Alasdair Macleod – 06 September 2013
Recent statistics are confirming “economic recovery” in the UK and even some of the weaker eurozone states. I put this in parenthesis, because what we are seeing is expanding nominal GDP, which is not the same thing. GDP reflects money and credit going into the economy, which everyone believes is the same thing.
Instead of economic recovery, GDP is reflecting money leaving financial markets, particularly bonds, for less interest-rate sensitive havens. Globally, bonds represent invested capital of over $150 trillion, or more than twice global GDP, so even marginal amounts unleashed by rising bond yields can be financially destabilising and the effect on GDP growth could be electric. The mistake of confusing economic progress (a better description of what we all desire) with GDP is about to bite the economic establishment big-time and pressure for interest rates to rise early and substantially will intensify as a result, dragged up by those rising bond yields.
The problem facing central planners is that this GDP chimera is driven by a predominantly financial community that has money to invest in capital assets such as housing and even motor cars. The vast majority of economic actors, comprised of pensioners, low-wage workers living from payday to payday and the unemployed are simply disadvantaged as prices, already often beyond their reach, become even more unaffordable. It is a misfortune encapsulated in the concept of the Pareto Principal, otherwise known as the 80/20 rule, the law of the vital few, where the substantial majority will be badly squeezed by rising prices generated by the spending of that few.
The central planners are understandably focused on the misfortunes of the majority. For many of them, as prices start to rise so too do costs for their employers, many of which will be squeezed out of business. How can interest rates possibly be permitted to rise in the face of these dangers?
Central banks have drawn their line in the sand over interest rates and they will eventually be forced to reconsider their position. They are almost certain to be too slow in raising interest rates and so the markets will continually expect higher bond yields and higher interest rates to come. For those of us with long memories it is a repeat of the late-seventies stagflation era. Except this time, aggressively raising interest rates to stabilise the purchasing power of the currency is not an option: it will simply break the banking system lumbered with its share of the $150 trillion invested in bonds.
Markets are blithely assuming that central banks are in control of events. They are not even in control of their own governments’ profligacy, and they are losing their control over markets as well, as the tapering episode showed. The fatal error of rescuing both the banking system and government finances by reckless currency inflation is in the process of becoming apparent to all. Unless this policy is somehow reversed we risk a global rerun of the collapse of the German mark in 1923.