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     Jan 5, 2013


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rates, this will stimulate interest-rate-sensitive areas of the economy, providing purchasing power to offset that withdrawn through higher taxation.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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