Keynesian spending that is being unleashed upon an unsuspecting world takes the
role of a stereotypical Hitchcock moment: after first beguiling audiences into
believing that danger lurks around the corner, the master movie maker usually
displays an anticlimactic result such as a harmless mewing cat; but before the
comic relief can fully set in he reveals a nasty turn as the real villain
enters from the other side of the screen.
For all the sounds and fury associated with the current meltdown in the global
economy, the outburst of Keynesian spending will likely create a far worse
result, namely hyperinflation that could
well take hold before the year is over. There are a number of factors leading
up to this, on both the supply and demand sides of the equation.
To the cynically minded few, there is a simple enough reason for this, namely
that inflation is usually the best cure for all debt overhang situations. To
explain that further using the example of the US economy, the overall "stock"
of private, government and corporate debt at the end of 2007 was around US$25
trillion, about double the country's annual gross domestic product. Against
this, there have been some $25 trillion of asset value reduction from $50
trillion in the value of stocks, homes and future pension values to around $25
trillion by the end of 2008.
According to Bloomberg (the professional service, not the mayor of New York
city), financial institutions have written off about $1.1 trillion between
banks ($800 billion), insurers ($150 billion) and US federal agencies ($120
billion). The gap between the write-offs of banks and those of insurers
probably requires a study unto itself; however it suffices to say here that
altering actuarial assumptions and differences in accounting logic help point
to a significant pile of undeclared losses at various insurance companies as
well as banks in Europe and Asia.
Even as the scale of this loss appears overwhelming, it stands at a mere 4%
when considered against the total debt figure quoted in the previous paragraph.
To paraphrase the old joke about Russian communists [1], surely the world
economy cannot have stopped spinning just because banks lost 4% of their
assets? The answer is most certainly that the actual scale of losses is more
likely to be in the region of 30-40%. Not to put too fine a point to the
proceedings, this is the developed world bankrupt many times over, but that
statement has an implicit assumption on the maintenance of purchasing power on
the part of the US dollar or indeed other "hard" currencies such as the euro
and yen.
Governments ranging from those in Britain and Germany all the way to the US
have already injected hundreds of billions into their banking systems;
guaranteeing capital positions and even asset quality in the process; all this
in reaction to these institutions wiping out barely 2% of their total assets.
To say that their ability to take further losses is fairly limited would be the
exaggeration of the day. Much like the understated losses of insurance
companies and pension funds, the rest of the system will also have to absorb
the losses of the "zombie" companies and individuals in one fashion or another.
The honest way to do this would be to write off the debt and the capital of all
financial companies and start all over again with vastly shrunk monetary bases:
however no liberal democracy - much less autocratic dictators - can withstand
wave upon wave of deflation that this entails. The opposite therefore must be
true: a burst of inflation that helps to reduce the purchasing power of money
while effectively reducing the difficulty associated with servicing mountains
of debt. This is all good for the people who have to repay their borrowings,
but what about those who own the assets, that is, the lenders?
The "cure" of inflation would be a whole lot worse than the "disease" of the
credit crunch as far as Asian savers are concerned. It is well nigh time to
junk all financial assets belonging to the Group of Seven leading
industrialized countries and re-embrace the historic investment of choice for
the region: gold.
Doing all this in the context of a new US government, geopolitical imbalances
and the Nash equilibrium I described in a recent article (see
Capitalism at the crossroads, Asia Times Online, January 16, 2009)
means that unprecedented changes could occur on both the demand and supply
sides; both pointing to inflationary shocks.
Demand shocks:
On the demand side, there are a number of factors that could produce an
artificial stability in consumption.
1. Keynesian spending - the biggest culprit of all in this respect would
be government spending on infamous bridges to nowhere in the manner that Japan
indulged in during its own crisis. Government spending is wasteful enough on
its own but when combined with endemic irresponsibility, we could easily see
the mother of all pork barrels being rolled out.
2. Asian consumption - losing money on their savings by the day, Asians
could well start substituting consumption for savings even if their governments
haven't thus far embraced the idea. Failing to export their way out of the
industrial decline in China and Southeast Asia, governments would be forced to
indulge in handouts as well as dead-letter projects.
3. Rising debt forgiveness actually works to increase the pain for
lenders but more importantly puts the deadbeats back into the economic system.
In countries ranging from the US to Europe, the new mantra is to forgive debt,
with banks writing off large portions of debt particularly borrowed by
individuals and "important" companies. With people all too willing to blame
others for their own debt ("it was Wall Street’s fault for making me borrow the
$3 million, honest"), the result is a one-off resumption of purchases by poor
people but at the cost of higher cost credit / unavailability of debt for those
with better credit records. 4. The lack of credit available to deserving companies and individuals
means that the process of upgrading efficiency has come to a quick stop. Much
like the Cubans who continue to use 50-year-old American cars because of a lack
of alternatives, it will soon be common to see middle-class Americans (hardest
hit by the downturn in wealth terms) using 10-year-old cars, avoiding home
improvements and so on. In effect, this pushes up consumption of products such
as oil.
Supply shocks:
Then there are the inevitable supply shocks, some of which are better
understood than others: 1. Cuts in credit that produce falling inefficiency (in demand shocks
above) also adversely affect the ability of companies to improve their
operations, increase production or provide adequate industrial security. All of
this translates to the world of supply shocks as companies using outdated and
old equipment find it all the more difficult to sustain or rebuild lost
production.
2. Geopolitical forces are also going out of control, as shown in the
example of Russia reacting to an impending decline of hundreds of billions of
dollars in lost revenue from falling oil prices. Much like Russia needs higher
oil prices to keep prime minister Vladimir Putin in power, so do the likes of
Venezuela and Saudi Arabia to keep their existing rulers in place. That argues
for an increase in geopolitical risks; which has always proved inflationary.
3. Weather disruptions are increasing around the world. Records from the
beginning of December point to sharp increases in both the variance and
averages for winter rainfall in much of the Northern Hemisphere; the outlook
for similar events in the Southern Hemisphere appears to have worsened equally
all along the Pacific coasts. That would in turn curb agricultural production
in vast areas of the world - Brazil, Argentina, Australia to name a few - in
turn producing severe shortages of agricultural commodities in months to come.
4. Adding insult to injury, much of the "hedging" mechanisms for
avoiding the problem of rising prices are now impossible to effect due to the
paucity of credit. Thus farmers cannot get credit to upgrade their lands or to
introduce new irrigation systems; industrial users cannot buy raw materials in
advance to offset a potential rise in prices later on.
Paper money's worth It is thus almost a dead certainty that the
combination of wasteful Keynesian spending (if you will ignore the tautology)
and supply-side effects would produce a sharp spike in inflation that is
designed to buttress the ability of borrowers to repay their obligations while
rendering the value of their payments almost moot for lenders.
Asians have saved a lot since the end of the Asian financial crisis, but will
find an acceleration of wealth diminution upon them in months to come. Their
only defense against this course of action that the G-7 countries have embarked
on would be to boycott all debt issuances from the US and Europe over the
near-term until yields rise fast and far enough to compensate for inflationary
risks. Unless this can be pushed through, the only safe assets would be those
that can hold a degree of their purchasing power,namely physical commodities
and, of course, precious metals such as gold.
Note:
1. This one has it the dead tsar met with Lenin in hell (surely a communist
couldn't have gone to heaven anyway) and asked him how things were in Russia.
Lenin admitted the bread queues were equally long, inflation was still a
problem, Russians were still lazy and unreliable but that alcohol content in
vodka had increased by 2% under the communists. To this, the venerable tsar
replied: so you killed me and my family for that extra 2% alcohol content?
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