Inflation & Deflation, Clockwise & Counterclockwise – Its How We See Time Differently

Steve Mansfield
Steve Mansfield

Inflation&Deflation Title Card

Inflation and deflation are not the normal subjects for this blog. Those who follow my personal social media accounts realize I am not just a watch innovator but also an investor. Saying I am an investor is like saying you are a watch collector – it covers a multitude of sins.

When I tell someone I am an investor, each person will conjure up a different image for each person.  Just as we looked into the difference between a watch collector and a collector of watches, there are differences in the investment community too.  Some may call me a trader rather than an investor, to me that is semantics. I believe an investor is anyone who seeks to manage their money in any market actively.  I consider The Watch Whisperer to be an investor – he just happens to invest in classic watches and cars.

What If The Unusual Is Correct?

The last 12 months have been a challenging time for all investors. There has been tremendous volatility. The financial markets of all kinds have been moving in unusual ways. Anyone short GameStop recently can attest to that. Or owners of a barrel of oil in April 2020. Some may say the markets are irrational – but what if they are rational? What if the markets are showing us the way?

On The 20 April 2020 you could have been paid to
On 20 April 2020, You Were Paid To “Buy” a Barrel Of Oil

This question has been nagging me as I look at the investment landscape. Especially the $10…$14…$18 trillion of bonds around the world that trade with a negative interest rate. What does that imply for our future? Negative interest rates seem naturally wrong. The trouble is, what if they signal something we should all be taking notice of?

Asking The Painful Question

These nagging doubts were crystallized when a very talented group of money managers wrote the following.

equity investment manager provides his views on negative interest rates in a deflationary environment
Read Once, This Appears Completely Rational. Only When Diving a Bit Deeper Do The Differences Between and Inflation and Deflation Investment Environment Become Evident.

There are several points made here, but the one that stuck with me was, “… the idea that someone pays you to borrow money is still ridiculous.”  Is it?  Before 20 April 2020, it was ridiculous to think you could be paid to buy a barrel of oil.

Ridiculous Has A Bad History

Nicolaus Copernicus was thought ridiculous (and perhaps worse) when he suggested that the earth orbited the sun rather than the other way around. The sweeping statement by this money manager compelled me to sit down and explore if I thought he was correct.  In the process perhaps I could clarify my thinking and hopefully further my understanding.

It Is Also Personal – Deflation Up Close

I hope you will indulge me. The reason is I feel I have seen this before. While Daniel was a young man selling watches in the Middle East, I was a young man trading equity derivatives in Tokyo. The year was 1994 and deflation was the last thing I ever thought possible.  It was a painful education I went through. Twenty-five years later, Japan has endured consistent deflation. This is regardless of the quantity of money the Japanese central bank prints or how many rounds of stimulus and emergency budgets have been enacted. Deflation is ingrained in Japan.

As we sit here today, four central banks worldwide are committed to printing money – the United States Federal Reserve, the European Central Bank, the Bank of Japan, and the Bank of England.  Interest rates are at all-time lows in many parts of the world. If inflation were around the corner, why are material portions of the global bond market trading at negative yields?


The Bank Of Japan Is Very Talented At Creating Money. Alas, There Seems No Correlation With Inflation. source: tradingeconomics.com

Can We Learn From Japan?

Could it be that the Japan situation is going global?  I can attest from living in Japan from 1994 to 2011 and still closely following their economic situation that deflation is a creeping and insidious force of nature.  You can see from the chart above that it appears that no amount of money printing can defeat it.  What creates the circumstances for deflation to take hold, and are we now looking at that scenario globally?

Who Is Asking?

This is a question that my friend Ken Shirley and I have discussed for over two years now. Ken also spent a considerable time living and working in Japan. He spent ten years as the analyst and one of the portfolio managers for Nippon Partners, a value investment fund created by Jim Grant of Grant’s Interest Rate Observer fame and referenced in the film, The Big Short.

During my time in Japan, I was a derivatives trader and then ran a hotel investment fund.  The anecdotal similarities Ken and I saw between Japan in the late 1990s and the global scenario unfolding before our eyes over the last two or three years prompted our investigation into deflation and negative interest rates. The question we posed ourselves was, “What is the chance that the deflationary Japan trap goes global?”

Writers’ Disclaimer

Before explaining our current thinking on the deflationary trap, I would like to make two points abundantly clear.  The first is that neither Ken nor I are economists or have any formal training in economics. We start from a very practical perspective: to seek to inform our investment decisions. We consider ourselves “armchair economists,” such that academic economists’ theories do not engage us particularly. We prefer to see the world in high resolution where the majority’s individual choices will ultimately prevail regardless of the macro statistics.

Second, what we layout in the following is not what we believe will happen.  Ken and I set up a hypothesis – that the world is sailing towards a long period of material deflation – and now seek to disprove our hypothesis.  Unfortunately, on that front, so far, we have failed.

The Japan Deflation Indicators

What started Ken and I investigating this world of deflation?  Three indicators set the alarm bells ringing for us. These are the conditions that we hypothesize are necessary to create the  conditions that  result in the “Japan Trap.”

