Interview with Edward Chancellor, with Gregor Mast of The Market, NZZ Financial Historian Edward Chancellor has never observed more bubbles than over the past 12 years. With central banks underwriting financial markets, they are not even completely irrational. A comeback of inflation would burst them. «In the years since the Lehman bust in 2008, we have been living through the most speculative era in the history of mankind», says economic historian Edward Chancellor, author of «Devil take the Hindmost», a book about the history of financial speculation. While financial markets are pushed higher by ever lower interest rates, the substance of paper wealth is getting wrecked, he cautions.
«The very term bubble means that it must at some stage collapse», Chancellor says. «Either it collapses politically by creating a swing of the political pendulum against it», says Chancellor in an in-depth conversation via Zoom – «or it will be the comeback of inflation which will end the bubble.»
While many experts doubt inflation is around the corner, Chancellor thinks we could be very close to a period with quite substantial inflation. «Central banks are expanding their base money, which is used for financing the deficits, and at the same time we have this interruption of global supply chains», he says. «If you maintain consumption while cutting supply, then that’s inflationary.»
The problem for investors is that there is almost nowhere to hide. «I can’t think of constructing a portfolio that would protect you under all circumstances. I actually don’t think prudent investing is possible these days», he warns. He sees some appeal in value stocks, as they are short duration assets.
Mr Chancellor, we often hear financial markets are in a bubble. Is that true?
Almost immediately after the central bank response in 2008, we observed a resurgence of bubbles. Since then, there were more bubbles around than in every period we find data. It’s almost hard to think of an asset which hasn’t built a bubble at some stage over the last twelve years.
How do you define a bubble?
When I was at GMO, we would define a bubble quite simplistically as a two standard deviation move away from trend. After 2008, all commodities – virtually every commodity with the exception of coal – were more than two standard deviations above their trend. The same applied for housing and equity markets in various parts of the world. Of course, the commodity bubble burst shortly thereafter.
What is driving these bubbles?
We’re seeing a speculative super cycle which is a corollary of the debt super cycle in which debt is going higher and higher. This in turn pushes the collective financial and real wealth of the world higher and higher. In order to do so, interest rates have to sink lower and lower. Once you have more debt, you can only sustain it with lower rates as you want to keep the debt service ratio at the same level. One person’s debt is another person’s assets – so the debt is part of the general wealth bubble.
So the foundation on which the wealth is built is not sound?
As the wealth bubble gets bigger, the substance of that bubble – which is the underlying capacity to generate income – is actually wrecked. In the 19th century, there were schemes which came up with virtual claims on wealth people could trade but actually did not represent anything. Crypto currencies are the purest version of this, but if you will, even a fiat currency bill is nothing more than a zero coupon perpetual note. It has no value whatsoever except that it is acceptable. A lot of our wealth is of that nature – it has a slim foundation.
How do you mean that?
People are paying $50 million for a balloon dog by the American artist Jeff Koons which he makes half a dozen of and doesn’t even touch them himself. A bank will probably loan you $25 million on your balloon dog as these are assets that can be used as collateral. Therefore, they can be translated into cash which can then be used to drive the economy forward. But for later generations, the balloon dog might be worth $50’000 only.
It is often said that the current activity of monetary stimulus is unprecedented. Is that true?
I find quite strong parallels between what John Law attempted exactly 300 years ago in Paris by severing the connection between money and gold by printing a lot of money through the central bank and using that money to purchase shares in the Mississippi Company. The valuation of the shares of the Mississippi Company rose in proportion to the decline in interest rates. Already back then, there was a clear inverse relationship between the interest rate level and the price of long dated assets like shares.
So one could say current valuations are justified by low interest rates. Couldn't it be that these bubbles are perfectly rational given the interest rate environment?
There are aspects of irrational bubbles such as crypto currencies or works of contemporary art. But yes, there is little point holding cash for precautionary reasons if central banks stand ready to support markets. One of the reasons to hold cash is to buy into markets when they are cheap. If the central bank guarantees to put a floor under the market when it’s 10% down, then of course you’re going to hold less cash even if you get a decent interest, and you buy more speculative assets as they are less risky. That’s definitely in the price of assets – it is sort of a moral hazard in central bank put valuation. Underneath, there is often a rationality behind a bubble.
Have nominal interest rates ever been that low?
