Snake Oil and Deflation

First, an apology for neglecting the blog this past week as I enjoyed the damp, cold, rainy discomfort of an English seaside resort in August.  As a European, I make no apologies for taking my full entitlement to holiday each year, but should have provided warning of my impending leave as I posted last Friday.  I regret not being active in the discussion which the Fisher Debt-Deflation Theory prompted, and will follow up with a further post taking up some of the many substantive comments when I’ve returned to my office and can organise myself again.


We are likely in future to have great debates on the who, how, why and wherefore of the coming recession/depression, particularly if it leads to global conflict and currency realignments that mark the end of Bretton Woods II and US economic hegemony.  At base we have the quote I opened with last week:

“Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”. – John Stuart Mill

The difficulty is that the policies which financed highly leveraged unproductive works are extremely popular to the extent of representing the culture of at least two generations.  While a deflationary recession/depression will make such policies even more costly and destructive than they have been in getting us to the critical point of failure, the same policies are such basic political drivers that without a culture change political and economic change become almost impossible.

It should be obvious that borrowing short through commercial paper to lend long on mortgages and credit cards to bad credits with inadequate collateral is not a sound business model.  And yet somehow the alchemy of securitisation with a sprinkling of AAA pixie dust was widely accepted as turning financial lead into gold.  It should be obvious that a house, once built, is not a productive asset as it produces no revenue but instead absorbs a high proportion of its owner’s income on mortgage interest, property taxes, maintenance and utilities.  It should be obvious that credit card debt, once consumption goods are purchased, produces no productive income stream for repayment of the debt but instead becomes an obstacle to future consumption as debt service eats up a rising proportion of stagnant wages.  It should be obvious that a car that weighs twice as much and uses twice as much fuel is not as productive as a car that is small and fuel efficient, and costing twice as much will harm more productive savings and investment with the excess debt borrowed for its purchase.  It should be obvious that the financial sector, as intermediaries between savers and productive ventures requiring capital, should never rise to the point where it alone represents over thirty percent of economic activity.  Nonetheless, markets all over the world carelessly followed the path of under-production, dis-savings and over-consumption as the path to prosperity rather than a betrayal of capital into hopelessly unproductive works.

It will be a very brave politician indeed that says that young people should save twenty percent cash for a downpayment on their first home (as is the rule generally in countries that never experience boom/bust property cycles like Germany and Switzerland).  It will be a very brave politician indeed that says that consumers should save cash to purchase electronic goods and cars.  It will be a very brave politician indeed that raises taxes on single family housing and privately owned cars in the face of a sustained housing market crash and sustained high oil prices.  It will be a very brave politican indeed that says that the financial sector should not be government subsidised with tax breaks on interest, tax breaks on unproductive speculation, tax avoidance through off-shore registration of hedge funds and private equity, and other magnanimous means of raising election year contributions.

In short, the system which has for sixty years precipitated the greatest debt cycle in history may be inadequate to address the greatest deflationary cycle in history if it chooses to prescribe the same snake oil which sickened the economy in the first place rather than the balanced (fiscal) diet and (strict economy) excercise we all know would be better for us.

Even bank supervisors, who should know better than others that rapid asset growth is the surest indicator of bank failure, chose instead to believe the hype and ignore the reality.  Instead of intervening to curb credit excess, regulators congratulated themselves on overseeing a robust and innovative financial sector while rewriting their rulebooks to embrace the market’s delusional ratings-based models for undercapitalising greater and less transparent risks.

If the core problem leading to the current seizure of the credit markets is the misallocation of credit into unproductive works during the boom years, then no amount of new credit will solve the problem unless the distortions promoting misallocation are redressed through fiscal and regulatory policy changes.  Bailouts and recapitalisation of failed policies of the past are only digging a deeper hole, betraying more capital of younger generations into the unproductive works financed by the current generation.

Correcting the bias toward betrayal of capital will not be popular or easy.  Correcting the bias toward unproductive investments will require a massive change of political structures, financial intermediation channels, savings and consumption habits, and economic incentives which challenge virtually every assumption made by at least two generations of American businessmen and consumers and exported globally.

Regulatory policies promoting misallocation of capital included elimination of restrictions on bank dealing and brokerage of securities and derivatives, self-determined models-based capital adequacy calculation, ratings-based weightings of capital assets, accounting reforms that permitted off-balance sheet financings and acceptance of ill-transparent corporate structures.  Re-knitting that sweater/jumper, however ill-fitting and itchy, won’t be easy either.

