Prozac-craving markets

Image by Salvatore Vuono

In my view, there is no escaping the fact that things are not getting better. If anything, they are getting worse. Following the large swings in financial markets this past week and reading the commentary in the press, it strikes me that there is still a surprisingly strong belief out there that our fate is in the hands of the policymakers, who presumably still have it in their power to make things better for the economy. How can they do this?  Well, expect nothing new here: Mainly by the time-worn strategy of lowering official interest rates again – where this is still possible – or by injecting more fiat money into the system through fresh loans to the banking industry or by yet another round of debt monetization. Talk about the laws of diminishing returns!

The only reason I could find in the finance commentary for why equity markets rallied last week was that the prospect of another dose of cheap money had appeared on the horizon. A week ago, on June 1, a rather dreadful employment report in the US – which, like all statistics, should not be taken at face value but treated with the utmost caution – had poured cold water over the notion of a self-sustaining recovery and instantly seemed to pull the rug from under the equity market. Then the usual pattern unfolded. Wait a minute, the markets seemed to say collectively, a weakening labour market in the US is just what is needed to tip Ben Bernanke over the edge and cause him to engage in another round of ‘quantitative easing’. And that was the basis for the rebound in global equities this week.

Please deceive me!

QE is, according to Bernanke’s own explanation, a policy tool that aims to improve the public’s sentiment and to cajole it into additional economic activity via the targeted manipulation of asset prices. For example, high equity markets usually make the economy appear healthy and are thus bound to make businessmen and women more optimistic. In a free market, low interest rates usually signal the availability of a large pool of voluntary savings that desires to be invested and to be translated into productive assets. But in the absence of a healthy economy that lifts equity markets, and in the absence of savings that can be used for true capital formation, a mirage of health and savings and capital can still be generated with the help of the printing press. QE, again by Bernanke’s own admission, is a giant placebo: It is not true medication as it evidently does not address the economy’s fundamental ills, but a tool for nationwide mass hypnosis. It is a kind-of anti-depressant, a kind of monetary Prozac.

Well, these are the policies that have been run on an unprecedented scale for a number of years now. To say they have been without effect would be wrong. As I see it, they have had numerous effects. But they certainly have not ended the crisis. What were the effects then?

Monetary accommodation has manufactured the occasional rally in ‘risk assets’ but these have usually been short-lived. After all, there still exists an unbridgeable gulf between an artificial rally created with injections of new fiat money and a re-pricing of productive assets in response to positive fundamentals. Additional effects were the following: the policy has allowed many banks to stay in business and thus hindered a recalibration of the banking industry; the policy sabotaged the redirection of scarce capital from the bubble-industries that had benefited from the credit boom toward new, productive and more sustainable employment in other sectors; it sustained an over-stretched financial industry a tad longer; it allowed governments to run big deficits and accumulate more debt; and by mis-pricing the cost of capital further it has most certainly directed entrepreneurs into areas that will prove to be disaster zones once the flow of cheap money slows.

If you believe – as I do – that large-scale mis-allocation of resources and substantial mis-pricing of assets, both the result of the extended credit boom that popped in 2007, are at the core of the present malaise then you may agree with me that monetary accommodation (QE and all that sort) will not only make the economy not better, it actively hinders the healing process. And it does so by providing a temporary placebo that seems to quickly lose its effectiveness.

Why so optimistic?

So, I ask myself, how can the prospect of another ECB rate cut or QE3 or QE4 from the Fed really make those hardened investment professionals more optimistic? I wonder, is their ostentatious enthusiasm for these deceptions genuine or is it some cynical ploy to offload ‘risk assets’ into the next artificial and short-lived rally and to then hunker down in anticipation of the unavoidable collapse? Is the apparently unfailing belief in the ultimate power of money-printing and ‘monetary stimulus’ not a sign of desperation rather than a rational assessment of a very messy situation?

Maybe they believe, with Paul Krugman, who appears very genuine in his pronouncements, that the next $2 trillion of new money from the Fed will achieve what the last $2 trillion obviously didn’t, or that the next 30% in government debt will do what the previous 30% didn’t, that is, cut through some imaginary, collective psychological knot and allow us all to be more productive. I don’t believe it but I am puzzled by the explanations and arguments that I read.

