Community editorial board: In the end, deflation will win
After having enjoyed years of rising stock prices, since January investors have been hit with an unexpected fall in the value of their portfolios. The question on many people’s minds is: Is this a temporary dip that presents a buying opportunity, or is this just the beginning of a long, wrenching period of wealth destruction?
To understand the current turbulence we must first understand the impact of the ultra-low interest rate policies pursued by the world’s major central banks in the wake of the 2008 financial crisis. What are the long-term consequences of such extraordinary rates?
At its simplest, assuming no risk and no inflation, interest is the payment made to a person with money in exchange for his or her patience. The saver, by lending his money to someone else, is no longer able to spend or invest that money himself. The borrower, by contrast, is willing to pay interest in order to spend or invest the saver’s money right away.
Left alone, interest rates reflect economic conditions and help to temper both booms and busts. When an economy is booming, businesses impatiently wanting to borrow to expand and consumers impatiently wanting to borrow to spend will find themselves competing for people’s savings. This competition will cause them to offer savers higher interest rates. These higher rates will, in turn, discourage frivolous borrowing and encourage prudent saving and so naturally cool off an overheating economy.
By contrast, when an economy is in a slump, businesses facing falling sales and consumers anxious about possibly losing their jobs are not interested in borrowing money to invest and spend. As a consequence, savers have to offer borrowers lower interest rates in order to entice them to take their money. Over time, as firms and households respond to these lower interest rates and begin once again to borrow, rising business investment and consumer spending herald a recovery.
Sadly, interest rates have not been determined by market conditions for decades. Central banks now set interest rates and for the past 16 years they have set them near zero percent. Never before in history have interest rates been so low for so long.
The central bankers behind this policy believe that such ultra-low interest rates stimulate borrowing, investment and spending. However, while lowering interest rates may pull planned spending and investment forward in the short term, over the longer term keeping interest rates near zero has created an environment of rampant oversupply and collapsing demand resulting in falling prices, profits and stock market indices.
In the immediate aftermath of the financial crisis of 2008, interest rates would naturally have fallen as people waited to see what would happen next before carrying out planned borrowing, spending and investment decisions. In the normal course of events, over the 18 to 24 months following the crisis most firms and households with prudent investment and spending plans would have taken advantage of the low rates to realize them. Thus, since at least 2012 near-zero percent interest rates have likely stimulated little or no valuable investment or spending.
What then did they do? On the investment side, they stimulated a great deal of wasteful investment. The carnage now taking place in the oil patch is the best example of this. Hydraulic fracturing (or fracking) only makes economic sense with low borrowing costs. The reason is that while conventional oil reserves yield about nine or 10 barrels of oil for every barrel of oil used in extraction, fracking only yields about four barrels of oil per barrel used. If other resources are factored into the equation, it is very likely that fracking consumes more resources than it produces. Such an inefficient and wasteful business model can only work if it is allowed to finance itself with ever-greater sums of cheap borrowed money. Inefficient as it may be, though, fracking nevertheless has increased the supply of oil on world markets. Similar malinvestment led to increased supply in a number of other markets such as copper, container ships and residential housing in China, where entire ‘ghost cities’ of empty buildings wait for residents.
On the consumption side, meanwhile, people who were looking to buy big-ticket items like cars have had eight years in which to do so. Personally, I was delighted to take advantage of an 84-month, zero percent interest rate promotion to replace my then-12 year old vehicle in 2012. Having replaced my car a scant three and a half years ago, though, I will not be buying another car anytime soon. Sadly for the automakers and other retailers, there are many other people in my position. While auto sales in the United States doubled from 2009 to 2015, over the past six months they have begun to fall, and the ratio of dealer vehicle inventory to sales has risen to levels not seen since 2008. While cars are being made and sent to the dealers, they are increasingly staying on dealers’ lots. Further evidence of consumer exhaustion can be found in the accelerating number of retail bankruptcies and closures, such as the announcement by Walmart last month that it would close 269 stores worldwide.
Putting the investment and spending pictures together, we can see that the ultra-low interest rates of the past eight years, by pulling forward both investment and spending, have led to a situation where firms with increased productive capacity are facing households with no desire (or, if they have already maxed out their credit cards, ability) to spend. Where rising supply meets falling demand the predictable result is falling prices, or deflation.
Falling commodity and goods prices, meanwhile, put pressure on company profits and therefore on stock prices. While this reality has been masked for a number of years by companies buying their own shares using cheap borrowed money, the growing deflationary pressures in the system will eventually overwhelm such accounting tricks.
As deflationary periods have historically led to portfolio-destroying bankruptcies and debt defaults it would be wise to take this correction seriously. Stock prices fell by 85 per cent between 1929 and 1932 during our last sustained episode of deflation, the Great Depression. While central banks will fight deflationary forces with ever-more desperate measures (such as negative interest rates, more money printing a.k.a. ‘quantitative easing’ and cash bans), these actions will become ever less effective even as the fundamental problems caused by central bank intervention get worse. In the end, deflation will win and, as U.S. Treasury Secretary Andrew Mellon put it in 1929, it “will purge the rottenness out of the system.” While that happens, it would be best if your wealth was safely out of harm's way.
Next week: Betty Ryan