Saturday, 5 August 2017

Deflationary delusions, the wealth effect, and the direction of causality

Of the many absurdities traditional economic theory has served up, one that I find particularly bemusing is the following: that deflation is an economy's mortal enemy because it causes consumers to defer consumption on the expectation that prices are likely to decline in the future, hobbling economic activity. The idea emerged after a multi-decade period of deflation in Japan which saw concurrent weak consumption/growth.

Consumers, we are supposed to believe, are such hyper-rational economic agents that they are willing and able to defer their collective consumptive gratification for extended periods in order to avail themselves of modest price declines in the order of perhaps 1-2% a year.

Economists would do well to occasionally check their theories against real world evidence and data, not to mention descend from their ivory towers to chat to Main Streeters from time to time. If they deigned to do so, they might quickly come to question some of their conclusions.

How does one, for instance, reconcile the theory with the fact that real world consumers' desire for instant gratification routinely causes them to pay interest rates of 20% or more on credit card balances? The existence of virtually the entire consumer financing industry stands in obstinate refutation to the theory. And further, how does one reconcile the argument with the fact that consumers routinely purchase new automobiles, televisions, and smart phones in the fullest of knowledge that their market value will rapidly depreciate as technological obsolescence inevitably follows?

The much more logical explanation for the historical relationship between weak consumption and deflationary outcomes in places like Japan is that economists have the direction of causality the wrong way around. It is far more likely that it is weak consumer demand that gives rise to deflationary pressures, not that deflationary pressures give rise to weak consumption (there are some things in life you have to have a PhD in economics to not understand).

So how did the direction of causality come to be so catastrophically misconstrued? It likely had a lot to do with another dubious neoclassical argument cum belief cum dogma: namely that lower interest rates ought to always result in a combination of reduced savings and (hence, by definition) increased consumption. The argument is that with the economic return to saving declining (i.e. interest rates), the incentive to defer consumption is reduced. Consequently, with interest rates so low in places like Japan - indeed zero or even less - savings ought to be low and consumption high.

However, for decades, the exact opposite happened in Japan. The lower interest rates went, seemingly the more consumers saved. Economists were stumped. This mysterious lack of willingness to consume meant either that (1) economists' models were wrong at a fairly fundamental level; or (2) consumers were perhaps deferring consumption due to deflating consumer prices (because it is impossible on their models that consumers would willingly save more in response to lower interest rates); deflation was, after all, the only apparently unique feature of Japan's economy in its post bubble years. Predictably, economists opted for the second alternative. The consumption conundrum was deflation's fault, it was decided, and deflation was declared public economic enemy number one.

The problem is that in the real world, there are actually very good reasons why consumers may decide to maintain or even increase their savings rates in response to lower interest rates. The idea that low rates ought to reduce consumers' incentive to save might have some validity if people never grew old and wanted/needed to retire. Alas, in the real world consumers do grow old and retire. Consequently, they need to time-shift their consumption (i.e. net save during their working years and net consumer during their retirement years), whether they would like to or not.

Low interest rates in fact inhibit this time shifting, by lowering the compounding investment return households' retirement savings can earn throughout their working lifetime, which results in households needing to save a higher percentage of their monthly paycheck to have any hope of reaching their retirement savings goals. It is quite likely this has - in conjunction with an aging and shrinking population that has amplified these forces - actively contributed to weak consumer demand and hence deflation.

This inverted reality is not a dry academic nicety without consequence, as the remedy of choice for central banks the world over to ward off deflationary threats has been to lower interest rates and undertake QE (which further lowers interest rates down the yield curve). It means, in short, that the medicine may in some instances actually prove worse than the disease.

But what about the West?

The obvious retort to the above is that lower interest rates have indeed succeeded in lowering household savings rates and increasing the level of household consumption for many years in a number of western current account deficit economies such as NZ, Australia, Canada, the UK, and the USA. Japan appears to have been anomaly (especially prior to 2007).

However, this has not been due to a rational decision to save less in response to reduced incentives to do so, but rather due to the wealth effect rising stock and (especially) house prices, which are an inevitable outcome of lower interest rates. The wealth effect results in consumers perceiving (incorrectly I might add) that they have already received 'free' savings from rising stock and real estate prices, and so fell less compelled to save out of current income.

The problem is that this boost is merely temporal and artificial in nature, because higher asset prices merely imply lower future returns on those assets. If you double the price of a perpetual bond yielding 10% at par, it now yields 5%. You might feel richer on paper, but the level of underlying income has not changed. The rational response from households would be to feel no richer, with their higher paper net worth being offset by a lower expected return on that net worth in the future. However, generally the exact opposite happens after a period of heady asset price gains - future return expectations rise. It is this divergence between perceived future returns and actual future prospective returns is the basis for the bubbly and artificial dimension to the consumption stimulus that derives from the wealth effect.*

When the reality of lower future returns come home to roost - either via an economic or housing market crash, or merely a long period of stagnant or slowly declining asset prices, the blissful illusion of retirements funded by perpetual asset price inflation dissipates, and in its wake emerges a growing realization of the inadequacy of one's retirement stockpile. This can only have one outcome - a significant increase in household savings rates. Japan's economy hit this point in about 1990 and has never recovered; the US and much of Europe hit it in 2007-08 (although it is possible QE triggers one final act of levitation that exceeds even pre-GFC folly).

It remains to be seen how conditions unfold in places like Australia, NZ, and Canada when the ability of low interest rates to juice up house prices by encouraging households to go deeper and deeper into debt (i.e. 'dissave') has not yet come to an end, but inevitably eventually will. It probably won't be pretty. However, one thing seems certain - central banks will likely continue in their vigorous belief that lower interest rates/QE are needed to encourage consumption and ward off deflation, even though the past decade has proven such policies to be ineffectual.

I believe it is likely rates will eventually be cut to zero in places like NZ/Australia/Canada for this reason. That will fail to rekindle growth, and QE will quite likely eventually be pursued in these markets as well. My guess is that the NZD/AUD/CAD will all fare extremely poorly at this point in time. However, when this point is ultimately reached is anyone's guess and could still be many years away.

LT3000


*In a delicious irony, the 'wealth effect' much discussed and relied on by economists relies on consumers being irrational, whereas many if not most of economists' other models rely on hyper-rationality; this is a somewhat bizarre contradiction.

The same can be said for concepts like market efficiency and the large amount of money (still) run by active managers. If markets were perfectly efficient (which relies on perfect investor information and rationality, amongst other things), it would be irrational for investors to put money into actively managed vehicles, and yet they have in significant size (albeit that it is shrinking). In a world of perfect rationality and efficiency, Las Vegas should not exist either.






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