It is not common for a central banker to say: “The US government has a technology called a printing press, it can produce as many US dollars as it wishes at essentially no cost.” That was Ben Bernanke in 2002, much before he took charge as Chairman of the US Federasl Reserve and quantitative easing kicked off in 2008. This technology, which only the US has been successful at manoeuvring through the global financial crisis of 2008-09, is an antidote to deflation. It’s a prescription that is being used again by the Fed now. Will it work this time as well? Or are we kicking the can down the road?

Irving Fisher in his debt-deflation theory in 1933, theorised how all the remaining factors carried less weightage when compared to debt and deflation in triggering a crisis of greater severity. So when the asset prices fall sharply, the Fed prints money enough to lift them; eventually, inflation keeps the real yields positive while the interest rates are still at zero per cent.

This means the debt will keep ballooning, and as it keeps financing the purchase of assets, their prices shall keep increasing beyond normal levels driven by leveraging. To understand what that means for the stock market, let’s examine how it works.

Debt obligation

Financial markets are premised on the fact that there are some underlying cash flows in companies and there are some earnings which get translated into a share price in the stock markets. This means price is not just a function of the earnings, but also the money that is available to buy those shares in the market.

In earlier times, we were limited in the amount of money that can buy the shares as we were running on the gold standard; thus, the price earnings multiple had some sanctity and some limits so what levels it could reach. However, with the ability to print dollars the P/E that we see in the financial markets causes a disconnect between the fundamentals and the price of the financial instruments. The market is then held higher (or lower) driven by the sentiments of the people operating there. The sentiments determine a larger and longer-term trend as well as short-term trends, and these remain consistent in the market cycles until a major event hits the market.

Such an event, like the combination of Covid-19 and a deep cut in oil prices, quickly triggers revaluation of the corporate debt and the country’s debt, and the cost of capital that is available to buy these debts. That is the ability to pay out the debt obligation.

Increased indebtedness

Policy intervention through expansion of the central bank’s balance sheet worked well for the US till about 2015 — and to an extent, China — because it is not only just about the economy but also about the geopolitical architecture where the primacy of the US (and China) limits what Japan, UK, the ECB and other countries can do.

The US and China are for the moment joined at the hip, whether they or the rest of the world likes it or not. On a GDP of $14 trillion, China exports $450 billion to the US. If the US does not consume, China is also in trouble. US consumption is, of course, fuelled by debt. Referring to the IMF’s GFSR, we understand that in the US, the speculative grade debt now constitutes 48 per cent of the total corporate debt — which is approximately $13 trillion, and is higher than the 2009 levels. In China, it is 50 per cent of the total. Relatively, Europe has been able to control this following the previous debt crisis.

However, two countries that haven’t done much in reducing the share of debt at risk are the US and the UK, with a share of over 30 per cent of total debt. All of this can weigh down the performance of financial institutions.

Fisher rightly said, “Debt and deflation are two diseases that act and react on each other in other words just as a bad cold leads to pneumonia, so over-indebtedness leads to deflation”. Needless to say, the US has been walking the path of over-indebtedness for a while now. The question is whether it will pay the price just like the countries that do not have the advantages of a reserve currency or a large foreign exchange war chest.

Covid-19 is just the trigger for a market that was overvalued, and the risks of a pandemic were not priced into such portfolios. The chain of economic consequences of a global pandemic has never been easy to measure; however, we can predict some events that will happen in the financial markets given the current lockdowns that are taking place.

The first thing that happens here is deleveraging, that is reducing the debt. That takes us back to the Fisher’s theory. So to prevent the precipitation of the crisis that starts with deleveraging and can extend into a deflation, the central bank reduces the rates — this time to zero — and starts printing more money. By doing so, they reduce the cost of debt and also provide firepower to firms by infusing cash through financial markets.

The early signs of economic downturn actually came in when the Fed started participating in the repo market after the rates shot up in September 2019; this was followed by announcement to buy $60 billion each month in October. And although Fed said it is not aiming for a QE, as the epidemic grew to a pandemic, it had to cut the rates to zero and step on the accelerator to pump $1.5 trillion, followed by an additional $500 billion, and then unlimited QE. The European Central Bank has followed suit with an unlimited bond purchase programme.

Oil prices

Amidst this rising debt and the pandemic came the oil price crash, the biggest since 1991, which fundamentally shifted the oil market dynamics. In the capital-intensive industry, the biggest hit were deep-sea oil explorers in Europe and Shale oil producers in the US and Canada. If real estate was the starting point of crisis in the last decade, then this decade that point would be crude oil, traced back to the US again. The major oil consuming countries may see this as an opportunity to stock their reserves.

In short, the recession we are seeing could be longer, if not for the similar time frame.

The fallout of the US-China trade war, increasing wealth disparity post last recession, mismanagement of debt since 2015, the oil fundamentals and managing the pandemic are all indicating that the America’s leadership in domestic and international diplomacy is failing. This failure has been clouded by populism. Historically, these are the times when power shifts happen.

Gold-backed currency

As we look at a new world order, a question that arises is whether gold will play a central role in defining the sovereign risks in competition to become a global currency. The failure of the euro and Brexit is making the path easier for the new reserve currency, the Chinese renminbi to be on higher demand. Its yields have declined from 4 per cent in January 2018 to 2.7 per cent in March 2020. And its share as part of global forex reserves has been rising steadily since 2016 and has now crossed 2 per cent, although it’s still at 62 per cent for dollar.

China has been accumulating gold steadily since 2013 at least. If the research by BullionStar is to be believed, the official gold reserves of China are not at 1,800 tonnes, but rather closer to 4,000 tonnes. Working with gold-backed yuan and speculation of gold-backed cryptocurrency are all adding credence to its future position. And ironically, because China and the US are joined at the hip, the transition may still be bumpy but peaceful. Of course, if the rest of the world blames China for this pandemic, the country will have to wait some more time for the “sentiments” to turn in its favour.

The writers are with the India Gold Policy Centre at IIM-Ahmedabad. Views are personal

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