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The bubble that led up to the collapse of 2008 was based on unusually high levels of trust across the financial system. Investors trusted banks. Banks trusted each other. Everyone trusted the ratings agencies. If all this trust hadn't existed, there is no way that so many stupidly complicated and generally worthless securities could have flooded, and all but destroyed, the credit markets.
That trust didn't disappear with the credit crunch. Instead, investors transferred their faith to their governments. The stockmarket rally since early 2009 has been based on the firm belief that governments can both take on the debt of the private sector and kick their economies back into action at the same time.
We should be glad that investors found that faith – imagine what would have happened had the fear of 2008 poured into 2009 and beyond. But it leaves us in a tough situation now. Why? Because there is no back stop to governments. I shared a speaking platform with the FT's Gillian Tett at a City lunch last week and the question we both posed – in slightly different ways – was what happens next: what happens if we lose our faith in governments to sort out the mess they somehow allowed us to get into?
It's a good time to be thinking about this. George Osborne's budget looked good – reasonably honest, probably fair, enough for the markets and enough for sufficient of the population to maintain trust in his government. But, as I said last week, the real detail on the cuts is still to come. And it isn't a given that the coalition will hold. Note the gloating headline in The Observer last weekend: "Support for Clegg slumps after U-turn on VAT".
Meanwhile, house prices have stopped rising again (down 0.2% in May, says the Land Registry), credit card write-offs are up, as is unemployment. We're trying to be mildly optimistic for now. But what would happen were the coalition to look as though it might break under the strain of a miserable electorate? We suspect the answer would be a huge outbreak of quantitative easing (printing money to buy government bonds), so as to avoid having to make the cuts.
The deflationists say this would make no difference – if the transmission mechanism for money is broken (the banks aren't lending) it doesn't matter how much money you print, it can't create inflation.
I think they miss the trust issue. When people lose trust in governments (as they might under such circumstances) the velocity of money goes up fast. Fearful of their currency losing value, people convert it into real assets as fast as they can, driving up nominal prices as they do so. Hyper-inflation can arise this way just as easily as it can from hectic bank lending. This isn't a forecast. Just a thought. But it's one that might explain why, even as deflation appears to be gripping the West, the gold price is still rising.
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Merryn Somerset Webb
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