Roach’s “Disequilibrium Economics” – and Inflation vs. Deflation
I found MSDW’s chief global economist Stephen Roach’s “Global: Disequilibrium Economics” essay of June 28th very provocative. Particular as it concerns possibilities for the Inflation/Deflation debate, as well as implications for K-wave trough economics.
Roaches essay can be referenced here:
morganstanley.com
I want to try to speculate on the relationship of what Roach refers to as “Disequilibrium Economics”, with the Inflation/Deflation argument, K-wave bust phenomena, and historical ruptures of Credit markets. Would very much appreciate and feedback anyone might offer. So here goes.
Disequilibrium Economics
I like the notion of “Disequilibrium Economics” because if meshes nicely with complex systems theory – in particular, the notion that systems have an inherent tendency to move into “far from equilibrium” conditions, which effect systemic crisis, when then sets in motion consequences which bring the system back into relative equilibrium.
I believe that there are actually layers of such disequilibrium phenomena, that likely correspond to cyclic harmonics of greater or lesser degree, which compound the effects of all cycles on the entire system. In economic terms, a very “base” cycle would be a K-wave cycle (say between 50 and 70 years). A relatively superficial cycle in comparison would be the business cycle (of approx 4 year duration).
Reality and Perception
Reality and Perception both appear to play important roles in providing temporal balance to economic systems. “Reality” would be the underlying productive factors that for a “deep” basis for the exchange of real goods and services in an economy. Like Benjamin Graham’s “market”, in the long run “reality” is a weighing mechanism.
On the other hand, in the short run, again like Ben Graham’s Mr. Market, the market is significantly a voting mechanism. And the proximate cause of equilibrium in the “near term” is the psychological perception of market participants that set prices in various markets where the marginal buyer meets the marginal seller.
The role of Credit
Credit in modern economies is a very interesting phenomenon. For it seems to have a grounding in both “reality” and “perception”. In the long-run, the “value” of Credit to my mind is again like a weighing mechanism. However, in the short-run, the value of credit (and its alter ego liquidity) is also significantly a voting mechanism. That is, there is a significant psychological element to the “value” of Credit.
K-Wave busts – Inflationary or Deflationary?
Historically, to my understanding, K-wave bust phenomena can be both – inflationary or deflationary – to the broader price structure. The key here appears to be the sophistication and stability of the financial system of the economy. For highly-developed financial systems, a highly inflationary response has the potential to destroy the credit market and banking system. This is a very high price to pay, and I believe history shows that a deflationary policy is usually the preferable option compared to the destruction of the banking and credit system.
For weak, peripheral economy, and particularly an economy that has emerged the loser in war and failed to have its post-war currency backed by a dominant power, hyperinflation is a more common policy response to a financial bust. Germany post WWI and the Confederacy post US-civil war are typical examples here.
K-wave Busts – “unreality” ruptures – part I
K-wave busts appear to have an inherent geopolitical aspect to them. They bridge the crossing from one regime (i.e. the “old regime) to another (i.e. the “new regime”).
What I find most fascinating about such K-wave ruptures is how frequently monetary systems collapse, or run into very serious trouble. If economic systems simply channel real production through economic incentives, why is it that they are prone to break? Can’t policy options simply be fiddled with until a new equilibrium emerges. Why is enlightened economic “gradualism” so prone to failure?
Well, this is the reason for the “reality vs. perception” section above. For in each case where a monetary regime fundamentally breaks, it appears that the economic credit structure (which, in our modern world post “haute finance”, is typically global in nature) contains fundamental illusions which cause great problems if left unattended (i.e. if allowed to reach extreme states of disequilibrium).
Let’s examine the 1920’s. Great Britain in particular, but also France, were losing their relative powers as Great Powers. However, the monetary system (i.e. the gold standard) was operated on the basis that this was not the case. To achieve this illusion, gold flows were “sterilized” so that exchange price parities could be maintained. That was one way exchange price parity was realized. Another major effort was to maintain an artificially “low” US$ and an assortment of “artificially high” weaker currencies – primarily the German mark.
But there was another insidious credit-related phenomena that occurred. As the US in particular built up significant current account surpluses, it recycled its current account surpluses to debtor nations, many (actually, nearly all) which had very precarious balance sheets. Furthermore, to prevent the US$ from rising (which would have damaged currency parity stability), the US kept interest rates artificially low (particularly in the late 1920’s), which created a global credit and asset boom.
Sounding familiar to anyone??? Substitute a few names and dates, and it’s pretty darned similar to our current situation.
Naturally, such “unbalanced” global growth imbalances resulted in a “make-believe” world, where aggregate demand and global resource utilization was far in excess of what the underlying fundamentals would have considered prudent.
Yes, the 1920’s was truly an era of “disequilibrium economics”.
