The Devastating Impact of Central Bank Intervention

Believe it or not, mistakes have consequences. But in politics and central banking, the mistakes rarely have consequences for those who make them. Those individuals tend to be found lurking in ivory towers by the time their intellectual world comes crashing down around them. Having intervened in the free market according to their personal opinions, they leave the real world to watch what happens from a safe distance.

Dr Marc Faber opened World War D by setting out to explain which interventions affected who, how, and what to do about it.

Faber’s view of economics is simple. You need oil and capital investment to be able to manufacture and export, so that you can generate enough prosperity to go on a holiday in South East Asia. But you’ve got to do it without borrowing too much money or starting a war. And that’s difficult to do if you believe in phony economics.

Developed nations have got oil and resources covered. Developing nations are muscling in. They’re increasingly close buddies with regimes in Africa, South America and Asia. As for oil, the key for everyone is the Middle East. Unfortunately, the Middle East is likely to ‘burst into flames‘ eventually. And the West is busy interfering with the shipping lanes required to keep the oil flowing. That doesn’t sit well with developing nations.

So Faber seems bullish on oil because he’s bearish on peace in the Middle East. He also pointed out that Chinese oil consumption has nowhere near kept pace with resource consumption. So there’s room for growth, especially as a middle class emerges.

But where do developed and developing nations differ? Savings, investment and capital investment.

Saving to generate capital for investment is shunned by Western policy makers in favour of consumption. Of course, that’s vastly flawed. You need savings to generate capital and you need to generate capital to drive productivity. Productivity enhances your ability to produce, and if you don’t produce you won’t be able to consume for long.

Saving and capital investment in developing nations is so high it’s unproductive, especially because it’s financed by a credit boom of unimaginable proportions.

Meanwhile, in America, consumption has taken over capital investment to an extent that productivity will suffer, reducing future income. Instead of borrowing to enhance production, Westerners are financing their holidays with debt and rising house prices. Borrowing to finance consumption is simply stealing from the future.

Faber is more worried about the developing world than the US though. Chinese growth is crucial to the world, he told the audience. The Australian contingent didn’t need convincing. But the then he said something they hadn’t heard. US growth isn’t important. That’s because it’s 70% consumption, of which services is the majority. Chinese growth is trade growth. It affects other countries very directly.

Because of this new inter-reliance, the balance of economic power has shifted to emerging economies. They have the oil, trade and manufacturing they need. Soon they’ll be showing up at travel agents.

Tourism featured heavily in Faber’s speech. His dad owned a hotel (where your editor broke his arm) in Engelberg, Switzerland. And Faber the younger now invests in South East Asian tourism. He sees it as China’s equivalent to Northern Europe’s Spain.

A little further south, Faber mentioned that we may eventually see 50 million Chinese tourists descending on the tramcars of Melbourne each year. Clearly Faber hasn’t been on the tram yet. Our shemozzle of a ticketing system, ‘Myki’, was specifically designed to prevent a Chinese tourist invasion. That’s why it may be rolled out in Sydney, even after the people of Melbourne let the politicians know they hate it.

It was interesting seeing Faber debate himself on China. On the one hand, there is an epic credit boom. Capital investment is excessive, unproductive and debt financed. On the other hand, China’s size and long term economic future is very positive.

We won’t reveal who won the debate here.

Of course, the western world isn’t going down to Chinese domination without a fight. Like Dick Cheney on a hunting trip, they’re shooting the wrong way.

Weapon number one in their arsenal is QE, also known as money printing. But that’s just another intervention in the free market. It creates problems, not solutions.

The proceeds of QE go somewhere different each time. They always create bubbles. Housing bubbles, tech bubbles, consumer price and wage bubbles and many more. An economist’s way of saying this is ‘money is not neutral’. It affects different people differently.

According to Faber, a US Federal Reserve official told him Greenspan created the tech bubble to spur innovation. Inflating stock market prices allowed more companies to raise capital on favourable terms. Nobel laureate economist Paul Krugman has also been advocating bubbles as a solution to economic malaise.

The problem with continuous bubbles is that the capital structure goes askew. Yes, we’re back to the capital investment. You see, it’s not just a question of how much investment there is, but where it’s going.

The financialisation of the economy is a prime example of it going wrong. Debt, share trading, and financial sector profits show how the economies of the West are becoming more and more financial. This isn’t productive. The financial sector is supposed to be an intermediary for the other sectors. Not a key source of GDP.

Debt is the biggest factor when it comes to the overweight financial sector. Borrowing for capital expenditure improves your ability to produce in the future, which in turn improves your ability to pay for consumption. Fair enough. But borrowing for consumption moves consumption from the future forward. It goes missing in a few years’ time. That’s one way leverage can be dangerous. Dr Faber explained another one.

The danger of debt is also felt in asset prices. Asset prices decline periodically. That’s a basic fact. However, sometimes this triggers a crisis. Why sometimes? Well there tend to be far fewer bankruptcies when there is less debt. Hong Kong property prices tumbled when Dr Faber first showed up there in the 70s. But there were no major bankruptcies because leverage was small.

Today, the world is in the opposite situation. Any fall in asset prices is dangerous because of the amount of leverage.

So where to from here according to Dr Faber? Well, we haven’t really had a recovery from the Global Financial Crisis. We’re just funding the next bubble. Interest rates are negative in real terms. This is how we inflated past bubbles.

But where is the bubble? Faber thinks it’s in company profits, for one. Corporate profits and interest rates are extremely closely correlated, as a brilliant chart to that effect showed. When rates swing up, corporate profits will crunch.

But when?

Time is a funny thing. It changes perceptions in ways we don’t really remember. Do you remember when Kodak and Polaroid were cash cows, Faber asked? Or when Detroit made cars and IBM dominated the computer market? Do you remember when printing money was taboo?

Of course, the very same fundamental changes that have happened couldn’t possibly happen in coming years. The future will look like the present, right?

For example, could we have a 20 year bear market like Japan? Are stock markets in another gigantic bubble? Could bond markets crash and interest rates surge?


Oh, we didn’t answer the question ‘when’. You can find out here.


Nick Hubble+
for Markets and Money

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Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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