Will you remember where you were when the German Constitutional Court ruled on Europe’s bailouts?
Markets and Money editor Greg Canavan will. With only minutes to go before the ruling he sent this message to the office:
Im locked out of my house. So i might miss all the action.
Sent from my iPhone
There didn’t seem to be too much action in the end anyway. The court ruled as everyone expected by approving the legality of past bailouts. As we suggested though, the court’s decision to make any further bailouts subject to the German parliament, more specifically the German Parliament’s Budget Committee, may put a serious dampener on further bailouts. That’s because politicians are feeling the heat in their electorate and may refuse to approve much more German spending on the Greek welfare system.
A more politically viable option would be to subsidise the Greek tourist industry by sending German vacationers on a free flight to Athens. They missed their chance though, with summer ending.
Regardless of goings on in Germany, Greek one-year bond yields hit a spectacular 97%. That means new buyers would nearly double their money… if Greece doesn’t default.
So it may be that all’s clear for bailouts, but all is not well in Europe.
In fact, economies and financial markets around the world are going haywire. Governments are making last ditch efforts to tame them. But it’s a lost cause. The world is taking a turn for the worse.
Not for investors though. They stand to do rather nicely… if on the right side of the trade as this plays out.
The first act in this play (you decide whether it’s a tragedy or comedy) is relatively predictable. The US dollar will rally as things get worse. That is, as banks need bailouts, governments need their debt monetised, people need welfare and prices generally tank. The US dollar’s rally is basically keeping with tradition under these circumstances. It’s a knee-jerk reaction – a self-fulfilling prophecy known as the flight to safety.
It’s what happens in Act Two that’s in question.
Here is one theory. There are few governments around the world in a moderately strong fiscal position. The Australian one is as the top end of the list. As other countries embark on endless bailouts and debt monetisation, the Australian economy will look comparatively better. That could imply, after a prolonged US dollar rally, that the Aussie dollar will end up a safer haven.
Please note that this is very different to calling the Aussie dollar a safe haven as things are now. In fact, there are reasons to be spectacularly bearish on Australia for now. China is looking shaky, the Australian house price bubble is popping, and the Aussie dollar has a long way to fall after its doubling in ten years.
The point is that Australia’s position once the dust has settled will be favourable compared to other options like Europe and the US. Our government will be financially stable, again comparatively speaking. That means banks will be bail-out-able with less monetary stimulus than is required overseas. That in turn means less currency depreciation.
At some point, investors will get sick of Bernanke and whoever is in the White House. They will get sick of interventions like the one that recently saw the Swiss franc tumble 8% in minutes. They will get sick of the politics and currency wars that are rapidly going from abstract theory to painful practice. They will want to find somewhere politically boring. And as the new sitcom featuring Julia Gillard made clear on TV Wednesday night, Australia is politically boring. Again, comparatively speaking.
If the above is how things play out over coming years, savvy Australian investors have the opportunity to position themselves very nicely. First for a US dollar rally and then an Australian dollar recovery. Probably sticking to low-risk assets both times.
It will pay to keep in mind that Australia may be better placed to deal with the terrible economic issues facing the world, but those issues remain very bad. As mentioned, they are potentially terrible for Australia in the short term. If the theory above is wrong – and Australia fares so badly over coming years that our institutions end up as bad as Europe’s and the US’s – then that will be exposed before investors need to expose themselves to the risk of Australia not ending up the ‘least bad option’. In other words, the theory will be worth binning before any action is taken. Investors would simply need to sit pretty in the US dollar.
But chances are the economic issues of the world will cause the situation in the major economic regions outside of Australia to deteriorate beyond tolerability. That’s because this time is different. It’s why the economic models used to predict recoveries have been confounded. Twice over. Firstly in the severity of the recession and secondly in its nature.
The first one is something we’ve come to think of as a synchronisation of business cycles. The second is that, this time, it’s a debt deflationary depression (like the Great Depression was). Put the two together and you get a ‘Synched DDD’. The distinctions are important. First, let’s look at the synchronisation part.
