![Russell Napier]()
Russell Napier is a financial historian and the founder of ERIC, an online research firm that aims at connecting analysts and investors.
Here he talks to Merryn Somerset Webb about the next deflationary bust – why it’s coming, what it means for you, and how you can survive it.
Merryn Somerset Webb: Let’s start at the beginning. You are a firm believer, as I understand it, in the idea that we live in a deflationary environment and there’s almost nothing that central banks can do to change that. So, maybe talk a little bit about why you think that is.
Russell Napier: OK.
MSW: First why we’re in a deflationary environment?
RN: Sure. There are some very, very big building blocks of this. Just before I go into those, the reason why we in recent times have deflation is not because supply is bigger than demand. That’s not the dangerous deflation. You might actually say that might be a good deflation. It’s because at some stage in that transition process from inflation downwards, we have a credit event which creates a shock for the financial system. Of course, that’s famously what happened in 2008-2009. But that also happened in 1998 with Russia and LTCM [Long Term Capital Management, a hedge fund investment firm that collapsed after the Russian government bond crisis] and it happened in 1982 with Mexico and their banking system.
So, when we talk about deflation, people say, “What’s so wrong with falling prices?” The answer is that usually that undermines somebody’s corporate cash flow. Somebody goes bankrupt and we get a credit event. That’s the likely way it goes forward. If it happens to be a big one, a country, a very large financial institution-we could name a few. So, that’s why it’s important. That’s why it’s likely to happen.
In terms of the big deflationary forces, there’s a significant overproduction in China. It’s very well-documented. I think potentially the biggest one is the ageing of the Baby Boom generation and their move away from consumption to saving and perhaps even more important, they’re de-gearing and what that means for the efficacy of monetary policy going forward. And just in the short run, a strong dollar has always been bad for people who link to the dollar. It forces them to run a tighter monetary policy.
MSW: Let’s go back briefly to demographics. You are partially blaming the deflationary impulse in the global economy on Baby Boomers in America de-gearing.
RN: Yes, not just America. The Baby Boomer phenomenon is everywhere. If you look at the balance sheet of the Baby Boomers, something important happens this Christmas. As of the 31st of December at midnight, there will not be a Baby Boomer in the world who is less than 50. The last Baby Boomer turns 50. So, people always think they’re retiring. They’re not retiring. They’re 69-50. They’re preparing to retire. They’re hoping to retire. The simple rule of retirement is retire your debt or don’t retire.
Now, it turns out, not only are they a demographic bulge, they are a big dominant customer of the banking system. Now, if we go back to monetary economics 101, money is created by banks extending credit, and in the process they create deposits. And if their biggest customer is de-gearing for structural, demographic reasons, then it’s going to be incredibly difficult for monetary policy to generate all this money that we need to inflate away our debt.
So, five or six years ago, the general view was, “Look at this monetary policy that the central banks are running. There will be lots of money.” It hasn’t worked. Why? Because the banks haven’t lent the money. Common diagnosis of that is that the banks don’t want to lend the money. But I think people are forgetting there’s a very strong headwind of that Baby Boomer generation who want to repay their debts.
MSW: OK. Now, we’ve been here before with demographics and deflation in Japan. Is this a repeat of that experience?
RN: It’s similar. You’ve got to remember that Japan’s got 15 years ahead in terms of the demographics. So, our demographics don’t look dissimilar to Japan in the mid-1990s. So, this could be one of the reasons why monetary policy is not as powerful as it used to be.
I think the way you should look at a quantitative easing which is the way it was looked at by the man who invented it, Irving Fisher, is that it’s the oil in the machine, but not the accelerator. So, what Fisher said is that there are sometimes when a society has to de-gear. I would say that’s where we are with the Baby Boomer generation. If you don’t create money as you de-gear, then you get a 1929-1932 experience. Fisher said the central banker has to be in there creating money as the credit comes down. That way we don’t get the high-friction and the high dislocations that we had during the ’29-’32 period.
In that extent, I think quantitative easing has succeeded to the extent that some private sectors, not all of them but some, particularly American private sector, has fairly smoothly de-geared as the success of quantitative easing, but it hasn’t forced anybody to re-gear. It hasn’t generated more growth. It’s done what Fisher said it would do, but it hasn’t done what the current Fed said it would do, which pushes back into high levels of nominal GDP growth. Will that GDP ratio start to decline? It certainly hasn’t done it in Europe.
MSW: So, in this interpretation, QE can prevent disaster but it can’t improve the underlying economy and it can’t create inflation.
RN: It was designed to stop a debt deflation. It seems to have succeeded. Everything else has a new and modern claim for it and it doesn’t seem to be succeeding in that.
MSW: Is there anything else that the central banks can do to create inflation or are we at a dead end?
