A Conversation With John Llewellyn: Part II

FROM DEBT CRISES TO CURRENCY CRISES

JB: When a debt crisis becomes a currency crisis you have a problem that is an order of magnitude greater, because at that point you are not only distorting macro price signals via ‘financial repression’ but as there is now so little confidence in the stability of the currency, and households and businesses no longer have confidence in their ability to manage their time preferences effectively. Austrian economists would argue that this is so damaging that, if sustained, it will destroy an economy’s capital stock through severe resource misallocation. Do you have some sympathy with this view or is it too pessimistic?

JL: I have some sympathy, but also some humility. When economies are so far away from where they have even been in modern economic history; when the structure of our economies, with their much, much larger government sectors, is so unprecedented; and when we have been told so confidently what will happen by economists who engage in a priori theorising only to be proved wrong later, I am, I confess, rather more humble.

JB: The alternative to printing your way out of a debt burden is to allow for bankruptcy, restructuring and reorganisation of the capital stock to take place instead. Josef Schumpeter called this ‘creative destruction’, and he believed that it was not only helpful but in fact essential for economic progress. Might a severe recession be exactly the bitter medicine required at this point to save the patient, rather than more of the palliative to date that appears not to be working, or perhaps even making the problems worse? Would you argue that Britain’s

basket case economy of the 1970s could only have been turned around in this way? Or could there have been a more mainstream, Keynesian way to go about it, such as an even larger currency devaluation?

JL: I have never liked ‘severe recession’ as the cure for anything. The spectre of all that lost output always appalls me. It smacks of the same mentality that advocated bloodletting and leeches. It has always seemed to me that more useful things could be done with potential output than just letting it flow out to sea. The state could build toll roads, harbours, airports, even certain types of housing, and sell them off later to the private sector later when confidence returned. Surely that ought to be possible.

JB: Let’s move a bit closer to your current home. What about the UK of today? Does the UK need to undergo another Thatcher-like experience, something beyond timid ‘austerity’, including more meaningful structural reforms to make it more competitive internationally in exports? If so, would that be easier to accomplish were the UK to leave the EU? You have said that there is a distinct possibility of that in the coming few years.

JL: I think that leaving the euro is a distraction from the real issue, which is that UK companies are sitting on a pile of cash and are so uncertain about the future that they will not invest. Meanwhile households are trying to reduce their borrowing; and so is the government. The only thing to be done, in my view, would have been for the government to have undertaken the type of investment that companies otherwise would have done, and sell it on later. But that idea ran straight up against political dogma.

JB: But if the UK economy needs to rebalance, doesn’t the US need to as well? And on the other side of these trade deficits are trade surpluses elsewhere. Can the world continue to grow without first correcting these imbalances to at least some degree? And doesn’t history suggest that imbalances this large are ultimately corrected only in periods of unusually weak growth?

JL: Here you are putting your finger on a problem that Keynes highlighted at the end of WWII, but which Harry Dexter White, the senior US Treasury official at the 1944 Bretton Woods conference, refused to acknowledge. Surpluses and deficits are mirror images of one another. Two sides of the same coin. There cannot be one without the other. Hence being in surplus is just as contributory to imbalances as being in deficit. In a properly run global world, policies would bear down on surplus economies and deficit economies equally. But they never do.

ON FINANCIAL MARKET VALUATIONS AND THE MONETARY FUTURE

JB: Taking into account our discussion so far, I think there are ample reasons why the stock market should appear ‘undervalued’ to many. P/E ratios may not be particularly high, even if profit margins are. The fact is, however, revenues simply cannot grow rapidly in this environment, at least not in real terms. And record profit margins cannot survive a proper global rebalancing as the cheap labour of emerging markets converges on the developed world. In my opinion, given the structural macroeconomic headwinds we have discussed, stock market valuations should, in fact, be at generational lows, perhaps below where they were in the early 1980s or early 1960s. Your thoughts?

JL: I think that that argument is correct as far as it goes. But given that investors are starting to lose confidence in paper assets, and particularly government paper, they want to hold something real: and that includes shares in companies. And it is not as if there is a stock market bubble – so far at least. PEs in the US and the UK are not far from their historical averages.

JB: But if stock market valuations need to adjust even lower from here, perhaps much lower if policymakers don’t embrace more meaningful structural reforms, and if bond markets are overvalued due to the risks of currency devaluations, where, exactly, is an investor to hide? I lean toward a diversified exposure to real assets, including raw commodities. Could you perhaps share your thoughts on that?

JL: Clearly, commodities, industrial, food, and of course gold, are obvious contenders.

