Debt and Delusion

Since the last serious outbreak of inflation in the 70s, central banks have conquered this pestilence and have practiced a responsible stewardship over national monetary systems ever since. Due in no small part to the benign inflationary environment that has followed their victory, stocks and bonds have outperformed historical averages. This reflects a high degree of confidence in future monetary stability and prosperity.

Or so we are constantly told.

That this consensus view is a twisted mirror of reality is the theme of an undeservedly obscure work of financial economics, Peter Warburton’s Debt and Delusion: Central Bank Follies that Threaten Economic Disaster.  Published in 1999, the work rapidly went out of print but has since become a cult classic among financial contrarians.1 2 Although not written from an Austrian point of view, the argument parallels an Austrian view of money and banking in many aspects.  My purpose in writing this article is to present Warburton’s main argument and to interpret it through an Austrian lens.

The Demise of Inflation

During the developed world’s flirtation with hyper-inflation in the 70s, wage and price increases were driven by a rapid expansion of the money supply created by central banks to fund government deficits. The upward spiral was finally stopped when Fed Chairman Volker raised short-term interest rates enough to slow down monetary growth.

The mechanism of the last major bout of inflation was the sale of government debt to commercial banks.  In this process, called "monetization," banks or the Fed create the money out of nothing with which to purchase the bonds.3  This is often referred to as "printing money," although in modern times, the money is usually created electronically rather than through the manufacture of paper notes.

After suffering through one episode of runaway prices, public opinion had turned against inflation by the early 80s. The political parties associated with the inflationary period had been voted out of office in the  US and the UK.  Chairman Volker had been appointed to head the Federal Reserve, a post from which he embarked upon a painful campaign of raising interest rates sufficiently to slow money supply growth.

Warburton’s story begins in the aftermath of Volker’s triumph. The conundrum facing governments at the time was: how to enable governments to continue to live beyond their means, without suffering inflationary consequences?  In this climate, a new outbreak of inflation would have contained the seeds of its own demise, for the following reason.  Lenders require a positive real return in order to lend; interest rates must then exceed the rate at which the currency is losing value, by some margin.  Having recently been burned by inflation, bond buyers would have resisted any signs of rising prices by insisting on higher bond yields.  Such a market-driven rise of interest rates would have given the central bank little choice but to follow with rate increases of its own to slow down money growth, or else risk a total destruction of the currency through accelerating inflation.

Central bankers offered a program to solve this dilemma, the centerpiece of which was a change in the method of financing government debt.   Deficit finance bonds would be sold to private investors through existing financial markets. This would place the bonds in the hands of investment funds, rather than on the books of commercial banks as would have been the case had they returned to the old style of monetization.  The subsequent explosion in the size and breadth of bond markets is illustrated by a few snapshots of gross issuances: less than $1 trillion in 1970; $23 trillion by 19974 and nearly $43 trillion by 2002.5

A second part of the central bankers’ program was to reign in government deficits so as to reduce the need for borrowing.  This advice has been mostly ignored. Borrowing to fund government deficits exploded under Reagan, continued to soar in spite of the phony "surpluses" of the  Clinton years, and has reached stupefying levels under George W. Bush.6 It is the interaction between this explosion of debt and what Warburton calls "the capital markets revolution" that has produced a new and deceptive form of inflation.

The Interest Rate Anomaly

Scarcity requires that when a good is demanded in increasing quantity, the price paid by the buyers will be successively higher.  This must happen because the sellers who value a good the least are the first in line to sell.  As buyers continue to search out a greater quantity of the good, potential sellers who place an increasingly greater valuation on the good must be recruited to supply it.   Buyers then bid up the price of a good up by demanding more of it.

