THE BEAR'S
LAIR Time to brace for
crash By Martin Hutchinson
The US public is unprecedentedly
pessimistic about the prospects going into 2013,
with 56% "fearful" against 40% "hopeful" according
to a recent Washington Post-ABC News poll. When
one looks at the world's markets, and at the
policies that have been almost universal since the
crash of 2008, one can see the rationale for their
pessimism. However this column wishes to inject an
element of cheer into the conversation: with good
luck, given a continuation of current policies, it
may be 2014 before an almighty market and economic
crash occurs!
One event that will
not itself cause a crash in 2013 is the
much-feared "fiscal cliff". If this goes into effect and
is not reversed, it will reduce the US federal
deficit by about US$700 billion per annum, to a
level of around $300 billion. By reducing
interest rates, this will
stimulate interest-rate-sensitive areas of the
economy, providing purchasing power to offset that
withdrawn through higher taxation. The result
will be a dip in output that lasts a few months,
probably not long or steep enough to qualify as a
recession. That will be followed by recovery on
the basis of an economy with lower consumption, a
smaller balance of payments of deficit and stable
public finances (assuming House Republicans can
prevent any counterproductive and wasteful
"stimulus" spending programs).
If
the "fiscal cliff" is allowed to take effect,
the problem will arise on the monetary side.
Ben Bernanke will continue pouring $85 billion
per month into Treasury and Agency bonds, over $1
trillion a year, but the demand from the Treasury
will have been reduced to only $300 billion
annually. With $700 billion being poured into the
economy with nowhere to go, inflation will take
off, initially through the commodity markets and
internationally, but quickly pouring into the US
economy also.
This would inevitably cause
a monetary crisis, a removal of Bernanke, who
will finally have lost market confidence, and his
replacement with a "sound money" Fed chairman such
as former Fed vice chairman Roger Ferguson. The
new Fed chairman will be forced to raise interest
rates to stem inflation, and will probably have
to raise them a long way, causing a major
recession, combined with a stock market crash.
However the resurgence of
inflation and the battle to replace Bernanke
will take considerable time, so on this trajectory
the recession will not occur until the first half
of 2014 at the earliest. It is not in any
case something to dread; its advent will signal
the restoration of sound policy in both fiscal
and monetary areas, so it will be
relatively short-lived and be followed by a massive resurgence
in US employment as in 1983-85, caused by
higher interest rates reducing the cost of labor
relative to capital. Overall, there is likely
in this scenario to be a "double-dip" in US
output, followed by a vigorous recovery, albeit
one in which after-tax incomes and wealth will be
lower than before because of the increase in
government bloat.
That's the trajectory
if the fiscal cliff taken effect; in its absence,
the picture looks rather different, since unsound
fiscal and monetary policies will continue as
before. The deal to avert the fiscal cliff will
avoid almost all the painful deficit reduction of
the fiscal cliff, concentrating tax increases on
the relatively wealthy, where they will exert
almost as much of a supply-side drag as the full
fiscal cliff, since the "middle class" tax
increases under the fiscal cliff are mostly flat
amounts, not affecting marginal rates. Thus for
the foreseeable future the United States will
continue to run trillion-dollar budget deficits,
financing them with trillion-dollar bond purchases
by the Fed.
Since the excess bond issue
and bond purchase amounts are in balance, this
will have little inflationary effect beyond what
we have already seen. However, other countries
will be joining in the "stimulus" game. Europe is
already tired of austerity (only Ireland and to an
extent Portugal having tried it effectively) and
is ready for the Keynesian siren-song of
undertaking stimulus first and austerity only
later if at all.
Undoubtedly the Italian
European Central Bank president, Mario Draghi,
concerned to preserve political stability in his
home country in the face of a February/March
election in which, as in Greece last summer,
anti-austerity forces will be strong, will
undertake bond purchases to finance the new
profligacy. Similarly Mark Carney, who might be
thought likely to provide a restraining hand at
the Bank of England, has given preliminary
indications that he is caught up in the "stimulus"
mania and will not do so.
