It seems that a lot of analysts have caught onto the MMT framework popularized by the late economist Wynne Godley and made topical in this downturn by Rob Parenteau of the Richebacher Letter. We have seen Martin Wolf use Godley and Parenteau’s financial sector balance approach to dissect both the Japanese and European macro-economy. More recently, I also pointed to a recent analysis by Paul McCulley of PIMCO that used the MMT framework to make some macro conclusionsregarding the developed and developing economies. Now, it’s James Montier’s turn.
In his latest piece for money manager Grantham, Mayerloo and Otto, Montier writes:
Let me share with you one of my guilty secrets: I occasionally indulge in the dark art of
macroeconomics. I don’t try to forecast the future (that would be truly pointless), but I do think that understanding the macro backdrop can, on occasion, help inform the investment process. For instance, those who understood the impact of a bursting credit bubble stayed well clear of the value trap opportunities offered in financial stocks during 2008. Those who focused purely on the bottom-up tended to plow in and repent at leisure, as the deteriorating fundamentals generated a permanent loss of capital. So why share this confession now? I think we are seeing a very worrying trend around the world: the rise of the Austerians. This breed is the latest incarnation of what used to be called the deficit hawks, a group set upon reducing what it sees as the government’s profligate spending.
The power of the paradox of thrift
The Austerians either ignore or dismiss the paradox of thrift… In essence, the paradox of thrift is a fallacy of composition. Whilst it may be perfectly rational for one household (or section of the economy) to save more, if everyone tries to save more, total income is lowered. If you aren’t spending, then neither are the people who depend upon you for their source of income. Firms won’t invest if there is no demand for their products, and we end up in a nasty downward spiral.
An alternative presentation was provided by my good friend, Rob Parenteau, in one of John Mauldin’s “Outside the Box”2 columns earlier this year. Parenteau reminds us that:
Domestic Private Sector Financial Balance +
Fiscal Balance + Foreign Financial Balance = 0
This makes it clear that it is impossible for all sectors to net save at the same time. As Parenteau notes, this isn’t a theory, it is an accounting identity. If this is wrong, then so are hundreds of years of double-entry bookkeeping.
Montier presents the following chart as a guide.
The paradox of public thrift is something that Edward Chancellor also talked about last month in an Op-Ed for the Financial Times, referring to Parenteau and Godley by name. He concluded:
There is a danger the proposed fiscal tightening in the eurozone will lead to further deflation and economic collapse. The Spanish government faces what Mr Parenteau calls “the paradox of public thrift”: the less it borrows, the more it will end up owing. It is unfortunate that it has taken a severe global recession to vindicate Prof Godley’s macroeconomic analysis. If economic policymakers start to pay more attention to financial balances, they might forestall the next crisis. European politicians might also understand the potentially dreadful consequences of their new-found frugality.
The point of course is that there are two sides to every financial transaction. You can’t look at fiscal austerity in a vacuum. A downward shift in the government’s net fiscal deficit means a downward shift in the private sector’s net fiscal surplus – totally doable except for this little thing called debt in places like Spain, the US, Ireland or the UK.
Moreover, the savings rate is already incredibly low in countries like the U.S. and the U.K. If the government tries to pare its fiscal deficit, the result will not be less private sector savings to meet the lower public sector deficit, but rather lower aggregate demand and a larger deficit – that’s the paradox of thrift. See Ireland as exhibit A. This is exactly what has happened there.
Now we are attempting the same experiment on a European wide basis – mostly because of the strictures of the Euro. This will lead to a weakening in demand and an even larger crisis for debt laden private sectors like Spain which will eventually feed through to the weak German banking sector as well. The UK which isn’t bound by the Euro has also signed up for the same programme in perhaps a more front-loaded way than other economies like Germany, where deficits are smaller and exports have buoyed recovery. At least the Germans are trying to make there budget cuts back-loaded.
This is all very deflationary of course, which means bonds would benefit (at least for now. Eventually, inflation will come into the picture again). What does Montier advise?
However, if deflationary pressure builds as a result of the Austerians, then bonds could well be a good speculation. How does a long-term value manager like GMO deal with this conundrum?
Generally, we simply can’t bring ourselves to own bonds at the yields on offer in most markets today. However, that doesn’t mean we are ignoring the short-term risks. So whilst we are generally inclined to be short nominal duration across portfolios (as suggested by the 7-year forecasts), we have been adding nominal duration. How can one add nominal duration when bonds are overpriced? Doesn’t this imply that we are betraying our value investing credentials?
Thankfully, no. There are a couple of bond markets that are still essentially at fair value (based on our measures): Australia and New Zealand both offer government bonds that look to be fairly priced. Are we happy about buying fair-priced bonds? Of course not. We are happy only when we buy cheap assets. However, these fair-priced bonds provide us with some useful insurance, without which our portfolios would be exposed to intensifying short-term deflation pressure. If deflation does arise, most likely we will be on the look-out for longer-term insurance against inflation. Ultimately, I suspect that is where we will end up. (And remember, the time to purchase insurance is when no else wants it as it’s likely to be cheap.)