If asked what the most important thing I have learned in 25 years in the finance business it would be this: almost all unforeseen market problems could have been “divined” if one had studied the ASSUMPTIONS of the current zeitgeist. Assumptions are where the rubber should meet the road in our mental constructs but all too often they don’t. Examples include property prices always go up, property prices are not correlated geographically, volatility is a proxy for risk, and diversification is a free lunch. This little insight seems very pertinent to today’s markets. Why?
The current assumptions underlying this market are a lot fewer and therefore more consequential. They are the only lynchpins holding the economy and the markets together. What are they? Firstly, that government borrowing in order to spend and re-create missing demand is desirable and secondly, that central banks will monetise enough to keep the banks and governments solvent and will keep the economy moving ahead at least in NOMINAL terms. At best they will create a little inflation, at worst they will create a “slack tide” between the forces of inflation and deflation.
What are the assumptions inherent in this last assumption? Firstly, they will not withdraw for ANY reason and, secondly, they will not do TOO MUCH. The risk of withdrawal is probably Europe’s for the taking. Japan, China and the US have the means, authority and the need to keep monetising. Europe is a bit more unclear in spite of what Draghi has said. Pure bureaucracy alone could undo any attempts to monetise the European debt at a fast enough rate to prevent a deflationary collapse. If Europe were to enter a deflationary spiral due to failure to keep ahead of the crisis, social unrest or any number of other black swans, being roughly 15 trillion USD in GDP, world growth would probably subsequently stall and a global deflationary spiral would probably ensue.
In fact there is a worse deflationary scenario, a deflationary collapse in the REAL economy accompanied by increased attempts to goose up the economy by creating money out of fresh air i.e. FINANCIAL inflation. Combined they give you the worse of all ‘flations – stagflation - what you have goes down and what you need goes up in price.
Can central banks do too much?
Again we look at the assumptions. Central banks assume they can contain inflation once they have created it by withdrawing liquidity and reserves from the financial markets. I am not so sure. They have control of the MASS of money but they have no control over the VELOCITY of money or transactional velocity. This means that when I, and millions of other people simultaneously, decide to not save our monthly wages but to spend it immediately because we sense prices will be higher if we delay, money velocity goes up EXPONENTIALLY and inflation follows suit. Once inflationary expectations start driving inflation, even reducing the supply of money might not be enough to curtail it.
If I had to assign probabilities, 30% deflation, 10% “slack tide” or nothing happening, 60% inflation (maybe hyper-). Geithner saw early on in the Euro crisis that their problem, a looming deflationary spiral, lay in the willingness to “do whatever it takes” to keep ahead of the storm and he hot-dogged it over to Europe to chivvy them on a bit knowing Europe’s problem would become the US’s. I wouldn’t be surprised if he added a “swap line” or two to help out.
In summary, the global economy is as unstable as marbles on a beach-ball. Any move in any direction, inflation or deflation could create a self-sustaining series of tail events. The prognosis for volatility and thus long volatility funds? This is best summed up by a poem by John Burroughs:
“Serene I fold my hands and wait
Nor care for wind nor tide nor sea
I rave no more ‘gainst time or fate
For Lo! my own shall come to me.”