When the Tide Turns

Governments are fond of referring to their dumping of cash into the economy as stimulus. There has been a huge amount of cash released into people’s bank accounts, and very little economic growth. How little? About 22 cents of GDP for each dollar of “stimulus” --- showing that governments have depleted their tools. They don’t know what to do. They are now sowing the seeds of a huge price inflation, and they don’t seem to care. Instead, they point to that lack of general price increases during this past year, and they have positioned Japan as the poster child debtor nation.

What appears to have eluded their notice is that the volatility of money is approaching zero --- a symptom of the lack of demand for goods and services. People want to save. Many are afraid to spend. So even though production and productive capacity are shrinking as businesses close down permanently, demand is falling even more, and prices have not escalated to the extent the money supply has. Once people feel confident, they will begin spending. Then see what happens to price levels. So far as Japan being an example, first, the Japanese economy has been stagnating for 30 years. Secondly, they owe that money to themselves, not to foreigners, so their very high debt to GDP ratio is not the problem our lower ratio is.

There is a problem developing. Commercial real estate has high vacancy rates. Many companies have come to see that they don’t really need all that office space. Empty buildings do not have the value of fully occupied ones. Prices of commercial buildings are bound to drop, at least in real terms, if not in nominal terms. I expect many of their owners will be in financial trouble and unable to meet their mortgage payments. This will reduce the value of the mortgages. The difference between the selling price of a mortgage and the contractual cash flow from the mortgage payments determines the effective interest rate. The cheaper a series of payments is to buy, the bigger the spread between cash paid for it and cash to be collected from it, and the higher the effective interest rate.

When mortgages can produce much higher yields than bonds now do, what will happen to bonds? Investors will not be willing to pay as much as they are now. So, bonds should fall in price. Makes sense since the bond market is a bubble waiting for a pin to pop it. I suspect that a deteriorating mortgage market will be the pin. This is a major economic problem. The bond market is much bigger than the stock market, and the value of daily bond trades dwarfs stock trades. Falling bond prices means higher effective interest rates. When interest rates rise, more real estate owners will be caught in a squeeze that will wipe them out and precipitate even greater problems in the mortgage and bond markets. As the value of real estate declines, balance sheets will deteriorate and credit will tighten up.

Of course, central banks may decide to buy the mortgages and bonds, thus monetizing the debt. More inflation. More problems. No, it’s not looking good.

It is time to be liquid (in cash or in investments that can almost instantly be converted into cash). Time to consider Warren Buffett’s expectation of a stock market crash. Stock markets will not take rising interest rates very well. Neither will real estate markets. There could be blood in the streets. It’s time now to mend relationships and build new ones.

Who Pays for Our Record Government Largesse?

The Government of Canada presented its Throne Speech today --- about an hour of trying to buy most people’s votes it seems to me. It was like an extended gift opening on Christmas morning. Something for everyone ….. all bought on credit. You can look up the details.

I agree with the Conservative observation, reflecting the comments of the Premier of Quebec, that the federal government is stepping into Provincial jurisdiction. My observation has been that the Liberals do not pay much attention to the constitutional separation of powers. They seem to think they know how to run people’s lives better than the individuals do, and it is reflected into their forays into health care and education.

I do not agree with the Conservative objection that the country will be saddled with debt that will be borne by future generations. The give-aways are funded by borrowed money, but mainly borrowed from the Bank of Canada. It works something like this. The Government issues a debt instrument to the Bank of Canada in exchange for cash. Cash is a liability of the Bank of Canada. So the Government debits Cash and credits Due to Bank of Canada, while the Bank of Canada debits Government Bonds and credits Cash outstanding (a payable). The Cash in the hands of the Government is liquid, and it gets spent. The entry ends up being debit Deficit and credit Cash. The final result is Government accounts that have a debit Deficit balance and a credit Due to Bank of Canada balance. Debt for the next generation? No. What it does is make the Canadian dollar worth less. It is not the future generations paying for the goodies; it’s the holders of Canadian dollars. But since other countries are essentially doing similar things, the Canadian dollar likely will not lose much ground against most major currencies. Where it will lose ground is in terms of how much of various commodities, goods and services it can buy.

If we get into negative interest rates, which will make it easy to handle such foreign debt as we do have, the velocity of money will increase quickly and we will likely have a major price inflation as people spend, spend, spend. The loss in purchasing power of the Canadian dollar could likely be more than mitigated if the country did away with all income tax at every level and funded government solely through the creation of money, sales tax, and fees for services. I suspect the economy would be vigorous as companies moved here and the production of goods and services increased. The retention of income taxes combined with massive amounts of new money and very low, and even negative, interest rates is likely the road to an inflationary depression.

 

Stock Prices Rising as the Economy Slows?

 

Investors are elated at recent all-time highs in the S&P 500: the covid crash has been resoundingly reversed. Hmmm…..not so fast. Microtek, Facebook, Amazon, Apple, Netflix, and Google between them account for about a third of the S&P 500 because those stocks have been doing very well. They have benefitted from the pandemic --- people sitting at home and buying, subscribing, and purchasing from them and their advertisers. Easy to do when there is so much new cash on the loose. So hard have they moved the S&P 500 that we may as well think of it as the S&P 6. The other 494 stocks as a group have not had the same recovery. About half the stocks that comprise the Dow Jones Industrial Average are tech stocks, so it has done well also. 

