Gavekal - On Market Stupidity

Of Central Bankers, Monkeys, and John Law
By Charles Gave via Mauldin Economics
April 17, 2015

A revealing experiment involved monkeys being placed in a cage with a pile of nuts stashed on an upper level. Their efforts to snaffle the food caused them to be doused in water, blasted with a siren and startled by an electric shock. After a number of attempts the monkeys gave up. Later, a second group of monkeys were introduced—the new entrants made a beeline for the goodies, but were quickly beaten back by the chastened first group of monkeys. Finally, this first group were removed from the cage and replaced by a fresh contingent. The new monkeys immediately made a dash for the nuts, but were beaten back by the second group; i.e., those who had never experienced the cold water, siren or shocks.
It does not take a wild imagination to see a parallel between our monkeys and central bankers. For generations central bankers were cowed by their inflation-scarred colleagues and accepted that the top of the cage was off limits. But then a rebel monkey, erh central banker, emerged in the shape of Alan Greenspan. As the gorilla in the pack he persuaded the rest that the fruits at the top of the cage may not be forbidden. The result of this “bravery” in economic policymaking has been two huge financial crises.

The funny thing is that the general public remains grateful to the central bankers since their “new-fangled” actions to “save” the world economy appear to be working. For the most part our monetary guardians have escaped responsibility for the crashes, with popular ire focusing instead on “nasty” commercial bankers. The concern must be that few experiments (certainly in economics) are “new”, except for those which ignore history. And, of course, to quote philosopher George Santayana “Those who cannot remember the past are condemned to repeat it”.

History has thrown up multiple attempts to create wealth by printing money from the Song Dynasty in China to renaissance era Italian bankers, through revolutionaries in France and their Assignat notes, to the more recent case of Zimbabwe. However, one of the most revealing cases took place in the early 18th century when France was ruled by the boy king Louis XV and power was exercised by his uncle, the Regent.

Heroes and villains

This story has two protagonists: the first being a classic villain in the shape of John Law, a Scottish professional gambler, who can been thought of as a proto Mario Draghi. Our hero was Richard Cantillon, an Irishman, whose actions shared similarities with Georges Soros, the investment manager who in 1992 forced the pound to leave the European exchange rate mechanism. Back in the early 18th century France was almost bankrupt because of the wars that accompanied the end of Louis XIV’s reign. As a result, the French “rente”, the equivalent of today’s OAT, was selling at a huge discount to its face value.

Enter John Law who presented the Regent with a simple solution to the kingdom’s straitened financial situation: the government would grant a client company “La Compagnie des Indes Orientales” (CIO) a monopoly to conduct international trade between France and French colonies in the new world. Later CIO would become Banque Royale as its notes were to be guaranteed by the crown. Law would arrange for shares in CIO to be sold to the public, allowing payment to be made using the discounted French rente at full value, rather than its discounted market price. The price of the shares, and also that of the rente, went through the roof, which we have come to recognize as the usual response to a quantitative easing program. Since the run lasted quite a while, it led to a remarkable boom, centered on the Palais Royal in Paris and the luxury industries.

At this point, Cantillon joins the story. He was an astute financial operator who, sensing an opportunity, decided to move to Paris. He quickly had three key insights:

•    No new wealth was being created in France; rather there was just a massive increase in the monetary value ascribed to older assets. In fact France was getting less, rather than more competitive. He went short the French currency and long the British pound, a trade which eventually made him a ton of money.
 
•    The main beneficiaries of the artificial wealth being created were those cronies closest to the Banque Royale which had been granted the trade monopoly. This phenomenon was later called the “Cantillon effect”.
 
•    The system could work only as long as nobody asked to be repaid in real money, at that time gold.
When Cantillon started to see great French aristocrats (those close to the Banque Royal such as Prince de Conti) selling their shares against gold he opened up a large short position, and made out like an (Irish) bandit. When the system imploded, he was sued for both shorting the French currency and also being short the shares of the colonial monopolist. He won, as at that time the courts in France were genuinely independent.

Fortunately, he committed his analysis to paper in the book “Traite sur la nature du commerce” which is a must-read for anyone interested in financial speculation. Schumpeter spoke highly of Cantillon, who was probably the first economist to clearly distinguish wealth from money. He recognized the distinction between asset prices rising due to an economy becoming more productive rather than as a result of a massive expansion of the supply of credit. In the second case, the value of money is going down versus the price of assets, which is a form of inflation.