However the
greatest "stimulus" will come from Japan, where
new Prime Minister Shinzo Abe has threatened to
introduce legislation removing central bank
independence if they do not adopt an inflation
target of 2% (compared to the current inflation
rate of around zero). In addition he has proposed
an additional $120 billion of public spending,
blowing through the existing limit on the budget
deficit, already excessively high. His objective
is to jerk the Japanese economy into enough growth
and inflation to reduce the debt/GDP ratio in
spite of increased government spending.
Since Japan already has
public debt of some 230% of GDP, there is a
certain "Death or Glory" quality about Abe's
policies. Unfortunately, like the Crimean War
charge of the Light Brigade memorialized by
Alfred, Lord Tennyson, they are based on misguided
principles and are hence very unlikely to succeed.
A country that has been running budget deficits of
5% of GDP or more mostly devoted to infrastructure
is hardly likely to revive its economy by another
$120 billion of spending on infrastructure.
Likewise, a country whose interest rates have been
near zero for a decade and a half, to the great
detriment of its savers, is hardly likely to solve
its economic problems by printing yet more money. The
correct approach would have been to take a savage
axe to public spending, reducing it to the 30% of
GDP traditional in Japan at which the budget is
more or less balanced. At the same time the
privatization of Japan's gigantic postal savings
bank, proposed in 2005 on a ludicrously long
12-year timetable and abandoned by the Democratic
Party of Japan government in 2009, should be given
top priority. Those two actions would have
eliminated the excessive drain of resources into
the government deficit, and re-directed a gigantic
pool of money to financing small business, its
proper purpose.
Abe is thus an economic
Lord Cardigan, the Light Brigade's commander,
plunging Japan's economy into the Valley of Death.
As with the charge, there will be an initial
period in which the momentum of the Light Brigade
will seem to carry all before it, but eventually
the Russian guns of insolvency will cause
destruction beyond belief.
Since Japan
remains the world's third-largest economy, its
Gotterdammerung is likely to drive the
global cycle. Initially, as money pours out of the
Bank of Japan (I don't rate highly its chances of
resisting a new prime minister with a two-thirds
majority, pursuing policies that are in vogue
worldwide) Japanese markets will soar, even as the
yen weakens.
With the EU, Britain and the
United States also printing money like madmen, we
likely to see a massive stock market and commodity
price boom, with corporate profits also boosted by
cheap money, but accompanied by disappointing,
unbalanced economic growth. The Dow Jones index,
currently around 13,000, could hit 20,000 or even
25,000, but investors may do even better in
precious metals, with gold rising beyond $3,000.
However, since the money created is vanishing down
the gigantic maw of the world's government
deficits, consumer price inflation will remain
relatively subdued.
My guess is that this
period of euphoria will make it through 2013 but
not through 2014. At some point, debt markets will
choke on all the rubbishy government paper and
bank leverage will become intolerable even
according to the politically-engineered rules of
the Basel III regulators. The cycle of confidence
will break, probably but not certainly first in
Japan, and government debt prices will be marked
down in a wealth-destroying death spiral very
similar to that of subprime mortgage bonds in
2007.
The result will be a collapse of
credit and a very nasty global recession.
Governments will be forced to balance their
budgets through inability to finance deficits,
while central banks will find their attempts to
solve their governments' financing problems
through money printing will be met with an
immediate upsurge in inflation, similar to those
in Latin American countries where currencies have
collapsed. This could even result in inflation at
triple digit rates, although corrupt government
statistical bureaus will attempt to disguise the
fact.
My crystal ball is clouded as to
whether the recession of 2014 will plunge us all
the way back into the 17th century, in which paper
money is unacceptable as a means of payment and
governments are forced to match revenues and
outgoings.
But the world has enjoyed
nearly two decades of irresponsible monetary
policies, followed by a fiscal splurge that has no
historical precedent. It would not be surprising
if the resulting downturn is itself unprecedented
in its unpleasantness, rivaling the Great
Depression in its intensity but with very
different symptoms.
Meanwhile, 2013
doesn't look too bad a year!
Martin
Hutchinson is the author of Great
Conservatives (Academica Press, 2005) - details
can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-13 David W Tice & Associates.)
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