Inflation, Default, or Super-Twist

The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default. Inflation vs default.

The “New Normal” is evolving, and we do not yet know what it will look like, or fully how the transition will happen. We do know that governments are printing massive amounts of debt to attempt to save what they can of their economies, with the hope that post-pandemic growth can accelerate and recover economies to pre-pandemic ‘health’. But that growing debt is a burden on countries and will stay as a burden for some time to come.

I keep reading that there are two options to deal with debt growth; inflation or default. I’m not sure that either is the actual ‘end game’. Certainly, a huge amount of money is being conjured out of the air and being pumped into economies. In the US Congress has just approved a $1.9 Trillion spending package, on top of a $2 trillion spending package last year, all on top of existing government expenditure. The UK government has been paying salaries at 80% since last April or so, and will continue to do so until September or later this year. That is effectively paying 80% of a huge number of Britons' salaries for over a year.

Not surprisingly, but seemingly strangely also we see personal savings rates increase, at the same time that unemployment is at record levels (I do not believe the US unemployment numbers of 6.5% or whatever they are saying it is, those numbers are fantasy).

But there is another option, and I expect this is what we will see - a "Super-Twist" of extreme long-dated government debt, bought by governments from themselves (and paying themselves interest at very low rates). 

Inflation

Inflation has been the tool for managing down large debt for centuries, and there is an expectation that this is what will happen now. I’m not sure. Inflation requires there to be more "money" than "goods", with the oversupply of money chasing fewer goods. This certainly is true at the higher end, with inflation in luxury goods, art and property (higher end). But that means that the excess money is in relatively fewer hands. “The rich get richer” argument. Well, if the rich are getting richer, than the products and assets that the wealthy are purchasing must either expand in quantity, or those products and assets will increase in price. Classic supply and demand pricing.

But if the income levels at the ‘not rich’ end of the economy are not increasing, and the quantity of products, services, and assets are remaining constant, then there should be little inflation at that level. In fact, prices in many cases are increasing while incomes remain stagnant or increase at a pace slower than the cost of those goods and services. But there has been creeping inflation underway for decades in the developed world, with wages effectively stagnant and production capacity exported to lower-wage economies.

There are numerous examples of the management of inflation figures in developed countries, driven by the use of ‘hedonics.’ for the calculation of inflation. If you get greater functionality from a smart-TV and pay more for that TV, there has been no inflation because you are getting more for your money. Therefore, the increased ‘hedonistic’ value of the greater functionality offsets any increase in the price paid. The fact that all TVs now have greater functionality and a similar cost to previous models does not equate to inflation, even though without the additional functionality, the unit's cost would, or should, reduce. When it comes to consumer electronics, this generally is true. But when it comes to higher education, it is impossible to apply hedonics to a 500% increase in the cost of a four-year university education in the US.

The average cost of attending a four-year college or university in the United States rose by 497% between the 1985-86 and 2017-18 academic years, more than twice the rate of inflation. (Forbes, 31August 2020)

That is twice the rate of the underlying inflation figure. Yet, the underlying inflation figures have been manipulated to ensure an overall lower figure. Why? There are several reasons, but a primary reason is the pegging of some national benefits (such as Social Security, the US national superannuation scheme) to the “Consumer Price Index” (CPI) measure of inflation.

In the UK, the introduction of a £9,000 per year tuition fee for almost all universities has certainly ‘inflated’ the cost of higher education to little or no additional benefit for students.

So there has already been ongoing inflation. The assumption has been that the fiscal stimulus will automatically result in inflation across all goods and services as the mechanism for the paying down or managing the debt.

For inflation to be the tool of choice to reduce the debt it will require policies that alter the distribution of income or constrain the quantity of goods and services available. The classic way to accomplish this is through changes in the taxation system, shifting the tax burden toward higher incomes while reducing the tax burden on lower incomes, and/or through employment policies that encourage unions and mandate higher wages. Tariffs act as a stealth means of inducing inflation through the imposition of an additional cost on products, effectively inducing inflation through artificial scarcity.

Increasing wages without increasing the stock of goods and services will drive up prices, based purely on the increase in money chasing the finite goods and services. Classic supply and demand at the middle and lower income levels. There will be inflation in areas such as housing (in the suburbs and ‘country towns’ and zero, limited or even negative inflation in cities) because the population continues to rise at a rate faster than additional housing stock is being built. That is classic supply and demand inflation, and until the housing stock (in the US and in the UK, for example) has grown – in the places people want to live – the unit price of housing will increase to meet what the market will accept.

But general hyperinflation needed to devalue the debt sufficient to ‘pay down the debt’ will not be happening anytime soon. The (policy) conditions to allow this are not in place yet and will be avoided until there is no other option.

In the US (and in some other “capitalist” countries) the policy changes required to allow (or not avoid) hyperinflation will be opposed as much as possible by business interests and shareholders; the managerial and rentier class that are the beneficiaries of lower wages. These people (as a group and as individuals) control government policy through the economics of the American electoral system, and policies that will boost individual incomes at the expense of the wealthy will not be acceptable (even under a Democratic administration).

Default

The alternative being discussed (in speculative writing) is a default in portions of the debt. Of course, this has never happened, except in country after country. It has not happened in the US and the UK, Japan, and other major developed economies. Default is the last refuge of countries that cannot continue to access international financial markets and therefore no longer able to finance their debt. But there are countries for whom international markets for their bonds are an “also” and not an “only” option.

For countries such as Argentina, default has been a strategic tool used once access to international markets becomes impossible based on existing government financing capacity. Other countries such as Greece have used “debt restructuring” to avoid any overt default.

The default route, including debt restructuring, comes at a terrible cost, with countries finding themselves cut off from financial markets, and being unable to meet obligations to their own populations.

