as special interest groups, politicians, or simply by inflexible legislation. Third, that middle ground is probably rather small, similar to a razor’s edge, and the chances of hitting that edge are minor, compared to the chances of falling on either side of the edge.

My sympathies lie with the inflationists, as most interests of the actors are biased towards inflation rather than deflation. However, authorities have hitherto shown a poor understanding of the crisis and rather late and little action. This could still turn the tide from the natural inflationary bias towards a deflationary bias. One thing is for sure – neither outcome will be very pleasant, however, the two outcomes will have radically different consequences for asset prices. The measures taken now by US authorities crucially affect on which side of the razor we will eventually find ourselves – and can therefore cause huge asset price swings in the coming weeks.

One cornerstone assumption underlying the viability of the Paulson Plan is that current market prices for subprime and Alt-A products differ by a significant margin from their “hold-to-maturity” value. Reasons for the persistent differences between market prices and a “fair” value are thought to be illiquidity and asymmetric information. If this were indeed true, then the plan could actually work – by restoring liquidity, depressed prices of poor quality assets would rise to “fair” levels, bank balance sheets would heal, and the taxpayer could even pocket some nice profits.

Unfortunately, we are probably not facing a liquidity crisis, but a solvency crisis. In a short recent paper (’No recourse’ and ‘put options’: Estimating the ‘fair value’ of US mortgage assets), Daniel Gros argues convincingly that lower quality mortgages do indeed have quite a low fair value, due to the implicit put option of homeowners which allows them to just walk away from their mortgage obligation.

If we are facing a solvency crisis, then liquidity measures will not make that crisis go away. A solvency crisis can either be ended by bankruptcy, which is not acceptable in case of the banking system, or by a bailout. There is therefore no way that the US taxpayer will profit from a plan to end a solvency crisis – on the contrary, he will ultimately foot the whole bill, both directly (by higher taxes) and indirectly (by higher inflation).

The correlation between gold and oil since the start of the commodity bull market around 2001 has been remarkable. However, from time to time, that correlation breaks down. There have been four breakdowns so far – first during a mini oil bubble which peaked on August 30, 2005, at $70/barrel, during the first gold bubble which peaked on May 12, 2006, at $730/oz, during the second gold bubble which peaked on March 17, 2008, at $1,031/oz, and during the second oil bubble, which peaked on July 11, 2008, at $147/barrel. In all four  instances, gold or oil decoupled, went parabolic, and crashed.

After all three previous bubbles, gold and oil met on their previous uptrend. In order to get back to their equilibrium after the last oil bubble, either oil should fall to around $90/barrel (given a gold price of $800/oz), or gold should rise to around $950/oz (given an oil price of $115/barrel).

Both ways, in order to move to the upper left, a decoupling of gold and oil must first take place - either oil must fall, without gold falling, or gold must rise, without oil rising. The gold bull market has therefore probably been put on ice until gold can decouple from oil.

Eric Kraus from Moscow, on Western hypocrisy towards Russia: The Widening Gyre.

Some rectifications concerning Russia, and a few thoughts on the world economy, by Eric Kraus from Moscow: Try Not to Panic.

Dozens of studies have proven that gold is a bad investment. Is it indeed? The below figure compares the return on the purchase of one ounce of gold at $35 in 1970 and an investment of $35 in stocks (S&P500, with monthly reinvestment of dividends, assuming no fees whatsoever, source: Robert Shiller ).

Now mentally subtract some management and rebalancing fees for the S&P investment, for example, 1% annually…

Another brilliant analysis by Eric Kraus from Moscow: Crack of Doom.

Road to Roota - an amazing comic book for elementary school children by the Fed Boston. Purportedly to “stimulate students’ imagination as they explore the economic problem of scarce resources, various methods of allocation, and how societies react to alleviate such problems”. Hard-core gold bugs, supporters of honest money and followers of Ayn Rand might just see more than that in this little innocuous comic book … however, they must be seeing things… obviously…

Deluded by low inflation expectations, the Federal Reserve and thus, world monetary policy, have been drifting farther and farther away from a neutral monetary policy stance in recent years. World monetary policy is not just “behind the curve”, it has actually lost sight of the curve altogether. How did we get to this stage?

The first main actor in the unfolding drama is the Fed. The Fed is convinced of the silly notion that inflation expectations are a harbinger, if not the primary cause, of actual inflation.
Consequently, the Fed is following the strategy to fight inflation only when inflation expectations are on the rise.

Enter the public. The public has no reason to doubt the Fed’s intention and ability to keep inflation low. Consequently, as long as actual inflation remains low, inflation expectations remain low.

Monetary policy and the public have been moving in a self-reinforcing circle for several years now. The public has low inflation expectations because it has faith in the Fed, and the Fed keeps printing money as long as inflation expectations remain low. Each party has been giving the other party the impression that things are under control, while actually nobody is in control.

Tail chasing cannot last forever. Inflation is still a monetary phenomenon and not an expectations phenomenon - the game is over when actual inflation begins to deviate persistently from inflation expectations. It appears that the chickens are coming home to roost soon - we are quickly approaching the moment of truth when expectations will finally adjust to reality, and when the Fed monetary policy will turn out to have been quite off the mark during the past several years. However, it is too late now to restrain inflation from rising further.

Monetary policy is sometimes said to be “pushing on a string” if one wants to emphasize the ineffectiveness of expansionary monetary policy. However, I think that this expression is misleading - in the long run, monetary policy is quite powerful. In the long run, monetary policy is therefore rather pulling on that string. And because the economy is a complex system, there is more than one string involved. In fact, one can compare setting monetary policy with playing a violin - both involves pushing, pulling and plucking strings in order to create a harmonic tune.

The strings of the Fed’s violin represent the different transmission channels of monetary policy. Due to the steady increase in wealth, asset markets have become a major string of the Fed violin in recent years. In the 1990s, the music played mainly in the stock markets, until that string broke in a crescendo in 2000. In its efforts to keep up the tune, the Fed then turned to the real estate string, which proved to be very effective, until it, too, broke under the heavy hand of the Maestro.

Unfortunately, the Fed does not know that it is playing a violin, let alone that two main strings of the violin are broken. In order to keep up the volume, the Fed now fiddles all the harder, which will eventually ruin even more strings. The brunt of the Fed’s musical ambitions is now on the commodity string. In time, it will break as well, but not after having wrought havoc on consumer price inflation around the world.

It is rightly said that monetary policy is more of an art than a science. Engineers have no business in the orchestra pit - neither have today’s typical economists, having gone through several years of brainwashing by would-be mathematicians.