Investors have observed a rally of the United States dollar over the last few weeks. This is more a result of what is happening to other major world currencies, than what is occurring in the United States. The analogy one can be put forward is that the American dollar (USD) is the cleanest shirt, among the soiled shirts in the dirty clothes closet. That is among the poor options available, the dollar remains the best choice among investors. Quantitative easing on a mass scale has occurred in Japan, the United Kingdom, the United States, China, and soon Europe as well. Interest rates around the world are at or near record lows. Over the objections of Germany, Mario Draghi head of the European Central Bank (ECB) lowered interest rates even further and announced that quantitative easing would begin in October 2014.
The problem with the easy money policies being employed by Central Banks around the world is when does it ever stop? Like crack is to a drug addict, domestic markets become addicted to the endless supply of cheap money. It creates a major distortion in the global economy and a resulting misapplication of investment across the board. There has been a run-up in asset prices and booming stock markets that are not sustainable. The only way to create wealth is real growth in the economy, not artificial expansion as the result of monetary policy. More than a few analysts have predicted that this will not end well.
The excessively low rates of traditional vehicles of investment, have necessarily forced investors into areas of higher risk. The result has been the ever ratcheting march upwards, in the stock markets around the globe. Worse yet, it forces institutions like pensions plans and annuities into more speculative investments. This is the only way to earn a somewhat decent return so commitments can be kept in entitlements and to investors. The problem is the rapidly increasing prices in the stock markets is largely the result of, the policies of quantitative easing. A similar run up is occurring in a number of tangible assets as well. It is simply not sustainable. When the pop and then the subsequent rapid decline in the markets arrives, it will be devastating across all sectors of the economy.
Quantitative easing is the final effort by the financial elites to jump start moribund economies. The central bank first credits its own account with money, it has simply created out of nothing. It then takes this made up money and begins to purchase financial assets. These will include government and corporate bonds from banks and other commercial institutions. This is referred to as open market operations.
These governmental purchases by way of account deposits, allow banks excess reserves which they can presumably lend out to create new economic activity. It is in essence, creating new money. This expansion in the currency supply is supposed to ultimately stimulate the economy.
The downside is that banks will often opt to simply allow this cash infusion to remain as part of their capital reserves in a era of increasing consumer defaults in their loan portfolios. Another danger is hyperinflation, as the currency begins to lose value on a massive scale.
Japan began the policy in the early 2000’s after a decade of stagnant growth in the 1990’s . The United States and the United Kingdom would follow during the financial crisis of 2008 and 2009. It is important to note that the policy did not work in the first round in Japan. It did not stimulate the economy enough to stave off deflation. Japan is engaging in a second round of quantitative easing rather than a restructuring of the economy.
The financial debacle of 2008 and 2009 was largely the result of a bubble in the real estate and asset markets. Much of the the damage was caused by the speculation in these markets that vastly exceeded realistic proportions. Investment houses and banks were selling mortgage backed securities that were in many cases nonperforming. That is they were no longer generating adequate income. This was the result of toxic assets (loans near or in default and not worth anywhere near their advertised value) that were bundled with mortgages that were still being paid for by customers. Making it worse was the real estate market had become vastly overvalued across the board.
It is true that government intervention at the height of the panic was necessary to calm fears in the financial markets. An infusion of money to stave off the collapse of private banks and financial companies went a long way to allay worries of the public at large, that there would be an economic meltdown. However, once the immediate crisis had passed it was time to get down to the serious work of allowing the economy to work through the problem of unsecured debt. It would of meant years of low growth and sacrifice. Policies of austerity would of needed to be enacted by the governments and corporations effected on a global scale. It would of forced needed reforms in business and government operations. Individual consumers would of felt the impact as well with the scaling back of government largess. Finally, everyone would have been forced to live within their means.
It was not to be. The fear of politicians at the time was that the public at large, would not be patient enough for this to be allowed to occur organically. They were most likely correct in this analysis. Voters had been permitted to believe over time, that a country could continue to provide benefits, that were not fully funded by tax collection and/or economic growth.
