Steen Jakobsen, chief economist of Saxo Bank in Denmark, says things are so bad they cannot get worse. Please consider Rediscovering the Price of Money.
I’ve been starting my speeches for some time now by saying: “I am the most optimistic I have been in almost thirty years in the market—if only because things can’t get any worse.”
Is that true, and more importantly, how do we get a fundamental change away from this extend-and-pretend which prevails not only in Europe but also the world?
History tells us that we only get real changes as a result of war, famine, social riots or collapsing stock markets. None of these is an issue for most of the world—at least not yet—but on the other hand we have never had less growth, worse demographics, or higher unemployment since WWII. This is a true paradox that somehow needs to be resolved, and quickly if we are to avoid wasting an entire generation of European youth.
Policymakers try to pretend we have achieved significant progress and stability as the result of their actions, but from a fundamental point of view that’s a mere illusion. Italian banks today own more government debt than before the banking crisis, leaving them systematically more exposed to their own government, not less. The spread on government bonds between Germany and Club Med is down below historic averages, but the price has been a total suspension of the “price discovery” of money.
The price discovery of money is the cruel capitalistic part of any system. An economics textbook would call it the modus operandi by which capital is allocated where it can find the highest marginal utility. In practice, this should mean that the market dictates the price of money beyond one year—while at durations of less than one year, the central banks determine the price of money. The beauty of the system is that money is allocated in an auction where the highest bidder for “money” or “credit” gets filled on the price he or she deems to match his expected price of money.
Contrast the market-driven model with the present “success story” of relatively low sovereign spreads in Europe, which are driven by the European Central Bank president Mario Draghi’s promise to do "whatever it takes" to keep the euro out of trouble. He has threatened to activate the European Financial Stability Facility and the European Stability Mechamism plus the full arsenal of policy tools to ensure stability.
By doing so, he has effectively suspended price discovery for sovereign debt and for money, as the ECB and local central banks will provide infinite liquidity to local banks and hence indirectly to their government in any market conditions. This one-sided offer from the ECB and the market means there is no power to discipline the government with higher rates or to allocate credit more generally. We have simply disconnected the market and the price of money.
This comes after Draghi’s longer-term refinancing operation, a cheap funding for banks with little or no collateral, or the closest thing to quantitative easing you can have without calling it quantitative easing.
This is a problem because corporations that need to finance long-term projects, like building a power station over six to eight years, need a price for the credit they require throughout the building period. Right now they have an almost flat yield curve from zero to 30 years, which would be fine if it were realistic. But the problem is that one day in the “distant future” when the market normalises, interest rates should revert to their normal price, which is roughly inflation plus a risk premium.
In the case of an industrial company, an appropriate loan rate calculation could be something like: inflation plus Libor plus a risk spread, which might work out to about seven percent. Compare this with the rates available for highly creditworthy companies. Recently, Nestle was able to issue a four-year corporate bond at 0.75 percent—the lowest ever. Yes, it’s nice for Nestle but remember the situation is created by the central banks presence in the market, not just due to the financial strength of Nestle.
A move from less than one percent to seven percent would administer an ugly shock to companies. We have created a negative vicious circle in which not only investors, but also companies are depending on low interest rates forever. They have priced their future earnings and costs on government support prices rather than on realistic market prices.
The worst thing about the situation, however, is that the reason a blue chip company like Nestle can borrow at less than one percent in the capital market is the lack of alternatives for banks and investors. Less creditworthy small and medium enterprises (SMEs) which make up as much as 80 percent of many countries’ economies are not allowed to borrow. They are deemed too risky to lend to at the current “market rates” even though they hold the key to improving the employment and productivity picture.
They are willing to work cheaper, longer, harder and with higher risk tolerance in order to survive. So the remaining 20 percent of the economy occupied by large and publicly listed companies and banks gets 95 percent of all credit and 99 percent of all political capital. In other words, blue chips receive artificially low interest rates only because the SMEs don’t get any credit. Herein lies my continued belief in the my traditional opening statement: things must get better soon because they can hardly get any worse.
We have never been in a more dysfunctional state at the corporate, political and individual level in history. It’s time to realise that the reason capitalism won the war against communism in the 1980s was its strong market based economy—itself based on price discovery. Now the policymakers in their “wisdom” are copying everything a planned economy entails: central planning and control, no price discovery, one supplier of credit, money and the corollary effect of suppressing SMEs and even individuals.
Finally, history offers a compelling lesson: the last time the Federal Reserve engaged in a sizeable quantitative easing was in the 1940s. The low growth and falling inflation only reversed when the Federal Reserve stopped intervening due to a severe recession brought on by the policy mistakes of keeping QE in place too long.
In 2014, a bout of near or real recession in Germany and the US could kick start the price discovery mechanism again, which will help us to start healing the deep wounds left by years of policymakers compounding their errors with round after round of extend-and-pretend. Getting to the bottom is good in one sense: the only way is up.
By Steen Jakobsen
Can Things Get Worse?
I certainly agree with Steen on the dysfunctional state of the global economy, price discovery, and the implied bubble in corporate bonds. But are things so bad they cannot get worse?
In what sense? Any normalization of interest rates is going to crash the corporate bond market. When bonds crash, stocks will join the party. Is that better? Actually it is, but most won't view the accompanying recession as "getting better".
Illusion vs. Reality
The Fed offers an illusion that things are getting better now. The reality is the global economy has been getting more dysfunctional (and that dysfunction happened to lift financial assets).
Why Can't Things Get Worse?
- Abenomics is guaranteed to heighten trade tensions and make things worse.
- What about the surge of the Eurosceptics in parts of Europe?
- What about the surge of Marine Le Pen' National Front party in France?
What's the Definition of "Better"?
What's "better" is in the eyes of the beholder. Some may construe anything that hastens the breakup of the eurozone is for the better.
Does the line stop at the National Front in France? With the neo-Nazi Golden Dawn party in Greece?
Breaking Point Optimism
Those who want to be optimistic on the basis "things cannot get more dysfunctional" have numerous things to be optimistic about
- Global Equity Bubble
- Corporate Bond Bubble
- Sovereign Bond Bubble
- Central Bank Intervention
- China Property Bubble
- China shadow Banking
- Trade Protectionism
- US Militarism
- Social Security Promises
- Pension Promises
- European Bank Leverage
- European Isolationism
- Canadian Housing Prices
- Australian Housing Prices
Recovery From the Ashes
Optimists who believe "things cannot get much worse" must expect the dam to break on most or all of those bubbles and distortions at once. Curiously if a dozen of the above dams/bubbles did break at once, it sure would not feel good when it happened, even to the optimists.
I suggest that if Steen's optimism is justified (and perhaps even if it's not) asset prices are highly likely to get clobbered, with equity prices dropping as much as 50%.
Yet, economically speaking, that would be a good thing, especially if a sound banking system (void of fractional reserve lending) arose from the economic ashes.
Unfortunately, a word of caution to the optimists is warranted. Central banks have a proven history of making matters worse over time and not learning anything along the way.
Mike "Mish" Shedlock