Doug Nolan

(Email from reader T.B.) “These various stages of capitalism, or finance, are interesting and descriptive. But I think the progression is rather simply explained as an ongoing perversion of capitalism caused by inflation: credit expansion or any kind of money-supply inflation.

Have you seen Henry Hazlitt's colorful statement about the consequences of inflation? If not, just consider this: “It [Inflation] discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse.” Henry Hazlitt, Economics in One Lesson, page 176

Isn’t this a nearly perfect short description of what is happening to us?”

Yes, it is. Henry Hazlitt (1894-1993) was a brilliant thinker and prolific writer. He was a noted journalist throughout the “Roaring Twenties” and Great Depression periods. Hazlitt learned his economics from some of the masters. He was friends with Benjamin Anderson (“Chase Economic Bulletin” and “Economics and the Public Welfare”). From Wikipedia: “According to Hazlitt, the greatest influence on his writing in economics was the work of Ludwig von Mises, and he is credited with introducing the ideas of the Austrian School of economics to the English-speaking layman.”

As an admirer of Hyman Minsky, I view “Minskian” analysis as the authority on critical aspects of financial evolution and institutional and Capitalistic development. At the same time, when it comes to economic analysis more generally, I am an “Austrian” at heart. Minsky seemed to hesitate when it came to discussing the profound impact finance and financial evolution had on the underlying economic structure. From the standpoint of my analytical framework, this void is filled superbly by Austrian thinking. When it comes to understanding the nature and destructive capacities of inflation, the “Austrians” put the “Keynesians” to shame.

A couple conventional definitions: “Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.” “Inflation is a process of continuously rising prices, or equivalently, of a continuously falling value of money.”

Yet a rise in consumer prices is just one of myriad possible inflationary manifestations. Mises viewed inflation as a general increase in the money supply. Simple enough, except for the layers of complexity inherent to both money and inflation. What comprises this so-called supply of “money”? We’re surely addressing more than just currency, but how much more? Bank reserves? Deposits? How about “repos,” money market funds or perhaps even liquid short-term debt instruments more generally? Then what about highly liquid funds invested in equity and bond instruments? Derivatives?

Mises, viewing monetary inflation in broad terms, wrote of “fiduciary media,” or instruments with the economic functionality of “narrow money”. In our age of globalized digitized/electronic finance, I’ve always taken the view that “money is as money does.” Generally, the broader the definition the better. And we must accept that contemporary “money” is certainly not what it should be; it’s not what we wish it were.

I was introduced to “Austrian” economic thinking back in 1990, when I began my monthly ritual of studying “The Richebacher Letter.” It was love at first reading. Then I had the good fortune to work with the great German economist, Dr. Kurt Richebacher, assisting with his publication from 1996 through 2001 or so. It was an especially rich period for financial and economic analysis – S.E. Asia, Russia, LTCM, “The Committee to Save the World,” “The New Paradigm,” the “tech Bubble,” etc. Contemporary finance – with it’s unfettered “money” and Credit – was wreaking increasing havoc. Central bankers and others seemed to go out of their way to misdiagnose the problem.

From Dr. Richebacher and my own analysis, it became clear that contemporary inflation was really a Credit phenomenon. Expand (inflate) Credit and monitor for consequences. These might include a rise in aggregates of consumer and producer prices - traditional “inflation.” But the creation of new purchasing power also inflated asset prices. “Austrian” analysis becomes even more powerful with the understanding of how Credit inflation feeds through to the real economy. Inflation begets distortions in spending and business investment - and over time exerts increasingly deleterious effects upon the underlying economic structure. Inflation and Bubbles redistribute and destroy wealth. Inflation alters decisions, perceptions and behavior, including the nurturing of subtle mayhem throughout saving and investment, the bedrock of Capitalism. You’d think by now the entire world would have adopted “Austrian” thinking.

Dr. Richebacher argued that of all the various consequences of Credit inflation, the rise in consumer prices was one of the least pernicious. With sufficient determination, policymakers could (Chairman Volcker did) tighten financial conditions and break inflationary processes and psychology. Expect an attentive constituency when it comes to reining in destabilizing CPI.

But how about asset price inflation and Bubbles? Well, there is a powerful proclivity for letting asset prices run. An inflationary bias in asset markets certainly “makes it more profitable to speculate than to produce.” And the larger the speculative Bubble the more powerful the constituencies that arise to demand government involvement, intervention and manipulation to sustain Bubble Dynamics. Misguided policymakers will endorse destabilizing asset inflation as confirmation of sound policies (Greenspan, Bernanke, Draghi, Kuroda…). In one of financial history’s most misconceived policy blunders, central bankers specifically targeted asset inflation as the primary mechanism for system reflation.

Let there be no doubt, Credit Bubbles are an inflationary phenomenon. Having badly mismanaged domestic Credit, the U.S. proceeded to export asset inflation and Credit Bubbles to the entire world. And as the global Credit inflation aged, broadened and became deeply entrenched, the consequences evolved. Limitless cheap finance on a global basis ensured a historic investment boom and resulting overcapacity in just about everything. Meanwhile, the myth persisted that central bankers were in control of a general price level. As such, monetary stimulus had to be ratcheted up to counteract downward price pressures and insufficient aggregate demand. With the protracted inflationary boom having reached the point of acute financial and economic fragility, desperate global central bankers embarked on unprecedented “money” printing that only exacerbated asset Bubbles and speculative excess.