Economies are destroyed. Banks are destroyed, companies cannot access revolving credit for operational expenditure, purchasing, payroll, etc. The national productivity gains that accrued during the borrowing and spending years (if some of that borrowing actually funded capability creation) are wiped out, and the entire economy performs a “hard reset”. Deflation across the board results in economies that, eventually, restart at a lower cost base, impacting profits for corporations and tax income for the government. Infrastructure project come to a halt, and social support networks collapse.

Argentina, Venezuela, Zimbabwe and Greece are examples, each responding in different ways. Argentina is the serial offender of Latin America with a cycle of recovery and exuberance, followed by over-borrowing and collapse. Venezuela and Zimbabwe are similar in that they converted national productive assets into social programmes to buy the support of the masses, only to ultimately “run out of other people’s money”, yet still not learn and restructure their economies for recovery. Both remain mired in poverty and hopelessness.

Greece has restructured its economy, and until the pandemic hit, the economy was growing again, within a huge debt overhang that was being managed.

Furthermore, in all cases of default, the losers will be the asset holders, and that means the wealthy, who see their net worth slashed.

And as the wealthy control the setting of policy and the justification of policy, and as they wish, first and foremost, to protect their own assets and interests, we can be confident that policies that may lead to default in the shorter term (3 – 5 years) will be avoided.

But what if these policies will result in a future potential default situation? Almost any policy will be acceptable if expected to preserve wealth in the short to medium term. Stimulus spending is meant to ensure the preservation of wealth by reducing the risk of a systemic collapse or a market implosion. To avoid those, ongoing imbalances are acceptable, because the alternatives are so frightening.

That is where we are now. The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default.

Another Way – Super-Twist

Do not expect the Fed or the Bank of England, or any other central bank that can, to either stop funding stimulus, to allow their currencies to collapse, or to default on sovereign bonds or gilts.

Any increase in inflation will convert into an increase in rates (the assumption is that rates provide a view of future inflation) and a corresponding increase in funding costs for governments. That vicious cycle results in governments being unable to fund their debt, and are the hilltop of the slippery slope to hyperinflation or default. Therefore, rates must and will be managed.

The provision of guaranteed liquidity under any circumstances is the bedrock of managing the markets. Too much liquidity and the markets turn into bubbles, while too little liquidity and the markets could collapse. So central bankers must send the message that there is unlimited liquidity, while at the same time drip-feeding that liquidity into markets is required, all the while “ignoring” the fire-hydrant of government spending. As the government borrows, in theory, liquidity is removed from the markets to fund that borrowing. The money has to come from somewhere.

Instead of borrowing solely from the markets, governments purchase from themselves (and from other governments in the process of spreading their risk and helping to prop each other up). The debt is purchased with varying maturities.

In 2011 the Fed implemented Operation Twist, with the objective of reducing the yield curve and extending duration of the Fed’s debt. Buy short duration debt to take it off the table while selling longer duration debt at the same or similar rate, pushing the debt out and reducing the yield curve, pushing down inflation expectations.

There has been speculation about a “Century-Bond” in the UK before, with questions about who would find such a gilt attractive. The basic answer would be the government itself. Any government that can issue debt in its own currency and purchase it from itself at such a long duration would be well incentivised to issue such debt. Of course, long-duration gilts and treasuries will not go away, nor will they be paid off. But at 1% interest the burden of debt required to impact annual budgeting would need to be multiples of total GDP and the tax take. And such gilts or treasuries held in ‘public’ hands would retain value and still be available for exchange.

How long could the UK or the US continue to issue such long duration debt (and purchase it from itself)? As long as the markets will purchase that debt. And when purchasers disappear, they can purchase it from themselves knowing that they will be making debt payments to themselves at 1% per year.

But Bubbles?

As long as governments are purchasing the debt at a rate that provides liquidity to the governments, they will retain the monetary policy tools to add or remove liquidity to external markets. As bubbles expand, excess liquidity can be drained off by shifting purchasing of the long-duration debt to themselves, and likewise, liquidity crunches can be avoided (or mitigated) by releasing funding to stabilise markets.

Will they be able to destroy “boom and bust”? I highly doubt it. But they will have the policy tools (and the cash) to smooth the busts and rein in the booms. Boom too fast, and liquidity will be removed. Likewise, the busts will see floods of liquidity to stave off systemic collapse or depression.

Of course, we should trust that those different governments will fail, increasing the potential for a pan-economy systemic crisis. But coordination between Central Banks should reduce the likelihood.

Am I placing too much faith in Central Banks? Absolutely, in the "short term". I am also confident that the hubris of success will lead directly to excess risk-taking by governments and Central Banks resulting in instability. Will the system be self-correcting? Probably, up to a point.

But there will be bubbles, and policy-makers will accept those as the cost of stability. Squeeze a balloon, and it will pop out somewhere else. Release the pressure, and the balloon will return to its ‘stable’ shape. Prick the balloon, and it will burst. Squeeze the balloon too hard, and it will burst. I trust the Central Bankers to squeeze within boundaries, until they don’t.

But we are still ‘early’ in the process of managing financial stability and growth through unconstrained government borrowing and expenditure. There will be many years to run before a real bursting of the balloon.

  

Inflation, Default, or Super-Twist

The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default. Inflation vs default.

The “New Normal” is evolving, and we do not yet know what it will look like, or fully how the transition will happen. We do know that governments are printing massive amounts of debt to attempt to save what they can of their economies, with the hope that post-pandemic growth can accelerate and recover economies to pre-pandemic ‘health’. But that growing debt is a burden on countries and will stay as a burden for some time to come.

