Ok so recently, Deutsche Bank’s Jim Reid decided it was about time someone sat down and penned a 94-page epic tome on the history of financial crises. So that’s what he did.
And as part of that War & Peace-ish manifesto, Reid also made a list of the “possible candidates” for the next crisis.
That note was easily one of the better pieces of research we’ve seen this year and although it’s impossible to do it justice with blog posts, we did endeavor to pen two missives based on short excerpts. Those two posts can be found here:
In that latter post, we talked at length about the extent to which an unanchored system (i.e. a regime not tethered to a universally accepted, finite store of value like a precious metal) is a double-edged sword. It provides the flexibility to respond to crises, but that flexibility involves adopting polices that will invariably sow the seeds for the next meltdown. The entire thing hinges on the extent to which the response to the previous crisis can be unwound (i.e. the countercyclical ammo replenished) by the time the excesses (the “boom”) that response created lead to the next bust.
But there’s a problem with that. It can’t work forever because implicit in the arrangement is that the booms and busts will get larger over time. At some point the bust will be so large that it overwhelms our ability to lean against it with the tools afforded us by an untethered system. Or, perhaps more accurately, it ensures that our attempts to counter busts will become increasingly absurd until we’re forced to resort to some iteration of helicopter money. Allow us to excerpt a few passages from our previous piece, because dammit, that post was pretty well-written. Here’s what we said:
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.
There’s something conspicuously missing from our analysis as presented in those excerpts. Specifically, a mention of the impact structural disinflation has on the ability of an unanchored system to respond.
“The basic premise is that a fiat currency system – the likes of which we’ve had since 1971 – is inherently unstable and prone to high inflation all other things being equal,” the above-mentioned Jim Reid writes, in a brand new piece expanding on his original work. He continues: “However, for the current system to have survived this long perhaps we’ve needed a huge offsetting disinflationary shock.”
And there it is. The missing piece of the puzzle that allows an inherently ridiculous system to persist. A disinflationary shock serves to short-circuit the mechanism that, in the absence of a countervailing force, would invariably translate unchecked credit creation and thin-air-money-printing into hyperinflation.
To be sure, Reid brings this up in his original post, but the argument is the backbone of the new piece. Here’s Jim:
In “The Next Financial Crisis” we suggested how China’s fairly sudden integration into the global economy at the end of the 1970s and a very favourable once-in-a-lifetime shift in demographics from around 1980 onwards could have contributed to the modern boom/bust culture that has made financial crises more regular in recent decades. The argument is based around a view that a positive labour supply shock from China and developed countries’ demographics between 1980-2015 has allowed inflation to be controlled externally as the surge in the global labour supply at a time of rapid globalisation has suppressed wages. With inflation controlled externally it has allowed governments and central banks the luxury of responding to every crisis and shock with more leverage, loose policy and latterly more and more money printing. Its not usually this easy as inflation would have normally increased with such stimulus and credit creation. It could be argued that this external disinflation shock has perhaps ‘saved’ fiat currencies after the runaway inflation of the 1970s in the immediate aftermath of the collapse of the Bretton Woods quasi Gold Standard from 1971 onwards.
What’s implicit there is that if the dynamics that “saved” the fiat regime were to reverse course, well then the untethered system could face an existential crisis.
But before he gets to that, Reid reminds you that contrary to the popular narrative, inflation is not “low” by historical standards. To wit:
Figure 1 shows our global median inflation index back over 800 years and then isolates the period post 1900 where inflation exploded relative to long-term history.
Figure 2 then shows this in year-on-year terms and as can be seen, in the 700 years before the twentieth century inflation and deflation were near equal bedfellows with only a gradual upward creep in inflation as new precious metals were mined or governments periodically punched holes in existing coins and thus slightly debasing the currency.
The message: this is relative. “As someone that has studied economic history it always amuses me to hear that we live in times of extremely low inflation when history would suggest these are relatively high inflation times,” Reid writes, delivering what is probably an uncomfortable reality check to anyone who isn’t steeped in eight centuries of econ data. Here’s how Reid explains our current situation:
What has happened though is that we saw a 35 year disinflationary period start in 1980 that took inflation down from the extremes at the start of that decade to what we think will be the secular lows around the middle of this decade.
Ok, so getting back to the question of whether we can continue to depend on the disinflationary shock that’s allowed the current system to persist (and that gives us the flexibility to respond to crises with inflationary policies), Reid’s answer is “perhaps not.”
“We think that the effective global labour force exploded from around 1980 due to natural global demographics and China opening up its economy to the outside world at the end of the 1970s,” Reid writes, adding that “in the two decades we have data for prior to 1980, real wage growth was much higher than the post 1980-period.”
Hopefully you can see where this is going. The idea here is that if the supply of labor falls and growth stays on trend, wage pressures rise. And while that’s great for workers in terms of helping to mitigate the disparity between capital and labor, it could imperil the fiat system. Here’s Reid:
The problem for the current global monetary system is that over the last 45 years it has relied on governments and central banks being able to turn on the stimulus spigots at the drop of a hat when a crisis has come. This has enabled each crisis to be dealt with via increasing leverage rather than creative destruction type policies. For this to be possible you’ve needed an offset to such stimulus to prevent such policies being inflationary. Fortunately (or unfortunately if you believe it’s an inherently unstable equilibrium) the external global downward pressure on labour costs ensured that this has happened. So what would happen to the global monetary system if labour costs started to reverse their 35 year trend? If central banks had their current mandates of keeping inflation around 2% then they would be duty bound to tighten policy more often regardless of the external environment. However, such an outcome is probably unrealistic given how much debt there is at a global level.
And so, inevitably, central banks would need to act to ensure that yields didn’t skyrocket (do quote Donald Trump: “DO SOMETHING!”). That would mean still more QE, and around we go until all vestiges of control are lost.
Then comes the end game:
Eventually, it’s possible that inflation becomes more and more uncontrollable and the era of fiat currencies looks vulnerable as people lose faith in paper money. Once the value of debt has been eroded the debate would likely be live as to what replaces fiat currencies as surely the backlash would be severe against the system that allowed us to get to such a situation.
Reid goes further to lay out the counter arguments, not the least of which is of course that technology represents a powerful source of structural deflation. That entire argument can be summed up in one visual:
But at the end of the day, the question for us is this: what does it say about a system when the feasibility of that system rests entirely on there being a disinflationary offset that allows something inherently dubious (fiat money) to remain some semblance of viable?
Something to think about.
And no, this post should not be seen as an endorsement of Bitcoin or as a call to buy physical gold, because although everything said above might leave you inclined to think that we’re believers in cryptocurrencies and shiny yellow metal as “stores of value”, regular readers know that’s not our position.