Under a sound monetary system where credit cannot be created out of nothing, credit can only be the supply of savings by a lender. If credit is demanded in increasing quantities, borrowing must take place at ever-higher interest rates because savings are necessarily scarce; a higher interest rate is necessary to draw more marginal savers into parting with their cash.  There is an inherent limit to the amount of borrowing that can occur: the point where savers cannot be enticed to part with any more present goods at any rate of interest.  The reason that the pool of savings cannot expand indefinitely is because people only have so many assets that they can save, and everyone must engage in some consumption in the present.7

Yet, as the fire hose of government bond issuances has flooded international capital markets with debt issues, interest rates have not risen much, are now lower than in the 70s (a time of less borrowing), and for the last year have been at or near generational lows.   It is dubious to maintain that the gargantuan volumes of bond purchases in recent years could have been funded out of savings when the  US personal savings rate has also dropped to long-term lows.

This anomaly has not attracted much attention or investigation.  Instead, most analysts now find this state of affairs to be utterly normal. An alleged quote attributed to Vice President Dick Cheney that "deficits don’t matter" perfectly summarizes the prevailing attitude.8  Notes Warburton, "the incongruity of the massive accumulation of government and corporate debt with a low inflation environment no longer provokes much curiosity, even among professionals."9; and, "a stratospheric stock market has become accepted as the normal state of affairs, requiring no special explanation."10

As he wryly noted:

Periodic bouts of price inflation, the tell-tale signs of a long-standing debt addiction, have all but vanished.  The central banks, as financial physicians, seem to have effected a cure. . . . Few have bothered to ask how the central banks have accomplished this feat, one which has proved elusive for more than 20 years. As long as inflation is absent, who really cares exactly what the central banks have been up to.11

The solution to this puzzling anomaly is to identify the source of demand for government bonds. For this, we must examine "what the central banks have been up to."

Financial Assets and Price Inflation

Economists have long known of a general correspondence between changes in the quantity of money and its purchasing power. A naïve quantity theory of money would have all prices moving by the same proportion in response to a change in the quantity of money.  According to the quantity theory, if apples cost $1 and bananas $2 today, then after an increase in the quantity of money, their new prices should still be in the ratio 1:2, perhaps $2 and $4.

Debt and Delusion argues that the institutional changes described above have confined the price adjustments resulting from monetary expansion to the financial system.   The character of the 80s and 90s inflation differed from that of the 70s.  In recent decades, price changes following money quantity changes have been in stocks and bond prices, rather than wages and consumption goods prices.

How can inflation sometimes affect financial assets and other times mostly consumer prices? The monetary framework of Ludwig von Mises can explain this. Mises accepted a general relationship between money quantity and money prices, but he argued that introduction of new money into a community will not affect all prices uniformly.  Relative as well as general price changes will result.12  The particulars of magnitude and goods depend on where the new money enters the economic system, and what the initial recipients spend it on.

The initial owners of new money, Mises noted, find themselves with a surplus of cash relative to their needs for immediate spending.  They are in a position to increase their demand for the goods or assets that they wish to purchase, which will bid up those prices.  The sellers of those goods then receive the money second-hand, putting them in a position to demand more of some other goods, and so forth.   In essence, "variations in the value of money always start from a given point and gradually spread out from this point through the whole community".13  In this way, monetary expansion will affect some prices more than others. 

Mises showed why after an inflation, the relative price of apples in terms of bananas might no longer be 1:2, for example, the apple might now cost $2 and the banana $6, a ratio of 1:3.  Price ratios are not stable under inflation.  Suppose that, instead of comparing to bananas, the prices of apples relative to stocks are compared.  If today apples cost $1 and the Dow Jones Average is at 5,000, and then money is created and used by the initial recipients to buy stocks, the apple may still cost $1, while the Dow might have attained 10,000.  

With financial assets absorbing most of the impact of new money, the outbreak of inflation into wages and consumption goods that proved so unpopular in the 70s has been (at least for a time) repressed.   Newly created money was injected into capital markets, where it was initially spent on the purchase of bonds.  The low yields in government bonds have made low-yielding corporate bonds more attractive and equities with low dividend yields in competition with bonds an increasingly good buy.  The inflationary price adjustments have leaked out of government bonds into other financial assets.

