December 2013 - Richard 'Jerry' Haworth: The Christmas delusion

It never ceases to amaze me how far we can delude ourselves when it is in our self-interest to do so.

We need to look no further than Christmas. As very young children we bought into the delusion completely. The fake snow-prints on the carpet on Christmas day, the thought that yes, a big man with a white beard and a red suit flies all over the world and delivers presents on a sled led by flying reindeer to deserving children. If we were to go back 2000 years and tell the Roman philosophers what we think today they would assume that our minds had been infected with a virus which has rendered it incapable of rational thought!

As we got older and should have known better, we “kinda” knew but we never questioned Santa for the longest time … why? Do you know of one child who had been bad and received no presents? Statistically we should have worked out long before we did that it was a scam because nobody was labelled bad by Santa even though we personally knew the evil ones. Even the scumbags got presents! We clung on the teat of belief because it was in our interest to do so. To avow otherwise would be to risk peer and parental disapproval not to mention the risk of getting no presents!

So too with the current financial system. Credit in the current financial system has been systematically expanded to “gothapotamus“ proportions. The big players are households, banks and governments. Households drew down 10 trillion between 1996 and 2006 in home equity refinancing in the US alone! Governments and banks … I don’t even have to explain.

How could this be possible?

Normally regulations, monetary policy and interest rates combine to deter a-would-be credit bubble. Regulations would normally dampen down animal spirits but a lot of this regulation was repealed pre-2008.  Interest rates would step in as an automatic thermostatic regulator, driven by market forces of supply and demand for money, driving interest rates higher as demand for future money increased. And if all else failed, monetary policy would step in and prick the bubble before it became too big a problem.

Interest rates, the “regulator” between future money (credit) and present money should have reacted long ago to ward off the current credit crisis but starting with Greenspan, the central banks turned monetary policy to the dark side, manipulated interest rates down, thwarting their regulating role in the economy. It’s like changing a car’s speedometer so that the faster you are going, the slower you appear to be going. Response? Hey, press the accelerator harder… and we have. Interest rates have been doing a bit of accelerating on their own … towards zero when they should have been doing the opposite.

The credit bubble is now way too big to contain without serious social upheaval. Central banks have aligned with governments to ensure the credit bubble doesn’t implode carrying the financial system with it. The regulations which are being put back in place are not going to help, leaving only monetary policy and interest rates. QE was/is part of the Fed’s answer: just change the denominator so although you owe the same, there are a lot more dollars around so inflation takes care of it. It automatically converts future money into present money. Simple!

Hang on aren’t they just starting to taper off this activity? Yes, but let’s be clear. It is only a start. That leaves interest rates to do the heavy lifting and they will really help if central banks leave them low enough. Japan is a good example of how to let a credit bubble deflate slowly over 20 years if you keep the cost of credit low enough. As we mentioned before, interest rates regulate the amount of present money versus future money the economy uses at any one point in time. Too high and we will use only present money, too low and we will use predominantly future money. So if central banks let them rise we predict the credit bubble will start to collapse as future money gets too expensive and everyone heads for the exit door.  Our guess is that they cannot raise them significantly without risking everything they are trying so hard to avoid. Thus, in all likelihood we are stuck in the zero bound, the land of mist where ALL investments make sense as you can use future money which only costs pennies to fund. Money for nothing and drinks for free…

The only remaining question for 2014 is … where is inflation?  At the moment the money spigot is directed mainly to the banks, who get money for effectively zero and reinvest in bonds at 3-5%, repeat cycle until solvent. So the money creation is first filling a debt hole but after that ….inflation. That is, if the very fragile shadow banking system in China doesn’t collapse as it seems to be doing as we speak.

All this potential disaster looming behind us because of the delusion that we can use credit infinitely without cost, that central bankers will come in their sleighs led by reindeer called Deregulation, Lax Oversight, Cornucopia, Pollyanna, Ostrich and Cronyism, delivering low interest rates and QE to all humanity good and bad, without cost.

Excuse me Sir, why is that man wearing no clothes?

“Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing ever happened”.
Winston Churchill