No. Interest rates of 0% in the English speaking world and below 0% in Europe and Japan, that’s simply unprecedented. The payment of interest on debt precedes money in terms of coinage which was introduced 700 BC. Interest was paid on debts with barley and silver in the third millennial BC. So you’ve got more than 5000 years of history in which interest rates never turned negative.
While the economy is collapsing, financial markets continue their upward trajectory. As a result, wealth inequality gets even more pronounced with the rich benefiting from the market recovery while the worker is losing his job and income. Is there a risk of a political reaction which could pop the bubble?
It’s not capitalism as we knew it. One of the consequences of very low interest rates is the misallocation of capital which means lower productivity growth. So the poor – or one can just say the younger generation – face lower real income growth, and all the things you need in the ascent of your life such as accumulating housing and pensions are much more expensive now. While central banks can buy time by lowering interest rates, they are also exacerbating generational inequities. When I left university, you could buy a flat in London for 3 or 4 times your starting annual salary. Now it’s 25 times. It’s much more difficult to get a stake in the system now. And if you don’t have a stake in the system, you criticise it. As a result, younger generations are much more radicalised now. In England, anti-capitalism is on the rise.
But will that pop the bubble?
I don’t think this wealth bubble can continue – the very term bubble means that it must at some stage collapse. Either it collapses politically by creating a swing of the political pendulum against it. We have seen that over the last five years with Brexit and Trump. They were interpreted as the rise of the masses against the establishment. But actually, it didn’t make any difference at all. My great hope is that inflation will bring the wealth bubble to an end.
Hoping for inflation?
I was brought up in the Seventies and I have studied a fair amount on the history of inflation – so I don’t have any illusions about inflation, I don’t think it’s a good thing. If we weren’t in that situation, I wouldn’t be welcoming inflation. But when you get inflation, you would be getting rid of a lot of this paper wealth and interest rates would rise. And as interest rates rise, the speculative bubble aspect of wealth would diminish.
Do you see any inflation on the horizon?
Governments have now realised that money doesn’t cost anything – so they will spend it. As you do that, you’re either creating a liability that someone has to pay off with taxes at some future date, or you have a piece of bubble paper that is going to be inflated away. I suspect inflation is what is going to happen, and it could happen quite soon.
Central banks are expanding their base money which is used for financing the deficits, and at the same time we have this interruption of global supply chains. Sometimes people see inflation as a supply shock problem rather than a monetary shock problem. But it seems to me we have the potential for a monetary shock and a supply shock. If in five years time the coronavirus marked the beginning of a return to quite substantial inflation, no one would be surprised. It might seem like the most obvious thing. The counter argument is that we live in such a financialised world that anything that breaks the financial system is immediately deflationary. That would mean that if we’re moving into inflation, markets could easily crash, and that would be very deflationary.
Another counter argument is that all the stimulus keeps unproductive companies – Zombies – alive, which keeps a lid on prices.
If you maintain consumption while cutting supply, then that’s inflationary. Over the last many years, the velocity of circulation of money has been very low despite low rates. And there is actually quite a large amount of cash on the sidelines. I do this myself – I operate with higher levels of cash even if it’s costing me 2% a year in terms of inflation that I wouldn’t do if inflation were running at 5% and threatening to go up to 10%. I would immediately get rid of one or two thirds of my cash. My own personal velocity of circulation would speed up. It doesn’t take much in a fiat money world for a mind shift changer. Limitless amounts of money printing are inflationary. If not, that would really go against the entire lesson of history that governments could finance themselves by printing money without inflation running hot.
What does this all mean for an investor?
Financial assets do not respond so much to the level of inflation but to the change in inflation rates. When inflation is taking off, gold tends to do quite well. I try to keep at least 80% of my wealth in real assets rather than in paper assets. I don’t own any long dated government bonds. I can’t think of constructing a portfolio that would protect you under all circumstances. I actually don’t think prudent investing is possible these days. There’s no way to hide apart from not buying into the most speculative assets.
If inflation returns, value stocks could finally have a revival.
Value is short duration – if you buy a stock at a P/E of 8, you’re going to get your money back in eight years, whereas when you’re buying a stock with a P/E of 50, it’s going to take fifty years. Obviously shorter duration should do better when interest rates rise. And value is low price to book – so you should be picking up some book value. If Europe has turned the corner realising it has to underwrite the whole Eurozone, maybe European value stocks are attractive. Once you have inflation, traditional investment virtue will return, and value stocks would be rewarded.