Looking Back in Order to Look Ahead

When the credit crisis broke out in Q3 2007, we were reminded about the horrendous mistakes of the past as the real culprit behind the bubble - many of us blamed Mr Greenspan! Central banks vowed not to repeat those mistakes while handling the problem. But as we slipped deeper into the mess, the old mistakes got repeated - this time with much higher magnitude and wider geographical spread. Now that the panic levels are easing, it is time to look back in order to look ahead.

Old recipe, compounding problems

Post 1980s, after every crisis, the monetary base in US expanded and long term interest rates declined (see US 10 year yield below). Cheaper money and easier availability was used as savior in every downturn. This has kept compounding the problem and has led to where we are today. Let's examine political and economic reasons behind this irreversible trend.

In Bretton Woods (1944), the US agreed to exchange every US$35 into an ounce of gold whenever asked - getting acceptance of the US dollar as an alternative to gold and thus becoming the world's central currency. This was the time when Curopean behemoths were war-torn, had large debts and needed huge public spending to re-build. On the other hand, the US was growing quite rapidly, had large current account surplus, held about 60% of foreign exchange reserves in gold and was the largest creditor to the world. Acceptance of the dollar as reserve currency worked in the interest of the everyone as US attained financial supremacy (which it rightly deserved) and could give away dollars grants/loans in exchange for market access in new regions while rest of the world got money they needed desperately.

Since mid 1980s, US spending on wars, arms and development took a steep upturn as the world happily financed it by hoarding dollars. As a result US gross external debt which was about 33% of GDP in 1980s grew to about 75% now - a 10 fold increase in absolute value. This works out about $36000 per capita currently against about $4000 per capita in 1980s. A transition from largest creditor to largest debtor needed a few structural policy changes. A declining interest rate (in order to reduce the interest burden) and expanding monetary base (providing liquidity for the world to fund deficits) were supreme amongst those. So far as the US Dollar retains the centre stage while reserve currency and US economy runs trade, budgetary and fiscal deficits, the long term interest trend will continue to slope down. This would effectively mean repetition of old mistakes.

Money pipeline has expanded enormously

We have seen a crisis of record magnitude in terms of wealth destruction and reach. However, we can't ignore that the response from governments and central banks has also been quite aggressive and unprecedented. Estimates suggest that the total effect of discount window buying, TARP, TALF, CP programme, treasury buy-back programme and other smaller initiatives could end up expanding the US Fed balance sheet by $3.5 trillion. Combine this with quantitative easing programmes (modern name for printing money) in UK ($210b), Japan (additional bond buying of $4b per month) and Switzerland as Bank of Canada prepares to follow. Analysts put estimates of toxic assets losses at $1-2 trillion. Without a doubt, money released into the system is much larger than that taken away by the credit crisis. Money pipeline has gotten bigger, we are now awaiting for it to start flowing as credit loosens up.

Two plausible scenarios

Cycles will turn, sentiments will change, dawn will follow dusk - as usual. However, timing would remain the big unknown. One can see two possible scenarios as the economic picture changes.

Scenario one: In an attempt to undo its recent liberal policies, central banks may start aggressive rate hikes pre-empting an economic recovery (known as leaning against air). Besides, governments may hike taxes and recoveries to minimise holes in their balance-sheet. This may tame growth to low rates for several years. I do not subscribe to this scenario for few simple reasons. Firstly, it is too idealistic to know the turning points; central banks have been slow to put their act together. Secondly, we love growth even at the cost of inflation and therefore we delay anchoring it in our short-term interest. Thirdly, we have short memories and hence err over and again.

Scenario two: We extend our mistakes and enjoy another big wave of growth, prosperity and inflation. While doing so we compound the problem even more. While a large part of value of toxic assets would have been lost for ever, the new money printed to cover those up will eventually find ways to asset markets thus creating a possible big scare of inflation. Not fearful? Well, our children should be.

Inflation and dollar: ticking time-bombs

For the last 65 years, the fabric of financial system has been built around US dollar. However, the fundamentals that justified the US Dollar as a benchmark currency have gone through significant metamorphosis. The US has turned from largest creditor in 1940s to largest debtor, from trade surplus to huge trade deficit and is no more the biggest holder of foreign exchange reserves (excluding dollar). Hence, the premises on which dollar was accepted as reserve currency don't exist. The lopsided world economy - with the monetary printing press in the US and real physical production in others - cannot continue beyond a point. It is better that we realise the problem and address it before it becomes over-whelming. Time is ticking and the geniuses of the financial world are rightly seeing inflation of 1970s to return. The good news is that an even higher level of prosperity awaits as asset prices could soar. The bad news is that the next chaos could be even more dreadful with the whole fabric of currency regime closing to break-down.

Looking ahead

While road to recovery out of the current crisis is still bumpy, we seem to be more than half way through the tunnel. Low prices, falling growth and job-losses could still hog limelights, but the macro-fund managers are preparing for next big wave of falling dollar and rising alternate asset prices. Let's keep a close eye on discussions of alternate reserve currency; this has potential to put "Gulal" on every rule of the game.

Comments

[Ferdinand E...:]

Some of this is very interesting. After reading the latest Newsweek I came to the conclusion that the big oil price increase contributed more to the bad news than I thought, however that price has now descended to a healthier level, and President Obama seems to have mobilized the enthusiasm of the people in the back room for a problem solving exercise.