This audacious attempt to monetize asset prices by printing money resulted in ruin for the French middle class, which had sold its weak but solvent French rente against worthless shares. What followed was a collapse in the credit sphere followed by a great deflation. The lesson is that a huge inflation in asset prices is seldom followed by inflation in retail prices; rather once asset prices start deflating what usually follows is a deflation in retail prices (see “The Debt Deflation Theory Of Great Depressions” by Irving Fisher).

The stability of the system was predicated on the guarantee that French government bonds could, if asked, be repaid in gold, and the same for the shares in CIO. At the peak of the “Mississippi Bubble” the Banque Royale had 4mn francs in its vault and outstanding notes totaling more than 100mn francs. So when the consummate insider, Prince de Conti, started to convert his positions for gold, the system began to collapse. Within a year the CIO share price had fallen by more than 80%. From start to finish, the episode lasted a little more than three years.

Why I am recounting this old story? Because we are at it again. Simply replace the French rente with current Italian or Spanish Bonds; the Regent with Francois Hollande; John Law with Mario Draghi and it is clear that very little has changed. My hope is that most of our clients will end up following Cantillon rather than face the predicament of France’s ruined middle class at such time that latter day Prince de Contis cash out.

In the current system, gold is being replaced by the willingness of Germans to keep accumulating financial assets issued by the rest of Europe, which will never be repaid. The ratio that exorcised Cantillon was the value of the gold stock / the value of engagements; the modern equivalent may be the net external balance of Germany vs the rest of Europe with Angela Merkel or the Bundestag playing the Prince de Conti.

And what has Mario Draghi, in the role of John Law, done to prolong the agony? He has manipulated the cost of money by increasing the quantity of money, or, at least, promised to do so in the hope that speculators front run the ECB. They have, of course, duly obliged. And what happened during the Mississipi Bubble is now unfolding in our time. The increase in the quantity of money in itself cannot lead to an increase in wealth. For confirmation, consider the case of Italy as shown in the chart below.

The blue line is the ratio between the Italian and the German industrial production indices. From 1960 to 2000, Italian industrial output grew faster than its German equivalent by 48%. However, since 2002, the Italian measure has declined 40% versus that in Germany. As a result, the Italian stock market, which outperformed the German market between 1970 and 2002 by a robust 250% (in common currency terms) has, since 2002, underperformed by 60% (red line, right scale). I have few doubts that a modern day Cantillon would have been short the Italian stock market versus the German one at least since 2002.

Indeed, it is clear that wealth creation in Italy has effectively stopped, as shown by the fact that since 2000 the economy has spent three quarters of its time in recession. Indeed, measured in absolute terms, industrial production today is 25% below where it was in 2000.

Of course, the only sensible approach for a heavily indebted country which has seen growth disappear would be to devalue its currency. Since that option was off the table due to the strictures of the euro system, the bond markets, from 2008 onwards started to play the default game. By 2012, spreads had opened to such an extent that it should have been obvious that the euro was doomed (see bottom pane of the chart above).

At this point “Derivative Draghi” did his worst and promised to do “whatever it takes”. The bond markets understood this as a promise that the ECB would buy Italian, Spanish and Portuguese government bonds. As a result, yields promptly collapsed. But, and this is a big but, the Italian economy kept shrinking and the German economy kept expanding. If the policy had succeeded, one would have expected the expression of the relative return-on-investment in the two economies (namely the ratio between the two stock markets indices) to change direction.

Nothing of the sort has happened. In fact, the Italian government can now borrow at 1.5% or so, while the average growth rate of the Italian economy has been -1% for the last two years. Italy was and remains solidly in a debt trap; debt as a share of GDP will keep rising as long as the 10-year yield is above -1%. The problem is that negative rates destroy a country’s savings industry and thus its long term growth rate. The same is true for France or Spain, not so much because interest rates are too high but because both countries have massive primary deficits.

Conclusion

So what should the savvy investor do? Remember Richard Cantillon and do not trust John Law. Stay short the Italian stock market versus the German one (equivalent to CIO stock in 1717). Remain short the German bond market versus the US (equivalent to being short the French currency vs. the British one in 1717).