Consumer credit is viewed as a fundamental necessity by virtually all classes of the workforce.  Weaning the populace from borrowing to saving would require a huge shift of policy and popular culture.  Few of the generations raised on instant gratification of desire will gracefully or voluntarily shift to living within their means and saving for their future requirements.

In short, there are no easy answers.  We have hypothecated our future prosperity to repayment of our current debts.  We will live less well in future, as will our children for a time.  Whether by inflation or deflation our debts must be extinguished.  Savings must be encouraged and must be allocated to productive investments that will yield not just future prosperity but social equity to minimise political conflicts. 

Those who sold us or imposed on us the current set of policies and practices will be re-bottling their snake oil under new labels.  We must be wary before buying bulk lots in the tens of billions of dollars worth of the same old snake oil that has sickened our economies and political processes already.  In the US, I class the bailouts of Bear Stearns/JPM and Freddie/Fannie as snake oil, that perpetuates the subsidies to speculation and unproductive housing markets.  In the UK, I class the talk of a cut in stamp duty (a transfer tax on house sales) as similar snake oil.  Snake oil, unfortunately, wins elections because it appeals to constituencies that are politically important.  As a result, we may be entering a dangerous phase where the democratic structures are biased to economically damaging policies that further harm future growth and prosperity because investment in unproductive works is so widespread as to form part of the popular culture.

Deflation challenges many of the assumptions that work in an inflationary context:  “Property is a safe investment.”  and “You’ll be fine in equities in the long term.”  and “Governments don’t default.”  When people are forced to reconsider these cherished touchstones of their financial beliefs, they will also reconsider the cherished notions of their political beliefs.  It was under similar conditions that nations in the past embraced racial hatred, ethnic divisions, discrimination by gender/sexual preference, economic imperialism and war as a means of directing public discontent away from threatened elites. 

Just bear in mind who sold you the snake oil that sickened you, and be wary of new bottles of whatever shape or size from the same salesmen.

28 Responses to "Snake Oil and Deflation"

  1. Alessandro   August 8, 2008 at 4:58 am

    @London Banker”It should be obvious…””It will be a very brave politician…”How sad and how true.The grim outlook you prospect makes me sick, but I cannot find one single crack in your reasoning. What will turn this recession into a full blown depression will be the elites battling against whoever will attempt to build a new system that actually works. Exactly as in the ’30s.I hope you don’t mind if I translate parts of the article into Italian and re-publish it, with attribution, on my blog. High in the “must-fix list” there is “people awareness and education” and we all can contribute our tiny bit to it.

  2. London Banker   August 8, 2008 at 5:37 am

    @ AlessandroI’ve no objection to any reuse of my writing, so long as you link back to the original either here or on I’m pleased you should find the ideas worth sharing.

  3. Gigi   August 8, 2008 at 9:58 am

    London Banker,Well said. Unfortunately, I don’t think things will change. People have forgotten the lessons of the past generation, don’t study history, have not made sacrifices. They will want everything at no cost and the politicians will try to buy votes by trying to give it to them. As the whole thing defies the laws for mathematics, it will fail.Look at Obama buying votes with $1000 rebate checks. Disgusting…

  4. DocBerg   August 8, 2008 at 3:26 pm

    Far be it from me to defend profligacy, but I can readily see why many people borrow instead of save for their larger purchases. For whatever reason, banks do not offer any sort of reasonable rate of return on savings. I parked a fair chunk of money in my savings account at a local bank while waiting for a closing on some property I bought. I was paid the princely rate of 0.55% on my money. This sort of return does not even come close to compensating or loss of value, even for the ridiculously understated federal inflation and cost of living statistics. If you save, you lose. Needless to say, if you want to borrow money from this bank, the interest rates are considerably higher. When my grandmother worked her way through the last Great Depression at a bank up in northern Wisconsin, the savings interest rate was 1.5% and the loan interest rate was 3.0%. Not only did that state bank survive when many others did not, but it is still in operation. If the money retained its value, and if it actually paid to save it and postpone purchases, I rather suspect that the savings rate would skyrocket. As it stands, since the banks are raping savers, those who seek to prudently provision themselves for the future are forced into the stock market where they are at the mercy of well connected wolves, and many are losing their capital in the current mess. I am neither a banker nor an economist, and I do not play either of them on television. But, I would think that if we want to have people prudently saving, some structural changes need to be made to avoid them losing their shirts and blouses in the process. Does anyone have any ideas on how this change might be facilitated?