At the same time, his desire to continue the war in Afghanistan strikes me as insane, and I hope that the other G20 participants try to talk some sense into him. I also hope that the promise to give money to the IMF (and probably the World Bank) was only a promise and not the real thing. If they really need money they can sell their headquarters in Washington to the Hilton Hotel people and
operate out of a toilet in the White House.

Apr 04 08:51 AM

[HChang:]

I'm buying RMB$. It's the next world currency.

Apr 04 10:18 AM

[reverse mor...:]

Years ago I had a girlfriend who told me I talked too much about my past. I told her that my future was rooted in my past, and from it sprouted the roots of my life (being a bit new age I'll admit). You can probably guess that we didn't last, yet through the years I have maintained that point of view.

It would be wonderful if we could impart to our children (or are investments) the knowledge and wisdom to learn from our mistakes, unfortunately that is rarely the case and we each must make our own mistakes. Collectively that makes up the economy and the markets and I wonder if the US can learn from it's mistakes (and successes of course) and chart a more stable financial path for the future.

Without a doubt I love this country, served in the USMC and proud of it, but I do at times wonder if we have not taken a turn that leads through a dark Forrest. Of course, being that a bit of that early new age thinking still hanging on for dear life, I know that is darkness, there is also light on the other side.

My industry is reverse mortgages, and while that is not something I'd have thought about becoming involved in years ago, it does bring a certain satisfaction since I can help people accomplish at least some of their dreams.

America, three cheers, now stand up straight and walk on.

Apr 04 11:11 AM

[skwestorange:]

A very thoughtful analysis. It should be clear to those old enough to recall the past major expansions and contractions, that each successive major contraction has been more painful than the last. Policy response to each contraction has always been to lower interest rate, reinflate, and foster economic expansion. In this current contraction we have added a new dimension to this stale policy response, i.e., massive government interventions in the markets. Once again we chose not to kill the ulcer and thus postpone the day of reckoning.

Apr 04 11:33 AM

[Dave Wrixon:]

Well, if the US thinks it can cope with another downturn even more painful than this own, now is the time to double down and throw the dice again!


On Apr 04 11:33 AM skwestorange wrote:

> A very thoughtful analysis. It should be clear to those old enough
> to recall the past major expansions and contractions, that each
> successive major contraction has been more painful than the last.
> Policy response to each contraction has always been to lower interest
> rate, reinflate, and foster economic expansion. In this current contraction
> we have added a new dimension to this stale policy response, i.e.,
> massive government interventions in the markets. Once again we chose
> not to kill the ulcer and thus postpone the day of reckoning.

Apr 04 11:52 AM

[baird:]

FEB,

I too am very puzzled about why Afghanistan makes any sense, even less than Iraq. Large scale military actions to eliminate "terrorist" strongholds will always be counterproductive, whatever Obama is he's not stupid, go figure. Maybe just a head fake to let everyone know he's not "weak" but I suspect that for all of O's feel good exterior inside he's about as tough as they come.


On Apr 04 08:51 AM Ferdinand E. Banks wrote:

> Some of this is very interesting. After reading the latest Newsweek
> I came to the conclusion that the big oil price increase contributed
> more to the bad news than I thought, however that price has now descended
> to a healthier level, and President Obama seems to have mobilized
> the enthusiasm of the people in the back room for a problem solving
> exercise.
>
> At the same time, his desire to continue the war in Afghanistan strikes
> me as insane, and I hope that the other G20 participants try to talk
> some sense into him. I also hope that the promise to give money to
> the IMF (and probably the World Bank) was only a promise and not
> the real thing. If they really need money they can sell their headquarters
> in Washington to the Hilton Hotel people and
> operate out of a toilet in the White House.

Apr 04 12:07 PM

[Allan Frain:]

I don't see how the analysis:

"The US has turned from largest creditor in 1940s to largest debtor, from trade surplus to huge trade deficit and is no more the biggest holder of foreign exchange reserves (excluding dollar). Hence, the premises on which dollar was accepted as reserve currency don't exist. The lopsided world economy - with the monetary printing press in the US and real physical production in others - cannot continue beyond a point. It is better that we realise the problem and address it before it becomes over-whelming."

Supports the conclusion:

"While road to recovery out of the current crisis is still bumpy, we seem to be more than half way through the tunnel."

Policy now seems to be to 1) try and keep property values up, 2) "rescue the banks", ostensibly for the good of the overall economy, and 3) create a previously (with previous being a credit bubble) unthinkable mount of new money.

The inflation forseen will drop real wages far sooner than the dollar devaluation will correct our trade balance, particularly since much of the world has hopped on the competitive devaluation train. This drop in real wages will weigh heavily on both savings and spending for some time.

From an unemployment standpoint we are about 7 months into this. Current policy will not restore the economy in a similar timeframe while the epic imbalances remain.

Apr 04 12:47 PM

[Lee Eugene ...:]

I agree with much of your analysis. You seem to be posing two choices: another bubble in some alternative asset class, followed by even greater destruction, and taking the necessary pain now, which I assume means bankruptcy for many of our largest financial institutions.

I wonder if any new amount of monetary creation will be able to inflate any sort of bubble, however, in this environment. It seems that a lot of the money is simply keeping asset prices from falling to affordable levels. Most Americans already seem to get the point, and have raised their savings level as they deleverage--at least for those who can--so consumer spending will continue to fall. I find it hard to see where a new bubble could start. I think the new money is simply keeping the old bubble from fully deflating. If there isn't a new bubble, then are we just throwing money down a black hole, saddling our children and grandchildren with debts we have no prospect of paying?

Apr 04 05:30 PM