JB: Speaking of gold, you are aware that I believe that there has now been so much global economic confidence lost that it will not be properly restored absent a return to some form of gold standard, if only for international rather than domestic commerce. While I know you are sceptical, you don’t disregard the idea entirely. You have mentioned before the possibility of an international pricing convention based on a ‘bancor’, a currency based on a fixed basket price of globally traded commodities. How might that work? And are you confident that there would be sufficient support for such a regime, given that global economic cooperation is endangered by the threat of competitive devaluation, trade wars and the rise of economic nationalism generally?

JL: It would work by governments setting fixed rates for converting currencies into a basket of commodities. I think that it makes logical sense; and it could help in spurring the production of commodities that would later be in demand as activity picked up. Kaldor thought a lot about this, and we discussed it when I worked under him. But equally, I am sure that it is a non-starter. Two decades of life in the OECD has shown me just how hard it is for countries to agree about anything so fundamental.

JB: Some economists simply dismiss the idea of a gold standard as archaic and unworkable. I don’t think you hold that strong an opinion. But what would you see as the primary disadvantages of a gold standard, or relative advantages of the current dollar reserve standard. Does it come down to how much confidence you have in policymakers?

JL: It is possible to have confidence in individual policymakers at the national level, while nevertheless having little confidence about their ability to agree to reforms to the international system as a whole. And that is where I come from. In any international negotiation of this sort, two types of country have disproportionate influence: the biggest; and those in current account surplus. Today, that would mean the US and China: and I doubt that they would agree on any reform that proved to be in the global interest.

IF JOHN WERE IN CHARGE

JB: Now I’m really going to put you on the spot. An economist of your stature must always be considered a potential candidate for a senior policy role, say as a senior advisor to a finance minister, or a member of a central bank policy committee. Were you to be appointed to a role in which you had a broad mandate to design and implement fiscal and monetary policy, say for the euro-area or the UK, what would you do? If hard choices need to be made and if you had the mandate to make them, what would these be?

JL: In the UK, about which I thought particularly as an adviser to the Treasury from 2009 to 2012, I would have “thrown everything at the 2008 crisis, including the kitchen sink” as my friend William Keegan put it and as, in fact, Alistair Darling [Chancellor of the Exchequer –JB] did. And I would thereafter have set out on much the same course of fiscal consolidation as Darling did, and Osborne continued. I think that Paul Krugman and Ed Balls [Darling’s successor –JB] understate the risk that would attach to the government borrowing substantially more. But, as I indicated above, I would also have embarked on finding ways to support private-sector-like investment. My proposition throughout has been that the government should have been willing to underwrite, or undertake, investment that produces marketable output – ports; airports; toll roads; certain types of housing, etc. These could be valued and entered as an explicit, verifiable, line in the National Accounts, and could later be sold to the private sector. The ratings agencies would, on my understanding, have been open to such a plan being explained to them.

JB: I’m pleased to hear that there are things that might yet be done within the existing policy framework to help, at least if people listen to you a bit more! Thanks so much for your time; I’m certain that Amphora Report readers will appreciate it.

JL: Thank you John.

JB: Perhaps we can do this again in a year or so to see how things are panning out?

JL: It would be my pleasure. Perhaps you will even eventually win our bet that Greece withdraws from the euro-area.

JB: Well as you recall that bet expires on 31 December. It appears I will need to treat you to dinner in the New Year.

JL: Ah yes. Well as you strategists sometimes say, all views are potentially correct; the timing, however, is always uncertain.

JB: Indeed. Well Happy Holidays!

JL: To you too John.

POST-SCRIPT: FROM RISK TO UNCERTAINTY

My many conversations with John, including those recent ones merged into the transcript above, were an important input into my 2012 Amphora Reports. While the primary purpose of these reports is to interpret contemporary economic and financial market developments through the lens of Austrian economics (and occasional, plain common sense), it is essential to continuously check assumptions, however strongly held. As I’m certain is clear from the conversation(s) above, John has provided an invaluable source of such checking.

This is not to say that we agree on most things. Far from it. For example, as alluded to briefly in closing, I am of the opinion that the euro-area cannot survive in its current form. John believes that it is indeed salvageable, although he does doubt the willingness of policymakers to do what is necessary.

This brings us, I believe, to the crux of the risks that lie ahead. Policymaker activism continues to escalate across economies. This is not going to change in the near-term, nor absent another crisis that clearly and plainly discredits economic central planning generally, be it in fiscal or monetary matters. As has increasingly been the case in recent years, future risks are going to originate primarily from policy decisions. They will, in other words, be qualitative rather than quantitative in nature.