I keep reading that there are two options to deal with debt growth; inflation or default. I’m not sure that either is the actual ‘end game’. Certainly, a huge amount of money is being conjured out of the air and being pumped into economies. In the US Congress has just approved a $1.9 Trillion spending package, on top of a $2 trillion spending package last year, all on top of existing government expenditure. The UK government has been paying salaries at 80% since last April or so, and will continue to do so until September or later this year. That is effectively paying 80% of a huge number of Britons' salaries for over a year.

Not surprisingly, but seemingly strangely also we see personal savings rates increase, at the same time that unemployment is at record levels (I do not believe the US unemployment numbers of 6.5% or whatever they are saying it is, those numbers are fantasy).

But there is another option, and I expect this is what we will see - a "Super-Twist" of extreme long-dated government debt, bought by governments from themselves (and paying themselves interest at very low rates). 

Inflation

Inflation has been the tool for managing down large debt for centuries, and there is an expectation that this is what will happen now. I’m not sure. Inflation requires there to be more "money" than "goods", with the oversupply of money chasing fewer goods. This certainly is true at the higher end, with inflation in luxury goods, art and property (higher end). But that means that the excess money is in relatively fewer hands. “The rich get richer” argument. Well, if the rich are getting richer, than the products and assets that the wealthy are purchasing must either expand in quantity, or those products and assets will increase in price. Classic supply and demand pricing.

But if the income levels at the ‘not rich’ end of the economy are not increasing, and the quantity of products, services, and assets are remaining constant, then there should be little inflation at that level. In fact, prices in many cases are increasing while incomes remain stagnant or increase at a pace slower than the cost of those goods and services. But there has been creeping inflation underway for decades in the developed world, with wages effectively stagnant and production capacity exported to lower-wage economies.

There are numerous examples of the management of inflation figures in developed countries, driven by the use of ‘hedonics.’ for the calculation of inflation. If you get greater functionality from a smart-TV and pay more for that TV, there has been no inflation because you are getting more for your money. Therefore, the increased ‘hedonistic’ value of the greater functionality offsets any increase in the price paid. The fact that all TVs now have greater functionality and a similar cost to previous models does not equate to inflation, even though without the additional functionality, the unit's cost would, or should, reduce. When it comes to consumer electronics, this generally is true. But when it comes to higher education, it is impossible to apply hedonics to a 500% increase in the cost of a four-year university education in the US.

The average cost of attending a four-year college or university in the United States rose by 497% between the 1985-86 and 2017-18 academic years, more than twice the rate of inflation. (Forbes, 31August 2020)

That is twice the rate of the underlying inflation figure. Yet, the underlying inflation figures have been manipulated to ensure an overall lower figure. Why? There are several reasons, but a primary reason is the pegging of some national benefits (such as Social Security, the US national superannuation scheme) to the “Consumer Price Index” (CPI) measure of inflation.

In the UK, the introduction of a £9,000 per year tuition fee for almost all universities has certainly ‘inflated’ the cost of higher education to little or no additional benefit for students.

So there has already been ongoing inflation. The assumption has been that the fiscal stimulus will automatically result in inflation across all goods and services as the mechanism for the paying down or managing the debt.

For inflation to be the tool of choice to reduce the debt it will require policies that alter the distribution of income or constrain the quantity of goods and services available. The classic way to accomplish this is through changes in the taxation system, shifting the tax burden toward higher incomes while reducing the tax burden on lower incomes, and/or through employment policies that encourage unions and mandate higher wages. Tariffs act as a stealth means of inducing inflation through the imposition of an additional cost on products, effectively inducing inflation through artificial scarcity.

Increasing wages without increasing the stock of goods and services will drive up prices, based purely on the increase in money chasing the finite goods and services. Classic supply and demand at the middle and lower income levels. There will be inflation in areas such as housing (in the suburbs and ‘country towns’ and zero, limited or even negative inflation in cities) because the population continues to rise at a rate faster than additional housing stock is being built. That is classic supply and demand inflation, and until the housing stock (in the US and in the UK, for example) has grown – in the places people want to live – the unit price of housing will increase to meet what the market will accept.

But general hyperinflation needed to devalue the debt sufficient to ‘pay down the debt’ will not be happening anytime soon. The (policy) conditions to allow this are not in place yet and will be avoided until there is no other option.

In the US (and in some other “capitalist” countries) the policy changes required to allow (or not avoid) hyperinflation will be opposed as much as possible by business interests and shareholders; the managerial and rentier class that are the beneficiaries of lower wages. These people (as a group and as individuals) control government policy through the economics of the American electoral system, and policies that will boost individual incomes at the expense of the wealthy will not be acceptable (even under a Democratic administration).

Default

The alternative being discussed (in speculative writing) is a default in portions of the debt. Of course, this has never happened, except in country after country. It has not happened in the US and the UK, Japan, and other major developed economies. Default is the last refuge of countries that cannot continue to access international financial markets and therefore no longer able to finance their debt. But there are countries for whom international markets for their bonds are an “also” and not an “only” option.

For countries such as Argentina, default has been a strategic tool used once access to international markets becomes impossible based on existing government financing capacity. Other countries such as Greece have used “debt restructuring” to avoid any overt default.

The default route, including debt restructuring, comes at a terrible cost, with countries finding themselves cut off from financial markets, and being unable to meet obligations to their own populations.

Economies are destroyed. Banks are destroyed, companies cannot access revolving credit for operational expenditure, purchasing, payroll, etc. The national productivity gains that accrued during the borrowing and spending years (if some of that borrowing actually funded capability creation) are wiped out, and the entire economy performs a “hard reset”. Deflation across the board results in economies that, eventually, restart at a lower cost base, impacting profits for corporations and tax income for the government. Infrastructure project come to a halt, and social support networks collapse.

