EconomicReason

“Deflation is set in stone” is what you read sometimes. The argument goes roughly like this: The fiscal and monetary injections amounting to a few trillion are no match for the dozens of trillions of wealth destroyed by the crisis. The underlying logic is that as long as government programs are dwarfed by wealth destruction, only deflation can result.

This sounds logical, but it is not. In particular, some things are badly mixed up. Actually, inflation could probably result with government support being much smaller than wealth losses.

First, real estate, stock, and risky credit were overpriced at the onset of the financial market crisis – their valuations were not backed by an equivalent stream of future production. Note that wealth is nothing else than a claim on future production. Therefore, pre-crisis levels of asset prices did not reflect actual wealth – in fact, there was no chance that these overpriced assets could ever have been converted into future production at prevailing prices. Expectations reflected in asset prices were exaggerated. In order to balance future aggregate demand and supply of goods and services, either consumer prices would have had to rise, or asset prices would have had to fall. The latter happened.

Enter the government. By reinflating prices of worthless assets above their intrinsic value, false wealth is restored. Furthermore, by backing AIG and honouring bets which were not honourable from the beginning, even more false wealth is created. Trying to restore exaggerated expectations is probably a bad idea and could turn out very inflationary.

The second flaw in the introductory reasoning is that apples are compared to oranges. A dollar in wealth (losses) is not the same as a dollar in money supply, which is not the same as a dollar actually spent for goods or services. In particular, wealth and money supply are stock variables, while spending is a flow variable. Simply aggregating the headline amount of government measures and comparing them to estimated wealth losses is therefore useless at best, if not misleading, in order to assess future inflationary tendencies.

Alecto, Tisiphone and Magaera, the three Furies, are the goddesses of vengeance and guardians of law in Roman mythology. They are called Erinyes in Greek mythology. The Furies intervene not only when a crime is committed against the positive law of a given society, but also when it is against the natural law. For example, they would protect beggars, strangers, dogs and young birds. In the Iliad, they are characterized as “those who beneath the earth punish whoever has sworn a false oath”. They are horrible to look at, with snakes as their hair, blood dripping from their eyes, carrying whips made of scorpions, with which they scourge the living and the dead. They are unrelenting in their pursuit of criminals, pitiless, but fair. Often, they are striking the offenders with madness.

It appears that Nemesis, executrix of justice, finally made up her mind that enough is enough. By calling the Furies to appear on Earth and sending them after the perpetrators of the current financial mess, justice should be restored. As an economist, I have no idea how the financial and economic crises are going to play out. However, taking guidance from mythology, the crisis might be far from over. Despite the severity of the crisis, there is still obvious and widespread fraud, corruption, arrogance and ignorance going unpunished, mainly in the financial sector. For divine justice to be be served, the crisis will have to worsen significantly.

Another excellent analysis by Eric Kraus from Moscow: Too Early to Tell.

Last year brought an increase in moral hazard on a grand scale. One year ago, there was still reasonable doubt whether governments would intervene in order to save illiquid, but solvent systemically important banks, and how punitive the terms of a bailout might be for shareholders and management.

Today, there is no doubt any more that governments will intervene in order to save illiquid and insolvent banks, systemically important and unimportant banks, insurance companies, states, countries, industries, home-owners, shareholders, management, and about everyone else who can plausibly argue that he needs a bailout and who can write (because you need to be able to fill out a two-page application form).

Basically, moral hazard makes agents behave more risk-seeking than is optimal for a society as a whole. There are several consequences of the increase in moral hazard. First, by definition, society as a whole will fare less well. Second, as soon as the current deleveraging will be over, risk-love and speculation could return with a vengeance. The next bubble, wherever it will be, will be something to behold. Third, an increase in moral hazard is equivalent to an expansion of monetary policy. This expansion represents a significant (and probably underestimated) boost to the economy and financial markets. Fourth, in the longer run, moral hazard increases systemic risk even further – the next bust might definitely finish off what this bust will have left over.

Moral hazard is the main culprit for the current financial crisis – investors, managers, and basically the whole society behaved recklessly because they were conditioned to be bailed out. The current instance has shown once again that in a democracy with a fiat currency regime, no laws can prevent large-scale bailouts to take place, and that expectations of a bailout are thus justified ex ante. Ultimately, there is probably just one way to credibly prevent governments from bailouts, and thus to eliminate the moral hazard problem – namely to render bailouts financially impossible. The possibility to inflate money supply must be taken away from governments. This could be implemented, for example, by backing money with commodities, possibly gold. The wheel does not have to be reinvented.

Another eloquent and scary analysis by Eric Kraus from Moscow: Things that Fall Apart.

Eric Kraus from Moscow: Havoc/Hope.

Equally also, our thrust has been founded on our unwavering belief that extraordinary circumstances must be confronted through extraordinary interventions…

As Monetary Authorities, we commend those of our peers, the world over, who have now seen the light on the need for the adoption of flexible and practical interventions and support to key sectors of the economy when faced with unusual circumstances.

From the Quarterly Report of the Reserve Bank of Zimbabwe, April 2008 (don’t bother to click on that link, it usually does not work…).

And for those who think this is a joke – here is the full Quarterly Report.

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.