The Boys Who Cried Wolf

Common Sense vs. Liquidity

Herbert Stein, one-time Chairman of the U.S. Council of Economic Advisers, had many claims to fame as an economist. But my favorite is what became known as Stein’s Law:

“That which cannot go on forever won’t”

It is always refreshing for an economist to use common sense rather than mathematics or esoteric lingo. But I am fond of Stein’s law for another reason: I believe that the affairs of man are cyclical. Cycles of nature influence our environment (climate, seasons, tides, sun spots, etc.), and crowds tend to be manic-depressive, oscillating between euphoria and depression. As a result of this cyclicality, few trends are forever. Trees, for example, don’t grow to the sky -- at least one never has but, having recently written about Black Swans (rare, unforeseeable events), I hesitate to be too categorical.

Over the centuries, markets have recurrently experienced bubbles – usually recognized as such only after they burst. The last acknowledged one was the Internet bubble of the late 1990s (there is still some debate about the more recent, global housing euphoria). Today, many instances of speculative fever can be observed, but few experts are willing to describe them as bubbles. More of them would probably rally around the recently-coined label of “Irrational Complacency” – a tongue-in-cheek take on Prof. Robert Shiller’s 2000 book -- “Irrational Exuberance”.

The fact is, many trends that proved destabilizing throughout the ages more recently have co-existed with apparent declines of both economic and financial-market volatility. But those who find this new-found “stability” a reason to be complacent presumably have forgotten (or never learned about) Hyman Minsky.

In a 1970s study of bubbles before the term became popular, Minsky postulated that “stability is unstable”, simply because unusually long periods of economic stability lull investors into taking on more risk. This leads them to borrow excessively and to overpay for assets. As a result, the longer a period of economic stability lasts, the more society moves towards being a house of cards built on excessively easy credit and speculation.

As it happens, by past standards, the current economic and financial environment has been quite stable for an unusually long time. There are a number of trends in force today that fly in the face of history, cannot last forever and most likely won’t. But so far they have persisted. Most of these, in some way, can be traced to the odd couple of disinflation (occasionally flirting with deflation, or actual price declines) and a global flood of “liquidity”.

The concept of liquidity is both complex and convenient, essentially for the same reason: it is hard to define and even harder to measure.

It used to be that one could measure it in terms of “money” – itself a not-so-simple concept, but one at least for which the creation process was understood and some measures had been developed. Central banks would inject into their banking systems some “high-powered” money, by lowering the amount of deposits commercial banks were required to hold in the form of cash reserves. Banks would then extend loans by a multiple of this high-powered money and, abracadabra, the supply of money had been increased.

Today, credit is being extended by all kinds of financial and quasi-financial institutions. It is routinely transferred to the public through “securitization”, and enhanced by a multitude of derivatives, insurance and “structured products”. As a result, commercial banks represent a much smaller and still-shrinking portion of total credit creation and the power of central banks to control liquidity has been correspondingly reduced. Not at the best of times…

In trying to sustain the weakest sectors of their economies (usually those threatened by globalization) and, occasionally, to avoid financial crises in other, frothier sectors (housing, hedge funds), the central banks of some developed economies tend to create too much money. This is especially so when their models underestimate the extent to which new financial technologies and engineering boost credit availability faster than money is created. Let us take the most obvious example: the United States.

With easy and cheap credit available to everyone, including consumers, the U.S. trade balance has suffered steady deterioration in recent years. Exporters to the United States -- typically smaller, less-developed economies, including China as well as oil and metal producers – reap huge trade surpluses because they cannot absorb imports as fast as their export revenues rise.

As the companies that have earned these dollars exchange them for local currency at their national central bank, the supply of local money is increased well beyond what is desirable. Theoretically, the local central bank can “sterilize” this new money, for example by floating local bonds that will soak up local savings. But there are limits to sterilization and, meanwhile, excessive money and overly cheap credit carry risks: economic overheating immediately and inflation in the longer-term.