But over time wouldn’t the second or third recipients of the money spend it on cars or food, causing the inflationary to leak out of financial markets into consumption goods?  The answer is no: in recent years, money has been injected into financial markets and the resulting price effects contained there.  The greater part of Debt and Delusion deals with the mechanisms of this containment.   They are interest rate arbitrage, gearing through financial derivatives, the attraction of private savings from banks into capital markets, and management of public opinion about inflation. More will be said about each one of these below.

Interest Rate Arbitrage

The rate at which commercial banks can borrow from the Fed for short-term loans is fixed by the Fed itself.  In the current institutional framework, interest rates do not rise with increased loan demand to reflect actual scarcity.   To hold the interest rate below the market-clearing level, the Fed must create whatever amount of money borrowers wish to borrow in order to prevent the natural rise of rates that would occur if credit were restrained by savings. 

Without central bank price fixing, interest rates of different maturities would tend to be the same.  Deviations could arise in one direction or another, but if, for example, 5-year bonds consistently yielded more than 1-year bonds, that would imply the existence of different rates of return not just for different bonds but also within the productive structure of the economy, something that could not persist permanently.14 15 Some empirical research by Paul Kasriel suggests that the long and short bond yields tended to be more nearly equal prior to the existence of the Fed than afterwards.16

As long as a rate differential between short term and long term bonds remains, an essentially risk-free profit opportunity (known as the "carry trade") will persist no matter how much "arbitrage" occurs. Banks or their favored clients borrow from the Fed at short-term rates to purchase bonds of longer maturity, when there is a sufficient price spread between them. For example, when the interest rate on a 90-day T-Bill is 1% and the 10-year Treasury yields 5%, there exists a profit opportunity of 4% for a borrower who has access to these rates.

Debt and Delusion locates the source of financial inflation in the ability of large bond buyers to borrow volumes of newly created money from the Fed at a fixed price.  Because the interest rate does not rise to meet increasing quantities of lending, this arrangement generates volumes of "synthetic demand" for the government bond markets at longer maturities.  Enough bonds are purchased to maintain their prices above and their yields below true market-clearing levels.  Warburton terms this "the illusion of an unlimited savings pool" and notes that this illusion "has grown more and more powerful and is matched by a new confidence among prospective bond issuers."17

When Austrians talk about entrepreneurial activity, they are describing the activity of insightful actors who perceive profit opportunities that others have missed, and are willing to risk their capital to test their ideas.   The continuing rearrangement of productive activity by entrepreneurs aligns production with consumer preferences.  Under central banking, financial markets are not real markets, although they are similar enough in appearance to fool a lot of people.  In this environment, the term "arbitrage" is a misnomer because borrowing and lending is no longer a market-driven price adjustment process.  Trading mainly recycles debt from the central bank to government borrowing.

Gearing

A second mechanism of financial asset inflation is the use of derivatives to create additional purchasing power.  Derivatives are financial contracts between two parties.  The value of the contract is thus derived from another reference price.  The value of a derivative contract is determined by some mathematical relation to the price of the underlying asset or commodity.  For example, an option contract on copper might reference the price of 25 tons of copper.  Derivatives on government bond interest rates are a large component of the total volume of these instruments.

The important feature of these contracts is the ability of one side to control a position whose value is that of a large volume of an underlying commodity for a much smaller amount of money.

Derivatives are used to secure the control of a more expensive asset from a much smaller commitment of capital.  The use of derivatives by hedge funds and the proprietary trading desks of large banks in relation to government bond markets represents itself as a grossly inflated demand for the underlying bonds.  This acts as an artificial support mechanism for both bond and equity markets, keeping yields lower and asset values higher than would otherwise be the case.  This synthetic source of demand is critically dependent on the downward progression of bond yields and on the slope of the yield curve.  While there is a sense in which all demand for financial assets are contingent on their expected performance, this is especially true of geared and unhedged derivatives positions.18