The financial panic did bring slower rates and even negative activity in economic growth, in many countries. This brought the next issue to the forefront. The lack of growth made the sovereign debt crisis no longer manageable. During the years of prosperity many governments around the world, had foolishly promised more than could afforded in the long run. In the short term these unwise politicians had met these commitments by running up massive governmental debt. Year after year budget deficits had accumulated a massive amount of national debt. In many countries the total debt in relation to GDP (Gross Domestic Product) is nearing the total size of the economy. In some cases, it already exceeds this milestone. In this category are the countries of Belgium at 102%, Greece with a staggering 175%, Ireland at 124%, Italy with 133%, Japan the highest at a whopping 227%, Portugal at 129%, and Singapore at 106%. In 2013 the United States joined the group at 101.53%
This excessive debt is not abstract, it needs to be serviced regularly. Interest payments are taking a larger and larger share of annual governmental spending. Add in the social contract that was made to the public, to fund programs that have now become massively expensive. One can easily understand the predicament many national government are now in. Taxes are already high in many of these countries, so further hikes are a non-starter and seem to often provide diminishing returns. The only answer is economic growth. It will be increasingly difficult for international investors and travelers, to find areas of the world that are economically stable under these conditions.
A return to growth is not as easy as it sounds. It is difficult to achieve in an economy that is saddled with massive debt, excessive regulation, high taxes and levies. In desperation political leaders turn to the so called financial wizards, to help them out of this quandary. Hence, we now have quantitative easing everywhere. Other elementary remedies have been tried to no avail. You had the massive stimulus program ($831 billion USD) passed by the United States government in 2009. Japan tried a similar program with a much larger amount (1.4 trillion USD) in 2013. The nonsensical idea being that in order to solve a national debt problem you create even more central government debt. There are some illogical economists who will still insist that it did not work because the stimulus was not large enough. Would any possible amount of governmental spending in their view be enough?
The ranks of more responsible countries in fiscal and monetary management continue to grow thinner. Their demands that austerity and market reforms be enacted as a way to restore growth are increasingly being ignored. Countries like Germany, Norway, Switzerland, Australia, Austria, Chile, Finland, Hong Kong, Denmark, the Netherlands, Poland, South Korea, and Taiwan.
Germany for example, which helped finance the bailout of a number of countries during the European Union sovereign debt crisis, will increasingly question the maintenance of the Euro as a national currency. There are now within the last few weeks three states in Germany that have representation in their state legislatures by the Alternative for Germany Party (AfD). These include the states of Brandenburg, Thuringia and Saxony. The party’s main reason for existence is to demand that fiscally conservative Germany abandon the Euro and return to the Deutschmark, or at least to a smaller more stable currency union among like minded nations. More troubling for Euro zone enthusiasts is that last May the party took 7 of Germany’s 96 seats in the European Parliament. Given the present motions of the ECB the AfD can be assured of growing support within Germany. It is likely such political movements will spread elsewhere as well.
If quantitative easing does not return individual countries and therefore the global economy back to growth, what is likely to happen? Investors can expect substantial inflation across the board. If there is an increased money supply, but no economic expansion to go with it, there is no other possible scenario. In order to stave off the collapse of individual currencies, interest rates will need to rise.
It could allow a return to traditional practices of business and investment. Individuals save money, which is then invested in expansion and further business development. The economy then grows allowing greater opportunities for jobs and companies overall. It is all contingent upon having interest rates high enough, that citizens are encouraged to save part of their earnings. Not excessively high, because that would choke off lending/credit to businesses and companies.
Does this return to fiscal and monetary sanity even possible? Government budgets will need to be pared considerably in many nations. Government at all levels will need to live with their means. That is budgets will depend on tax collection. Excessive promises will need to be abandoned as pensions and social programs are scaled back. Politically this will be difficult, especially when the moment to tackle the hangover in huge national debt accumulations arrives. Achieving primary budget balance that is where spending matches tax collection on an annual basis is only the first step. Greece for example, has finally been able to reach this milestone after 6 years of wrenching economic restructuring and austerity. Then comes the even more difficult step. That is the accumulation of annual surpluses to pay down the sovereign debt. Eventually declining interest payments on the reduced national debt will become easier.
The question of course is, will the citizenry accept this process? Or shall they agree to even more desperate measures? Abandoning currency unions may work for some countries, others will be tempted to return to a gold or silver standard. Still more, will be tempted by the siren call of the need for a one world currency. When the next crisis arrives, which is no more than a year or two away, there will no longer be the option of more government stimulus or quantitative easing. It will be at this moment, that policy makers will finally have to deal with the financial and monetary catastrophe, that has largely been of their own making.
I have been an Investment Manager for almost 30 years, and totally agree that this can only end really badly. None of the debt has gone at all, and most is now significantly larger than before the crisis.
I think we are actually closer than a year or two away from the collapse, and believe the catalyst will be Europe this autumn. Note Mr Draghi’s irritability this week due to his now impotency, and France’s abandonment of austerity!