Argentina, Venezuela, Zimbabwe and Greece are examples, each responding in different ways. Argentina is the serial offender of Latin America with a cycle of recovery and exuberance, followed by over-borrowing and collapse. Venezuela and Zimbabwe are similar in that they converted national productive assets into social programmes to buy the support of the masses, only to ultimately “run out of other people’s money”, yet still not learn and restructure their economies for recovery. Both remain mired in poverty and hopelessness.

Greece has restructured its economy, and until the pandemic hit, the economy was growing again, within a huge debt overhang that was being managed.

Furthermore, in all cases of default, the losers will be the asset holders, and that means the wealthy, who see their net worth slashed.

And as the wealthy control the setting of policy and the justification of policy, and as they wish, first and foremost, to protect their own assets and interests, we can be confident that policies that may lead to default in the shorter term (3 – 5 years) will be avoided.

But what if these policies will result in a future potential default situation? Almost any policy will be acceptable if expected to preserve wealth in the short to medium term. Stimulus spending is meant to ensure the preservation of wealth by reducing the risk of a systemic collapse or a market implosion. To avoid those, ongoing imbalances are acceptable, because the alternatives are so frightening.

That is where we are now. The policies of deficit spending by governments to prop up economies through the pandemics have created imbalances that will, it is assumed, at some indeterminate time in the future, create a situation in which the only two options are hyperinflation or default.

Another Way – Super-Twist

Do not expect the Fed or the Bank of England, or any other central bank that can, to either stop funding stimulus, to allow their currencies to collapse, or to default on sovereign bonds or gilts.

Any increase in inflation will convert into an increase in rates (the assumption is that rates provide a view of future inflation) and a corresponding increase in funding costs for governments. That vicious cycle results in governments being unable to fund their debt, and are the hilltop of the slippery slope to hyperinflation or default. Therefore, rates must and will be managed.

The provision of guaranteed liquidity under any circumstances is the bedrock of managing the markets. Too much liquidity and the markets turn into bubbles, while too little liquidity and the markets could collapse. So central bankers must send the message that there is unlimited liquidity, while at the same time drip-feeding that liquidity into markets is required, all the while “ignoring” the fire-hydrant of government spending. As the government borrows, in theory, liquidity is removed from the markets to fund that borrowing. The money has to come from somewhere.

Instead of borrowing solely from the markets, governments purchase from themselves (and from other governments in the process of spreading their risk and helping to prop each other up). The debt is purchased with varying maturities.

In 2011 the Fed implemented Operation Twist, with the objective of reducing the yield curve and extending duration of the Fed’s debt. Buy short duration debt to take it off the table while selling longer duration debt at the same or similar rate, pushing the debt out and reducing the yield curve, pushing down inflation expectations.

There has been speculation about a “Century-Bond” in the UK before, with questions about who would find such a gilt attractive. The basic answer would be the government itself. Any government that can issue debt in its own currency and purchase it from itself at such a long duration would be well incentivised to issue such debt. Of course, long-duration gilts and treasuries will not go away, nor will they be paid off. But at 1% interest the burden of debt required to impact annual budgeting would need to be multiples of total GDP and the tax take. And such gilts or treasuries held in ‘public’ hands would retain value and still be available for exchange.

How long could the UK or the US continue to issue such long duration debt (and purchase it from itself)? As long as the markets will purchase that debt. And when purchasers disappear, they can purchase it from themselves knowing that they will be making debt payments to themselves at 1% per year.

But Bubbles?

As long as governments are purchasing the debt at a rate that provides liquidity to the governments, they will retain the monetary policy tools to add or remove liquidity to external markets. As bubbles expand, excess liquidity can be drained off by shifting purchasing of the long-duration debt to themselves, and likewise, liquidity crunches can be avoided (or mitigated) by releasing funding to stabilise markets.

Will they be able to destroy “boom and bust”? I highly doubt it. But they will have the policy tools (and the cash) to smooth the busts and rein in the booms. Boom too fast, and liquidity will be removed. Likewise, the busts will see floods of liquidity to stave off systemic collapse or depression.

Of course, we should trust that those different governments will fail, increasing the potential for a pan-economy systemic crisis. But coordination between Central Banks should reduce the likelihood.

Am I placing too much faith in Central Banks? Absolutely, in the "short term". I am also confident that the hubris of success will lead directly to excess risk-taking by governments and Central Banks resulting in instability. Will the system be self-correcting? Probably, up to a point.

But there will be bubbles, and policy-makers will accept those as the cost of stability. Squeeze a balloon, and it will pop out somewhere else. Release the pressure, and the balloon will return to its ‘stable’ shape. Prick the balloon, and it will burst. Squeeze the balloon too hard, and it will burst. I trust the Central Bankers to squeeze within boundaries, until they don’t.

But we are still ‘early’ in the process of managing financial stability and growth through unconstrained government borrowing and expenditure. There will be many years to run before a real bursting of the balloon.

  

Enjoy the fantasy of a V while you can

It is too early to project what the new world will look like after this, but the world will change. The Black Death of 1347 – 1351 brought about huge changes, including contributing to the breakdown of the system of serfdom. The ability for individual labourers to demand a higher level of payment (money and food) for working on the lord’s, or the neighbouring lord’s fields, was opposed by the nobility and even resulted in the “Statute of Labourers” making it illegal to pay more than pre-plague wages / amounts. The Statute ultimately failed, but was implemented in places. The depopulation of manors and loss of serfs made the reality on the ground, so to speak, the driver for having to attract labour through increased wages.

So what types of changes might we see, and why?

