“The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
Remarks by Governor Ben S. Bernanke, before the National Economists Club, Washington, D.C. November 21, 2002 “Deflation: Making Sure “It” Doesn’t Happen Here”
Despite being highly sought after, money has no intrinsic economic value: its worth can only be defined or measured relative to the assets, goods or services that it can be exchanged for. The recent announcement that the Federal Reserve intends to create more money should therefore boost the prices of all assets, goods and services, by virtue of there being more money in existence and the same quantity of goods. This should encourage the production of assets, goods and services which are now worth more relative to the historic cost of making them. Quantitative easing – the printing of more money – should therefore be good for nominal economic growth but at the cost of higher inflation. Real economic growth (nominal growth minus inflation) may remain unchanged. Whilst too much inflation may be considered less bad than too much deflation, any impression of an overall increase in wealth may be somewhat illusory.
Inflation through the existence of more money has several implications for investors. Money that sits idle on deposit and money invested in all forms of debt will be worth less relatively and therefore also less in absolute terms (since money has no intrinsic value). By contrast, money invested in all forms of equity will rise in absolute and relative terms. Irving Fisher, once America’s most famous economist, wrote a brilliant book in 1928 called “The Money Illusion” highlighting how a failure to understand the impact of inflation – not least how it erodes the purchasing power of debt to the benefit of the equity owner – leads to poor investment decisions amongst the general public. An example cited by Fisher, is that of a company funded with $100m of debt and $100m of equity with $10m of profits split equally between the debt and equity investors. With a doubling of the price level on the same volume of business, sales and expenses double but so do profits. The company finds itself with $20m of profit, of which the bond holders still only get $5m (no change in nominal terms but in real terms a loss of 50% given the doubling of the price level) but the shareholders get $15m (an improvement of 200% of nominal terms and 50% in real terms). There is no default here nor is there any destruction of overall wealth. As a result society is as a whole slow to understand the transfer of wealth between creditors (who have lent money) and debtors (who have borrowed money) that has taken place:
“Inflation, quite impersonally, if you please, has picked the pockets of the bondholders and put the value into stockholders’ pockets, simply by the change in the value of the dollar.”1
An alien with an economics degree visiting the planet for the first time may therefore find today’s popularity of bonds and the unpopularity of equities somewhat difficult to understand in view of the characteristics of money discussed above and the further quantitative easing announced by the world’s most powerful central bank. Stretched comparative valuations would further confuse the alien. It used to be considered a good buying opportunity for equities when dividend yields exceeded (10 year) government bond yields. Today, for the first time since the 1970s, European equity dividend yields not only exceed those of (10 year) government bonds, but they also exceed those of corporate bonds of the same duration (see Figure 1 “Yield Crossover”).
It is worth looking at some stock examples to understand this wide differential between equity and bond valuations. Nestlé, for example, pays a dividend of 3.3%, which its investors would perhaps expect the Swiss food giant to double over the next decade, whilst a bond investor has locked in a measly 1.5% return by lending Nestlé money fixed over the same time period (just 1.1% over five years). Shares in Spain’s Telefonica – a blue chip telecom operator with good Latin American growth opportunities – currently yield 7.4%. In the corporate bond world only a very risky company would pay this. Particularly amongst non-financial companies there is now a significant gap between dividend yield and corporate bond yield in the favour of shareholders (see Appendix 1).
Indeed corporate bonds are now more popular in terms of inflows than equity mutual funds at the height of the technology “bubble” in 1999-20002. Finance Directors have taken advantage of this abundant liquidity and the lowest interest rates across the yield curve since 19463 to issue bonds at record low rates fixed for record long periods4. Whilst it is debatable whether corporate bonds are in “bubble” valuation territory, what is undeniable is that the valuation gap between cheap equity valuations and rich bond valuations can only be explained by ongoing and widespread fears over anaemic economic growth. The investment world today is priced for low levels of nominal growth and non-existent inflation. Any other outcome will lead to significant valuation anomalies.