In particular, I am surprised by how much observers appear to be willing to twist the notion of the capitalist economy to be able to squeeze a modicum of optimism out of the prospect of even more blatant government intervention. I wonder if there is not some self-deception involved. Here is an interesting quote from this morning’s Financial Times, explaining why China’s surprise rate cut yesterday was a reason for optimism:

“‘We believe that the rate cut will be effective in meeting the short-term objective of getting credit and the economy moving,’ said Mark Williams at Capital Economics. ‘There could be no stronger signal that policy makers are focused on growth. That alone should prompt more activity at the large state-owned sector.’”

Well, hooray for that!

I do not know Mr. Williams and I have no intention of criticizing him personally. I only quote him here because I think that his brief statement is an excellent representation of what must be the economic belief-system of those who manage to derive optimism from these policy announcements.

Do people really believe that the ingredients for a well-functioning economy and a sustainable recovery are credit expansion based on printed money rather than savings, are interest rates that reflect the priorities of policymakers rather than the interaction of savers and borrowers on markets, and that more activity from a large state-owned sector that readily transmits the wishes of policy-makers is a good basis for a prosperous economy?

Again, I am not even implying that this is Mr. William’s view. It may well be that all he was trying to say was that these measures were bound to boost GDP statistics in the short term. And I agree with that. Chances are we will get a growth blip in China as a result. But so what? Big deal. This is no reason for real optimism, in my view. Does it mean that we have turned the corner in this crisis? I don’t think so. In fact, every component of this quote makes me bearish on China’s medium-term outlook: easy money, ‘get credit moving’, large state-owned sector. What is not to dislike about this toxic mix?

Since the financial crisis started China has expanded its money supply in the M2 definition by about 90%, or more than 13% p.a., something in which it was greatly assisted by an obedient state-controlled banking sector that understood that the policy makers were focused on growth. Such monetary stimulus is always good for one thing: blow a few bubbles. On many measures China’s real estate boom has gone further than the one in the US prior to 2006, and is more similar to the one in Japan in the 1980s. And how well that ended!

I am no expert on China but all I am saying is this: what precisely should I get optimistic for? Cheap money for the large state-owned sector?

No safe havens, sorry.

We are in a proper mess and I am sorry to say there are no painless exits, there are no cheap assets and there are no safe havens. Gold remains my favourite asset because it is something that has maintained wealth for a long time and it cannot be printed by Bernanke and not issued en masse by Geithner.

Yet, as I explained last week in detail, gold is not cheap. I believe its price already reflects the expectation that the Fed will print vast amounts of additional dollars and that an inflationary endgame to the global economic malady has a high probability. I don’t call it a bubble because so many things are actually pointing in the direction of such an outcome. Yet, any reluctance on the part of Bernanke to use the printing press more aggressively – and I believe he has good reasons to be cautious – is likely to depress the premium in the gold price over gold’s long run PPP. It is not an easy trade.

I think last week’s volatile price action in gold supports this interpretation. When the poor labour report came out on June 1, gold enjoyed its biggest one-day rally in more than 3 years, evidently in expectation of more central bank activism. But with Bernanke appearing reluctant in his testimony on Wednesday to prepare markets for another round of debt monetization, gold retreated quite sharply.

Gold is the eternal alternative to state fiat money. It is not surprising that it has now become predominantly a play on the probability of the Fed ultimately pressing the monetary nuclear button. But any gains in the so-called ‘risk assets’, such as equities, now seem to be driven not by any fundamentally justified optimism on the real economy but, too, by the prospect of another dose of monetary Prozac.

I am not sure if Warren Buffett and Charlie Munger of Berkshire Hathaway appreciate the irony here. But the ‘unproductive and uncivilised’ asset ‘gold’ that they so detest, and the ‘productive and civilised’ assets ‘equities and farm land’ that they so prefer, are presently driven by the same forces. After so much policy intervention nobody knows what the ‘real’ prices of these assets should be anyway but it seems to me that without the prospect of ongoing and constant fiat money debasement nobody can justify the nominal prices of any of them.

In the meantime, the debasement of paper money continues.