  5. Gloomy   August 8, 2008 at 3:28 pm

    Wow, LB!! Talk about hitting the nail on the head!!

  6. interested reader   August 8, 2008 at 5:02 pm

    Germany and Switzerland in fact did experience their housing boom and bust in the nineties.Moreover, readdressing the economy might not be as difficult as you think. Thomas Palley is right. Instead of targeting randomly low inflation thus effectively subsidizing credit and financial assets, central banks should switch to full employment targeting. Everything else takes care of itself. Incomes would certainly be higher than now which reduces the need and demand for credit. Average inflation would be higher thus increasing the incentive to invest in real, productive assets rather than in financial assets and debt. By expanding the productive capital stock and ensuring sufficient demand through higher employment, the economy’s productivity grows, living standards increase, inequality shrinks because capital holders are not a priori winners by just shifting their money back and forth instead of putting it to productive use and taking a risk. Yes, there would be cyclical overinvestment etc but I think we all prefer the occasional embarrassment of riches to what we have now.How can we know what the full employment rate is? Well, how could we know what the inflation target should be?

  7. OuterBeltway   August 8, 2008 at 5:33 pm

    @LB:You said:

    As a result, we may be entering a dangerous phase where the democratic structures are biased to economically damaging policies that further harm future growth and prosperity because investment in unproductive works is so widespread as to form part of the popular culture.

    With this quote, you reveal the flip side of the “blame the bankers” coin. The people, and the politicians that feed on them, are weakened by decades of “you deserve a break today” thinking.I think the only remedy for this is pain and disillusionment for the thick, and rapid re-positioning for the clever.Many readers know I am a big proponent of finding new ways to get capital into the hands of those people that actually create wealth (the old “alloction” saw).Proper allocation is truly an enabler – but it’s not the independent variable in the equation. The larger problem you’ve identified, LB, is that so few people really understand how to create wealth in the first place. This is probably the major underlying reason why all that credit got mis-allocated. There just aren’t enough entrepreneurs out there that know what they’re doing, and have the emotional stamina to do it (the entrepreneur thing – it’s exhausting, and there’s usually a lot of deferred-reward syndrome).LB, you are doing your readers a great service. Keep that lantern held high.

  8. Alessandro   August 8, 2008 at 5:58 pm

    @interested readerfor deity sake do no spread the hype!A central bank can’t do **** about the economy, the only thing that they can do is create money and in the process rob the productive sector of the economy to give to the government and to the banks.That’s all a CB can do and that’s precisely the reason the CB has been created in the first place (surprisingly by the banks and the government). By setting interest rates they may choose to rob a little more or a little less. And even that is just marginal, since a CB cannot really go too far away from the bond market rates.The only reason a CB cares about the economy is that they need to be careful not to rob too much so that people will not notice and will not moan against inflation.Did you ever wondered why the inflation target for ECB and BOE is 2% (and not 0%)? Well that’s exactly how much the mafia asks for protection to any economic activity in Sicily. Funny, isn’t it?/rant

  9. Alessandro   August 8, 2008 at 6:00 pm

    Back to the Italian translation. LB it is no walk in the park to translate you!

  10. Michael   August 8, 2008 at 6:16 pm

    LB – Thank you for discussing the heart of the matter – a multi-generational Finance Nation culture. Who on earth really believed that an economic path based on never paying off the government debt, reducing national savings rate from 10% to less than 0%, and shooting aggregate debt to 350% of GDP was sustainable? Who cared, as the unconstrained-market-caveat-emptor-worshippers got complete control of finance and politics and made themselves very rich? At least the Great Depression generation accepted that the irresponsible practices of the twenties led to their troubles and they resolved to make some fundamental changes. All we want is the credit faucet to be turned back on and run endlessly.FINANCE NATIONDefinitions -Money: Cedit, debt, loans, leverage, derivatives, etc.Wealth: More credit, bigger and more houses, vehicles, toys, vacations, etc.Savings: Huh?Model – Lust for Wealth-> Worship of Growth-> Expansion of Credit-> Maximization of Leverage-> Increase of Default-> Contraction of Credit-> Desperation-> Rescue Me Now!!!