It was the evolution to securitization and market-based finance that fundamentally – and fatefully - changed inflationary dynamics. For one, the tantalizing New Age Credit apparatus was inherently unstable. This ensured increasing government meddling. Government guarantees and backstops further incentivized speculation, exacerbating speculative leveraging and Bubbles Dynamics. Faltering Bubble mayhem then fostered QE, where central bankers intervened directly in the marketplace place with massive buy programs. Central bankers then became hostage to unwieldy global Bubbles dependent upon ongoing massive monetary stimulus.

Inflation Dynamics have created a world of record high securities prices, including $13.4 TN (per FT) of negative-yielding government bonds. The most hopelessly indebted governments in the world now borrow at a cost of about nothing. Negative yields in Japan. Italian 10-year yields ended the week at a record low 1.04%. In blow-off dynamics that rival Internet stocks and subprime CDOs, “money” is flooding into bond ETFs. Meanwhile, U.S. stock prices are at all-time highs, with real estate prices essentially back to highs.

August 12 – Financial times (Robin Wigglesworth and Eric Platt): “The value of negative-yielding bonds swelled to $13.4tn this week, as negative interest rates and central bank bond buying ripple through the debt market. The universe of sub-zero yielding debt — primarily government bonds in Europe and Japan but also a mounting number of highly-rated corporate bonds — has grown from $13.1tn last week… ‘It’s surreal,’ said Gregory Peters, senior investment officer at Prudential Fixed Income. ‘It’s clear that central banks are dominating markets. There’s a race to the bottom. Central banks are the main drivers of this, it’s not fundamental.’”
August 12 – Financial Times (Joe Rennison and Eric Platt): “Investors have poured more money into US fixed income exchange traded funds so far this year than for the whole of 2015, as the hunt for returns intensifies with nearly $13tn of global bond yields trades below zero. US fixed income ETFs have attracted more than $60bn of money this year — outstripping 2015, when the funds lured just under this year’s current total, according to… Deutsche Bank. International investors seeking fixed rates of return via bonds are targeting the higher yields on US government and corporate debt via fixed income ETFs, which track bonds and trade like a stock price on an exchange… Large bond ETFs like the iShares Core US aggregate bond fund, which gives exposure to US investment grade debt, have outstripped inflows to larger equity ETFs.”
This week’s tiny move in the S&P500 masked what was ongoing global market instability. It appears short squeeze dynamics remain in force, although they now shift around the globe and between markets. Global financial stocks rallied sharply this week. Hong Kong’s Hang Seng Financials surged 5.3%. Japan’s TOPIX Banks Stock Index jumped 3.9% (Nikkei 225 up 4.1%). The STOXX Europe 600 Bank Index rose 3.2%. Italian Banks surged 4.0%. Overall, European equities were strong. Germany’s DAX surged 3.3%, with major indices up about 2% in France, Spain and Italy. EM markets were on a tear. Mexican equities jumped 2.5%, with Turkish stocks up 2.8% and the Shanghai Composite 2.5% higher. The Mexican peso surged 2.6%.

It’s ironic. As market participants and global central bankers over recent decades fretted the prospect of deflation, global debt and asset markets experienced history’s greatest inflationary Bubble. It’s my view that global markets are these days dominated by a historic dislocation in debt trading. There are hundreds of Trillions of interest-rate derivatives outstanding. And global bond yields have done this year what no one thought possible. As was the case with previous derivative-related melt-ups (i.e. mortgages 1993, SE Asia 1996, Nasdaq 1999), these types of dislocations foment extraordinary underlying leverage (i.e. levered bond holdings as hedges against derivative exposures).

This leveraging creates marketplace liquidity, while spurring self-reinforcing short-covering and speculation. These kinds of speculative blow-offs also tend to take on a life of their own. 

The squeeze that propelled U.S. stock indices to record highs has now fully engulfed corporate Credit and EM more generally. A couple of Friday evening FT headlines make the point: “Record-Breaking US Stocks are a Sideshow Next to Bond Bonanza” and “Emerging Market Monetary Conditions Ease Dramatically”.
It is not hyperbole to posit that global securities markets are in the midst of a historic short squeeze and the greatest ever market dislocation. And it’s not unreasonable to suggest that this is a sadly fitting climax to the world’s most spectacular inflationary Bubble.

Yet through the façade of unprecedented perceived global wealth, one can begin to more clearly identify the the Scourge of Inflationism: “It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls.”

It’s been akin to a wreaking ball. We’ve seen the general population unknowingly surrender wealth to Inflationism. In the face of so-called disinflation, millions have suffered at the hand of inflating costs for housing, health care, tuition and insurance, to name a few. We’ve seen these serial booms and busts take a terrible toll on many workers, families and communities. We witnessed many lose much of their retirements – and faith in the markets - in two major stock market busts. Millions lost much of their life’s savings during the collapse of the mortgage finance Bubble. Millions of students have taken on tremendous loads of debt to finance higher education and vocational training. Millions have been lured by (years of) low monthly payments into purchasing homes, automobiles, vacation properties, recreation vehicles, etc. that they cannot afford.

Inflationism has seen real wages for much of the workforce stagnate or worse over the past decade. Inflationism and his accomplice malinvestment are the culprits behind pathetic productivity trends and declining living standards. Worse yet, Inflationism and his many cohorts are fomenting disturbing social, political and geopolitical turmoil. And reminiscent of the Weimar hyperinflation, central bankers somehow remain oblivious that their operations are of primary responsibility. If people don’t these days trust central bankers, politicians, Wall Street, and governments and institutions more generally, just wait until the Bubble bursts.

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