The death of the “punchbowl” metaphor

By J Saft
October 29, 2009

jamessaft1.jpg (James Saft is a Reuters columnist. The opinions expressed are his own)

Don’t expect the year-long rally in risky assets to be undermined any time soon by the Federal Reserve becoming concerned about inflation.

The old metaphor — that the Fed’s job is to take away the punchbowl just when the party starts getting good — just doesn’t apply in the current circumstances. That’s not to say inflation isn’t a threat in the medium term — it is virtually a promise.

But punchbowl thinking dates from a time when firstly the Fed was presumed to have a degree of control over events we now know is not true and secondly to an era when asset prices were the caboose rather than the engine of the economic train.

Even with an economy that is now growing, the risk of a self-reinforcing de-leveraging spiral is enough to ensure that the Fed will not pull the trigger on tightening any time soon.

“Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up, economies don’t do well, and when they go down, the economy can be horrid,” Pimco bond chief Bill Gross writes in his most recent letter to investors.

Gross argues that leverage inflated the price of assets even as investment in the U.S. real economy flagged. As this happened the U.S. economy became ever more dependent on asset prices and on the sectors, such as finance, which intermediated the borrowing. When the debt and asset bubble is pinched, the whole edifice is threatened, leading to a response like the one we’ve seen: massive and overwhelming aid trained on markets irrespective of the costs.

Pimco data shows that the prices of assets in the United States over the past 50 years have gone up 1.3 percent a year more than would have been expected given nominal growth in the economy, leading to a putative 100 percent overvaluation if you reason that the assets which depend on the economy for income shouldn’t outgrow it.

Unsurprisingly, the real outperformance of asset prices against economic growth has come in the past 30 years, since when debt growth has accelerated.

There are other explanations for why asset prices have outpaced economic growth. For one thing, off-shoring and outsourcing have both suppressed wages in the United States, leading to higher returns on capital, and increased the income that U.S. assets receive from overseas.

It’s obvious that the past 25 years have not been kind to labor, and as its share of GDP has declined the share going to asset owners has increased. In that sense increasing asset prices make economic sense, though there seems to be every chance that workers start to recapture some of what they have lost.

GROWTH, DEFAULT OR INFLATION?

Taxes on capital and profits have also fallen in the United States, and, like wages, this is a trend that could easily be reversed in coming years, especially given the huge amount of public debt that will have to be paid back.

This brings us to the other very strong reason the Fed may have for not pulling away the punchbowl — or water bowl as perhaps we had better see it — even when the party turns inflationary: public debt.

Since the United States have taken a decision to not allow too much of the private debt to default, it has taken on a corresponding increase in public debt which will have to be repaid ultimately. U.S. debt as a percentage of GDP will exceed 60 percent, a level not seen since World War II.

But unlike the post-war period, Europe doesn’t need  rebuilding and though Asia will grow hugely those profits won’t flow to U.S. coffers.

So, if growth doesn’t allow the United States to repay debts, there are two options, neither pretty; default or inflation.

“No policymaker in the developed world — and, by now, few in the developing world — would want to countenance default as an option,” writes economist Spyros Andreopoulos of Morgan Stanley in London in a note to clients.

“This leaves inflation.”

To be sure, the Federal Reserve takes its mandate to control inflation and its independence seriously, but it is going to find itself in a very difficult squeeze, partly of its own making. The debt is high, growth will be poor and the time for private defaults is past. Threats to its independence will only grow.

Given that, and the dependence of the economy on asset prices, it’s not hard to bet that the evil we will be left with is inflation. Whether it is engineered or just kind of happens is less interesting than the reasonably high likelihood that it will happen at all.

For a time at least, that would argue that risky assets, particularly real assets and emerging markets, do well.

Longer term, things get stickier and stickier.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

23 comments

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I always enjoy your articles. And I think what you are saying is that the US cannot maintain that just because it “paid too much for that muffler” the economy that sold that muffler is therefor wealthy.

Assets in this country – especially commercial buildings- are notoriously impermanent. They are generally designed to last the life of their mortgages and than to be resold and rebuilt or demolished to be replaced by another impermanent structure. Those structures are also depreciated more quickly than the term of the mortgage and that usually means they are sold before the mortgage is ever completely amortized. Other than the site – which itself is prone to the loss of value if the location is no longer good for business, there is nothing but junk sitting on that site. and it is an expense to dispose of those millions of tons of rubbish – almost nothing of which has any value except for some recycled materials (another fluctuating value).

In the modern economy we cannot total our asset value the way people historically assessed their wealth. They would total up the value of everything in the building includng the fixtures, the furniture, the linens and even the bed pans. Today most of the contents have little value once they have left the store. That also applies to jewelry. A computer system has a useful life of a few years before it is fit only for the dump. You can’t even give them away. The manufacturers would love a world where everyone was obligated to replace them every year. Consumer goods are really only excuses to spend money and their value is almost nonexistant as second hand – every garage sale proves that point.

Tangible assets, especially commercial property and apartment houses, are only as valuable as their ability to generate an income.

Posted by paul rosa | Report as abusive

But the real cause,namely,Derivatives Trading,in which at least $600 trillion,is circulating,continues….Without banning this,no solution can be found.

Many of our leaders (especially on the right), like to extol the virtues of living a moral life based on Christian values. But these same people also moved to bail out the banks and put their constituents on the hook for generations to come.

So what would Jesus REALLY do?

(95) Jesus said, “If you have money, do not lend it at interest, but give it to one from whom you will not get it back.”

(Gospel of Thomas) Thomas O. Lambdin translation.

We are not animals. And we should not be content to live as such.