Go to the fringes of the investing world and you will find individuals with unconventional approaches, strong alternative opinions, or both.
There are various topics around which these strong opinions are formed: gold, the accuracy of various economic schools of thought, the ability of governments to create money, different measures of economic data and the actual underlying strength of different economies, the value and predictive power of various cycles and their accompany indicators…
But one of the simplest – and most divisive – of these topics is inflation. How much will money in the bank today, be able to buy you in the future?
You get the inflationistas, who believe the world is on a terminal trajectory towards currency devaluation on a vast scale, where cash gets trashed and the price of milk (along with everything else that’s tangible) rockets…
And then you get the deflationistas, who see the global debt burden and the oncoming horde of retirees driving down demand for goods and services to the point where those who provide them keep cutting and cutting costs to stay afloat. A world where everything just gets cheaper and cheaper (stocks included), and employees expect pay-cuts every year (the Japanese experience).
There are also folks in the middle, who believe that the latter scenario will lead to the former – that the brutal impact of prolonged inflation will be so painful that governments will throw the kitchen sink at the problem, in classic fashion go too far, and unleash the aforementioned bull market in the price of milk.
The inflationista/deflationista battle rages on at the fringes, while the mainstream financial industry is mostly content with the idea that the world will muddle through whatever happens, and everything will be OK provided you’ve invested your money with them and they’re taking a clip off the top.
What I’ve found interesting to watch this year is that some of the individuals in the deflation camp have switched sides, moving over to the inflation camp due to the response of governments to the WuFlu.
One of these individuals is the great market historian Russell Napier based up in Edinburgh, who I’ve a great deal of respect for, as do several others at Southbank Investment Research – in fact, he spoke at one of our conferences a few years ago. I’m continually fascinated by his observations, and was very interested to discover why after 25 years of seeing the world facing deflationary problems, he now believes we have entered “the era of inflation”.
We’ve written a fair bit this week on the topic of inflation and how it could destroy the wealth of investors who are unprepared for it. So far, we’ve been dwelling on the union of both governments and central banks as the probable cause. Napier points to a more subtle, yet just as destructive mechanism – which has been unwittingly discovered and already set in motion by the UK government.
Inflation machine
A while back in an email thread, myself, a few editors, and our publisher Nick O’Connor were discussing what the results of all the monetary and fiscal stimulus would be.
I highlighted that the speed with which money was being spent through the economy – the “velocity” of money – was collapsing, which was offsetting the attempts by those at the Bank of England to speed it up through cheaper borrowing costs. For all the cheap money on the table at the central bank, it didn’t appear that the commercial banks were lending it out to anybody – quite possibly because few people are out shopping for new houses in lockdown.
Nick O’Connor’s view on the commercial banks’ reluctance was, “They’ll find someone to lend it to. Or they’ll be forced to.”
It turns out that the government doesn’t actually need to use the stick to force money creation by the commercial banks, but the carrot instead. The government hasn’t opted to force lending – instead it’s guaranteed loans, which incentivises it.
That way, the banks will lend (thus creating money) whether the person or company they are lending to is likely to pay it back or not. Worst case scenario, the bank gets the loan paid back with interest, which is all it was in the game for in the first place. What bank wouldn’t do it? It can’t lose.
Napier has highlighted how the “Bounce Back” loan facility the government created in the wake of the crisis for businesses has created exactly the above dynamic. The scheme was intended to help tide businesses over through the lockdown with commercial bank loans that were backed by the government.
From an Financial Times article on the matter from late May, emphasis mine:
UK banks are warning that up to half of the £18.5bn of “bounce back” coronavirus loans are unlikely to be repaid and are lobbying the chancellor to prepare for the collapse of hundreds of thousands of small businesses.
Three senior bankers estimated between 40 per cent and 50 per cent of the 608,000 borrowers who have accessed the Bounce Back Loan Scheme, or BBLS, could eventually default on the debt as the prospect of a quick economic recovery fades. The emergency BBLS facilities are capped at ÂŁ50,000 with a term of up to six years and come with a 100 per cent government guarantee on the capital and interest…
One executive said about a quarter of the loans would not have been made under normal lending practices. However, the Treasury instructed banks not to perform standard credit checks — apart from basic viability and fraud screening — to speed up the payments and help stave off bankruptcy for companies unable to endure the lockdown.
“Some arrangements will have to be made. A lot of them will be written off or converted into something else,” said one bank chairman. “In most cases the idea of the government taking equity in these companies is unrealistic — they are simply too small. So the question is what’s going to happen to all of these loans?”
… Some Tory MPs share bankers’ fears and believe the government could not afford the political fallout of so many small businesses being closed down after being pursued by the state.Â
The majority of money within our economy is created by the commercial banks – the likes of TSB, Lloyds, HSBC, Santander – who create that money by lending it out. With the government placing a guarantee on a certain type of loan, it is in the banks’ best interest to create as many of those loans (create as much money) as possible regardless of the creditworthiness of those taking it – indeed, in the above example the Treasury itself told banks not to do credit checks! In this way, a government backstop creates a structural change in bank behaviour to create money without bothering to be reasonably sure they’ll get it back – an incentive to create money for its own sake.
It’s like the banks are creating money to spend on the government’s behalf… and the government only has to chip in for it in the cases when the money can’t be retrieved afterwards.
It’s Napier’s belief that this government’s newly discovered power to drive money creation at political problems through commercial banks is here to stay, and will be directed at the likes of climate change next. There’s nothing so permanent as a temporary government programme, after all. But as we mentioned earlier, commercial banks control a much greater share of the money supply than the central banks… and the money they create has a much greater impact on things in the real world – like the price of milk.
It’s hard to imagine the government giving up such a power. But if you accept that, it’s hard to imagine how inflation doesn’t return with a vengeance too. Luckily, investors in the UK have a trick up their sleeve in protecting themselves against inflation – a trick investors in many other developed nations don’t have. But one which few people recognise – which we’ll be exploring tomorrow.
All the best,
Boaz Shoshan
Editor, Capital & Conflict
Category: Market updates