  1. Massive amounts of debt in the private economy and on and off government balance sheets worldwide, including debt securities and obligations such as healthcare and pensions.
  2. Large numbers of poorly performing debtors.  These are sometimes referred to as “zombie companies.” Generally defined as companies that are unable to earn a return sufficient to service their outstanding debt. This is the corporate equivalent of paying off your credit cards with more credit card debt.
  3. A stagnating population, in particular a stagnating working-age population that is subsequently going to go into decline.

Where To Start?

These are complex areas to explore, even for someone who has been involved in the markets for many years. It has involved a great deal of reading and thought to craft our hypothesis.  Along the way, two books have impacted our thinking significantly. The first is called Capital Returns, edited by Edward Chancellor.  The second is The Great Wave by David Hackett Fischer.

It Is All About Returns

Let us look first at Capital Returns. This is a compilation of investment letters from Marathon Asset Management to their investors from 2002 to 2015.  It is an excellent read and worthwhile for anyone interested in the financial markets. Marathon follows an investment process based on investment cycle theory.  They look at industries and see investment cycles, the location of any industry in a cycle can be identified by the quantum of investment.

It can be summarised as follows. When investment in a particular industrial segment is high, the additional investment tends to compete away equity returns.  Eventually, this leads to a process of capital destruction when supply exceeds demand.  Once the capital destruction process has occurred and the industry is “right-sized,” then equity returns increase, and the cycle of attracting investment starts again. Crucially, the point to observe is that once debt levels rise above a critical point, equity returns tend towards zero and ultimately turn negative as capital is destroyed. This is a necessary process that has to occur before equity investors can enjoy returns once again.

Marathon observes that the investment cycle works at the company level, across an industry, and also for an entire country. Look, for example, at Japan. The broad TOPIX large-cap index garnered lots of headlines recently when it reached a 30-year high. But not every article bothered to mention it is still 30% below its all-time high of December 1989, the peak of Japan’s massive debt-fueled bubble. Is the world about to explore whether this investment cycle proposition holds true across multiple economies simultaneously?

History Provides Situational Awareness

The second book is one of history.  Something that struck Ken in particular as we went through our discussions was how much of the accepted body of economic theory had been written in the 20th century.  In the grand scheme of things, this is a particularly short period when considering our economic future.  The Great Wave provides a much larger context to consider as it starts its analysis from the twelfth century. The author does a fantastic job of tracking prices and socio-economic cycles from the twelfth century to the late twentieth century.

The critical understanding we both took from this book (with sincerest apologies to Drs. Friedman and Schwartz) is that it seems highly unlikely that inflation is a monetary phenomenon. It seems more likely to have been driven by population.  The analysis that leads us to this conclusion is laid out in historical terms in the book. Still, interestingly, periods of deflation appear to have been as common as periods of inflation before the 1930s. I find it intuitively correct that inflation (or even deflation) results from the summation of many billions of individual human decisions rather than something that can be imposed on society by central banks at a whim.

Back to Today

If we bring the discussion back to the current situation today, this does appear to be consistent with the Japanese experience. As we broaden our perspective and look at several European countries, like Italy, Spain, and Portugal, they seem to be following closely in Japan’s footsteps. They have high levels of government borrowing, population stagnation or decline, and significant bad debts in the banking system.

When Ken and I took a step back and reviewed the last 800 years of inflation and deflation cycles as laid out in The Great Wave, it provided a new perspective on the academic orthodoxy that seems to rule in finance, economics, and thus government these days.  All the modern ideas of interest rates, inflation, and deflation have been formulated during an era of unusual population growth. It would appear that if we selected a single day at random prior to 1890, it is just as likely that inflation was being experienced as deflation on that day. Furthermore, during the three Great Waves that preceded the current wave we are in, the average annual rate of price inflation was less than 2%. This is a far cry from the average of the current Great Wave of over 4%. It appears that inflation is not the default but this “modern” wave is the highest rate of sustained inflationary increase, by far, in known human history.

This boom in inflation over the last 90 or so years has also coincided with the most significant increase in the human population on the earth. It also poses the question of whether the most recent academic literature that focuses on these issues suffers from recency bias?  Even if that “recency” happens to be the last 130 years of economic history.

Banks In A Deflationary Environment

What if we happen to be right about this? What if we have entered a protracted global deflationary (or, at least, non-inflationary) environment? What are the practical implications? How might the world look?

Going back to the comments of our fund manager, he posits that “…the idea that someone pays you to borrow money is ridiculous.”  Well, is it?

For every transaction, there need to be two parties, the borrower and the lender, and there must be an incentive for both sides to enter into the transaction. First, let us consider a lending transaction by a bank in a severely deflationary environment. (Warning: Things will get strange from here. Your brain might hurt.)

Deflation – The Banks Still Win.

