Axel Merk wrote a great piece the other day regarding the importance of confidence in a market. In summary he says:
“Confidence is the most important thing, more important than gold or currency.”
That saying couldn’t be more true. Markets are made up of people. People react based on their emotions. If you don’t have confidence in something it’s very unlikely that you’ll put your hard earned money behind that idea.
Deflation is particularly dangerous because it creates a negative feedback loop. You see prices falling and you say to yourself, “oh, I’ll buy in 6 months when things are cheaper.” But in 6 months when prices have fallen you say “hmm, prices are still falling so maybe I’ll wait another 6 months.” This is the kind of mentality that occurred in Japan in the 90’s. There was no confidence in the market because the government’s actions repeatedly failed. The velocity of money never picked up because the consumers didn’t have the confidence to send the money into the economy. The result is they hoard it.
Bernanke thinks there is a cure for deflation. He thinks he can pump so much money into the system that it will overcome the deflationary effects. (You can lead a horse to water….) There is no monetary cure for deflation so long as consumers lack confidence. The best thing you can do to combat deflation is inject confidence into the market while the market normalizes. The best outcome you can hope for is swift price declines and even swifter stability that is the direct result of massive confidence. Unfortunately, deflation occurs due to massive excesses in the system so you have no choice but to let the markets revert back to normalcy, i.e., prices fall. The worst thing you can do is try to fix prices as Japan did. That only prolongs the markets necessary price drops and exacerbates the negative feedback loop as your policy actions appear to be continual failures.
As I too often do, I’ll revert to a medical analogy. The patient has a tumor. We can either let the tumor stay and hope the immune system eventually defeats it or we can attack it. If your doc tells you you’re dying of cancer, but he hopes it will go away you’re unlikely to respond rationally. On the other hand, if your doc tells you he has pinpointed the problem and plans to attack it tomorrow in surgery you’re likely to feel more confident.
This is exactly what happens in a deflationary spiral. The leaders fail to attack the problem and it spirals out of control. If the problems are not attacked head-on and eliminated the market remains uncertain, fearful and irrational. I think the main difference between Japan and Sweden were psychological. Sweden was proactive while Japan was reactive. Sweden was transparent with their problems. Japan wasn’t. The results were drastically different. Sweden’s consumers were entirely behind their bank nationalization as they knew their government was being transparent and proactive. The Japanese hoarded cash as their reactive government failed them. This crisis is all about confidence and we’re running low on it….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.