Absolute Return Partners letter for the month ended July 31, 2016; titled, “Thinking Outside The Box.”
“Every economic problem can now be solved, but governments prevent the solutions from being implemented.” — Woody Brock
As a boy, my parents always told me I talked too much. “Think before you talk”, was my parents’ standard response, when I went into another tirade. Many moons later, those words continue to sit firmly in the back of my head. I have so much to say about Brexit, but I need to think before I talk.
Consequently, I have decided to publish a one-off mid-month Absolute Return Letter, covering the potential ramifications of Brexit and a few other thoughts related to the Brexit subject, and I can assure you that one or two of them will raise a few eyebrows. You should therefore do yourself a favor and read the Brexit letter, when it arrives in your inbox about ten days from now.
On a different note altogether, imagine sitting in one of the finer restaurants in Geneva with a prospective client and Woody Brock, your economic adviser. A waiter approaches your table and asks if anyone has any questions re the menu. Woody inquires about the chicken dish. “Oh, that is delicious”, the waiter says. “Most definitely one of my favourites”. “But is the chicken breast from a lesbian chicken?” Woody inquires. The poor waiter is gobsmacked and doesn’t know what to say. At first, the client and I are both convinced that Woody is just trying to wind up the waiter, but we quickly realise that he is dead serious. “Those chicken breasts are by far the juiciest, and you should know that”, Woody reprimands us, and for a while we feel like schoolchildren.
Now, many years after the chicken night in Geneva, as I still call it, I cannot remember how it all ended (that’s what happens when you are in stitches of laughter), apart from the fact that I learned a couple of important lessons that evening. I learned that economists come in many varieties, and that Woody is certainly one of the more colourful ones, and I learned that he is exceptionally good at thinking outside the box, which he has proven again and again over the many years that have since passed.
He proved it again as recently as three weeks ago, when he stopped by our offices in London, as he usually does, when he is in Europe. For those of you who don’t know him, he is probably best described as an economist extraordinaire. He is way past the point of trying to estimate how fast CPI is currently climbing, or whether GDP is rising 1.25% or 1.5% this year. He lets the mere mortals deal with simple things like that. Woody’s full and undiluted attention is instead on longer term topics that are likely to change the world in front of us. What I particularly like about him is that he is usually right for the right reasons. His observations and conclusions are so well researched that you rarely (if ever) catch him in skating on thin ice.
So, when he came to see us recently, I had high expectations, as I always do when Woody is in town. Having known him for many years, I have come to expect one or two surprises every time we meet, and he didn’t disappoint me this time either. In fairness to Woody, he didn’t use those exact words, but essentially he told us that the only solution to the ongoing global growth misery is helicopter money.
Closing the loop on the June Absolute Return Letter
Let me share his thinking with you but, before I do so, I want to make a point or two about last month’s Absolute Return Letter. I received quite a lot of feedback on that letter (which is always greatly appreciated – thank you), and I have certainly been guilty of not responding to every single reader who wrote to me, but I hope you understand that I also have a day job to do.
The common denominator in the emails I received was something like this: “How can you be certain that ageing will lead to higher inflation? It hasn’t done so in Japan”. My English is obviously not as good as I thought it was, if that was the impression I left, but I thought I made it quite clear that this was a viewpoint expressed by the Bank for International Settlements (‘BIS’) and that, if BIS are proven correct, a lot of people – me included – could be taken by surprise in the years to come.
Another point raised, and a very valid one indeed, is how can one be sure that we are dealing with independent variables? How can one be sure that rising inflation in the 1970s and falling inflation since was caused by a change in the dependency ratio and not by wildly fluctuating oil prices? BIS obviously tested for this and claim that their results are robust but, as I haven’t seen the test results, I can only take their word for it.
It all began with declining inflation
Back to the topic of this month’s letter. Why does Woody think that the only solution is helicopter money? Before I answer that question, I need to provide a bit of background, and the story starts with the dramatic fall in inflation most of us have experienced since the early 1980s.
It started in earnest when Reagan and Thatcher broke the back of the unions. By doing that, they managed to break the wage-price spiral. Adding to that, a number of positive productivity shocks have made it possible to produce more at lower prices, and no productivity shock has been bigger than the .com revolution.
Global competition has intensified at the same time, adding further to overall pricing pressure and, in that context, no country has had a bigger impact on global pricing than China. At the same time, cost-push inflation has become less and less of an issue, and animal spirits took a knock, when the Global Financial Crisis turned almost the entire world upside down in 2008. As a result of all of the above, inflation expectations declined and, when they did, actual inflation also dropped.
Moreover, country specific factors also contributed. In the U.S., for example, a very strong dollar when measured on a trade-weighted basis, has added further downward pressure and, in Europe, the Eurozone crisis, which peaked in 2011-12, continues to do considerable damage to animal spirits. Meanwhile, in Japan, a very strong Yen hasn’t exactly made it any easier for the Bank of Japan to create that little bit of inflation that is synonymous with a successful monetary policy program. Most recently, the Brexit crisis hasn’t exactly helped either.
A combination of all those factors (and more) has had the effect of pushing the demand curve to the left and the supply curve to the right (chart 1). Demand is no longer represented by D but by D1 in chart 1, and supply is now S1. The result? A declining inflation rate, which will ultimately lead to falling prices in absolute terms – i.e. outright deflation – if no action is taken.