Warburton explains how these leveraged contracts are used to generate a synthetic source of demand for financial securities. A hedge fund wishing to purchase $100 million of stock can put up $8 million and borrow the remaining amount from an investment bank.19 Then:

It is possible to use unrealized gains in financial assets (including derivative contracts) as collateral for further purchases.  The persistent upward trend in underlying asset prices has amplified these unrealized gains and has enabled and encouraged the progressive doubling-up of ‘long’ positions, particularly in government bond futures.  It is easy to envisage how the cumulative actions of a small minority of market participants over a number of years can mature into a significant underlying demand for bonds.  While financial commentators are apt to attribute a falling USTreasury bond yield to a lowering of inflation expectations or a new credibility that the federal budget will be balanced, the true explanation may lie in progressive gearing.20

The initial injection of new money into the bond market explains why the effects of inflation would show up there first. The continued containment of inflation within the financial sector as money is spent, and then re-spent on financial securities, is created by the leveraging available through derivatives.  The funding of these derivatives is complex, but again it ultimately relies on borrowing at fixed low yields from the central bank.  The process circulates the newly created purchasing power again and again back into the financial sector, rather than allowing it to leak out into wages or consumption goods.

The Management of Expectations

Mises’s investigations showed that the purchasing power of money depends on the supply and demand for money itself.  The greatest determinant of the demand for money is public expectations of future prices.21  If prices have been stable, people will expect them to remain stable and money demand will remain about the same.  If prices have been falling slowly for many years, people will expect them to continue to fall.  In spite of accelerating money supply growth, if people do not believe that prices will rise in the future, inflation expectations can remain low while the growth of money supply proceeds.22  Rothbard has commented:

On the other hand, suppose that people anticipate a large increase in the money supply and hence a large future increase in prices. . . . People now know in their hearts that prices will rise substantially in the near future. As a result, they decide to buy now—to buy the car, the house or the washing machine—instead of waiting for a year or two when they know full well that prices will be higher. In response to inflationary expectations, then, people will draw down their cash balances…But as people act on their expectations of rising prices, their lowered demand for cash pushes up the prices now rather than later. The more people anticipate future price increases, the faster will those increases occur. . . . Deflationary price expectations, then, will lower prices, and inflationary expectations will raise them.23

Recent history would also suggest that people attribute more importance to the recent price changes of consumption goods in forming expectations about the future trends in the prices of consumption goods. Similarly, consumer's attribute more importance to price trends in financial assets in forming opinions about the future price trends in financial assets.  For example, investor Marc Faber has observed that moves in asset price tend to attract little interest from the mass of investors until a trend has been in place for several years.24

To the extent that any price increases at all have leaked out of financial assets into consumption goods, the deliberate distortions in the measurement of the Consumer Price Index (CPI) have been introduced in order to create a false consensus that "there is no inflation."  A variety of questionable price adjustment stratagems have been instituted in the CPI computation: the exclusion of food and energy, the use of lower "quality-adjusted" prices, seasonal adjustments, and the replacement of home prices with rental rates.  The index incorporates only consumption goods, when most of the price increases are showing up in financial assets.25 26

So successful has been the management of expectations that inflation has disappeared from public discussion. Most of the public did not view a succession of all-time highs in the stock market as in any way relevant to the price they would have to pay for milk. Growth in the money supply attracted no analytical attention from the mainstream financial media. Some prominent "supply-side" economists even advanced the ludicrous idea that the US economy was experiencing a deflation during the 90s stock market bubble, and called upon the Fed to inflate even more.

The successful management of inflation expectations has forestalled the eventual rejection of cash in favor of tangible goods that ultimately results from excessive money printing.  "The impressive reduction of inflation," writes Warburton, "is a dangerous illusion; it has been obtained largely by substituting one set of serious problems for another."27 In the end, the public, intoxicated with the gains from stock market inflation, had adopted a don’t ask, don’t tell policy toward central banks.

