What’s on our wish list for 2012?
Many are hoping for a simple policy ‘fix’. According to the mainstream commentators we read, it’s just a matter of ‘political will’ to solve the many problems plaguing the world economy. They think the solutions are more spending, more debt and more growth.
You can’t solve a problem if you don’t understand the cause. The 40-year boom in credit, which came to a shuddering halt in 2007/08, caused the current global economic malaise. It is the elephant in the room that few want to discuss. More on that in a moment.
First, our wish list. Well, it’s not actually ours. Dr John Hussman put it better than we could have in his recent weekly letter. He is a doctor, after all.
…our hope is that in 2012, the market will finally “clear,” in the sense that bad debt around the world will be recognized as bad and restructured; that overleveraged financials will be taken into receivership instead of forcing austerity on every corner of the global economy in order to make them flush again; that rates of return will rise enough to compensate and encourage saving – and high enough to encourage borrowers and other users of capital to allocate the funds productively. Of course, in order to restructure bad debt, someone has to accept a loss. In order for rates of return to rise, valuations must decline. In short, our hope is for events that will unchain the global economy from an irresponsible past and open the gates toward a prosperous future
That is a wish indeed. It’s not going to happen. If it did equity markets would probably collapse by around 50% worldwide. That sounds like a death wish more than anything, right? Yes it does. But it would create an environment for lasting recovery.
Instead of playing a daily game of ‘guess what the idiots running this place will do next?’, we could just go back to analysing unmolested economies and good old security analysis. It would be a tad boring in comparison, but certainly much better for your wealth and health alike.
But we’ll cast that wish aside. Expecting banks to take their medicine (write-offs and probable bankruptcy) is like expecting central bankers to admit they have no idea what they are doing. It’s not going to happen in either case.
The issue is that the world has gone through a ‘golden period’ of credit driven economic growth. This period is definitively over but the only playbook the central bankers have is to keep the game going.
Bill Gross, head of global bond fund manager PIMCO, sums up the situation nicely – from where we’ve been to where we are now -in his latest letter:
It actually began with early 20th century fractional reserve banking, but came into its adulthood in 1971 when the U.S. and the world departed from gold to a debt-based credit foundation. Some called it a dollar standard but it was really a credit standard based on dollars and unlike gold with its scarcity and hard money character, the new credit-based standard had no anchor – dollar or otherwise.
All developed economies from 1971 and beyond learned to use credit and the expansion of debt to drive growth and prosperity. Almost all developed and some emerging economies became hooked on credit as a substitution for investment in tangible real things – plant, equipment and an educated labor force.
They made paper, not things, so much of it it seems, that they debased it. Interest rates were lowered and assets securitized to the point where they could go no further and in the aftermath of Lehman 2008 markets substituted sovereign for private credit until it appears that that trend can go no further either. Now we are left with zero-bound yields and creditors that trust no one and very few countries. The financial markets are slowly imploding – delevering – because there’s too much paper and too little trust.
The important point in the excerpt is the ‘zero-bound yields’. That is jargon for zero per cent interest rates. Gross reckons such policy settings (which have spread from Japan to the US, UK and soon Europe) are ‘eating away like invisible termites at our 40-year global credit expansion.’
The whole central banking mantra is that lower interest rates lead to more spending and more risk taking. This supposedly revives the economy in question back in to growth mode.
This type of thinking assumes an unlimited demand for credit: central bankers promote supply and the economy just gobbles it up. But as Gross points out, zero percent interest rates create no incentive to expand credit.
…when the return on money becomes close to zero in nominal terms and substantially negative in real terms, then normal functionality may break down.
This leads not to credit expansion (1971-2008 R.I.P) but to credit contraction. In other words, deleveraging.
Before you hunker down to cope with the age of deleveraging, you must take our old foes the central banks into account. What will they do? Stand by as idle spectators? Of course not. The real question is when they will push the next QE button and in what form.
With oil over US$100 a barrel and the Dow over 12,000, don’t expect Bernanke to play the QE card just yet. Oil at US$80 and the Dow at 10,000 is a different story indeed.
Will such money printing work? It depends what you mean by ‘work’. It creates the illusion of prosperity and benefits those closest to the source of the new money – the bankers and financial firms.. Savers, pensioners, wage earners, and society in general, all get screwed.
There are two possible outcomes to expect as 2012 unfolds. One is system implosion, bad debt writedowns and sharp equity market declines. The other is massive central bank intervention, more speculative risk-taking, and currency market mayhem.
Are you prepared?
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