K-wave Busts – “unreality” ruptures – part II
But what is the nature of this “unreality” exactly? To my mind, it is this: the entire credit system operates under the illusion that the “old regime” can maintain its economic dynamic-ness, and therefore that its credit is good. Then, based on this illusion “at the core”, further credit is extended out to the entire credit system (i.e. global economy) which further leverages this illusion.
Emerging powers – i.e. the core of strength of the new regime – sensing there emerging strength, feel the power of capital flowing through its economic veins, and builds productive capacity “as if” the underlying credit structure of the “old regime” was in fact “good”.
When the bust occurs, therefore, there is trouble all around. The “old regime” is revealed to be both (a) effectively bankrupt, and (b) not the sprite young economic dynamo that it once was, and its earning power is shown to be vastly underpowered to service its existing debt obligations. And the “new regime” has built up productive capacity and extended loans on the basis of future aggregate demand that proves to be highly illusionary.
So effectively, Capitalism breaks …
… which is exactly what happened in the 1930’s. And it broke hard.
Which is rather paradoxical. Because you have vastly higher productivity, and prior to the break, wealth “appears” to exist in abundance. Is it not possible through proper monetary policy to effect some “gradualist” transition to bring equilibrium back into the global economy?
Oddly enough, history does not support this thesis. Which does not necessarily mean it can’t be done. Actually, this is a very confounding thing. And I really don’t even have any idea at all how to answer this conundrum. I think the answer lies in the creation of an entire new incentive system outside the existing monetary regime. That after the foundation of such an incentive system is laid, a new monetary regime can emerge that acknowledges the newly emergent power relations of the “new regime”. But this is a very embryonic thesis.
So how does today’s situation play out?
Which brings this discussion full circle back to Roach’s essay on “disequilibrium economics”. To my mind, you have wildly excessive consumption/demand in the U.S. particularly, but through a leveraged credit structure, also globally. This is the inevitable consequence of a non-normal interest rate structure, and negative real interest rates.
At the same time, this “non-real” excessive demand has resulted in “non-real” excessive productive capacity – most particularly in China.
So we have a global economy that is in a very “far from equilibrium” condition … which is another way in my mind of saying “perception” and “reality” are very far apart in incentive structures and relative prices in the global economy.
I really only see ultimately one corrective path here to begin to bring the global economy back into a state of relative equilibrium – and that is precisely what Roach alludes to – i.e. Americans have to raise real interest rates, save more, and consume less. Alternatively, China needs to raise real interest rates, continue to build its real wealth over time, and cool down its economy.
The problem is the situation of the global economy has gotten “so far” from equilibrium, or put another way, is highly leveraged to a “unreal” condition. Therefore, the path to equilibrium to my mind could be very, very painful.
Can the U.S. inflate its way out of this problem?
In the near term, I believe the answer is largely no. In the long term, imbalances appear to be so massive, I don’t see how devaluation of the U.S. currency and a higher price structure in the U.S. is not all but inevitable.
But first, the U.S. to my mind has to normalize its interest rate structure. That is the most important thing. That at least would begin to create the right incentive structure to create a long-term trajectory towards equilibrium. Once this trajectory is more firmly established, then I can see inflation playing its appropriate role.
What is the outlook for Commodities?
I believe that the collapse in aggregate demand will hurt the price of global commodities – precious metals perhaps excepted.
But I’m not clear on this. It really depends on the nature of the rupture in the global financial system, if it occurs. And how skillful is the policy response to reestablish global aggregate demand. Russ Winter and others have pointed out how tight commodity inventories are, so certainly given existing trendlines, there is a strong case to be made for higher commodity prices.
The key is really whether aggregate demand in excessive of available supplies of key raw materials. It is a bit of an open question to my mind. And I’m hedging my bets on this one.
What would convince me I was wrong?
I remember a debate Stephen Roach had with I believe it was Ed Hyman a couple years back, where Roach felt it was important that he consider how his argument could be wrong. I think this is a valuable exercise, so I ask myself what would convince me that I was wrong in my above assessment? Well, a few things:
1 – I became convinced that the disparity between “reality” and “unreality” in the global economy was much less that I currently anticipate. This would mean the path to equilibrium could be much less painful.
2 - Related to (1) above, somehow, someway, a "gradulist" path to financial and economic system equilibrium can be achieved. For this to occur, aggregate demand must be sustained at levels sufficient such that the global price structure does not implode (i.e. inflation), while at the same time, existing credit imbalances can be gracefully unwound.
3 – Interested parties/elites in the global financial system are willing to push the global economy into even greater disequilibrium, and are able to prevent the system from breaking. This would mean the result would still be the same, almost certainly worse in fact, but present asset inflation and non-normalized interest rates and credit conditions could continue for the foreseeable future.
4 – Events prove me to be wrong. :) That would definitely convince me I was wrong. LOL!
Anyway, just some theoretical ramblings, which I thought I’d share in case they triggered any ideas from anyone.
Regards,
Glenn |