In summary, expect cascading failures and pull-backs from existing economic activity to become self-perpetuating. Business failures will increase unemployment and reduce disposable income across the business services and service industries. Reduced incomes will impact retail while staff returning to the office will be entering a new world, with fewer people in the office at any time, and ‘home working’ becoming common. Manufacturing with recover, slowly, but during that recovery excess capacity will act as a drag on capital expenditure. Financial institutions, regardless of the level of government support and bailouts, will suffer a rising wave of commercial and individual defaults and bankruptcies. There will be failures of financial institutions, especially local banks and financial institutions are not considered of national or international systemic importance. The dream of recovered stock markets will die along with the destruction of Price/Earnings ratios and revenue projections. Social unrest and backlash against an uneven bailout will grow further, and will eclipse the “Occupy Wall Street” movement. The real danger is that the failure of “Occupy Wall Street” to result in any meaningful change will drive more hard-line social unrest.

So let us enjoy this time of quarantine and fear, when we are being told and still believe that everything will somehow return to the status-quo-ante. Let us enjoy this moment of the fantasy of the coming “V” shaped economic recovery, before we realise that a Nike Swoosh is probably the best we can hope. Yes, there will be a powerful rebound, but that will not be sustainable, and full recovery from the underlying recession or depression will take a considerable time.

Although this article focuses on the economics and potential economic impact of the crisis, there will be massive social and cultural impacts. I'm not addressing those here, though the impact will be more significant than we expect.

Employment

One of the first things that I hope we have all learned is that our society, no, our civilisation, is held together by people paid minimum wages. That profit is the primary motivator of companies, even in this time of crisis. As horrible as it may sound, to many companies, people are a fungible resource.

When economies do stagger back to life, businesses will discover that they are extremely tight for resources and cash, and that labour is plentiful. Are hiring companies going to pay a "living wage" if they can hire at slave wages and serfdom conditions? Profit is still the only meaningful motivation, and it will stay that way.

Yes, even in the middle of this crisis, profit comes first. There have been stories of private-equity backed Healthcare providers cutting the salaries, time off, and retirement benefits of staff, citing lost revenue. Let me just say, there is a special place in hell for people who make decisions like this. Maybe there will be regulatory intervention, and personally, I hope so, but I am not hopeful that the kleptocracy that runs corporations has a soul (certainly there are some, but I admit that I'm speaking in generalities here), or that it has any god before money.

Expect that as workers return, they will be returning to a working world in which their benefits have been cut and their pay is less, and they will be reminded that they should be thankful that they have a job. This is in no small part because a lesson from this crisis is that machines and automation do not need safe working distances, do not get sick, and do not suffer from rising health insurance costs, where employers cannot get out of paying health insurance.

The Statute of Labourers failed because the shortage of labour changed the economic equation. This time, if there is a Statute it will be for safe workplaces to protect production, not people. There will be no need for the Statute to constrain the cost of labour, because automation, reduced economic activity, and reduced demand will further undermine labour, with more labour than will be required.

There will still be very good employers, and there will be companies for whom their internal society is terribly important, and their people truly matter to the owners and managers. Yet most of these will be the privately held companies, and for the listed companies that rely on the highly skilled and knowledge workers.

Tourism

The first area of fundamental change will be tourism. Let’s look at one example; why will tourism and annual migrations from the UK to Spain be a casualty? First, we need to see why it grew and became the reality that it is. We need to follow the chain.

Higher incomes allowed people to travel to Spain every year. Cheap flights were possible because so many people could afford to travel, and the volume of flights and available seats that grew to meet that need drove down prices. The high level of available flights created the opportunity for the development of huge resorts, which once again become ‘cheap’ due to volume. Safe water and food removed concerns about health. Rising incomes in the UK led to more travel, which generated more airline seats, feeding more and larger resorts, building better destination infrastructure (including food and health), boosting local incomes, creating the economic capacity for outbound travel. And so a “virtuous” cycle continues.

Destroy any link in that chain, and that virtuous cycle collapses.

• Remove flights and seats, and the numbers of travellers plummet, resorts lose business and lay off workers, local incomes drop, impacting local infrastructure that services tourists.
• Remove perceptions that Spain is a ‘healthy’ destination, and the desire to travel falls, and with that fewer travellers, fewer flights, failing resorts, and carry on around the circle.
• Shut resorts (even for a short while) and local unemployment increases, reducing incomes, increasing pressures on infrastructure, and follow the circle. A high percentage of hotels are at risk of bankruptcy in tourist destination countries.
• Bankrupt hotels and resorts, and the property values of private residents will fall, making it difficult to sell those properties, creating a glut and resulting in property development projects failing and new projects being stopped. Properties go empty, jobs are lost, travel slows, and follow the circle.

How much will tourism change? I have no idea, but I do not expect tourism to ‘rebound’ any time soon. “Safe” destinations will be few, and capacity to carry tourists will be also limit any rebound. Even the perception of destination health will be impacted by reduced capacity due to loss of demand from reduced economic activity in the source countries. 2020 will be the “year without tourists”.

Greece, for example, is accepting already that there will be no meaningful tourist season this year. The economic damage will be significant, for a country that survives on tourism. There are large, high-end resorts on the island of Karpathos that are reliant almost entirely on tourism from Italy. That will not be happening this year. These high-end resorts will simply not open this year. But their debt will not disappear, nor will the need for basic maintenance, though that, of course, will be reduced by the reduced wear and tear from zero guests.

And yet tourism is only one sector.

Commercial property is another. There are two commercial property markets that will change. While we may not know exactly how “retail” or “business” will be impacted, we can guess. Each will be impacted differently, but for similar reasons.

Retail commercial property

In much of the developed world, in-store retail has been in decline with online retail taking a growing percentage of sales, though still small. In the UK, online grocery shopping has exploded, and may well become the norm. What will this mean? Supermarkets will shrink. Local grocery and ‘convenience’ store will remain, servicing smaller sales and local customers who do not move online. But I expect that in six months, possibly 50% of grocery sales will be online and delivery or collection.

