Hayek’s The Road to Serfdom described how personal freedoms are
progressively eroded by the state in the name of the common good.
His warning is more associated with totalitarianism and dictatorships,
than modern democracies, but the statist attitudes he warned about still
apply today and lead to the same loss of personal freedom and increase of
state control. In the main, the serfs are patient and tolerant of their
masters, but in a democracy, the establishment behind the state risks being
challenged. And that has happened twice this year, first with Brexit and now
with Trump in America.
We can be certain that the establishment in Britain and America will
reinvent itself. Theresa May is not out to change the world, but is adapting
to the new realities. Donald Trump is still mostly an unknown quantity, but
the initial impression is one of appalling economic ignorance, dressed up as
the new Reaganomics. He proposes substantial tax cuts and state-directed
infrastructure spending “to make America great again”. But unless tax cuts
and infrastructure commitments are made in lock-step with reductions in
government spending, which seems extremely unlikely, the outcome will be to
stimulate latent price inflation to a surprising degree.
The starting point for “Trumpenomics” could hardly be worse. The level of
debt in both the government and private sectors is too high to be sustained
already, and from this elevated base it is proposed to print and borrow much
more. Payment for this profligacy can only come from credit creation, as
banks mobilise and gear up on their excess reserves at the Fed to buy
government bonds. The accumulation of latent fiat money since the financial
crisis will at last be applied to driving up prices on Main Street, instead
of mainly on Wall Street as heretofore. The status quo has concealed enormous
economic and monetary distortions, the unwinding of which will have unexpected
consequences for prices.
Private sector wealth and savings have already suffered considerable
dilution from decades of the Fed’s monetary policies. Significant numbers of
the American population are finding it hard to make ends meet, and have been
in financial difficulties for many years. Accelerated government deficit
spending is an added malevolent influence, which can be expected to drive up
prices of ordinary goods, all other factors being equal. While Keynesians
believe in economic stimulation, the reality is an added round of monetary
debasement will increase the impoverishment of the “deplorables” who voted
for Trump. It will turn out to be a destructive Keynesian policy additional
to existing policy mistakes.
For the moment, with the stock market roaring on the prospects of all this
lovely stimulus, no one seems that worried. But already, we see the US
Treasury market falling rapidly, with 10-year Treasury prices down roughly
8%, a catastrophe for investors who have bought into the Yellen put. The
dollar has also risen against other currencies, reflecting the attractions of
higher dollar yields. And at the same time, commodity prices are roaring. The
chart below, which is a composite of industrial raw materials, illustrates
this problem.
The surge in raw material prices is not widely appreciated. For now,
higher raw material prices are expected to be absorbed by retail businesses,
as Mark Carney stated at Tuesday’s UK Parliamentary Treasury Committee
meeting. It’s a case for the three wise monkeys. But only so much can be
absorbed by margin compression before customers pay up, or retailers shut
shop and manufactures scale back production. Welcome to the new great
America.
We are now seeing term rates rising and the purchasing power of the
dollar, measured in industrial materials, falling significantly before any
stimulation from Trump’s accelerated deficit spending. He’s too late and will
only aggravate a bad situation. The reason commodity prices are rising is
mainly due to stockpiling by China, which plans its own infrastructure boost.
Instead of only the largest country measured by global trade looking to spend
on infrastructure development, in addition we will have the largest country
measured by GDP looking to do the same. The timing of Trump’s planned
spending-spree could hardly be worse, from a price-inflation perspective.
The rise in the dollar against other currencies is also creating
destructive chaos. The reserve currency everyone has borrowed is rising in
value against local currencies, leading to a scramble for cover, and a
shortage of dollars in the interbank markets. These difficulties should not
be underestimated, being extremely costly for indebted businesses in emerging
markets and in the Eurozone. The rise in dollar term-rates also exposes the
ECB’s and Bank of Japan’s monetary policies as being entirely wrong. It has
led to substantial falls in the euro and yen against the dollar, and massive
additional losses on bond investments denominated in these currencies.
Europe
The EU and the ECB have been badly affected by the Trump surprise.
Suddenly, Brexit looks like a prescient move, with the UK likely to get a
better trade deal with an Anglo-Saxon partner, than originally thought. Other
nations could well have their own serf-driven rebellions, with many elections
and referendums due in the next year. Furthermore, Trump is likely to reduce
America’s NATO commitment in a new policy of détente with Russia. The
political situation has suddenly become very dicey, and the economic
situation has just become worse as well.
The ECB has for the last eight years successfully contained a systemic
banking crisis, involving variously Ireland, Cyprus, Greece and Portugal,
with real threats from Italy, Spain and even Germany. To maintain the value
of the collateral and investments held on bank balance sheets, the ECB has
reduced interest rates and elevated bond prices by buying large quantities of
debt in the market. It is a policy that has worked so far, because exogenous
threats were also contained. This is no longer the case, and Eurozone bond
prices have been exposed as considerably more overvalued than US Treasuries,
given prices that imparted negative yields to German bunds. The effect of
further bond price falls on bank balance sheets could well be catastrophic.
Today, the obvious weak point in the financial system is Italy. Italy
faces a constitutional referendum on December 4th, which has been postponed
from October. The vote is an attempt by Matteo Renzi, Italy’s Prime Minister,
to reduce the Senate’s power. In effect, the power lost to the Senate will be
transferred to the executive. Originally, Renzi pledged to resign if the
referendum went against him, but recently he appears to have backed away from
this commitment as the chance of failure has increased. Italy matters,
because it is on the verge of a major banking and economic crisis and the
serfs smell a constitutional rat.
The weakness of Italy’s banking system is no secret, but commentators miss
the underlying point, that the fundamental problem is with the economy.
Non-performing loans in the banking system are officially recognised at 18%
of GDP. But the public sector is 52% of GDP, which means that NPLs are over
40% of private sector GDP, bearing in mind that this is where NPLs are
confined. And it is a fair bet that the NPL problem is worse than officially
recognised. So even if the banks are successfully restructured or bailed out,
it is unlikely to resolve the underlying economic malaise.
Trumpenomics has just made the ECB’s bailouts considerably more difficult,
because as well as non-performing loans, the banks have massive
mark-to-market bond losses to absorb as well. Furthermore, the ECB will
almost certainly have to raise interest rates more than the Fed, particularly
if the euro continues to weaken against the dollar, as seems likely. That is
where the crisis will hit, and probably not before long.
In conclusion, Trumpenomics as proposed (though it is obviously not yet in
its final form) will lead to accelerating price inflation, accompanied not by
better conditions for the “basket of deplorables” as Hillary Clinton
described Trump’s supporters, but their further impoverishment through the
realisation of the wealth-transfer mechanism of price inflation.
Stagflationary conditions are already on the cards, but as a matter of simple
economics it is being accelerated further by Trump’s intended plans. The
black swan event, the unforeseen consequence, is likely to bring forward the
political and economic disintegration of Europe and the euro area, through a
falling currency and collapsing bond prices. Welcome to The Donald’s world.
The serfs never win, as Hayek recognised.
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