'Hopium' And Its Effects

by: Jeremy Robson

I don't know who first used the term 'hopium' but it seems to me to capture the present state of the world. Hopium seems to be having a major influence on our expected outcomes for all of the following:

1. The European debt crisis is solvable - It's 6 and 0 for successful crisis meetings. When the seventh comes, hopes will soar once again of an easy resolution.

2. China's house prices will not fall substantially - House prices in the major cities of China rose 300% from 2005-11. Think about that in relation to the price of your house and what it would be now. There is a good update here on the latest position. Consensus opinion is that this will not cause major problems. US -sub prime redux?

3. US will de-couple from any European recession - There is an interesting article from the FT here. It suggests de-coupling is very unlikely.

4. The US economy is nothing like Japan and it's path will not be the same - Japan's debt to GDP was 68% at the start of their decline, it is now 211%. The US entered the crisis in 2008 with a debt to GDP of 70%, it is now 102% and rising. Both 'saved' their banks, both have instituted fiscal stimulus and QE programs. Seems there are some similarities.

5. The Fed will not allow any crisis to happen in the US - The Fed may be able to pull it off, but you need to close your eyes and bite your lips for the next 5 years to be sure.

It may be that everything works out just fine, but I think that this view relies heavily on the recently coined 'hopium'. This got me thinking whether hopium is actually positive for the economy or is actually a hindrance to the changes that are required to return us to a normal growth path.

I have thought for some time that progress towards a sustainable economic position in the Western world has almost completely stalled. All countries are presently engaged in major can kicking in the hope that growth will suddenly emerge from somewhere. In general I think that this is because we fear the medicine that will cure the disease more than the disease itself.

So what would happen if we replaced hope with reality? Let's look at the 5 situations above

1. The European debt crisis - The Germans are eventually going to have to decide if they think that they are better off paying for the weaker countries' mistakes or not. Once they do, the Eurozone either breaks up, as they leave, or Eurobonds are born. It seems that presently we are all waiting for this decision. The Germans are hoping that all of the weaker southern countries are suddenly going to see the light and become more German, substantially reducing the cost to them. If we abandoned 'hopium' we would know that none of these countries will be able to fully pay off their debts and we would start managed restructuring of debt, country by country, starting with Greece. The Germans will either pay or not. Either way there is progress to a long term solution as debt forgiveness will have begun. Many have argued that the present solutions involving the IMF, the EFSF and the EMS are just replacing one type of debt with another; just 'smoke and mirrors' in effect.

2. China's house prices will not fall substantially - If China ignores it's real estate bubble there could be serious consequences for all of us. Is the Chinese banking system prepared for a serious house price decline? Chinese banks have taken virtually no write downs of real estate loans. If we abandon 'hopium' we would start this write down process now and spread it over several years, reducing the potential for any crisis. Having appreciated 300% in 6 years it is hard to believe that there will not be some sort of correction in house prices.

3. The US will decouple from any European recession - The US is very unlikely to de-couple from a recession in Europe if it is brought on by a financial crisis. If realism took over here we would have more QE now and possible fiscal stimulus. In the long term this is more can kicking, so not positive.

4. The US economy is nothing like Japan and its path will not be the same - If the US legislature feared falling into the same economic outcome as Japan, would we at last see some progress on tackling the problem of debt and legislation to reform the US economy. I think so. I first started investing in 1982. In Britain, the Chancellor of the Exchequer was Nigel Lawson; in the US, Ronald Regan had just become president. Regan immediately rejected balanced budgets and the debt buildup had begun. I remember Lawson getting much criticism for running budget surpluses in the mid eighties while America was growing faster on budget deficits. He just kept reiterating 'sound finances' until he resigned in 1989. 'Sound finances' in those days involved 40% debt/GDP and a balanced budget over the economic cycle. If we took off our rose colored glasses perhaps we could return to 'sound finances'. Now that would be a change from the Japanese experience.

5. The Fed will not allow any crisis to happen in the US - If there were a perception that the Fed is out of bullets, we would certainly see much greater pressure on Congress to take action. I guess it depends on what they would do. If they legislated change, which must be a possibility, it would be very positive.

For me we win in 4 out of the 5 scenarios, if we adjust to reality. In my investing lifetime, I have never seen a perfect investment backdrop; the world will always have economic problems to solve. However, in all that time, I have never seen a situation where all of the world's economies refuse to solve the problems they face, instead they are enacting policies to put them off. I have wondered for some time why we are stuck in this rut?

I am convinced that fear of the consequences of the solutions that we all know are required are holding us back. I am fast coming to the conclusion that 'hopium' that we can avoid the change and its consequences is encouraging us to keep trying all of the can kicking policies. Would we be better off if we abandon the drug of 'hopium' and proceed with sustainable policies? At this point some of you have probably concluded that I have lost control of my senses. All of the above 'so called solutions' would lead us back to crisis again. For me that just puts you in the 'fear of the consequences' camp.

To be in that camp you have to believe in the muddle through economy where the Fed intervenes for several years, whilst debt is repaid. To believe in this view, I will have to see a muddle through economy with no crises until the end of 2013. If we pull that off I will be much more positive. Is this just more 'hopium', I ask myself?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: short S&P500 & Dax futures, long RWM