RN: If we’re sitting here in ten years, I’m fairly sure we’ll have inflation. I’m fairly sure nominal GDP growth with be above the growth of debt and all the democracies will be getting rid of debt in their tried and traditional methodology and way. I think we’ll attribute it, though, to the People’s Bank of China and not to the Federal Reserve.
We need a monetary policy which can generate-well, a central bank policy which can generate money and final demand. It seems to be the obvious place where that can happen is China, where you have a younger generation who are, let’s say, pro-consumption. That’s my euphemism for the younger generation of China. If we can get consumer debt flowing to them in a better way, then I think they would go out and consume a lot. It would be very, very easy for China to have 30-40% money supply growth within a year or year and a half if they chose to do it. I think that’s why China can potentially reflate the world.
But here’s the catch: it’s highly unlikely they do that without devaluing the currency in the process. So, that’s something we’re going to have to live through, I believe – a major devaluation of the Chinese currency. But the good news is that can set the field for true independent monetary policy in China, an end to their mercantilist pro-export system, a move towards consumerism. But we can’t get that move until we change the monetary policy, the focus on the dollar.
MSW: OK. Back to China, then, when do you think this happens? How does this happen? What makes China decide to reflate and save the world?
RN: Well, China has had an incredibly strange financial system in that they have retained the command economy banking system. They’ve changed many things in China but held onto that. They’ve had an economy which has grown where money supply wealth has grown at double nominal GDP. So, it’s an economy with a command economy banking system which has needed a huge amount of money to grow.
At this stage, their only supply growth is done at a very low level. Now, that suggests when we’ve seem this historically that the financial system may begin to creak at the edges. It may not be that stable. It may be unstable. Whether it’s the formal system or the informal system, things might start to go wrong.
Now, there’s a very simple playbook for that. We’ve seen it in 2008-2009. We’ve seen it over and over again. What do you do when your financial system starts to creak, when it looks like it might crack and capital might decline? You print money. If you’re going to print money and you have an exchange rate target, you’re going to massively increase the supply of currency. It’s most likely, not inevitably, most likely that the exchange rate will come down.
So, I think they’ll go to America and they’re probably go directly to Tim Geithner. They’ll probably hire him as an adviser. “What do we do now?” Tim will say, “Well, you can print money.” “OK. Let’s try that.” And then they can go to America and say, “The currency came down. We had to let that happen because if we didn’t let that happen, our financial system would be in trouble and that’s exactly what you did.”
That’s the playbook for China when the time is necessary. They’ve undervalued the currency since 1994. Obviously that let it go up a little bit. If it was this easy, we’d all do it, all paying to the currency of the dollar at a lower level and just sit back forever and have high export growth forever and it would be a wonderful policy. But it doesn’t work that way because eventually you get internal inflation which makes you uncompetitive. That’s where China is today. So, it is only a matter of time until the currency has to come down.
MSW: OK. When you wrote your book all that time ago, Anatomy of the Bear, you talked about how the next great bear market would play out. How does what we just talked about translate into your view on markets?
RN: Well, fortunately in the 2009 edition, I actually put in a bit in the preface saying they’re going to go up a lot first.
MSW: Phew.
RN: Indeed. So, there were signs that the deflationary expectations were overdone, that inflation was coming back. I said we were in for a huge rally in the bear market. Well, it’s been a bigger rally than I thought for sure. I thought that was probably coming to an end by the middle of 2011.
Since the middle of 2011, I’ve been writing about deflation and why that would inevitably bring the market down again. Of course, it hasn’t. But it is worth pointing out what has come down since the middle of 2011. So, emerging market equities peak in April of 2011. Commodity prices peak in September, 2011. So, some things have been in a bear market since 2011, but clearly not developed world equities.
So, someone said to me once, “Well, you got everything right except the market”. Well, given that my job is to get the market right, that’s not a great consolation. So, I’ve been wrong on the market for three years. So, what I note from financial history is the thing that can bring markets down quickly is deflation. Runaway inflation tends to bring them down more slowly. I just see so much evidence of the deflation out there that I think that’s what brings them down. I’ve been saying it for three years. So, maybe one day it will be right.
MSW: What will be the turning point that makes it right? You say you see deflation all around you. You expect more deflation. So, why haven’t the markets down already? It presumably is down to the constant money printing.
RN: The dollar, I think, is key to this. I’ve got a little chart of the dollar in my brain. It’s only in the last three or four months that it’s really become strong and really become a very strong propellant on the upward side. I think that’s the catalyst. I can analyse all these factors. But until the dollar starts to go up, that’s when you say, “Well, this could be the time.”
So, people will ask, “Why, what’s so important about the dollar?” There are so many people who link their currencies to the dollar. So, if you link yourself to a strong currency and you have to force your currency up in line with the dollar, that, on the whole, forces you to a tighter monetary policy. But worse than that, it’s highly borrowed cross-border. So, the world is full of people who borrow dollars, take the money and invest it in Chinese yuan, invest it in Indian rupee, invest it in the Brazilian real and they use it to fund assets or purchases in those currencies. When the dollar starts going up, you effectively short the dollar.
