Dangerous summer
This is the best time of
year in England, particularly when the weather is so
good that it is hard to imagine much in the world is
awry. At home, we have a new government which seems to
have a mandate to do some of the right things. The acute
concerns over Greece, Portugal and Spain and the
European banking system are retreating from our
consciousness. The US, with the dollar seemingly stable,
is far from our thoughts. But summer’s lease hath all
too short a date.
Things are gently
sliding. Stock market sentiment has been eroding since
May, and in the UK there are early signs the residential
property market is running out of steam. Key indicators,
such as the Baltic Shipping Index which has halved over
the last six weeks, and the growth rate of the US weekly
leading indicators which has turned sharply negative,
suggest that all in the world is not well.
It is time to briefly
reflect on global economic developments.
Europe
Trouble has been brewing
in Euroland ever since its creation. The interest rates
that reflected the characteristics of individual member
states were replaced with a one-size-fits-all. In
practice, this meant that credit expanded rapidly in the
profligate states with the predictable result of wrongly
directed investment, unsustainable rates of consumption,
and speculative bubbles. The crisis that erupted with
Greece was merely an event in a larger continuing
crisis, not the crisis itself. Greece is not the only
Mediterranean state with this problem, and the problem
is not confined to the Mediterranean. Public sector debt
levels are also unsustainable in France and Belgium
(which threatens at any moment to become an ex-country).
The rapid expansion of low cost euro-denominated credit
into Central and Eastern Europe has given these regions
the same wrongly directed investment, unsustainable
rates of consumption and speculative bubbles.
The banks have been the
unwitting intermediaries in this euro-farce and are now
in trouble themselves. This the European politicians can
now see, but they believe this to be the crisis and are
oblivious to the larger problem. It is important to
appreciate that policy responses to events of this type
will always involve belated attempts to cover the
cracks, because the underlying problem will never be
actually faced.
The next cover-up will
be the stress-test of 91 selected banks due to be
published at the end of this month. The worst-case
assumptions are said to be a 17% haircut for Greek
sovereign debt, and 3% for Spain. You don’t have to be
unduly cynical to expect a positive, but unconvincing
outcome to this exercise. The reality is that the
European banks are insolvent, and playing for time makes
matters worse.
Euroland’s fate will
play out differently from elsewhere because it consists
of 16 member states and one semi-detached note-issuing
central bank. The link whereby an individual government
finances its spending by creating money is broken. This
makes it harder to conceal the deterioration in a member
state’s public finances, which in turn ensures that one
state’s problems become a Euroland crisis requiring the
ECB to break its own rules. The order of events is
always problem first, solution second, and there is no
mechanism for anticipation.
So far, the ECB has
printed money by buying government debt from the banks
or taking it in as collateral. It has promised to
neutralise the inflationary effect, a promise that is
little more than an undersized fig leaf over a growing
member. While banks are being bailed out of their
sovereign debt positions, the sovereign debt crisis
itself is deteriorating daily with substantial debt
roll-overs to be refinanced, particularly in Italy. And
no one considers Italy a problem – yet.
It is hard to see how
this rapidly deteriorating situation will not develop
into a banking, and therefore a sovereign, debt crisis
on a Europe-wide basis.
The U.S.
We have become inured to
the accelerating pace of government debt creation in the
US. Obama was officially elected President 18 months
ago, since when government debt has increased by $2.6
trillion, and the portion officially held by the public
has increased by 37%. This does not include off-balance
sheet items such as the wars in the Middle East, but
that is a paltry $250bn or so. Some of Federal spending
has been indirectly financed by an increase in the
monetary base of $1.2 trillion, a rise of 145%, the most
rapid increase in money supply ever engineered by the
Fed.
According to the
Keynesians, this stimulus should guarantee a return to
economic growth; however on every front this
unprecedented reflation is failing. Despite the rescue
and effective nationalisation of the mortgage industry,
house prices are beginning to slide again, with over one
quarter of all houses already in negative equity.
Unemployment remains stubbornly high, with the
proportion of civilians of working age actually employed
falling from 64.5% to under 59%.
Obama and his Keynesian
advisors are now in serious difficulties. Furthermore
his stimulus programme has occurred against an
international background of similar stimuli around the
world, but other countries have had to backtrack on this
approach. America’s growing isolation was papered over
at the recent G20 summit in Toronto, but it racks up the
risks for Obama’s continuing profligacy. The vibes
coming out of Washington suggests that the Fed is ready
to respond to the growing possibility of a reduced
fiscal stimulus by injecting a further large sum of up
to $5 trillion into the economy to stop it sliding into
an Irving Fisher debt-deflation spiral.