  11. Alessandro   August 8, 2008 at 6:23 pm

    Off-TopicLB, for your citation book, a great one by Gloomy over on Roubini’s blog:”The system is highly leveraged and appears to [be] destabilizing. Black swans are definitely in season.”

  12. 2cents   August 9, 2008 at 12:21 am

    @LBGreat post and insight.Your statement Correcting the bias toward betrayal of capital will not be popular or easy. Correcting the bias toward unproductive investments will require a massive change of political structures, financial intermediation channels, savings and consumption habits, and economic incentives which challenge virtually every assumption made by at least two generations of American businessmen and consumers and exported globally. sums up what should happen.Unfortunately, power (all kinds including political) is derived from helping or perceiving to help other people. This help can be in the form of favors, money, protection, etc. This is in conflict with the efficient use of resources and capital for the greater good you espouse above. So while you are eminently correct from a humankind perspective, the reality is TPTB don’t give a %[email protected] They don’t have to help all the people, just the ones necessary to obtain/maintain power.The critical task is to craft a solution that benefits everyone but mollifies the TPTB. That’s how taxes got started in the first place! Oh well, I guess we can just lean over and take our licks like big boys.No, the solution is to have a selfless someone who enters the world stage and leads.

  13. Alessandro   August 9, 2008 at 4:04 am

    @Italian speaking guysThe Italian translation of London Banker piece is up at:[email protected] and OuterBeltwaylooking at the bigger picture the only way to get a better system is to raise awareness and financial education to the masses. If consumers do not understand what debt, savings, wealth and capital are (or just act as they understood), they will not make an efficient market. I see this on myself, until I didn’t start thinking for myself and building a bit of economic and financial know-how from the internet, I took a lot of completely mindless and idiotic decisions.Obviously we cannot count of politics to push awareness to the masses (they are literally banking on un-awareness), it is our responsibility to build it bottom-up.

  14. Rich   August 9, 2008 at 7:37 am

    @LBExcellent post. The only solution is to vote all incumbents out to shake up the status quo. Perhaps then some real leaders will appear who are true populists and not owned.Deregulation occurred because both sides and executive branch were ‘owned’. US campaign laws and lobbying are beyond repair and should just be ended.

  15. interested reader   August 9, 2008 at 10:51 am

    @ Alessandro:That’s exactly the problem. You complain about the ways that brought you where you are but you would never really change them when presented with an alternative. Keep complaining.

  16. Gloomy   August 9, 2008 at 10:55 am

    SNAKE OILLB-If we follow you advice, what will we do with all the snake oil? I know, let’s use it as an alternative energy source!

  17. London Banker   August 9, 2008 at 12:15 pm

    I’m back home. It rained the whole six hour drive through heavy holiday traffic. It’s good to be among the familiar comforts, with reliable pizza delivery a phone call away.I listened to BBC Radio 4 the whole way. Several of the shows were about the effects of the credit crunch on consumer habits and green issues. It’s wonderful to have the BBC in a period of rapid change and conflict as they alone can give sufficient time and depth to discussion of complex issues. The commercial networks wouldn’t touch these issues with a bargepole, but public airing of complex, unpleasant policy choices is where the BBC really shines. I particularly enjoyed Any Questions which has a live panel of politicians from all parties coping with live questions from an audience. That is followed by Any Answers which invites the listeners to e-mail or call in with their views on the issues discussed on the previous programme. Both were intelligent, lively and reinforced my faith that British institutions will cope with the coming downturn fairly well, however serious it turns out to be.Listen online any time if you want to get an insight into British public life and political interaction.[email protected] GloomyYou are in great form! If we could all drive our cars on distilled snake oil, the energy crisis would be quickly resolved. I am going to use a reference to one of your quotes in a future post title. Watch for the hattip.

  18. USJohn   August 9, 2008 at 5:53 pm

    Great post! I believe corruption of the system got us here, and unfortunately we can’t begin to solve this problem until we get rid of the corruption. All the proposed solutions we see are just for the benefit of the most politically connected. Fighting terrorism with military excursions, securing the homeland with a long fence, improving infrastructure with bridges to nowhere, and energy policy that flows from hydrogen to ethanol to coup attempts and military occupation. I think the only thing that will stop this machine is cutting off it’s fuel source – foreign credit. LB – why hasn’t this happened? Foreign central banks seem to be encouraging our behavior.

