On secular bear markets and more on the primacy of monetary policy
Just after I posted today, I ran across two posts from March that I wrote on government and private debt that are related to theme of today’s commentary on potential housing bubbles in Germany and Sweden. I am writing here to more tightly couple the primacy of monetary policy and equity market multiple expansion or contraction.
The gist of today’s commentary was that housing bubbles in Europe are the outgrowth of the same policies that led to housing bubbles in the periphery and the U.S. last decade. The over-reliance on monetary policy as a policy tool is central to why we are seeing these bubbles. Here’s the context.
Back in the 1990s when the Japanese economy collapsed after its epic bubble, everyone was devising different schemes to help Japan escape from the incipient debt deflationary trap. Richard Werner, an economist at Fleming Securities, came up with a scheme which he dubbed quantitative easing for how to escape the debt deflationary trap. And although the term has caught on, Werner insists that the QE as practised is ineffective compared to the type of QE that he recommended in 1995. I was fortunate enough to get a link to the paper from someone on my Twitter feed. And so I want to make a few comments about Werner’s proposal in the context of today’s debt deflation and the accompanying secular bear market.
The first thing to notice is how Werner disparages fiscal policy but advises an aggressive, even hyper-aggressive, monetary policy.
“It would take a very long time for the private sector on its own to escape from this downward deflationary spiral, and therefore government intervention is indispensable. But whether the policies adopted by the government are beneficial or not depends on whether they increase the purchasing power in the entire economy. This most crucial point must be made clear, otherwise government policies aimed at boosting the economy will not prove helpful, and Keynesian fiscal policies will achieve nothing.
Pure fiscal policy withdraws money from the private sector, as it is funded either through bond issuance or via increased taxes. Pure fiscal policy does not increase overall purchasing power, but merely transfers existing purchasing power from one part of the economy to another. This is the reason why the large fiscal stimulation packages over the past two years have failed to stimulate the economy significantly. the same reason, the BoJ’s policies, which have focused on interest rates, have not produced sufficient results.
Due to deflation, real interest rates will rise. Simply reducing nominal interest rates will be ineffective. Even serial reductions in the official discount rate will not be able to stimulate the economy.
In such a situation the single most vital policy is for the government to act and focus on increasing total purchasing power in the economy. Put simply, the central bank can print money and purchase assets in the markets from participants beyond the banking system. It can intervene in the foreign exchange markets, without sterilising the monetary expansion. In these wa ys the central bank can inject new purchasing power in the economy. If this were done, then the overall amount of purchasing power in the economy would increase and commercial transactions throughout business would be revived. If such policies were taken, within 6 months we could see a marked improvement in business conditions.
The BoJ’s past tight monetary policies have become the target of criticism, but it can also be said that its policies have started a historic structural transformation. At this stage, where Japan’s structural reform has reached a cross-roads, it is precisely by now changing to a policy focused on quantitative easing that the Bank of Japan can redeem its prior tight monetary policy stance.” [emphasis in original]
What Werner is saying is that fiscal policy doesn’t work, and that even traditional interest-rate focused monetary policy doesn’t work in a debt deflation. Therefore, he opines, quantitative easing needs to come into play. This is textbook monetarism.
Here’s the problem: There is no transmission mechanism. The central bank can print all the money it wants. That’s not going to get people to take on more debt when they are already overly-indebted.
The central bank is most definitely not giving people new purchasing power either. It is simply trying to artificially boost asset prices by lowering discount rates and increasing risk appetite. This does not lead to permanent increases in wealth; after all no real resources are created by financial engineering. The central bank merely reallocates the distribution of real resource ownership within the private sector.
I wrote in a March post on government debt that “government economic policy should be geared toward helping to maximize the efficient long-term use of real resources. The goal has to be on the real resources.” My conclusion in a March post on private debt was that we “are likely to continue to see loss socialization, bailouts and deficit fetishism for some time to come. And the result will be low growth and susceptibility to recession until the private debt levels have been reduced to less systemically challenging levels. This is the backdrop for a secular bear market, not a secular bull market. So I do expect multiples to expand now during the cyclical upturn as they have done. But I also expect the next downturn to have an unusually severe negative impact on multiples, bringing stock prices down by a considerable amount.”
We are in a cyclical expansion right now. And unless this expansion is creating wealth through the increase of real productive resources, we are eventually going to perceive the uptick in growth and asset prices as phantom additions. What I am saying here is that the potential bubbles we see in Germany and Sweden are signs that the policy mix has engendered malinvestment such that resources are already being misallocated in a way that will not lead to the longer-term increase of real productive resources. If indeed, the economic recovery is predicated on these dodgy foundations, then the give back will be large and the secular bear market that started when the tech bubble burst will resume in earnest when earnings plummet at the end of the business cycle. The over-reliance on monetary policy will be directly responsible for the carnage.
I am also willing to believe in this recovery as a real recovery but we will need to see what happens from peak to trough first.
Update: Looking into some of what Werner has to say elsewhere, I think he would vehemently dispute the monetarist label I have given his QE solution. See here at Wikipedia for example. A journalist showed me the following link to a 2012 paper Werner did that acknowledges the primacy of bank-created money in the credit system. The paper is very dense but it displays an understanding of the credit process that is more complex than a textbook monetarist approach. Nonetheless, his 1995 piece on the Japanese problem is very heavy on monetary policy and dismissive of fiscal policy in a way that smacks of monetarism.
My view here is that the Japanese crisis and the current one is a private debt problem. Therefore the solution is to permanently increase the nominal income and wages of private agents or to permanently decrease their relative debt aggregates. What we want to see is private debt levels that are low enough so as not to engender a widespread economy-wide round of deleveraging. And one can attack this by making debt in economic sectors experiencing debt deflation sustainable for the income thrown off by the assets the debt creates. This means writedowns, increased wages, inflation, and economic growth will all work to eliminate the problem.