I’m Out Of Bullets, How About You?

Perhaps the most critical thing to understand about policymakers’ response to the 2008 crisis is the extent to which it represents unbridled money printing and out-of-control credit and debt creation taken to its logical extreme. It is, in short, the fiat regime unleashed.

“Although the post Bretton Woods financial order has been more crisis and shock prone than the prior 25+ years, and also that seen through most of observable financial history, the reality is that the current period of fiat currencies also arguably allows a buffer against an even greater number of them,” Deutsche Bank wrote, in a truly expansive study of global financial crises released earlier this week. The abandonment of sound money in favor of the current system thus represents “a real double edged sword,” the bank goes to observe.

While we can observe an increased frequency of crises in a world that’s abandoned the gold standard and while we can draw common sense conclusions from that observation, there’s still the old “correlation doesn’t always equal causation” problem to contend with. That is, “yes” it is likely that the lack of discipline which invariably accompanies an unanchored system contributes directly to the incidence of busts. But it is certain that a constrained system lacks the flexibility to respond to busts when they occur. So if even one crisis out of a dozen isn’t attributable to the adoption of an unanchored system (i.e. a system not based on gold), then by tethering our fate to an archaic concept we may be unnecessarily ensuring a complete collapse from which there is no recovery. Hence Deutsche’s “double edged sword” metaphor.

The worry now however, is that in this latest iteration of responding to a crisis with intervention and money creation, we have exhausted our capacity to leverage (figuratively and literally) the flexibility afforded by an unanchored system to rescue us from the abyss. There’s a cruel irony inherent in that. Each time we respond to a panic with the tools afforded us by a system based not on some finite store of value, but rather based solely on the “full faith and credit” of governments and their printing presses, we almost always exacerbate (in one way or another) the imbalances that led to the very crisis to which we’re responding. The inevitable result: a rolling boom-bust cycle that snowballs with each turn, ensuring that each new crisis and each crisis response is even more spectacular than the last.

The only way this can go on in perpetuity is if we assume there is no limit on the extent to which we can leverage (again, both figuratively and literally) the flexibility inherent in an unanchored (i.e. a fiat-based) system. If the busts keep getting bigger, it will of course be painful and harrowing, but if the capacity of the fiat system to respond with ever larger money printing programs is limitless, then theoretically we will just boom-bust our way along forever until finally we’re all losing everything once every six months only to have central bankers make us all millionaires the very next day by topping up our bank accounts with newly-created money.

Needless to say, that probably won’t work forever. Eventually, avocados will cost $86,000 each (up from their current price of $50,000 each). So assuming we eventually exhaust the capacity of the fiat system to offset the crises that system itself facilitates, the inevitable conclusion is that one day, we’re going to get a bust (that, by definition as described above, will be larger than its predecessors) and our options for coping with it will be exhausted.

This reality, we argue, is one explanation for why policymakers (e.g. Yellen and Draghi) are suddenly predisposed to describing subdued inflation as “transitory” even though the data suggests it is anything but. What they’re trying to do is rationalize normalization because normalization equates to replenishing the ammo. The more rate hikes you can squeeze in, the more room you have to cut later. The more you can shrink the balance sheet now, the more you can expand it later. They seem to believe we have reached the limit in terms of the fiat regime’s capacity to overwhelm crises with money printing, credit creation, and debt. Here’s how we put it last week:

The other possibility here is that by persisting in this, we’re exhausting our capacity to respond to future crises. Of course, if one waits around long enough, another crisis is bound to occur. When that happens not only will we be short on ammunition (e.g. if the next crisis started tomorrow, we’d be going into it from ZIRP/NIRP and with already bloated CB balance sheets), we’ll also be approaching it from nosebleed levels thanks largely to the fact that we never exited the state of exception instituted to cope with the previous crisis.

So that is the context for the following excerpts from Deutsche Bank – excerpts which, in our opinion, you should carefully consider (unless of course your name is Kuroda, in which case carry on because we know you don’t care about any of this)…

Via Deutsche Bank

Are we out of bullets when the next recession arrives?

The analysis in the previous section highlighted the fact that debt levels globally continue to climb at a time of all time low yields and unparalleled levels of QE that seem to have now past their peak in terms of the rate of accumulation of assets. With the Fed soon to stop reinvestment and the ECB keen to taper further, the great unwind is perhaps underway. However this is occurring at a very advanced stage of the economic cycle relative to history, and as Figure 37 highlights, by Q1 2018, this current US expansion will be the second longest in history. If we see a recession soon, are we close to being out of ammunition given that central banks remain at or near the zero bound, with many still buying lots of assets? With Government debt levels spiking since the last recession, are politicians able to act as aggressively as they might need to? Could the next recession be the one where policy makers are the most impotent they’ve been for 45 years or will they simply go for even more extreme tactics and resort to full on monetisation to pay for a fiscal splurge? It does feel that we’re at a crossroads and the next downturn could be marked by extreme events given the policy cul-de-sac we seem to be nearing the end of.

While the length of expansions are not in themselves a predictor of an upcoming recession, the graph above reminds us that over the last 167 years there have been 34 expansions and 33 recessions. So as certain as one can be that night follows day we can be sure that a recession is coming. They are a natural and normal occurrence and many more will occur in our careers and lifetimes.

It does feel though that the excesses in the system in recent years mean that each recession is systemically more and more risky. In turn this means central banks and governments have tended to do everything in their power to avert them. The cost of this in recent years and even recent decades is more and more leverage.

At some point, the authorities will have their hands tied more than they have over the last 35 years of extremely elongated cycles relative to history. Since around 1980, global inflation seems to have been on a downward path independent of central bank and government action. As discussed earlier, favourable demographics and the dramatic and sudden integration of China into the global economic system has produced a huge positive labour supply shock on the world and has depressed the price of labour (workers) in a way that has meant that inflation has been continually depressed.

So it has been possible to address every crisis or economic slowdown with stimulus without any subsequent inflationary shock. As such economic cycles have generally lasted much longer than in the pre-1980s days. However the net result of this entire stimulus is a huge expansion of leverage. So good news in the short-term but storing up imbalances for later, especially if inflation turns from something that is externally under control to where it goes up at a global level independent of central bank action.