The Corruption of Savings

A peculiar feature of the social psychology of financial asset prices is their self-reinforcing character.   The upward trend in stock and bond prices has served to enhance the respectability of capital markets and their perceived safety as repositories of capital, which in turn has aided their cause of attracting even more of the meager available savings from the private sector.28

Warburton documents a long-term trend of investment funds essentially chasing price inflation: shifting their cash out of low-yielding bank accounts, CDs, and money funds into bonds of longer maturities, and eventually, equities.29

Some commentators reason that inflation must now be quite low because the credit markets are patrolled by "bond vigilantes," astute traders ever alert to punish central banks for their inflationary indiscretions, ready to dispense rough justice in the form of higher interest rates.  This analysis assumes that inflation is reflected primarily in consumption goods, and that bond yields are free to move on their own to convey meaningful information about changes in the value of the monetary unit. These assumptions are more or less the reverse of reality: the funneling of inflation into bonds as described above provides a floor under bond prices and hence a ceiling on bond yields.  The bond vigilantes have gone on an extended vacation.

Another popular argument is a stock market that is expensive measured by P/E ratios is cheap or at least fairly valued because low interest rates justify higher multiples.  Stocks appear to be cheap in a dividend discount model that uses the current bond yields to discount future earnings.  This view fails to take into account that the bond bull market is a symptom of high inflation, not low inflation.  Inflated prices for bonds might make stocks look relatively cheap in comparison to bonds, but in the absolute sense both are inflated.30

Conclusions

But what does it matter if stock and bond prices rise relative to consumption goods?  As economist Paul Krugman once wrote, "It's paper gains today, paper losses tomorrow; who cares?" The problem with financial inflation is that investment decisions by entrepreneurs are based on relative prices.  When relative prices are disrupted, as by financial inflation, the entire productive structure of the economy is distorted.  The movement of real savings into real investment is stymied.   As Mises wrote, "The endeavors to expand the quantity of money in circulation either in order to increase the government's capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation."31

The "financialization" of the economy—the expansion of the financial sector relative to mining, agriculture, manufacturing, transportation, energy, transportation, and retail—is but one example of these distortions.   Various measures of the size of financial assets, such as the stock market capitalization to GDP ratio, and Tobin’s "Q" ratio (which measure total stock market capitalization to replacement cost) reached all-time highs in the late 90s and are still above long-term average values.

The increasing domination of the stock market capitalization and economic activity by financial institutions is noted by the New York Times:

 . . . in recent years, financial services companies have quietly come to dominate the S&P 500.

Right now, these companies make up 20.4 percent of the index, up from 12.8 percent 10 years ago. The current weight of financial services is almost double that of industrial company stocks and more than triple that of energy shares.

… It is also worth noting that the current weight of financial services companies in the S&P is significantly understated because the 82 financial stocks in the index do not include General Electric, General Motors or Ford Motor. All of these companies have big financial operations that have contributed significantly to their earnings in recent years.

… Financial companies now generate about 30 percent of the profits, after taxes, ofUnited States’ companies, [financial economist Andrew] Smithers said. That is up from 7 percent in 1982. In addition, profit margins at financial companies in the first quarter of 2004 stood at 32.6 percent of all corporate output, around 11 percent higher than their average since 1929 [Smithers] said.

The economic purpose of capital markets is to provide a nexus between savers and borrowers for the financing of productive investment.   Financial entrepreneurs, such as venture capitalists, traders, and speculators, are essential in forecasting the best uses of available savings and bearing the risk in an uncertain world.   But a society cannot prosper by printing ever-increasing quantities of paper tickets representing claims for real goods and drawing more of the population into trading these tickets back and forth among themselves.  We cannot all be day traders: someone must produce the goods that are consumed.

Warburton calls the recent period "an excursion into the realm of financial fantasy."  The fantasy is that central bankers have found a way to inflate without any negative consequences.  While the effects of money supply growth can be confined to stocks and bonds, inflation is hidden in plain sight.  The adjustment of relative prices between financial assets and consumption goods cannot be postponed indefinitely.  The unwinding will not be easy or painless. Surely central bank follies now threaten economic disaster.