What happens to the dollars acquired by exporters? Their central bank may diversify a small portion into other currencies and invest, for example, in Euro bonds. But the great bulk is still being invested in U.S. Treasury securities, thus adding to the liquidity created domestically by the Federal Reserve and its minions.

As long as this global liquidity pump keeps pumping, everyone is a winner, especially as long as inflation does not rear its ugly head.

In the past, excessive money creation (monetary inflation) was promptly followed by price inflation. Newly-created money first translated into higher prices for financial assets (while the economies were operating below potential) and eventually into higher prices for goods and services when the economies recovered. Today, despite an ageing global economic boom driven by overflowing financial liquidity, inflation has remained conspicuously subdued.

One reason is the massive relocation of production from developed economies to low-cost ones with ample and eager labor. This massive shift has caused overcapacity in manufacturing industries, as old-world capacity is shut down more slowly than new-world capacity is built. And it is deflationary because the excess supply depresses the global price of manufactured goods. At the same time, the emergence of three billion new consumers in “Chindia” (China and India), and the massive “mortar” investment in BRIC (Brazil, Russia, India and China), has boosted the price of commodities used in production. This co-habitation of price inflation and deflation has been aptly described as biflation.

There is an additional explanation for the subdued inflation. In recent years, there has been a massive shift in commercial flows, resulting in huge financial imbalances between countries. The most visible consequences have been the gaping trade deficit of the United States and the bulging foreign currency reserves of China, but the surpluses of oil producers have also soared. When massive liquidity flows to an economy faster than it can be used efficiently, it tends to be invested in plants and projects that are not needed, thus contributing to overcapacity and deflationary tendencies.

The corollary of the global disinflationary tendencies we have experienced in recent years has been lower long-term interest rates: when inflation rises, higher bond yields are needed to offset the declining purchasing power of bondholders’ capital; when inflation declines, the reverse happens.

Declining bond rates, in turn, tend to coincide with rising price/earnings ratios for stocks. Price/earnings ratios are just an inverse expression of stocks’ earnings yield, a measure of the return offered by stocks to shareholders.

In “Ahead of the Curve” (Harvard Business School Press – 2005), Joseph H. Ellis explains the following: “Because of the inverse relationship between interest rates and stocks’ price-earnings ratios, rising interest rates from 1960 to 1982 contributed to a compound annual appreciation of only 2.9% in the S&P 500 Index. Conversely, falling interest rates from 1982 to 2003 were a major long-term stimulus to the stock market, helping produce compound annual growth in the S&P 500 of 10.5%. Note that bear markets from 1960 to 1982 were more frequent and longer, whereas from 1982 to 2003 they were less frequent and shorter in duration.”

Long-term interest-rate changes and the stock market

Source: Joseph H. Ellis

Why should this apparently virtuous cycle of rising liquidity, disinflation, low interest rates, resilient-to-booming economies and rising stock markets ever end? Because of Stein’s Law: “That which cannot go on forever won’t”.

Today, liquidity is more a function of the widespread availability of credit than of traditional money creation. But credit availability, itself, is in good part a function of crowd psychology: in particular the optimism (or myopia) of lenders. It sort of appears out of nowhere and, sooner or later, it evaporates. Many of the world’s central banks have been raising short-term interest rates or implementing some kinds of credit controls (U.S. guidelines on sub-prime lending or Chinese limits on real estate and car financing). Hedge funds have been closing after disappointing performances and money outflows. One day, we will wake up and liquidity will have shrunk – but maybe it will be too late.

Many investors whose judgment and long-term performance I respect have been warning for a while that some kind of serious trauma eventually will be the price to pay for the excesses and complacency of recent years. But, as in “The Boy Who Cried Wolf” tale, their warnings have become progressively discredited as economies and financial markets brushed off successive crises. Under pressure from public opinion, the number of boys crying “wolf” has been melting like ice under the sun.

But, as Victor Hugo wrote in a pamphlet against Napoleon III, “If but one remains, I shall be that one”.

François Sicart, in Paris
May 14, 2007