Investors in general, in other words, are not convinced that quantitative easing works and continue to price assets as if the threat of deflation is still very real. After all, it is argued that quantitative easing was tried in Japan and failed. It was also attempted in larger quantities ($1,750bn compared to $600bn today) by the Federal Reserve in Q1 2009 and it has not to date produced a sufficiently robust recovery. Fed Chairman Bernanke’s monetarist logic that “sufficient injections of money will ultimately always reverse a deflation” has been challenged by economists, such as Richard Koo, who have argued that quantitative easing in Japan whereby the Bank of Japan pumped Y25trillion (equivalent to five times banks’ required reserves) into the banking system (2001-2006) was a “non-event5”: that instead of banks taking advantage of increased liquidity to boost lending, there were “no borrowers” as debt-burdened companies continued to pay down debt irrespective of its availability or cost. Although there was a rapid expansion in the Japanese monetary base (the money supply in the banking system), company management and consumers continued to shrink their balance sheets by paying down debt. As a result there was little expansion in the money supply in the real economy or in economic activity as the extra money was not put to use. The problem, according to Koo, was the borrowers’ ability to borrow, not the lenders’ capacity to lend6. In today’s supposedly over-leveraged Western economies who has the capacity to borrow?
Can this same Japanese “liquidity trap” be observed in the expansion of the US monetary base since the start of quantitative easing in 2008? As a result of its asset purchases, the US monetary base (cash plus the reserves banks hold at the central bank i.e. money in the banking system ready to be lent) rose from $800bn to $2,000bn (see Fig 2), whilst M1 money supply (cash plus overnight deposits held by non-banks i.e. money in the real economy ready to be spent) grew less robustly from $1,400bn to $1,800bn over the same period. In other words the transmission mechanism (the velocity of money) between the money in the banking system and the real economy was very inefficient. Banks ended up putting most of the extra liquidity back on deposit with the Federal Reserve as excess bank reserves ($1,200bn).
Without an increase of demand for loans from the real economy, the additional $600bn of asset purchases involved in QE2 risks adding substantially to already excess liquidity in the banking sector, potentially without any significant effect on the real economy. If, over the course of QE2, excess banking reserves rise from $1,200bn to $1,800bn it will be a sign that quantitative easing has had very little immediate effect on the real economy. It will mean that for all the liquidity in the banking system ready to be lent, there are not enough willing to borrow.
So why has there not been an increase in credit demand in the real economy despite this increase in liquidity in the banking system? The most obvious answer is that in any recession, companies and individuals become more risk adverse and prioritise paying back debt. So it is quite normal to have a “liquidity trap” in the first stages of economic recovery. It is therefore crucial to put the downturn in demand for money into some kind of historical perspective. We can see from the Fed’s “Flow of Funds” data series, which was established in 1951 (Fig 3), that home mortgage volumes contracted four quarters in a row in 2008 for the first time, having always previously maintained growth of above 4%.
The downturn in consumer credit has been more comparable with previous recessions, but has been slow to recover. On the other hand, the demand for credit in the non-financial corporate sector has been less severe than in the early 1990s and on a par with the 2001-2002 experience. As stated by Fed Governor Duke:
“with the exception of housing, lending over the current downturn does not appear to have been particularly weak or subdued relative to other downturns…………that said, the likely path of lending in the current downturn without any policy response would have been notably more contractionary than in the 1990-91 recession given that the earlier episode – while characterized by a financial crisis – did not face as extreme an episode as the one experienced last September”7.
So although the transmission mechanism of quantitative easing to the real economy has to date been inefficient, it is difficult to argue that it has had no impact. After all, M1 (money in the real economy ready to be spent) has risen by $400bn over the last two years (Fig 2), which will have offset some of the deflationary pressures in the real economy. US Senior Loan Officer surveys now show the majority of respondents saying that credit is not “difficult” to obtain, having seen record “difficulty” only two years previously (Fig 4).
Moreover, the same surveys show that demand for credit in the US in all categories (large firms, small firms, commercial real estate, household lands, prime residential) is close to turning positive; following five years of declining demand in most categories (Fig 5). Recent ECB credit surveys show a similar pick-up in credit demand in Europe. At the same time leading US macro indicators from ISM new orders, regional Fed surveys and private payrolls have all picked up momentum from a soft patch over the summer, which may have justified further stimulus. But unsatisfied with the pace of recovery – rather than fearing the recovery is imperilled – the Fed has announced that a further $600bn will be pumped into the monetary base, where $1,200 of excess bank reserves already exist just in case. Liquidity ready to be lent in the banking system (excess banking reserves) will stand at $1,800bn following QE2. This compares to liquidity ready to be spent in the real economy (notes and coins in circulation plus non financial institutional money on deposit) of $1,800bn. It is not unrealistic that the price level in the real economy could therefore at least double if unchecked demand for money meets current availability of money8.