Globalisation has forged economic ties around the world like never before. Countries used to go through prosperous times largely irrespective of each other’s economic performance. As trade flourished, they began to become interdependent and competitive. Trade became a competition for who gets to export and who gets to import. War became about destroying and looting instead of invading and settling.
Since the pair of World Wars and the drawdown of the Cold War, countries have moved to a more cooperative economic framework. Originally, the US was the dominant producer and therefore the most prosperous. Then prosperity swept eastward as the Cold War wound up. The ability to go into debt disguised the demise of America’s productive capacity to the benefit of countries going through the various stages of liberalisation and industrialisation. In other words, debt disguised the reduced prosperity that goes with turning from exporter to importer. From goods to services. Now that debt is maxed out. And much of Western Europe joined the economic position of the US over the last few decades.
Economies are realising it is time to pay for all the debt. That means the traditional consumers should begin to produce and vice versa.
There are several problems with the transition. Firstly, the current state of affairs, with the West consuming by borrowing and the East producing and lending, has been artificially maintained beyond its natural life cycle. And not just by debt. Also by currency manipulation on behalf of the East.
So the East has been manipulating and the West has been borrowing. There is a direct link between the two artificial props in that the East’s manipulation financed the debt of the West. But it’s the consequences of the interventions that are crucial. Firstly, these economic issues are now highly political. For example, US government borrowing and Chinese currency manipulation are political decisions. Without government involvement, the trade cycle would simple flow back and forth much more mildly.
Secondly, both economic regions will struggle to realign their production/consumption balance. That creates an environment where economic ills can be blamed on other government’s interventions and profligate borrowing. That tension is dangerous.
So far we have looked at the synchronised nature of the problem. The way in which all major economic regions of the world face a dangerous rebalancing. We have looked at why this problem emerged and the artificial props worsening the inherent cycle of trade balances between economic regions of the world. Those props being debt and currency manipulation, which are in themselves related. All this adds up to a very serious economic issue.
But it is another aspect of debt that has the potential for turning the whole thing into an economic disaster. That’s because debt exacerbates both prosperity and crises. It does this by inflating and deflating credit, which is synonymous with money in a debt-based monetary system. When gold is money, a dollar bill represents the right to claim gold. It represents a debt owed to the holder of the note or coin. But without gold backing, a dollar represents a debt to pay … a dollar. Because nothing of real value stands behind the debt a dollar represents, it can be created infinitely and quickly. By central banks and banks when they lend.
It can also be wiped out quickly when people repay their debts. If this repayment overwhelms new borrowing, meaning that the amount of debt in the economy is falling, that equates to a falling money supply. If the money supply falls fast enough, the deflation can get so bad that the real value of debt increases despite being paid off. The more is paid off, the more deflation there is. This is a debt deflationary depression. And we’re in the beginning of one.
Having digested all of the above, it’s time to explain the ridiculous title of this article. Don Quixote de la Mancha is a character in a novel dubbed by some as the ‘best literary work ever written’. Wikipedia explains that the main character Don Quixote becomes ‘obsessed with books of chivalry, and believes their every word to be true, despite the fact that many of the events in them are clearly impossible.’
He spends his time riding around in armour and jousting with windmills he believes to be giants. As you will have guessed, Ben Bernanke is the real world’s Don Quixote. He believes economic theories that are impossible and spends his time fighting the bogeymen of his imagination. But it’s the windmills of the analogy that are the point here. After all, central bankers have been causing business cycles since their creation.
The importance of the windmills is in the problem of resonance. As wind turbines spin, they can create resonance. If that resonance falls in lockstep with other vibrations, say the waves of an offshore windmill or the footsteps of a bridge mounted windmill, there is a risk that the resonance will suddenly become self-sustaining and violent. What happens next is usually bad for anyone near the windmill.
The same is taking place with the synchronisation of business cycles. The resonance of cycles has fallen into lockstep. And debt levels are peaking. We have a worldwide debt deflationary depression in the making.
Until next week,
Markets and Money Weekend Edition