The lessons of the crisis of 40 years ago
By Andrew Lees, UBS
With the 40 year anniversary of Nixon defaulting on the US dollar commitment all over the press, and his policy of printing money to get out of the mess, I thought it was worth a quick reminder that, far from supporting economic growth like Nixon thought, the printing presses eroded growth. To begin with equities rallied heavily, up 30% from the abandonment of Bretton Woods until their highs in January 1973, but then started to fall in both nominal and real terms. In fact the S&P did not return to its January 1973 high in nominal terms until July 1980 (chart 1) and in real terms, not until 1987 just before the crash. It didn’t return to its 1960’s highs until early into the 1990’s – (chart 2). In real terms the S&P didn’t bottom until July 1982, 2 1/4 years after inflation had peaked.
So what? The US was suffering from a disinflationary shock due to the constraints that gold standard was imposing on it. Inflation had fallen from 6% plus in 1970 to just over 2% by the end of 1971/start of 1972 hence Nixon’s printing money exercise. To begin with the monetisation supported asset prices, both pushing equities aggressively higher and supporting lower Treasury yields, but eventually the monetisation became self defeating. The monetisation simply pushed commodity prices higher, offsetting the benefits of cheap money. Effectively the return per unit of additional monetisation collapsed – sound familiar?
A lot of people have said that equities should be supported by the recent fall in oil price, but of course that is nonsense as the oil price fall is simply due to reduced end demand; it is not because of the sudden productivity gain that has made more oil available at a lower price. Any return to monetisation therefore is likely to push oil prices back to their highs, choking off any fledgling recovery. Just as in the 1970’s therefore, the initial boost to equities (both nominal, but especially real) quickly faded. Monetisation instead shifted from asset price inflation to real inflation. Chart 3 overlays the M3 money supply growth (red line) against CPI and Treasury yields. In that first phase of monetisation mentioned above when equities rallied heavily, inflation and 10 year Treasury yields declined, but once the monetisation started having this self-defeating effect, equities slumped in real terms and bond yields started to soar.
I would suggest that we must be nearing this watershed whereby inflation shifts from asset prices to real prices with obvious consequences. This is when commodity prices are likely to start accelerating upwards against equity prices – (see chart 4 for gold vs S&P which as you can see went exponential in the 1970’s when this watershed had happened) – as equities must de-rate. Unfortunately monetisation and Keynesian stimulus that people see as the solution now becomes the problem as the misallocation of capital has become simply too extreme.
Ed,
Given current slack in real resources (labor and cap util), how do you see this inflation shift occurring? Also asset prices have not increased terribly in nominal terms since 2000 let alone in real terms… Gold?
So if not with a strong jolt to Demand via Keynesian stim (major jobs program, major debt write down, etc.) how do you see us coming out of this downward spiral?
This is Andy Lees writing here. But I can take a crack at answering. I really don’t see inflation happening except via the commodities or currency depreciation channels and those don’t get embedded unless it translates into wage gains. So to me the major trend is debt deflationary until we see these more transitory ‘one-off’ changes in the price level are transmitted through to wages. Rising prices without rising wages makes the real burden of debt that much greater to a wage earner and thus leads to lower consumption demand, debt distress, and default. That’s debt deflation.
“I would suggest that we must be nearing this watershed whereby inflation shifts from asset prices to real prices with obvious consequences. This is when commodity prices are likely to start accelerating upwards against equity prices – (see chart 4 for gold vs S&P which as you can see went exponential in the 1970’s when this watershed had happened) – as equities must de-rate.”
Ok, there are some conceptual flaws IMO with this.
1) The M3 rise was driven by credit expansion, that’s what got us here eventually. It’s the credit system that drives most monetary expansion. With “peak debt” there is simply no space for ‘monetisation’, if anything, the central banks what are doing is closing the gaps left by credit destruction and deleveraging. Unless they go by dropping money in helicopters (which they haven’t yet).
2) This can be seen because acceleration of M2/M3 has a tight correlation with CPI. This still applies today and has done since forever. Credit expansion soared a bit after the short recession in 2009 (which drove prices down), that’s what has caused the aggregate price increases, because M3 was rising again.
3) But it has topped again, M3 is again decelerating and we can see falling CPI again and consumption. There will be recession again and oil prices will fall (however, maybe with higher lows than the last time in 2009, probably).
The fatal flaw is that of ‘monetisation’, without increasing spending (that’s what happened to some point in the last decades, along with debt expansion, increased spending) there can’t be monetisation, and what the FED does is basically stop the random fires of falling asset prices. The QE2 did drive prices up not because of the QE2, but because there was also the effects of stimulus propping up the economy fundamentally. Without this QE2 wouldn’t have done nothing other that hold the existing money stock constant or ease the fall of stocks.
What mumbo jumbo! How about this instead: Surplus developing countries are recycling their dollar (other currency) holdings in the US (and other developed countries) to fuel their continued growth. To do so, they are lending to the American (developed country) consumers and the US (developed country) governments. That is what led to the crisis, by creating over-consumption in developed countries and massive misallocation of capital thanks to an out-of-control financial system. But now what? The developed countries consumers are deleveraging, and the developed countries governments are entering a cycle of austerity (maybe), because letting the debt grow out of control is just unsustainable in the long run. Consequence: drop in demand from the developed countries and slow growth there, leading to an inevitable slow down of the developing countries that have adopted export strategies to develop. Conclusion: world deflation, not inflation. Fiat currencies have zip to do with this story, but massive structural trade imbalances do.
I cannot see asset prices staying this high for long. The S&P and Dow are hugely overvalued and I see big falls in stocks over the next decade. As the cost cutting will not produce the profits that they hope for they could slide for some time. Though company share buybacks will give executives their bonuses until the cash piles are exhausted, and might slow the slide for stocks for a while. This will be an era of stock picking.
Real estate will probably fall to levels not seen for decades as the slump resumes. This will be global. It could lead to bank failures globally. Inflation might climb but if it does then expect stagnant real estate prices as they reduce the need for nominal price falls. Though twenty years of stagnation will erode real estate as an investment.
While QE might be out of the question the only thing stopping Keynesian stimulus is political will. That will not happen till governments fear for their own survival. So China will probably resume stimulus as the global economy slows. India will definitely have problems. Politically India is about to transition but to what will determine the economy for years.
While the big economies might go into depression caused by austerity, the global economy will probably tick along steadily. The slump will continue as long as debts are still not cleared. Bankruptcies will accelerate the return to recovery but that is being resisted at all costs.
I think Rick Perry’s statements about the Fed and Bernanke have a very ‘Zeitgeist’ quality to them. He captured the essence of the political constraints on the Fed that I keep saying are so important to the Fed’s present monetary policy,
Well I do think that having ultra low rates that slow up the de-leveraging that is needed will just drag this out. So in effect enabling the theft of income from the prudent, and slowing the clear out of bad debts.
What Perry was hoping to do was stop any QE before the election so that the economy is as bad as possible. Nothing to do with Zeitgeist.