This still leaves the question of who has the capacity to borrow? The answer is companies, and not just in America. The globalisation of financial markets means that investors can borrow dollars to invest elsewhere in the world, and therefore another round of quantitative easing will keep credit easier for longer on a global basis. Moreover, the Japanese-style scenario where companies are so indebted that they remain focused on paying down debt whatever its price9 is just not relevant to the current situation in the US or Europe. Indeed outside of the financial sector leverage ratios are well below average. If we look at the largest 50 non-financial companies by market capitalisation in the Pan-European market as an illustration of this (Appendix 2), we can see that 22% have net cash and that the average net debt outstanding to cash generation (EBITDA) is just 1.1x (with a median of 0.9x). This is hardly comparable to over-indebted Japan in the 1990s. European (non-financial) companies have low levels of debt at a time when debt is at record levels of cheapness to borrow.
Furthermore, unlike corporate Japan in the 1990s, equity today is cheap to buy and expensive to issue. If we look back at the same largest 50 Pan-European companies (Appendix 1) we can see that the average earnings yield in 2010 is 7.5% (a P/E of 13x earnings). The financial directors of these companies will have noticed that their cost of debt (over 5 years) is on average just 2.5% in comparison. In other words, they can borrow money at a third of their implied costs of raising money through issuing new shares (2.5% versus 7.5%). There would also be a further benefit of not paying corporate tax on debt capital as opposed to equity10. They are therefore highly incentivised to borrow money cheaply to buy either the cheap equity of their own company, or of other companies.
But what capacity do these companies have to borrow? If we assume that to retain investment grade status a company will need to retain a net debt/cashflow (EBITDA) ratio of 3x or less on average, then we can see that 47 out of 50 companies have the capability to make acquisitions, whilst 23 out of 50 would be able to buy equity equivalent to more than a third of their market capitalisation. So the months ahead should see the (non-financial) corporate world in Europe and the US engaged in widespread merger and acquisition (M&A) activity. This should form a significant part of the pick-up in demand for money in general, with the cash proceeds providing a stimulus to spending in the real economy, and equity funding for those parts of the economy that still need to bring leverage down. Higher prices for financial assets can therefore provide a positive feedback loop into the real economy.
If and when inflation begins to pick up central banks always have the option to withdraw easy money but in practice it will be difficult for the Federal Reserve to sell the $2 trillion plus of financial assets on its balance sheet without incurring losses, which, in view of their (relatively small) $50bn equity capitalisation, may be problematic10. This means that all, or most, of the asset purchases may have to be held to maturity thus making it more difficult for the bank to withdraw inappropriate stimulus. Withdrawing stimulus will also be problematic for other central banks: the European Central Bank in view of the long-term problems of the “periphery”; the Bank of England in view of its effect on UK regional house prices and the Swiss National Bank in view of its likely effect on boosting the Swiss Franc further. Emerging markets such as China – for whom further additional monetary stimulus is unwelcome – are likely to get it nevertheless as long as they insist on maintaining currency regimes pegged to the US dollar. Fighting inflation can be left for another day. As investors we should consider the possibility of a prolonged period of negative real interest rates, during which the real value of debt will be eroded by a higher price level.
The relevance of the “Money Illusion” to investing today may entail a change of attitude in the wealth management industry, where the mindset of aversion to capital losses has taken hold. Memories are not long enough to remember that “safe” investments are not necessarily always “good” investments in preserving wealth and that investors can be “victims” of “safe” investments as well as “risky” ones. To illustrate this, Fisher tells the story of a lady who was left a $50,000 fortune by her father in 1892. The money was invested in “so-called “safe” bonds”. In 1920, Fisher accompanied the lady on a visit to the trustee of the fund, who explained how careful he had been about the investment of this money, keeping the principal intact (with the exception of a loss of $2,000 on a railway bond). Fisher explained to the trustee that the purchasing power of $50,000 in 1892 was the equivalent of $190,000 by 1920, and that the portfolio loss of $2,000 was really $142,000 or 75% in real terms:
“Just as this lady’s income and principal was only one quarter (in value) of what it was when this trust began, so every bondholder’s “steady” income is a delusion and a snare, so long as we have an unsteady dollar”
He enquired:”Who has won what she has lost?” I answered: “she is a creditor – a bondholder. The debtors – the stockholders – won it”11
The most pressing question for wealth management today is whether today’s unsteady dollar is a new “Money Illusion” in which bondholders and investors in all “safe” assets are similarly deluded. Will tomorrow’s bondholder losses be won by today's shareholder?
Barry Norris
Partner, Argonaut Capital