Already a major supermarket chain in New Zealand has closed one of its large stores and converted it into a fulfilment centre for online orders. It is easier to fulfil from one location and provide central delivery management than to implement a store-picked and collect system in each store.

Grocery is only one area where this will become a new norm. Electronics, household, possibly even furniture will be bought online and delivered. Ikea, famous for their massive stores, may well find that much of their product moves online, and that foot traffic drops.

All is not lost. Expect shoe and clothing stores to, possibly, ‘survive’ because is it difficult to try on a pair of shoes, a shirt or jeans online. Browsing will also change, with some stores, clothing and other, already scheduling the booking time of patrons, or as in the case of Greece, limiting the number of shoppers to 1 shopper per “x” square metres or feet of retail space.

Commercial office property.

If we have learned one thing already, it is that we can work from home, and that people can be productive outside the office. Yes, some are not productive, but some were not productive in the office. “Video meetings of multiple people are not possible.” Well, actually, it has been possible for well over a decade, there just has not been "compelling reasons" to do so, when everyone was able and expected to come into the office, and business travel was inexpensive.

No more. There is now a compelling reason to not be in the office.

I’m guessing that once out the other side of this, total office floor space requirements will fall. While there will be a mandated increase in the floor space per person, the number of people in offices will drop dramatically.

For example, the number of people that actually need to be in the office has been falling for some time already. The General Medical Council in the UK has reduced floor space in London over the past years. Many jobs were moved to Manchester from London, and the London office was reduced to a single floor. Yet total employees in London began to rise again. As the numbers of people on the floor came close to reaching saturation, the order went out for all workers to work one day a week from home, and to hot-desk when in the office.

This worked, and it proved that people can work from home.

Many businesses are now discovering that all their staff can work from home. Internet speeds can be an issue, as can the availability of laptop computers for all staff. But computing capability and internet access in developed countries are ubiquitous, and companies are functioning.

Many businesses have discovered that they can work from home. Recently an Audit Committee met via video meeting from four locations, when historically all participants would have flown to the corporate headquarters. That was before the full work from the home requirement. Another meeting after complete lock-down brought together over a dozen company Directors for a working session, each via video from their home offices.

When this has passed and people are expected to return to the office, we probably will not have everyone in the office at any time. We may well divide our companies into Teams-A, B and C. Only one team would be in the office any given week. This would be to allow the socialisation aspects of work that are so important for company culture and giving people a sense of belonging, to allow training, and to provide the opportunity for face to face administrative activities (hiring, firings, reviews, etc). In such a scenario, even with each person requiring more space, the total floor space required by the company would drop by a third.

Reducing office space requirement by a third, even for a subset of companies, will depress significantly the total commercial office space required. It will also impact the supporting businesses that provide services, food and drink to workers, and the transport infrastructure required at peak times to move people to and from workplaces.

The fall in office space demand has started, and it will “fall off a cliff” through 2020 as companies change how they work, and of course, as existing companies go out of business in the recession/depression that is upon us, thus “freeing up” even more commercial office space.

The difference is that recovery will be slowed by the fundamental change in the way people work and in the way companies bring their people together for work.

Service industry

Considering the drop that we can expect in commercial office demand, the ripples from this will be catastrophic, or not, depending on your perspective. Possibly the only industry that will grow will be the professional cleaning services, who may find that the amount and detail of cleaning that will be required will shoot up and remain up, once businesses are able to reoccupy offices. The need to deep clean offices will remain, and pre-Covid cleaning was not enough.

But the CBD (Central Business District) coffee and sandwich shops, dry cleaners, document destruction services (printing could drop by 50% or more) and almost any business that supports offices will be returning to an environment in which much of client base has disappeared.

Public transport utilisation will drop. There will be fewer commuters, and there will be fewer miles driven (though people will use cars over public transport if at all possible). All services that rely on commuters and traffic will find their volumes have reduced and will take longer to recover than hoped. Public transport will continue to be the primary form of commuting in urban areas, but quite probably the ridership levels will decrease. Certainly, there will be a demand for higher levels of cleaning to continue.

Yet the rot will go far beyond services, and into production and manufacturing.

Manufacturing

Consider the Automobile industry. Shocked by supply chain shortages first originating from the shutdown of factories in China, automobile plants in Korea shut, and in the US factories have been shuttering temporarily. The collapse in the automobile industry was beginning before Covid, as a combination of market saturation and excessive debt was already manifest in reduced sales around the world. Covid has crushed not only demand but supply as well.

And with the economic depression that is coming, demand will remain low.

Demand will remain low across a range of products and services. Where there is demand today, that demand will be lower in the coming year or two, pushing small and medium manufacturing companies to the wall. For example, steel fabrication companies could be in trouble, if commercial and multi-residency property construction declines or fails.

Again, failures or contractions in one area of the economy will ripple through to other segments. Reduced personal and corporate incomes will reduce capital spending on higher value or cost items. This will result in lower production and lower incomes for manufacturing, resulting in failing companies and fewer workers, and so the cycle will continue.

As the companies fail or are so constrained in income and payment delays to survive, loans delinquencies will increase. And not just corporate loans.

Financial Services

This section might sound like "unfinished business" from the 2008 crisis, and the reason is that there indeed remains "unfinished business".

A new age of deleveraging is upon us. And unlike the 2008 crisis, this will not be short term. Of course, immediate deleveraging is not going to happen. The first thing that will happen will be massive stimulus to attempt to soften the blow and hopefully keep businesses open, or at least enable them to reopen after the lock-downs are lifted and people can circulate freely once again. But heaven help us after the end of the sugar rush – a rush as monsterous in size as it is becoming.

