Hendry: There Are No Policy Remedies for Debt Deflation

Hugh Hendry is back writing after a long hiatus. His latest commentary to investors makes for good reading. His thesis: we are in a world of debt deflation for which there are no policy remedies; the Fed is fighting an uphill battle and it will lose. Long-time readers will now I agree with the thrust of Hendry’s core thesis. I certainly advocate some policy remedies, but I do not expect them to arrest the debt deflationary trend, simply to mitigate its effects.

He starts in on quantitative easing this way:

I fear that just as Whitman’s musings on sex and sexuality seem rather tame to the modern eye, a later generation might feel the same way about our squeamish reaction to the Fed’s initial stab at quantitative easing. They might guffaw, “two trillion dollars, how quaint. And they thought that might produce inflation!?” For a not so distant future generation may bear witness to far greater monetary debauchery.This has been my argument in April 2009. Given the impediment of such a large quantity of private sector indebtedness, I speculated that should the global economy suffer a further debilitating setback over the course of the next two years, the Fed and especially its acolytes at the Bank of Japan would print much, much more paper money. And only under such dramatic economic circumstances would we establish the pretext for a truly gigantic monetary intervention which would surely undermine the fiat system.

Today, however, we are learning that additional money, perhaps $600bn, is to be printed even without the occurrence of a serious crisis. This has come as something of a surprise to me. I had thought that intense scrutiny and political discontent from the US Congress would have tempered the ardour for such intervention. The QE announcement has also produced a rise in the risk premium associated with term structure. The yield on the ten year Treasury has shot up from just under 2.5% in August to almost 3% in November.

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I see this episode differently. QE2 as the Fed’s latest campaign is called is really quite tame in comparison to the first. I have called it QE-lite. The Fed is not buying municipal bonds or targeting rates with a potentially unlimited supply of liquidity – although this may eventually come. In fact, the furore over QE2 is much bigger than the one over QE1 despite the fact that QE1 was a more radical program. So clearly, people have had their fill of the Fed’s prescribing more cowbell and the Fed has reacted accordingly by pulling in its horns somewhat. Hendry draws the right conclusion based on this – namely that the Fed has shifted private portfolio preferences as intended – mostly toward risk-on trades; however, the shift has been in the wrong direction for Treasuries i.e. a preference for shorter maturities over longer. The Fed had wanted to persuade market participants to move out on the yield curve and they have done just the opposite. So far, QE is a bust. Hendry has taken a hit as a result.

But what about what I have called the "Scylla and Charybdis flation challenge"? The Fed is conducting an expansionary monetary policy to counterbalance the debt deflation associated with the financial crisis. Who wins that tug-of-war? Here’s what Hendry says:

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Evidently there is an all-out war being waged between what we might refer to as the Fed’s fiat money (the ability to increase dollar banking liabilities), and the private sector’s debt-based money (the willingness of the private sector to hold dollar banking assets). The market favours the prospect of fiat printing winning. Perhaps the outcome is a foregone conclusion. However, I continue to argue that the odds seem stacked against this outcome occurring in the short term. Consider that the US authorities are battling against the $34trn of gross debt added by the private sector since the start of Greenspan’s tenure as Fed chairman in 1987. This is a formidable obstacle to quantitative easing…

Exactly. How is the Fed going to be able to counteract $34 trillion of gross debt without going all-in. That’s the Schiff-Schilling debate, isn’t it? And it’s a political question: would the Fed risk extreme levels of currency revulsion and the attendant tax evasion of going all-in? Would Congress allow them to do so? For me the answer is no. You can certainly get other opinions from Marc Faber or Jim Rogers. But I am saying no. More likely, the Fed will have to rein in its horns – unless we hit a Depressionary spiral and then it can take more extreme actions like buying municipal debt or even corporate debt.

I couched it this way last year:

  • Since state and local governments are constrained by falling tax revenue… and the inability to print money, only the Federal Government can run large deficits.
  • Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
  • Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
  • As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
  • Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
  • From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.