As mentioned above, the
growth rate of the US weekly leading indicators has
turned sharply negative in the last three weeks,
increasing the likelihood of a new expansion of the
monetary base. The monetarists are focused on asset
deflation and a likely fall in the sale value of durable
goods, and are missing the potential inflationary rise
in the price of necessities. The former is the unwinding
of credit-fuelled asset and spending bubbles, and as a
necessary event should be expected; the latter is where
stagflation will become evident.
It is hard to separate
out the necessities of life from the CPI statistics, but
let us assume that they are food and beverages, energy,
medical care and transportation: these are required for
people to live and work and other spending can generally
be deferred. Food and beverages have benefited from
ultra-low agricultural commodity prices that have yet to
reflect the increase in the standard of living in the
BRICs, which between them represent 40% of the global
population. Energy prices may have some potential to
fall on a slump in US demand, but they are increasingly
being set by other factors, such as rising demand from
South East Asia and a tightening supply situation.
Medial care costs can be expected to escalate as a
result of changes to the healthcare system, and
transport costs are substantially fuel-dependant. With
the exception of healthcare costs, these CPI components
are directly exposed to a weak dollar, which is the
inevitable consequence of further monetary expansion.
To summarise, the US is
set for asset deflation now and accelerating price
inflation in a year or two’s time.
China
China’s economic
strategy is confirmation that all is not well in the
West. Having grown her manufacturing infrastructure on
the back of western consumption, she realises that that
phase of her development is ending. She has now begun to
invest in surrounding South East Asian countries,
expanding her chains of production into them. This
strategy overrides political considerations, as
evidenced by recent commercial agreements entered into
with Taiwan. Meanwhile, she continues to invest in the
extraction of natural resources in Africa, South America
and at home, thereby securing the necessary raw
materials for the future.
By developing commercial
ties with her neighbours, China is turning the whole
South East Asian region into an economic bloc that in a
short time will rival the West. All the countries in the
region share the Chinese savings ethos, and by elevating
the populations out of day-to-day subsistence, multiple
new Japans are being created under China’s aegis, driven
by the generation and availability of savings and common
free-market goals.
China will pursue this
strategy because she can no longer depend on growing
income from exports to consumer-driven nations. History
will record how these sinking nations merely provided a
stepping stone to China’s true potential.
There are western
analysts who point to an impending property crash, and
that the Chinese stock market is down over 40% in the
last 2˝ years. In the West, this could be disastrous,
but for China the analysts miss the point. In the West
the consumer needs speculative gains to replace the
absence of savings; the Chinese can afford to loose
money gambling on assets because they have savings.
But by becoming
independent from the west, China can in time abandon it
to its self-inflicted economic decline. Meanwhile, she
plays her cards carefully. Her announcement ahead of the
G20 meeting in Ottawa, that she was removing the
currency peg against the dollar, is meaningless but
defused her critics. The reality is that it is against
her interests to destabilise the west. She will recycle
her dollars and euros into US and euro debt, accepting
it will eventually be written off. Europe and America
are of now secondary consideration, and there is nothing
to be gained from antagonising them.
Conclusion
In the language of
today, America and Europe are entering the second dip of
a double dip. The most likely consequence is a
substantial economic failure – a slump as credit
distortions unwind.
In the past when America
and Europe between them dominated the global economy,
the effect of a slump on commodities at this stage of
the cycle would be significantly lower prices. Today,
commodity prices may fall somewhat, but any fall will be
limited by growing demand from South East Asia for both
industrial and agricultural commodities. The impact on
consumer prices will be transmitted through the
performance of Western fiat currencies. Here the outlook
is grim, given the determination of Western central
banks to print money at an accelerating pace to
compensate for tightening fiscal policies. While these
central banks have got away with accelerating monetary
inflation to stave off deflation in previous economic
cycles, it is the wrong policy this time round, because
crucially it does not allow for the ascent of the BRICs.
The outlook for all the
currencies of the consuming nations is accelerating
stagflation. In the shorter term, the financial
difficulties of the banks in Europe and America make a
whole-scale banking crisis difficult to avoid. Since
sovereign states are determined to support their own
banks, this can be expected to evolve into a sovereign
debt crisis. Nothing in this is new, but it is just a
little more obvious than a few months ago.
Meanwhile, the sun
shines, the Pimm’s is poured, and there is the prospect
of leather on willow in the afternoon.
12 July 2010
