In today’s issue:
- How to learn Japanese
- Narratives control financial markets
- Fiscal Dominance is what we believe now
Japanese school children have to memorise thousands of kanji like this one in order to read: 小松. Partly so they can translate everyday things for their foreign (i.e. stupid) father…
The question is how to do it with minimal whining.
It’s a bit rich for me to pontificate, because I’ve given up on kanji altogether. But the most successful way is to harnesses the power of stories.
Apparently, human minds are designed to memorise narratives.
We find it impossible to memorise a series of random colours. But create a story about some guy called Roy G. Biv and it’s easy to remember the colours of the rainbow.
Indeed, many of us can recite every scene from our favourite film, but couldn’t memorise ten objects in a photograph. Unless you can create a story about them in your head. Which is the point.
How to learn Japanese
The kanji above is the name of the Japanese town I’m spending most of the year in. It’s famous for a Kabuki play about a prince who must be smuggled through a gate to safety.
But the gate keeper suspects something is up. And so the climax of the play is when the manservant of the prince launches into a Shakespearian monologue about how the well-disguised prince is nothing but a shabby commoner who should be allowed to pass.
As you can imagine, no Japanese prince could possibly be insulted by his manservant. And so the manservant’s eloquent and nasty abuse of the shabbily dressed prince is a juxtaposition of Japanese culture. Or something like that…
The thing is, that kanji, the name of the town, looks a bit like the three main characters from the story. The prince is kneeling on the left with his arms out, as commoners do. The gate keeper is in the middle, standing tall. And the prince’s guardian is on the right, trying to distract the gate keeper with a famously gaudy outfit. He’s even pulling on the gate keeper’s sleeve if you look closely: 小松.
And so it becomes possible to recognise them in the kanji. And thereby recognise the kanji’s meaning – the name of the town. And thereby read everyday road signs without getting lost. If you do it all fast enough.
For locals, such recognition of kanji takes place in a matter of milliseconds, of course. But the point is the power of a narrative to the human mind. It shapes the very way we think, communicate and act.
All this is true of economics and investing too. It’s called “narrative economics”.
And there’s a simple reason why you need to hear about it now. A narrative has recently flipped. The world’s economic policymakers have just reversed how they see the world. They’ve adopted an entirely new ideology. We’re not in 小松 any more.
But before I explain their new worldview, and what it means for investors, consider just how important such narrative economics has been in the past…
The power of narratives in financial markets
We’ve seen many narratives come and go over the past few decades. Ways of looking at the world that determined what happened next.
You might recall the idea of austerity to fix the government budget. Cutting spending and taxing more eases the burden of government debt, right?
Well, it might be true. Or it might not. But that’s beside the point. Consider it as just one narrative. While that narrative held sway, we knew what would happen next in politics and financial markets.
We knew governments would pursue austerity. Or would be forced to by central banks, the International Monetary Fund and other institutions.
Economic projections from economists would use assumptions that favoured the narrative of austerity. After all, they had to make it look good for their bosses.
But we eventually abandoned that ideology. These days, no government is pursuing austerity. And no economist uses assumptions that make austerity look plausible.
The last few years, Modern Monetary Theory (MMT) has held sway instead. The idea was that we can just get central banks to print the money we need. No austerity or taxation needed.
This ended in inflation. Which is why a new narrative has popped up. Back to that in a moment.
Between 2003 and 2007, the narrative of “the Great Moderation” held sway. It claimed that central banks had mastered the business cycle and there would be no more 2008-type crises…
The narrative that a portfolio of 40% bonds and 60% stocks is diversified held for many years. Until 2022 made it a downright dangerous thing to believe.
The narrative that stocks go up in the long run, and you should therefore use passive investing, is another example. This would’ve been described as bad financial advice only a few decades ago. Stocks can go nowhere for decades, after all. The whole point of investing was to try to be Warren Buffett.
The story of retail investors attacking hedge fund short sellers was an especially popular narrative that moved markets in extraordinary ways during the pandemic.
I could go on. But you get the idea. The point is that when the narrative we are all thinking with changes, our interpretation of the same facts can change too. As does our reaction and behaviour.
Here’s one shift I think we are on the cusp of…
What if higher interest rates actually increase inflation? Someone is earning all that interest, after all. And spending it.
Do you see how the same fact – high inflation – can lead to the opposite conclusion depending on your beliefs and narrative? And trigger precisely the opposite policy response?
Central bankers could soon be cutting interest rates to reduce inflation. Some already do, in countries facing a currency crisis. So it’s not that farfetched.
But the big narrative change that’s just occurred recently, which will shape financial markets for the next few years is this one…
Fiscal Dominance is what we believe now
In a way, it’s a very simple idea.
Government debt is too high to raise interest rates. Any more hikes would send governments bust.
That means central banks are now powerless. Monetary policy is moot.
Fiscal policy (government spending and taxation) now holds the cards when it comes to economic policy.
If the government spends too much and taxes too little, you get inflation.
If it spends too little and taxes too much, you get a recession.
Central banks have no choice but to fund the government and keep interest rates low to avoid a sovereign debt crisis.
This makes inflation a fiscal phenomenon.
The implication? Politicians now run the economic policy show, not central bankers.
That’s a concerning idea.
Politicians can’t run an economy and certainly can’t be trusted to manage inflation. That’s why we came up with central bank independence in the first place.
If this world view really does take hold, we can expect deficits and inflation to continue. Government debt can continue to rise even higher, as it did in Japan, thanks to the central banks’ implicit and explicit backing.
But is it true? In one sense, it doesn’t matter, if that’s what policymakers believe…
The real question is, what are you going to do about it?
Until next time,
Nick Hubble
Editor, Fortune & Freedom