This has certainly been the path so far. I certainly don’t rule out a multi-year recovery; with more tax cuts and deficit spending, it almost looks like a base case again, frankly. But I expect weakness in the medium term and don’t intend to alter my longer-term view unless the data say otherwise.

Hugh Hendry has a lot more to say about this subject, the success of QE1, the divergence of interests within Europe and between the financial class and the common man and a lot of other related matters. This is thought-provoking stuff. The full letter is embedded below. Enjoy.

Eclectica Fund Manager Commentary 2010 12


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  1. Tom Hickey says

    Yes, we are in a secular bear until the debt clears and deleveraging is over. The world is in the final stage of the long financial cycle that ends in Ponzi finance as described by Hyman Minsky, and which threatens to culminate in debt-deflation as described by Irving Fisher.

    There are only a few escape routes, none of them palatable. First, write off the debts that cannot be paid and liquidate malinvestment. This risks initiating a deflationary spiral. Secondly, “extend and pretend” as long as it takes the deleveraging takes, hoping that the rot doesn’t come through the paper. This risks years of stagnation, as well as the possibility that it will not be successful and the house of cards will fall in as bad debt cannot be paid and even more debt is incurred by strapped households, when some catalyst comes along to yank out the rug. Thirdly, inflate out of the debt hole by depreciating the nominal value of the debt. This can only be done through massive deficit spending that is probably impossible politically, short of much wider war anyway.

    The US, UK, and EZ are taking route two, as did Japan, likely with the same result. However, the risk is that a shock will force a detour to route one, culminating in full-on debt deflation on a global scale. That shock is already manifesting in the UK and EZ as social unrest as austerity bites. There is a good chance that the US will succumb to this, too, as political gridlock sets in deeper, locking up fiscal control mechanisms with monetary policy already shown useless. Inflation is not going to happen, either from bank lending in a environment where deleveraging prevails or for from huge fiscal stimulus in this political climate.

    There is a fourth way that lies through a combination of the first three, but that would take intelligence, cooperation, and coordination, which are sorely lacking with the present leadership, at a time of political and social divisiveness, and in a growing atmosphere of every man for himself.

    1. Edward Harrison says

      Well said. That’s pretty much where I am on this. If done right the fourth route could get things back to normal much more quickly. But there is no political will for that kind of remedy.

  2. Ralph Musgrave says

    Hendry, like 99% of the population including economists, describes QE as “printing money”. This is so misleading that it is essentially nonsense. Certainly where government bonds are QE’d, all that happens is that one valuable bit of government / central bank produced paper is swapped for another. And 99% of QE in the UK has involved government rather than private sector bonds. I understand the intention in the US is for QE2 to involve mainly government bonds.

    As for QEing short term government bonds, this is little different to swapping $10 bills for $20 bills.

    REAL money printing is an unfunded deficit, i.e. having the central bank / government simply write checks drawn on the central bank with no borrowing or taxation to cover the sums concerned. That’s real helicopter money: i.e. it increases the private sectors net financial assets, unlike Q.E.

    As for Hendry’s claim that there are “no policy remedies for debt deflation” my reaction is “total and complete bunk”. What happens in a recession if the average household is simply presented with $10,000 of helicopter money? Presumably Hendry thinks they do nothing with the money. Hendry (like many economists) has lost contact with reality. If anyone isn’t sure what households would do with windfalls, I suggest they ask their plumber, electrician or the nearest street sweeper. Or if anyone out there wants to see some research into what households do with windfalls, the URLs below would be a start. Turns out that (surprise, surprise) households spend a significant proportion of windfalls and save a significant proportion as well.


  3. SouthWabashSoul says

    Edward, Any thoughts on where the debt deflation has to take us in relation to GDP as far as when we can see an expansionary period again? Is there a larger capacity to service debt today than there was, say, 75 years ago? I’m not sure we have to go all the way back to historical norms, which would be truly devastating. Are you aware of any writings on this? By the way, the 4th way seemed to be suggested on your blog today by Randall Wray. Thanks for presenting such commentary on your site.

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