Financial markets are notoriously bad at pricing in qualitative risks, or ‘uncertainty’ if you prefer. Anything that doesn’t fit a Gaussian (ie ‘normal’) distribution cannot be put through any conventional asset valuation model, or any robust quantitative model for that matter.

Take, for example, the low level of benchmark interest rates in developed economies. One reads frequently that this indicates that the financial markets are complacent about the risks of unusually large sovereign debt burdens and unconventional monetary policy. That is simply not true. In much the same way that a plunging share price or credit spread is both indicator and exacerbating cause of corporate distress, when it comes to the interest rate at which a heavily indebted sovereign borrower funds itself, a sharp rise does not merely indicate an increasing risk of a crisis; rather, it IS the crisis!

Financial market risk premia are never stable, in part because they cannot be calculated with certainty. They are in constant flux with each and every transaction. For financial assets, the process commonly referred to as ‘price discovery’ is really a process of ‘risk discovery’. With policymakers intervening in their debt markets to an unprecedentedextent via QE and various forms of financial repression, it is a stretch to believe that observable ‘market’ interest rates tell us anything at all about the true, underlying riskiness of sovereign debts.

Far more useful is to look at risk measures that remain relatively free from government or central bank intervention. For example, take a look at corporate valuations in a historical comparision, adjusted for the low level of interest rates: Risk premia are high, not low. Take a look at dividend payout ratios: They are high, not low. Take a look at the low rate of fixed capital formation which, net of depreciation, is outright negative in many developed economies. Why are economies consuming the very capital that enables economic growth?

I will tell you why: Financial market participants are strongly negative about the true, real, after-tax future returns on capital invested because they know that expansive central planning produces poor and perhaps even disastrous economic outcomes. And as we know, actions speak louder than words.

But is this pessimism overdone? Is it now time to buy risk assets? Momentum has turned positive of late. Is this the turning point? Or merely short covering? Or year-end, low-volume noise?

To answer these questions, we need only consider again how we got into this mess in the first place: Policymaker activism. Whether it be setting interest rates too low; stimulating consumption with easy credit; discouraging savings through taxation; subsidising risk taking in various ways, including outright bailouts of failing institutions; centrally allocating scarce resources with ‘green pork’ or other largely uneconomic policies; or whatever, the fact is that policymaker activism caused the bubbles and thus caused the busts. With policymaker activism now having escalated to unprecedented levels, I would argue that risky asset valuations should have sunk to unprecedented lows. Yet they have not.

I have written so before and I do so again here: Before we have seen the bottom in real (ie inflation-adjusted) risky asset prices we are going to see valuations in developed markets drop below those seen in the late 1970s/early 1980s, when confidence in economic policy was also weak. We have come a long way, to be sure, but we have perhaps an equally long way to go yet (even when assuming that policymakers eventually get their act together).

While well over a generation has passed since there was general stability in money and credit growth and prior to the relentless rise of the modern, debt-financed welfare state, in my experience most people, young and old alike, are quick learners when their livelihoods depend on it. People who have pushed paper around their entire working lives wondering how it possibly adds value to anything will wonder no longer when the incentives are right. They will go about the business of doing what receives acceptable compensation and stop doing that which does not. Resources, labour and capital will bereallocated, economies will deleverage and then growth will begin anew.

Once this is recognised by the financial markets—rather quickly I should think—then valuations will begin to rise again, only this time on a healthy and sustainable (if necessarily subjective) basis. When the entirely necessary if at times painful economic restructuring is mixed with all the wonderful technological advances of modern times, an era of great prosperity is highly likely to commence.

I have little idea how long it is going to take to get there or just how big the crisis will be that finally forces policymakers to step back and allow a free market in goods, services and in money itself. But I certainly believe I know what to look out for and I hope regular Amphora Report readers feel as if they do too. An opportunistic investment approach based on a qualitative, policy paradigm-shift is the way to play it, whether in 2013 or well-beyond. Patience—or ‘low time-preference’ if you prefer—is indeed a virtue, albeit one in unusually short supply amid zero interest rates and other artificial, unsustainable economic stimulus. Only an arch-Keynesian paperbug could think otherwise.

In the meantime, portfolios should be overweight ‘insurance’ and by that I don’t mean shares of insurers. I mean the ultimate forms of financial insurance, that is, unencumbered real assets (eg gold, other marketable commodities) and broad diversification across assets, jurisdictions, etc.

Along those lines, here is a final ‘picture’ of advice as I also offered in the last edition, immediately following a sharp drop in the gold price:

kepp calm and buy gold

John Butler | Amphora Capital

Mr Butler is the author of The Golden Revolution: How to Prepare for the Coming Global Gold Standard

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