Alasdair Macleod – 12 July 2010
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.
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.
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’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 2½ 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.
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.