Deflationary fiscal versus reflationary monetary: who wins?
Japan has joined the crowd and started an even more aggressive asset purchase program as the Japanese economy weakens. Meanwhile, serious tax hikes are poised to go into effect very soon. Japan plans to cut state spending because the country could run out of money in a month as deficit hawks are on the warpath. This juxtaposition between reflationary monetary policy and deflationary fiscal policy is evident everywhere in the developed economies.
Right now, every major central bank is supporting domestic growth with very aggressive monetary and currency policy. In Europe, the ECB is doing “whatever it takes” by offering unlimited liquidity in support of periphery debt. In Britain, the Bank of England has repeatedly added liquidity in the form of government debt purchases despite above-target inflation rates. In Japan, the Bank of Japan is still in the midst of a decade long easing campaign as the economy fights deflation. In Switzerland, the Swiss National Bank has renewed its pledge to support the economy by pegging an upper bound on the Swiss France – Euro exchange rate, with unlimited intervention if necessary. This is the most aggressive monetary blitz the world has ever seen.
But of course, all of these countries are not seeing serious fiscal accommodation. The opposite is true as countries try to reduce debt and deficits. Europe is acting in the most contractionary fashion, with the periphery deep into depression. Britain has double-dipped from its austerity drive. And I suspect the US and Japan will also suffer greatly as they also move into deficit hawk mode. Now all of this was predictable. As I wrote three years ago:
- Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
- Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
- As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
- Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
- From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.
So we are seeing this prediction pan out – not just in the US, but globally. Even in countries like China, the policy path is less fiscal easing and more monetary easing to combat this second synchronized global slowing. The question is what this juxtaposition means for the economy and investors. I believe it means that the secular bear market that began in 1998 with the Asian Crisis will continue for a few more years yet. When the scale of fiscal contraction we are seeing plans for actually hits the developed economies, the global economy will have serious convulsions. And I do not think policy makers will act quickly enough to overcome these to prevent a hard landing. I know that Ray Dalio is on record taking the bullish side of this question, suggesting he believes policy will be accommodative enough. But I think he underestimates the depth of ideological opposition to large deficit spending because I do not believe monetary policy alone can save the day.
Bottom line: fiscal wins – and if fiscal stays non-accomodative, that is bearish.