The age of massive consumer debt will come to a shuddering end. Without assets, there will be no credit, and leveraged assets are the first thing that is going to disappear. Leveraged assets include credit card debt and capacity, mortgage capacity, and the ability to borrow against the equity in high-value property or other assets. Consumer credit will increase in cost at the same time that consumer credit (credit cards, revolving loans, auto loans and student debt) will go into arrears, and default rates will climb. There simply will not be enough stimulus available to keep those loans from going bad.

It won’t happen overnight, but it will happen within months, not years.

Mortgages, rental and utility payments will not be forgiven, even if there is a moratorium on evictions of foreclosures. All that will happen is that the pain will be pushed out by a period of months, because rental property owners, individuals and small or large businesses are themselves leveraged, with their own mortgages or other loan facilities payments due.

Take away the incomes from a population that already lives pay-cheque to pay-cheque and stimulus will not keep them in their homes (rented or mortgaged) and will not pay utility bills. What will give first?

Moving now to corporate debt. Bond purchases by national governments can only carry on for so long. Eventually, the only bonds left to buy (or issue) will be junk, and governments will know that they are purchasing assets in the form of bonds that will default, because the underlying businesses will not be able to survive. We will see bonds being issues to pay operating costs and not for capital investment or other productivity creating an investment.

And be clear, with or without bans on share buybacks, clever CFOs around the world will be finding ways to shuffle bailout monies to the shareholders. These CFOs know full well that the defaults will rest only on the companies, employees and counterparties and ultimately of the government agencies that have purchased their debt. Yes, the shareholders will “lose everything”. But that “everything” lost will be lost after every last penny that could have been sent their way has been. Managerial bonuses will be paid, but not as bonuses. Advances on projected income; personal loan forgiveness, contractual obligations to forward pay multi-year benefits, and stuffed personal pension funds will ensure management gets the pie.

Yet all that will come at a cost to the financial sector as loans default, collateral is rendered valueless, and bonds default. Non-Performing Loans are going to grow at a scary rate in the coming year, and eventually, we should expect the creation of one or more national “bad banks” to hold the non-performing debt, while more money is pumped into zombie corporations that are “systemically important”. Of course, the money will not be pumped into the original failed companies, but into the companies that will be required, via central bank mandated shotgun weddings, to purchase the assets of the failed companies, including their outstanding debt.

Ultimately that newly created debt will need to be paid, and there are two options only; greater productivity that grows at a pace faster than the debt, or through inflation. And inflation will need to be at a pace, ultimately, that is faster than the growth of the debt.

So who has confidence that their government will be able to manage that and not turn all our countries into later day Zimbabwes?

Prediction: A Minsky Moment is coming sooner than you think

Tipping points, unstable situations, Minsky Moments.  In 1996 Greenspan used the now famous phrase "irrational exuberance" to describe the Dot-Com bubble of the 1990s. "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions," he asked.

He was foreshadowing the coming Minsky Moment when the bubble popped. We are almost there, again.

Well, the US markets have reached a new record high. They have been pushing for that, ignoring data and building on the dream of new records. Each tweet from Trump is met with either a small market retreat (if bellicose) or a jump when he declares victory and withdraws (what I call the "Vietnam Solution"). Each manufactured crisis is shrugged off for the noise that it is, while each resolution of the manufactured crisis is greeted as a stunning "victory", and the markets move accordingly. Irrational Exuberance anyone?

Yet behind all the noise is the real economy, both the US and the Global economy as composed of a myriad of individual and linked economies. The reality is that the real economy(ies) are not in great shape, and this has not been priced in.

The past two weeks I've been watching the US markets go up and up, while at the same time the safe-haven, go-to-when afraid Gold price has bounced above $1400 for the first time since 2013. Normally when stocks go up, fear assets such as gold go down.

The US is now in uncharted territory, having entered the longest recovery on record. So just how much more "up-side" is there, or are investors "picking up nickels in front of a steamroller"?

Meanwhile, industrial production indices such as the monthly ISM are falling, and in some national (Germany) and US regional cases have fallen below 50, meaning contraction.

House prices have been falling in London for over a year, and housing starts and purchases in the US have been falling for months. 

The yield curve has now fully inverted. Why does this matter? Every (US) recession for the past 50 years has been preceded by a yield curve inversion, with the average time to start of the recession being 9 months from date of inversion. The yield curve inverted in March.

This to a background of continually rising corporate debt through the issuance of corporate bonds. "Companies from advanced economies, which hold 79% of the total global outstanding amount as of 2018, have seen their corporate bond volume grow by 70%, from USD 5.97 trillion in 2008 to USD 10.17 trillion in 2018." These bonds loads are easy to manage in a world of low interest rates and high liquidity.

And - the Fed is talking about cutting rates. Really? Cutting rate in the best economy ever? The entire point of starting to raise rates was to ensure there was enough "ammunition" (Feb rate cutting ability) to withstand another recession.

Finally, some are saying that the US (and the globe, for that matter) may already be in a recession.

Yet the US unemployment rate continues to fall, the participation rate (the percentage of the population that is employed) remains stubbornly lower than before the Great Recession.

So, when will we have our Minsky Moment, when sentiment turns and the rout begins in earnest?

It cannot be far away. And three months is probably very far at this point. 

How far will markets fall? That is anyone's guess. But they will fall, and it will be farther than most people would imagine today.

Baltic Dry Index - dropped like a stone

In September I suggested that the Baltic Dry Index was telling us to worry. Now it is telling us to be very afraid. Then I highlighted the fact that the Baltic Dry Index had dropped almost $300 to $1477 from its high of $1774. That turned out to be transient, and there was some recovery. In the last month, however, the BDIY (technically the Baltic Exchange Dry Index) has dropped like a stone, and now stands at close to one-third of its previous high.