There’s an old quote in financial history from Daniel Drew, one of the first great speculators. It goes like this. It says, “He who sells what isn’t his’n, buys it back or goes to prison.” If you’ve borrowed dollars, put it in yuan and the dollar starts going up, your board is going to say, “Cover it.” Don’t cover 100% of it because it may not continue, but cover a little bit of it.
So, there are these very rare periods of financial history where you get forced buying of the dollar as people seek to cover it. If you look at the chart of the dollar, it looks like we’re there. Forecasting currencies is incredibly difficult until you get forced buyers. It’s beginning to look like that.
MSW: So, how do we invest, assuming you’re right, which I’m sure you are at some point, how do we invest to deal with that really extraordinary environment?
RN: Well, I believe that the beauty of being a private investor is that you can do nothing. I know people reading this would not agree with that. But believe me, your options to do nothing are significantly stronger than the ability of a professional investor.
MSW: But there’s no such thing as nothing. Nothing is holding cash, right? This is not a nothing.
RN: That’s what I mean by doing nothing. Unless you think I’m completely wrong and we’re heading to rampant inflation-and of course, I could be and if that’s your view, you don’t own cash-but we’re at least in a period of low inflation. I think most people would agree with that. In a period of low inflation, you’re losing something on cash, but perhaps not a lot on cash.
I’ve often tried to find where I read this by Adam Smith, but he once said that, “The greatest of cause of distress amongst men of wealth is feeling that they have to do something.” Apparently Winnie the Pooh said something very similar. So, if Adam Smith and Winnie the Pooh thought it was good advice, I think it remains good advice. You have to wait for the right opportunity.
If I look back in financial history, certainly before World War II, the great financial success stories, the great wealth accumulators were people that had cash at the bottom to buy, whether it was Rockefeller, JP Morgan, Mellon. That all ended post-World War II because we never had deflation. Having all that money to buy assets, cheap assets from distressed sellers hasn’t really been much of a policy in the post-World War II era but we’ve never lived through a period of deflation.
So, if you’re like me and you genuinely believe that that deflation is coming, then you take from the playbook of Mellon, Rockefeller, Morgan, Carnegie and you’re ready to buy. So, it’s not doing nothing, as you say, being in cash. But in a period of low inflation, it’s as close as you get. You wait for what Buffett calls the fat pitch. There are very, very few fat pitches out there. In the world of deflation, there will be quite a few.
MSW: Is your own money in cash, Russell?
RN: It is, largely. It has some Japanese equities hedged back into the dollar. Apart from that, it’s pretty much cash.
MSW: Is there any market at all that you would dabble in apart from Japan?
RN: No.
MSW: No. OK.
RN: People should know that I still have money in all equity markets, because I might be wrong. It’s a very low weighting, but I won’t say what it is. It’s not a huge percentage. But it’s public knowledge because I’m on the board of two investment trusts and they are global investment trusts. Because I’m a director, my shareholding is disclosed. So, I have money invested across the global stock market, but it’s not a high percentage. I think even the most bearish person in the world would probably have 20-30% of their money in equities because you might be wrong.
MSW: What about gold? Are you looking at gold just in case?
RN: Just a little bit but not very much. As a deflationist for three years, I have not been that keen on gold, but – and it’s a very big but – at some stage, if monetary policy doesn’t work, we get something else. That’s going to be government activism of some form. That’s what we discussed. We discussed it in context of forgiveness of student debt, but it could be something else. It could be exchange controls. It’s very hard to know what it could be.
Now, when you move from monetary policy to government activism, then I think there’s a chance that reinvigorates gold because it’s a confiscatory issue. If people believe that the state is in the business of confiscating their assets – I meet people every day who believe that already. They don’t have to see it in action for them to believe it. But if that becomes a prevalent view, then even in the world of deflation, it’s likely that the gold price would go up.
People would legitimately say, “Are you a bull or a bear? What are you actually saying?” What I’m saying is this – as a deflationist, you should have known it. If it starts to trade up on bad news, then it’s in a very prolonged bull market. The tinkering that the government does is bullish for it. When the government finally gets us back to a world flowing with milk and inflation, that’s very good for it. So, I think as someone who’s seeing a very long-term historical view, watch it trade. If it trades up on bad news, then that’s the time. But it doesn’t look like it’s doing that at the moment.
MSW: Thank you, Russell. I think we can summarise that by saying there is deflation. There will be more deflation. Hold lots of cash. Have some equities in case you’re wrong and never take your eye off gold.
RN: Yeah. And there’s nothing wrong in doing nothing.
MSW: Thank you.
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Russell Napier is a financial historian and 
In November 2010, 