I think that eventually, people will wake up to realize that a P/E ratio of 33 for Facebook, 80 for Netflix, and 119 for Amazon may be unwarranted. Yeah, when customers of each of these companies could be numbered only in the millions, it may have made sense to anticipate the kind of growth in earnings that would justify such large P/Es, but once you have half the world’s population as your customers, does it make sense? How much higher can your customer base grow then? Or, maybe you think that existing customers will start spending a lot more. Maybe they will. Or even more likely, maybe they will tighten their belts as the economy contracts. Once government covid subsidies cease and businesses are footing their own payroll burden, watch for huge layoff numbers. It is already happening, even with the subsidies. The disparity between a slowing economy and a rising stock market will disappear as they align for the trip down. At least that is my expectation.

But Prices ARE Rising

My last post almost seems obsolete from the news of the past week. Almost. There I was arguing that prices are not rising because people are not spending despite the flood of cash into the economy, and we get the June retail sales figures. In Canada, up 23% from the month before. With so many retail chains going out of business, I have to wonder who made all those sales. Maybe Walmart and Amazon. 

I notice that larger capital goods are increasing in value: houses, RVs, boats, etc. People are spending money. And look at the stock market --- the U.S. market is trading the all-time highs. That surprises me. Up until not so long ago, the chart was looking a lot like 1929-1930, and I was expecting a crash, but investor liquidity is a lot better now than it was in 1929, plus it is so much easier to trade than it was then. So I guess I shouldn’t be surprised. I think now that my earlier expectation of a deflationary depression that would turn inflationary is off. It appears we may be in an inflationary depression. I’m still betting on the depression. A depression is mainly characterized by a decrease in the production and distribution of goods and services, and that is what has happened. Changing price levels do not alter that fact any more than putting rouge on the cheeks of a corpse can resurrect it. 

We have grown accustomed to seeing interest rates rise in inflationary times. I don’t see that happening this time. Interest rate is a function of money supply and demand. The supply is large. It would take a huge increase in demand to outpace the growth of the supply. Perhaps rising prices of major assets that buyers want to finance will be enough to create that demand, but in order to avoid being bankrupted by higher interest costs on their atrocious debt levels, national governments will inflate the supply of money to outpace the demand for money. At least, that is what I expect. 

If I am right, it sounds like a great time to leverage the purchase of investment assets --- rising prices obtained by using someone else’s money for low cost.  The problem is that doing so would be a huge gamble with liquidity and ability to pay. People get scared in a depression and the demand for assets may suddenly disappear, leaving the borrower with a lot of debt secured by assets that are crashing.

Why Prices are not Rising

There is an article in the July-August number of Foreign Affairs on the magic of easy money. The author, obviously knowledgeable, as writers in the magazine tend to be, discusses the huge expansion of the money supply and expresses perplexity at how it is that prices have not been rising accordingly.  Recently I saw a similar puzzlement expressed in an article found in The Atlantic. Talented financial writers note that we are flooded with money without price inflation. They find it even more remarkable in the absence of increased production of goods and services. You could understand prices not going up if the production was rising just as quickly, but the current case consists of much more money chasing after fewer goods and services. How can that be? We don’t know, they say; it’s a mystery, but it is how it is, and apparently we can print unlimited money without price inflation resulting. 

What they are missing is that the extra money is not chasing goods and services very hard. The velocity of money has slowed way down. People aren’t spending. At least, not quickly. This is a behavior that characterized the Great Depression. The Social Credit Party recognized the congruence between the low velocity of money and depression and tried to use their “funny money” to raise the frequency of economic transactions. The value of their money was programmed to decline by a fixed amount each week. One had to spend it to get rid of it to avoid the erosion.

The drop in the velocity of money is one indicator that we are in a depression. I don’t think that we may be sliding into it; I think we are in the early stages already. It will last for several years, and damage will be high.

I do not want to imply that the velocity of money is an independent phenomenon. It is dependent on individuals making decisions about whether to spend. The question each person has is which do they want more --- the money, or the goods and services? It appears that right now people have become inclined to choose money more readily than they were before the pandemic. I attribute it to their uncertainty about the future.

We might view the velocity of money as nothing more than the velocity of goods as Henry Hazlitt argued --- a function of decreased demand. Decreased demand tends towards economic slowdown: why produce what people don’t want?

My expectation is that once people begin to feel more certain about the future, or at least more certain about the probability of some plausible futures, particularly in regards to a decreased likelihood of outliers they today view with alarm, they will once again be wanting to buy more. And they will be operating with more cash. The M1 money supply has grown with the government having created cash out of credit. The result will be a run-up in prices. The chickens will come home to roost.

My guess is that we are already in a depression (a lengthy and deep slowdown in production) which will tend to be a deflationary depression that will turn into an inflationary depression. People are going to get hurt. And it will last for several years at least.