Daily Times

Most investors tend to focus on the current business cycle or the next possible downturn, few think in terms of eras.

The current era began with the collapse of Bretton Woods and its replacement with a fiat currency system that provided policymakers with enormous latitude in setting policy and accumulating debt. The growing imbalance created by numerous attempts to mitigate the downside of the business cycle is leading to recurrent crises. The most severe began nearly ten year ago and is still unfolding, with the emerging markets its latest epicentre.

While there is little disagreement on how the crisis has developed, there is a big split on what it means or what happens next. Some believe this is a banking crisis that has largely been addressed and, in time, the system will revert to equilibrium. The opposing view is that this is largely an insolvency problem resulting from an excess of supply relative to demand combined with a mountain of debt collateralised with overinflated assets. Disinflation, weak capex, and currency wars are just symptoms of this broader malaise.

True reform is difficult, so instead policymakers have been experimenting with how far they can push monetary policy. But monetary policy is not well suited to dealing with the problems that we currently confront (for all of central bankers’ efforts we still have anaemic growth in the developed world and emerging markets in varying states of crisis). All that has been done is buy time, but even that comes with the collateral damage of distorted asset prices and ever more debt.

There is a popular saying that if you want to get out of a hole, you should first stop digging. Monetary policy is providing the shovels for the global economy to carry on digging an ever deeper hole.

The most charitable explanation for the actions of policymakers is that they have been guilty of reacting to outmoded models. The goal of any interest rate cut is to stimulate demand. The working assumption of policymakers is that lower interest rates act as an incentive to consumption and a disincentive to savings.

Unfortunately, this relationship seems to have broken down. This may be partly a function of demographics and partly psychology. In the aftermath of the Great Depression, regardless of the interest rate, people refused to spend. They were so worried about another downturn that they rebuilt their savings. John Maynard Keynes became a Keynesian when he realised that monetary policy was not sufficient to stimulate demand under these conditions.

We are reaching the limits of monetary policy. In all likelihood interest rates will head further into negative territory. When that fails, the probable conclusion will be a fiscal expansion that is likely to be monetised. The mindset shift towards such an outcome has become more established in academic circles and another crisis will quickly spread it to policymakers.

It is possible that the ultimate goal is to generate enough inflation to act as a wealth transfer between generations and from savers to borrowers. This may well be the democratically acceptable way of defaulting on debt. But it may prove more difficult to create inflation in the current environment.

Even if it this may take longer than hoped for, inflation is a monetary phenomenon and in a fiat currency system policymakers will eventually succeed in creating it. In such an environment the best thing you can do is try to identify assets that will perform reasonably well regardless of the future course of policy and its impact on growth and inflation rather than try to maximise return in the shorter term.

Ideally such an asset should possess two key characteristics: good cash flow visibility and stability; and an embedded inflation hedge. That tends to lead you to hard assets rather than financial assets; though there are parts of securities markets that also have these attributes.

While demographics, debt accumulation and globalisation were all supportive of growth in the 1980s and 1990s, those tailwinds have reversed and are increasingly headwinds. This is an interlocking problem with no easy way out. There are steps that can be taken that would help. Reform of the social contract between generations is clearly needed. Productivity also needs to increase though this is proving very difficult to achieve in the developed world.

The challenges we currently confront are profound and intractable and it seems likely that we are approaching the end of an era. A new monetary order will eventually emerge but it is still difficult to discern its outlines. In academic circles there are already debates around what form this will take.

These range from relatively modest evolution, for example using the IMF’s special drawing rights as an anchor for exchange rates, to radical proposals such as an end to fractional reserve banking. One thing seems to be certain; the new order will arise only after another significant crisis as the political system seems incapable of implementing true reforms without it. Robert Louis Stevenson wrote: “Sooner or later everyone sits down to a banquet of consequences.” That moment is coming.