  19. DocBerg   August 9, 2008 at 9:07 pm

    @Gloomy & London Banker: Are you implying that we should go long on snakes?

  20. François   August 10, 2008 at 11:37 am

    Hat off to London banker on this one again.Difficult not to agree 100% on the issue. Special mention for the tackling consumer credit in supposedly temples of capital, US and Britain.Coming from a British commenter, this is especially courageous.Of course, consumer credit is a destructive monetary practice as are below inflation real interest rates.As much as is the foreign financing of housing…

  21. Phil   August 10, 2008 at 5:28 pm

    Glad to hear we weren’t the only ones braving a soggy August in the UK, London Banker! (Anglesey in our case, should anyone care.)So. Where do we go from here? Clearly we need to redirect investment into productive assets quick sharp. I guess renewables would be a good place to start, where proven technologies exist — plenty of mega-engineering projects on the drawing board to choose from!

  22. Guest   August 10, 2008 at 6:52 pm

    @DocBergOnly on long snakes…

  23. Guest   August 10, 2008 at 7:52 pm

    LB–Another great post, thank you! It sure is easier to see what is amiss than to know what the heck to do about it. I mean not what should be done but how what should be done could possibly come about.I hope you weren’t on Chesil Beach. That would be worse than rain.

  24. Sneaker   August 11, 2008 at 6:59 am

    In your last article, you state”This very scary chart (click through to view) gives a measure of the threat in comparing Depression era total debt to GDP to today’s much higher debt to GDP.”Reviewing this and the work of John Williams of Shadowstats reveals that contemporary GDP figures are significantly overstated due to corrections for Substitution, Imputation and Hedonics.The chart of debt to “true” GDP may be even scarier still.

  25. London Banker   August 11, 2008 at 7:19 am

    @ SneakerYou and John Williams confirm something I have long suspected. The massaging of balance sheets to inflate revenues (e.g., booking contracted revenues for future dates as current revenue) and inflate assets (e.g., Level 2 and Level 3 and corporate good will, etc.) has the potential to vastly overstate real GDP.We may find that deflation is aggravated by the collapse of the GDP denominator as well as by the excess growth of the total debt numerator. And, yes, that is much [email protected] PhilOne thing I value about the British temperment is that we make a joke out of adversity with genuine good will and tolerance toward our community (and then blame the government). I expect that Britain, particularly modern Britain with its large immigrant population, will pretty quickly experiment with new models to find the most workable, and adapt fluidly to the demands of the future, including credit constraint. Our tolerance and openness will help us change to whatever works.The same is true of much of America, but America’s dependence on cars and single family housing and private medical insurance limit their scope for flexible adaptation.

  26. Rich   August 11, 2008 at 7:20 am

    @LBOne observation. The debt/financial services/real estate and de-regulation ‘lovefest’ happened in a Right of Center US, Australian and Left of Center UK, NZ, Irish and Spanish governments and also occurred to a lesser degree in both France and Germany.I think this is significant. How did policy become so far afield of sound principles? Is their more influence, peddled differently in these political operating constructs? Was it simple Gee, let’s jump on the bandwagon greed? Or was the massive pools of hedge fund and prime brokerage capital?

  27. London Banker   August 11, 2008 at 8:19 am

    @ RichHaving been party to some of the de-regulation lovefest, I can confirm that there was a lot of “me too-ism” and just about everyone was browbeaten by the US Fed, SEC and banks to adopt their models of regulation, accounting, open markets and business practice. This all happened at quite rapid speed, pushed to a pre-formed agenda, that marginalised any opposition as backwards, reactionary or protectionist.Non-English speakers were disadvantaged by the rapid turn around times put on consultation drafts. If you look at the record of who were the principal drafters or secretaries of the relevant documents and working groups, you will see huge dominance by the Fed, SEC, FSA, Bank of England, with a few Canadians and Australians for good measure.Each crisis – BCCI or Barings for example – was used to drive an agenda toward “harmonisation” that always started with the US model as the ideal. Everyone else, being busy enough not to care too much, let it happen, usually believing that the US approach must be correct as Wall Street seemed so prosperous and dynamic compared to their sleepy domestic markets.I will say that the Germans and French often put up a good fight, but it was usually not enough against the US-UK axis.

  28. Phil   August 12, 2008 at 1:52 pm

    @LB: Your comments on the problems the US faces with it’s car dependence reminded me of for your thoughtful posts here:they’re much appreciated.