Some wise words from John Kemp at Reuters on Tuesday, now contemplating the side-effects of the bubble in fear:
It is the importance of non-rational motivations that explains why Keynes placed so much emphasis on “animal spirits” or the state of investors’ and entrepreneurs’ expectations. By sapping that willingness to shoulder a degree of incalculable uncertainty, the bubble in fear destroys the vital process by which economies form capital, grow and generate employment.
In short, irrational fears are prompting a run on safe assets which in themselves are leading to irrational voluntary destruction of principal via self-imposed negative rates.
And as we’ve noted previously, this sort of self-imposed austerity now incentivises economically destructive processes, or as Kemp puts it, the destruction of the vital processes by which “economies form capital, grown and generate employment”.
So what to do in such a crisis?
As Kemp points out, one option is for authorities to challenge investors on their irrationality. Impose rates that seem even more irrational than those investors are currently willing to inflict on themselves.
In other words, cut rates below the rates that are being imposed in the non-banking universe — the one area which cannot benefit from artificially propped up rates by central banks:
In responding to a bubble in fear and unwillingness to invest, one option for the authorities is to try to burst the bubble by raising the costs of holding safe, liquid assets, force investors to reconsider their preference for liquidity, and shift into riskier assets.
Keynes was scornful about “investors” who wanted returns without shouldering any risk and uncertainty, and called for the “euthanasia of the rentier” through policies calculated to slash the returns on riskless assets or even make them negative.
Since the zero-bound complicates matters, central banks have used quantitative easing to work around the problem.
This works by supplying the market with more liquidity than it needs. Or rather, more liquidity than the world’s existing stock of risk-free assets can ever hope to absorb … on the hope that investors will opt to direct the surplus into riskier securities — rather than suffer principal destruction in the safe ones.
But the problem is that principal destruction is not turning investors off safe assets. The bubble in fear still dominates.
As Kemp notes, this is a situation that Keynes himself envisaged — one reason he advocated government stimulus and intervention:
Keynes himself, though, was sceptical about whether monetary policy could overcome a bubble in fear and extreme demand for liquidity. It is why he argued that, in some circumstances, the government should step in to commission the investment that firms and households declined to commission themselves.
Because the government can spread risk across the whole of society, its capacity to accept negative outcomes on at least some projects, is far higher than for any single business or individual. It was the government’s superior capacity to bear risk — not any inherent belief in its capacity to make better decisions — that led Keynes to advocate greater state-led investment when the economy becomes gripped by a bubble of fear.
This in a way is what we are seeing in China.
The authorities there are clearly worried less about investing money wisely than in distributing credit to the masses. Indeed the thinking seems to be that, providing the needs of the many are served, who cares if a few bad investments pop up here and there.
It’s a view that accounts nicely for China’s general disregard of default stigma.
Indeed, we wonder, would a subprime crisis ever generate as many foreclosures in China as we saw in the US?
In many respects, the country’s socialist mindset, makes it ideally suited for dispensing Keynesian-style stimuli and in that sense much more capable of dealing with the ‘fear bubble’.
Hence last week’s moves to cut bank profitability in favour of providing the system with exactly what it needs (in terms of credit). When action is needed, action is bold.
That said, even in the west, there’s a good chance that the fear bubble will peter out eventually, says Kemp:
With or without government intervention, the bubble in fear will eventually unwind. Sharp observers have already begun to mutter darkly about “financial repression.” But financial repression is no accident. It is the deliberate objective of a policy designed to curb the demand for liquid assets and force greater willingness to commit to less liquid forms of investment.
Eventually, enough households and businesses will recognise they are overpaying for liquidity and safety. In the meantime the best way to think about current financial conditions is as a bubble in fear and demand for liquidity, which has continued to inflate even as real economic and financial risks have begun to recede, and must eventually collapse when the usual bubble-generating processes are no longer capable of inflating it further.
His point on financial repression, we think, is a particularly good one.
It is, as he says, the system’s natural reaction to being overcome by liquidity anxiety. Capital must be destroyed in order for liquidity to be usefully deployed once again — especially if it is to deliver investment returns.
Hence, why wars are so hugely useful for dealing with economic depressions. They permanently and effectively destroy capacity. Not just the surplus capacity that plagues the system, but core capacity, which serves a genuine economic need. Indeed, it’s the need for the capacity to be reinstalled that in many ways justifies a return on investment again.
If the system needs the capacity, the investor will be rewarded for funding it. If the system doesn’t need it, they won’t.
At this point, however, we have to respectfully disagree with Kemp. We simply don’t think that this particular fear bubble will unwind in the way he envisages.
As we’ve written before, that’s because there’s a good chance that this time may truly be different — in-so-much as the system hasn’t just been satiated in terms of capacity, it’s been completely overwhelmed.
To revive returns we’d either need to destroy capacity on a horrific level –– and make ourselves much, much poorer as a result — or come to terms with the fact that returns on investment will never be the same again.
If the last point is true, that means learning to deploy liquidity (or capital) in a completely new way. Investing to cater to society’s non-material and less tangible needs — such as the added value, the personal touch, services, human interaction, education and so on — rather than material goods outright.
It’s a shift that’s arguably already begun (chart courtesy of James White at Colonial First State Global Asset Management):
Of course if that is the case, the fear bubble won’t so much burst, as eat itself out.
Simply speaking, on-tap liquidity combined with zero default stigma (just look at the recoveries of Ireland and Iceland) ultimately leads to all risk-free “store of values” inevitably becoming redundant.
Enough is enough of the age of consumption – FT
Beyond scarcity – FT Alphaville
The negative carry universe – FT Alphaville
On price stability during an ‘abundance shock’ – FT Alphaville