Fix the real economy first: lessons from James Montier

James Montier has a very good piece out via John Mauldin ([email protected]) on the need for real economy stimulus over financial sector stimulus.

The quote I find most memorable goes to the heart of our debate about the financial system:

Investors seem to be rather excited about banks posting profits at the moment. Frankly, if a bank didn’t post a profit in this environment it should be shot out of kindness. The environment for profitability from banks has rarely been better, but that doesn’t make them solvent.

I thought the piece important enough to post parts here with a few comments. The original is on John’s site at the link at the bottom of this post.

As Albert and I regularly point out during meetings, we have never been more unsure on the inflation/deflation outlook. I have previously said I was torn between the deflationary impact of the bursting credit bubble, and the inflationary pressures of the policy response. When we read something by the deflationists we sit there nodding our heads in agreement, then we pick up something by the proponents of a return of inflation and we find ourselves agreeing with that as well. The respective sides seem deeply entrenched in their positions.

In contrast, we are trying to keep an open mind on the subject. Albert is biased towards a Japanese style outcome, and I am biased towards an inflationary outcome, but neither of us has any strong conviction.

Fisher and the debt-deflation theory of depressions

In the face of this uncertainty I decided to return to history and see what it has to say about the way out of a depression. My first point of call was Irving Fisher’s “The debt-deflation theory of Great Depressions” published in 19331. Fisher is probably most infamous to those in finance for his pronouncements of a new era of permanently high stock prices in 1929. But in the wake of his disastrous calls he turned to trying to understand the experience of the depression. Incidentally, he also invented the Rolodex.

In his debt-deflation theory, he posits “two dominant factors” in driving depressions “Namely over-indebtedness to start with and deflation following soon after… In short, the big bad actors are debt disturbances and price-level disturbances”. He continues “Deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debt cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed.” That is to say, debt-deflation spirals can easily become self-reinforcing.

The good news is that Fisher is also very clear on how to end a debt-deflation spiral: “It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors… I would emphasize… that great depressions are curable and preventable through reflation and stabilization”. The irony of Fisher’s route out of deflation is that, probably only the Fed – after helping lead us into this mess2 – can now get us out of it.

I am very much in the same situation as Edwards and Montier — struggling with the arguments for and against deflation versus inflation. At this juncture, it is far from clear where things are headed going forward. While I leaned toward deflation up until recently, the balance is tipping in the other direction for me right now.

You should note that the concept that easy money is a viable way out of a deflationary spiral is considered heresy in Libertarians circles. However, this is essentially what Irving Fisher has suggested. More to the point, he also says that one needs to fix the real economy first. People don’t buy things when they don’t have jobs. This one reason that increasing wages should be central to economic policy right now.

Montier uses an analysis by Christina Romer, the head of Barack Obama’s Council of Economic Advisors, to make his points. In discussing this with Marshall Auerback, he took issue with her underselling of fiscal stimulus. To his mind, fiscal stimulus is more important than monetary. Nevertheless, I think much of what she has to say is spot on. Below I have highlighted the bits I find most important.  In a nutshell, they are:

  • The Great Depression’s fiscal expansion was small
  • Printing money can break the deflationary spiral (this is essentially Paul Krugman’s philosophy.  I am instictively negative about the concept of easy money being used as a mechanism to stop a deflationary spiral, but this is the path we are on.  Call it an ideological bias on my part.
  • If you stimulate, you cannot undo it overnight.  This was the mistake in 1937 and in Japan in 1997 (see my post, “Beware of deficit hawks“)
  • The most important point as I see it is the need to get the real economy going.  In my view, this means increasing wages.
  • Competitive currency devaluations ca actually be beneficial by creating inflationary expectations.  I am skeptical here.

Romer’s lessons from the Great Depression

After reading Fisher’s analysis of the 1930s, I came across a recent speech given by Christina Romer, who is now the head of the Council of Economic Advisers, and who made her name in academic circles studying the events which ended the Great Depression. In the speech, Romer offers six lessons from the Great depression for the current juncture.

Lesson 1 – Small fiscal expansion has only small effects

Romer wrote a paper in 19923 arguing that fiscal policy was not the key driver in the recovery from the Great Depression. Not because fiscal expansion is ineffectual per se, but rather because the fiscal stimulus that was conducted wasn’t large. As Romer notes “When Roosevelt took office in 1933, real GDP was more than 30% below its normal trend level… The deficit rose by about one and a half percent of GDP in 1934”.