For ease of illustration, I have chosen large numbers. These are in no way meant to be a prediction of the future but are selected so that hopefully, the economic incentives are more apparent.  Let us consider a country where deflation is -5%, and the deposit rate is at -4%. The bank will continue to make a sound interest rate spread if they lend the money at -2% per year. This means the bank will pay their borrower 2% of the loan amount per year to take on the loan, and the bank will make a 2% interest rate spread as they can borrow money at -4% (i.e. remove 4% of your money from your bank account every year on average).  Furthermore, let us assume the bank will receive back its principal at the end of 5 years in a non-default scenario.

The bank should be happy with this transaction. Deflation has been increasing the purchasing power of each unit of money at the rate of 5% per year. The magic of compounding means that at the end of the five-year loan, the unit of money the bank has lent now has a purchasing power that is 27.6% more than the original unit lent.

Let’s look at the same transaction on a deflation-adjusted basis. The borrower will have received 1.104 of value for each unit borrowed (initial principal plus the coupons they received) and paid back 1.276 units.

This is the opposite of how we typically think of debt.  In an inflationary world, the purchasing power of money reduces over time, and thus the burden of debt falls over time.  In the deflationary world, the real value of debt increases over time.  The clear conclusion is that this is a logical transaction for any bank to consider in a deflationary world.

Deflation For The Borrower

The other side of this equation is the borrower’s perspective. This is where things become interesting.  This is also at the crux of our disagreement with our fund manager. He posits as follows:

We do agree that what our money manager laid out is not correct. Their suggestion is that if anyone can borrow money at a negative interest rate, then the value of assets is infinite. But is this correct in a deflationary environment?

This deserves more investigation. I will start by assuming that if interest rates are negative to any significant extent, deflation is in control.  For the consumer, at street-level, the easiest way to think about this is any item or asset’s nominal price will be less tomorrow than it is today. This process has been at work in Japan for decades and one that I found normal after very few years of living there.  It was particularly pronounced with the price of beer, something I celebrated.

Borrowing Money In Deflationary Environment

Any borrower in a deflationary environment would find himself in a difficult situation. Let us assume that, in this case, the borrower purchases a piece of real estate. With deflation in control, the nominal value of the property decreases with every day that passes. Yet, the value of the loan remains constant (and is increasing in real terms).  Where do these losses materialize? We suspect through the destruction of equity.

To illustrate this further, consider Landlord A, who takes out a loan and builds a tower block with deflation running at -5%.  Landlord B comes along five years later to build an identical and competing tower block. He can build it for 27.6% less than Landlord A. This means that Landlord B can have cheaper rents (potentially 27.6% cheaper) and provide a newer product to the market yet still make the same or better return on his invested capital than Landlord A. To add insult to injury, the loan Landlord A took out to build his tower block is larger in real terms, and the nominal value of his property has dropped in line with deflation.  Here is the destruction of equity.

Being Paid To Borrow Money – Not As Good As It Sounds

Our fund manager said the idea “…that someone pays you to borrow money is still ridiculous.” Based on our thinking, it is perfectly logical. The only problem we see is that banks cannot pay enough for anyone to want to borrow money in a deflationary environment! In any logical lending situation where the bank is making money, the borrower will be in a losing position because their equity will be reduced merely with the passage of time.

Returning, once again, to Japan is quite illustrative. Over the last ten years, the Bank of Japan’s balance sheet has increased over seven times and now exceeds 100% of GDP. The country’s largest hedge fund…sorry, the central bank owns 45% of all outstanding Japanese Government Bonds and $344 billion of equities.

If our fund manager is correct negative rates lead to stratospheric equity valuations.  So what happened in Japan? If unhinged money printing leads to runaway price increases, why is my donut in Japan 20% less than it was 20 years ago? Deflation appears to be as ingrained as ever in the land of the rising sun.

Japan Is Different, or Is It?

This is a conundrum Ken and I continue to debate, and the best explanation we have come up with is that when interest rates fall close to zero, it portends deflation.  The low rates do not ignite the animal spirits of borrowers – borrowers are logical.  What does happen is that demand for loans collapses, people choose not to borrow, and the velocity of money falls. All the money accumulates in the financial system. Very little is deployed into the economy at the grassroots level resulting in a massive balance sheet at the central bank level.  This describes Japan.

So do we think this is a potential outcome for the major economies of the world?  Specifically, and at such levels, maybe not. But generally, yes. As with all things of the future, I am sure what we have laid out here will not transpire.  What is of crucial interest to Ken and I is to understand how we get to the next bout of inflation. Are we about to return to a world of inflation after a bit of a deflationary wobble? Or will we be entering a period of deflation and equity destruction to return to inflation ultimately?

The majority appears to believe we are heading to rampant inflation. We believe we have laid out a reasonable outline of the alternative from a very different perspective to those in the financial orthodoxy. We invite those interested in challenging our hypothesis to join the discussion here.  Ken and I have failed to destroy our own hypothesis, which could be for many reasons. We are keen to find our errors and are fully aware of our scholarly limitations. So, for those who have spent more time on this than we have and have insight and understanding to help us course-correct, please fire away. We would be most appreciative.

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