Crunch Time For Credit

Nigel Aitkins - Mon 28 Feb, 2005

"...Inflation, deflation, stagflation...just where is the global economy now headed - and what next for the illusion of prosperity in Britain today? Only the US Fed has the answer!..."

Why are the financial markets currently sending out conflicting messages? The low yields on bonds, for instance, appear to signal deflation. The soaring commodities markets, on the other hand, might be interpreted as a harbinger of inflation.

In my view, the answer to this question lies in the nature of the credit bubble; a bubble that has unwittingly been inflated by the US Federal Reserve - which considers its prime purpose the avoidance of either inflation or deflation. In their different ways, both the bond and commodities markets are indicating that the Fed's attempt to stabilise prices may be about to end in failure.

To the vast majority, especially to those who lived through the 1970s era of intermittent economic growth and surging inflation, it might seem indisputable that the pursuit of stable prices should be the prime aim of monetary policy. Inflation, after all, confuses price signals, makes long-term planning difficult, and undermines the position of those whose fortunes are dependent on fixed contracts. Deflation is even worse; it increases the real value of outstanding debt, undermines the solvency of financial institutions and depresses expectations of both households and companies.

If only prices can be kept stable, says the common chorus, there is nothing to worry about. But this view would be correct in a static economy with no growth. Introduce changes to productivity, however, and the picture changes dramatically.

An increase in productivity implies that output has increased for the same amount of input. Everything else being equal, we would expect prices to fall when productivity rises. So what happens when the authorities intervene to prevent prices from falling in response to productivity improvements?

The American economist George Selgin, in an intriguing paper, 'Less than Zero' (Institute of Economic Affairs, 1997), provides a simple model to answer this question. Selgin suggests that during productivity revolutions the aggregate supply curve shifts to the right. When this happens, the authorities can prevent prices from falling by boosting aggregate demand - i.e. by forcing the demand curve out to the right.

This increase in aggregate demand can be achieved by expanding the money supply, and by reducing interest rates to a lower level than would otherwise have been the case. The prime beneficiaries of this policy of price stabilisation are companies whose input costs are reduced by productivity improvements and whose output prices are sustained by monetary policy. As a result, corporate profits rise. Low inflation, a loose monetary policy and mounting corporate profits provide the ideal conditions for a bull market in equities and other assets.

The main losers of the price stabilisation policy are working people who are deprived of the benefits of increasing productivity. After all, when prices are prevented from falling, real incomes are prevented from rising. However, cheap and plentiful credit in an era of low inflation can make good the shortfall in household income.

Now let us consider what has happened in the United States economy over the past decade. The two key features of the last decade has been the surging growth in productivity, a consequence of the technology revolution, and the increasing integration of China and other emerging market countries into the global economy. As a result of these developments, the cost of both information technology and traded goods have sunk steadily in recent years. The average price level, however, has not declined.

In a speech on 3 January 2004, Alan Greenspan suggested that “as a consequence of the improving trend in structural productivity growth that was apparent from 1995 forward, we at the Fed were able to be much more accommodative to the rise in economic growth than our past experience would have deemed prudent.”

But an alternative interpretation would suggest that over the past decade, average prices have been sustained by strong money supply growth. In order to achieve a stable average price index, the deflation of traded goods and information technology prices has been offset by a corresponding inflation in the prices of US services and non-traded goods.

Not only have workers been deprived of gains to real incomes that would otherwise have resulted from falling prices, but wage growth has lagged productivity gains over the past decade. Corporate profits, on the other hand, climbed to record levels relative to GDP. In the absence of real wage growth, aggregate demand has been sustained by rising household debt, which has climbed by 250% over the past decade. During the same period, nominal GDP has increased by just 90%.  

In short, the experience of the United States in recent years appears to conform to Selgin's theoretical description of what happens when the authorities attempt to prevent prices from falling during a productivity revolution.

Is this boost to demand - provided by monetary policy in the face of a supply shock - to be considered sustainable? The answer is yes, providing two conditions are met.

First, credit must continue expanding at its new higher level and must not be allowed to fall back. Secondly, interest rates must be allowed over time to return to their level before the monetary authorities intervened to stabilise prices.

What happens if interest rates are not allowed to rise? Selgin tells me that: "if the authorities try to combat the tendency of interest rates to return to their 'natural' levels by further boosting the money supply, prices must rise; the more the authorities pursue the same policy, the more prices must rise."

In my view, both conditions are too much to demand of the US economy after a decade-long credit boom. As we have seen, in recent years aggregate demand has been sustained by credit expanding faster than incomes. If the disparity between income and credit growth were to be maintained for long, the US household sector would face an overwhelming debt burden. Secondly, anecdotal evidence suggests that households, corporations and other financial players have taken on more debt in the expectation of permanently lower interest rates. Despite several recent rate increases since the middle of 2004, real interest rates in the US remain negative (and one standard-deviation below the norm, according to Goldman Sachs).

If US interest rates were to return to their 'natural' level, we can guess what might happen to the prices of houses, junk bonds, and many other risky assets.

This analysis suggests two potential endings to the credit bubble. If credit ceases expanding and aggregate demand begins to sink, either because of a credit crunch or because of falling asset prices, then deflation is the most likely outcome. This is what happened in the aftermath of the credit bubbles of the US in the 1920s and, less severely, of Japan in the 1980s.

However, if the authorities keep interest rates too low, then surging inflation, or stagflation, is more probable. This is what happened after the Federal Reserve maintained negative interest rates in the aftermath of the last great US productivity boom of the 1960s.

Since the eventual outcome depends on the future course of monetary policy, we cannot tell at present whether the future will bring either deflation or stagflation. What we do know is that either scenario would be bad news for equities. It took 25 years and 17 years respectively for the Dow Jones to regain its peaks of 1929 and 1966.

The era of Fed-created price stability may be drawing to a close. That, at least, is what the bond and commodities markets are telling us. Intelligent investors should prepare themselves for the challenging times ahead.


Edward Chancellor
for the Daily Reckoning