Lesson 2 – Monetary expansion can help heal an economy even when interest rates are near zero

Romer notes that actually it was the Treasury rather than the Federal Reserve that drove the monetary expansion (a peculiarity of the system under the Gold Standard). In April 1933, Roosevelt suspended convertibility to gold on a temporary basis, and the dollar depreciated. When the US returned to gold at the new higher price, gold flowed into the US, allowing the Treasury to issue gold certificates which were interchangeable with Federal Reserve notes. As Romer notes “The result was that the money supply, defined narrowly as currency and reserves, grew by nearly 17% per year between 1933 and 1936”. Romer argues that this “Devaluation followed by rapid monetary expansion broke the deflationary spiral” – empirical evidence to support Fisher’s hypothesis outlined above.

Lesson 3 – Beware of cutting back on stimulus too soon

The monetary expansion seems to have produced remarkable results in terms of real growth: the US economy grew by 11% in 1934, 9% in 1935 and 13% in 1936 in real terms. This lulled the authorities into thinking that all was well with the system again. Hence, in 1937, the deficit was reduced by approximately two and half percent of GDP. Monetary policy was also tightened, as Romer notes “The Federal Reserve doubled the reserve requirement in three steps in 1936 and 1937”. She concludes “taking the wrong turn in 1937 effectively added two years to the Depression”.

Lesson 4 – Financial recovery and real recovery go hand in hand

Romer points out the inseparable nature of the real and financial recoveries. This meshes with our analysis that the banks aren’t really the problem in a debt-deflation environment, rather they are a symptom of the problem. The current policy in the US seems to be aimed at “fixing the financial system”, witness Bernanke’s recent comments “Recovery is not going to happen until the financial markets and the banks are stabilized”. This appears to be a misperception, as, Romer notes “Strengthening the real economy improved the health of the financial system. Bank profits moved from large and negative in 1933 to large and positive in 1935, and remained high through the end of the Depression”.

Investors seem to be rather excited about banks posting profits at the moment. Frankly, if a bank didn’t post a profit in this environment it should be shot out of kindness. The environment for profitability from banks has rarely been better, but that doesn’t make them solvent. If you were starting a business today, then setting up a bank would be a very attractive option. However, history – as represented by the balance sheet – cannot simply be ignored when it is inconvenient. As John Hussman noted “The excitement of investors last week about Citigroup posting an operating profit in the first two months of the year simply indicates that investors may not fully understand the term “operating profit.” Citigroup could burst into flames while Vikram Pandit sells lemonade in the parking lot, and Citi would still post an operating profit. Operating profits exclude what happens on the balance sheet.”

Lesson 5 – Worldwide expansionary policy shares the burdens

Given the worldwide nature of the current slump, Romer makes an interesting point on the effectiveness of competitive devaluations, “Going off the gold standard and increasing the domestic money supply was a key factor in generating recovery… across a wide range of countries in the 1930s… These actions worked to lower world [real] interest rates… rather than just to shift expansion from one country to another“.

This is something that Albert and I have been discussing of late. We have been pondering the possibility of competitive devaluation (obviously ultimately a zero sum game in terms of exchange rates) having enough of an impact on local monetary creation to increase inflationary expectations, thus helping countries reflate. It appears as if Romer has sympathy with this view.

Lesson 6 – The Great Depression did eventually end

The final lesson that Romer offers may be of use to investors at the current juncture. She makes the point that the Great Depression did finally end. As Romer puts it “Despite the devastating loss of wealth, chaos in our financial markets, and a loss of confidence so great that it nearly destroyed American’s fundamental faith in capitalism, the economy came back. Indeed, the growth between 1933 and 1937 was the highest we have ever experienced outside of wartime. Had the U.S. not had the terrible policy-induced setback in 1937, we, like most other countries… would probably have been fully recovered before the outbreak of World War II” This is a reminder that the current obsession with no scenario being too pessimistic is probably ill advised.

I am going to stop here. But, Montier’s post has much more to it, so if you want to read it, click the link below.