The Baltic Dry Index provides a composite cost of shipping bulk goods and commodities, and provides a forward-looking view of global expected trade volumes.

Late last year, the index began to fall, and into the new year the fall has picked up steam. Year-to-date the index is down almost 50%, and has dropped almost two/thirds from its 2018 high. 

The BDIY is now at $610, a drop of $1164 in the past six months, and a drop of 52% from 1 January 2019, six weeks ago.

Baltic Dry Index as of 8 February 2019

It looks like we may be at the start of a recession due to a build-up of inventories and a concurrent reduction in international trade. The 1920/21 recession, usually attributed to difficulties in the economy adapting to the post-WWI increase in the labour force, also saw the forward buying of inventory resulted in bloated inventories and a collapse in demand. The resulting deep-V recession recovered because there was no intervention. This time, there will be significant intervention again, which instead of allowing the system to cleanse itself, will probably simply extend the period required for a real recovery.

If the Baltic Dry Index is right, and trade volumes are collapsing, then we are in for a rough ride, starting sooner rather than later.

Flocking Black Swans

Thinking and talking about "Black Swans" as unexpected or unforeseen market or economic events has become almost blase, yet the use of the term in this context is quite new, dating to Taleb's analysis of the 2008 financial crisis. Now almost anything that we don't (or didn't) see coming is a "Black Swan".

How many of these Black Swans are actually unforeseen? How many are simply emerging risks that have come to fruition? Should we really be unprepared for these events?

Right now, without even adding meteors or pandemics, I can list a series of potential Black Swans, any of which could have a serious impact on the global economy. These range from Tariffs/Trade War to Brexit induced recessions in the UK and Europe, to Emerging Market credit crises or Chinese economic woes. It reminds me, again, of one of my favourite phrases: "It is easy to predict the future; getting the dates right it the difficult part".

And so the question; When? Some of these Black Swans could be brewing now, and may already have caused the underlying damage that will only be apparent with hindsight. Others may eventuate at any time. 

Flocks

When considering Black Swans, the most important difference between "reality" and the concept is that Black Swans, the birds, stand out because they tend to be a solitary, and are not intermingled in flocks of White Swans. 

Swans, while solitary, do pair and can be seen in bevies, eyrars, or even gargles or herds, especially on the River Thames, where all "mute" or unmarked swans are property of the Queen (Act of Swans, 1482). Each year the Upping of the Swans takes place in the third week of July, when over a section of the Themes, all swans are caught, inspected, given a health check, and then released. 

All this to say that we think of Black Swans (back to the the economic events) as singular events, when in reality they cluster, or to use some of the collective nouns for swans, there could be a "bank of (black) swans", or even a "whiteness of (black) swans". The initiating event may not even be readily apparent during the period of crisis. 

Contagion

So which was the primary cause of the Global Financial Crisis: the collapse in values due to the MBS/CDO sub-prime collapse, or the resulting impact of Mark-to-Market and resulting impact on the capital value of financial institutions? It could be argued, and was, that as financial institutions typically match their assets to their liabilities from a duration perspective, they were holding securities that were to be held to maturity, and therefore there was not financial impact unless they were required to sell their bond holdings.

The point is that any of a number of Black Swans may arrive concurrently or with only a few months between. Some will create the conditions that bring about additional crisis.

So to timing

As mentioned above, it is quite possible that some of our Black Swans have already inflicted the damage, and we are simply waiting for the evidence to come through - the evidence that may push some other situations over the edge.

The Trade War, Emerging Market debt, and the Chinese Economy are good examples of potential contagion. 

The recent +4.1% GDP change print for the US is being presented as a great result, but is it a reflection of underlying economic strength, or a reaction to threats of higher costs from tariffs? I do not know the answer, and we will only know with certainly at the next GDP print in October, just in time for the mid-terms.

One thing we do know is that the tariffs and global uncertainty aremdriving the value of the US$ higher, imposing additional costs on Emerging Markets while also suppressing US exports. This is supporting an expansion of the US trade deficit, and is hitting Emerging Market bonds with significantly higher costs.

So if, and it remains a big "if", the GDP print this past quarter is a reflection of anticipation of the impact of tariff and a Trade War, then we will know for certain in three months. But the damage will already be done, and the US economy may well have flipped into recession by then.

Equally, the Trade War may drive another potential Black Swan; an Emerging Markets financial crisis. Certainly that crisis may arrive all by itself, with an end-of-credit-cycle unwinding of EM opportunities as US, UK and EU treasuries are forced to pay higher yields, and a consequent "flight to safety".

Mixed in with all of this, there is the potential Black Swan of a serious credit squeeze in China, resulting in another huge stimulus program, and a potential draw-down of US treasuries to pay for the stimulus. When Russia sold almost $50 billion in US treasuries earlier in 2018, US 10-year rates jumped to 3.1% from a around 2.9%. What would be the impact of a $100 or $200 sale of US treasuries by China as part of a stimulus programme?

Let's guess at timing

We need to keep watching  indicators from around the world, and look for specific activities. The Baltic Dry Index provides a good indicator for us to watch. In the past moths, the Index has risen from $1250 to over $1700 now. The Baltic Dry Index provides a reliable surrogate for global trade volatility, with higher trade volumes increasing the cost of freight, and falling freight volumes driving down the BDI. 

It is also is a close to real-time indicator, with pricing of freight being highly sensitive to the actual trade volumes and projected volumes. 

I will be watching that over the next three months, looking to see if the Index remains high, or if as I suspect, pre-tariff activity will taper off, and we will see the Index fall.