Roadmap To Inflation And Sources Of Cheap Insurance – James Montier via John Mauldin

  1. John says

    The inflating strategy is flawed. It is not reasonable to look at the average price level. You need to have price levels rise in more useful areas. If instead, these price rises find there ways to property and natural resources, then ultimately the economy will be undermined. The price level rise will actually choke a large segment of the middle class who is still trying to rebuild its balance sheet.

    I am sure at the end of this American experiment this theory will be proven false.

  2. aitrader says

    Stating that the real economy must recover so that the “unreal” FIRE (finance, insurance, real estate) economy can grow seems almost trite. How can one expand an economy based on little or no production of goods and services? (Ok, insurance is a service, but a small one in relation to its cost). Why is the goal of this “recovery” to reignite the fallacy that a FIRE based economic system, that caused this collapse in the first place, will lead us out of this?

    FIRE is not production and is barely a service. Finance is capital allocation and it should be forced to do this with as low a cost as the economy can achieve. The idea that finance itself is a major profit center for a growing economic system creates a huge misallocation and waste of capital and credit. We starve the real economy while rewarding the stewards of capital allocation with 40% of its benefits. Is it any wonder the system is collapsing? It is standing on legs of sand.

    Michael Hudson has a very good bit on this ridiculous notion that FIRE is production and growth. The concept is nothing new. The fallacy was seen for what it is back in the days of Sumer and Akkad. Those that do not understand history are doomed to repeat it, over and over again it seems. Hudson did an interview recently with the Renegade Economist on YouTube found here that highlights what our distant ancestors understood so well –

    As to the idea that monetary expansion can re-inflate the economy to pull us out of this near depression I have two points. One is that the real economy (meaning actual production of goods and to a lesser extent services based on those goods) must be healthy and growing or you are simply re-inflating the empty FIRE sector, which will lead to a *larger* depression. Prices will continue to deflate until the real economy has reached price levels where it is profitable to produce again.

    The second point relates to the real economy (again non-FIRE) and the velocity of money. Money is an exchange medium. It is nothing else. If it is not exchanged it is not money. It is static, unused paper, bits in a computer database. If it is not allocated and reallocated there is no turnover hence no velocity. When the real economy is stagnant you can try to re-inflate as much as you like. The result is a larger and larger pile of static funds. There is no effect on exchange hence no effect on the velocity of money and efficient allocation of capital.

    The current downturn, in my opinion, will be a depression of staggering magnitude. Team Obama’s plan is to re-inflate the unproductive FIRE sector, since that is where they come from and they hold a shared fallacious view of its importance, not the real economy. China, Japan, and the Middle East sovereign wealth funds appear increasingly unable to loan them money to do this. Without an outside source of capital and with little internal capital available (or at least not enough to kickstart money exchange and real production) the TARP, TALF, et al programs are exhausting what hope we might have had to support a real goods and services restart that would eventually led to re-flation and a bottom of this downturn – with a foothold toward an eventual recovery.

    In light of the above I consider the recent bump in the DOW and S&P a true suckers’ rally. Watch out below. Catching falling knives is costly and painful. I see pain and severed digits ahead.

    1. Edward Harrison says

      Now, that’s a comment, aitrader! Well done. I do have a few things to say in response. I generally agree with your comments regarding the financial sector vs. the real economy. I would say: the U.S., Ireland and the U.K. have been on a mission to increase the size of their financial sectors in a way that has destabilized each of these countries’ economies. Now the day of reckoning is upon us. My hope is that we can right size finance and get moving on increasing investment in the real economy going forward.

      As for the stock market, it has already hit my bogey i.e. 1998 and 2002 lows. Any downside from here will be entirely due to policy errors lengthening and deepening the downturn. In my view, stocks are undervalued here. That doesn’t mean they can’t go lower still. It will be interesting to see if we are seeing another bear market rally here.

  3. aitrader says

    Thanks Edward. Always nice to read an optimistic view. I hope you are right, but I see history rhyming the “Great Depression” with the “Great War” (WWI->WWII, GDI->…). Lot of ’80’s stuff in the air these days IMO – meaning sub-3,000 at the bottom. Seems unbelievable but in 1929 who would have predicted a high of 382 would bottom three years later at 41? I’m in that, unfortunately pessimistic, camp.

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