RECOVERY?
Economic forecasts are being wound back fairly dramatically as practitioners have realised that they have got their 2011 forecasts wrong as Bernanke’s stimulus bounties underwrote the 2010 recovery which ran out of steam in April 2011. Take away the drip feed and the patient becomes comotosed.
As an example, world growth according to Westpac Economics latest projections is expected to average 3.5% over calendar 2011 and 2012 compared with 4.2% just 3 months ago. The circa 1% difference is about US$700 billion in real terms. Fears of double-dip recession are expressed daily from reputable sources. America is struggling on all levels – fiscal, monetary, militarily, national identity; Europe has a banking and sovereign debt crisis, Japan is recovering from a natural disaster and years of almost zero growth, the Middle East and North Africa are at various stages of civil war.
Strife abounds, which in historic terms means we are in the early stage of the opportunity cycle. We repeat ad nauseum, that bottoming is a process, not an event.
Though there won’t be much evidence of recovery in calendar 2011, if policy makers and politicians work hard on policy and communications, and politicians in particular start to behave like adults, then the world should experience a normal recovery in the last 3 quarters of 2012. The US election cycle will, of course, create some volatility.
OUR QUESTION
Q: Is austerity or reflation the pathway to economic recovery?
A: A strong measure of austerity is necessary, coupled with a stronger measure of reflation.
Austerity should proceed along the lines of cutting waste, reducing the size of government, or at least curbing its current rate of growth, and re-directing the moneys saved into sustainable projects such as infrastructure. All welfare should be centralised by the Commonwealth taking it over so that only one cheque or set of social benefits issues per household or person, rather than a plethora of payments and social benefits from separate government departments. At the same time reflation should occur by cutting taxes, making the tax system more efficient. Simple measures like phasing out stamp duty on house transfers, phase out payroll tax, and reduce capital gains on long-term assets held. Ecinya has written on taxation matters in various Insight articles.
Remember that all taxes ultimately reflect in all prices… goods, services, assets…… such that special-interest pleadings generally miss the holistic picture. Government has to raise a certain amount of public capital. The real danger comes when political parties use the tax system to re-distribute income and garner votes via hand-outs which are tantamount to bribes. There are shades and shadows of the Greek disease in Australia and the USA.
THIS WEEK
The purpose of this week’s Ecinya Insight is to have a quick look at a few numbers on the global economy to underline our macro thesis that the recovery and stock markets are currently fragile and unconvincing with insufficient evidence of viable change. Bandaids are no substitute for patient and sustainable policy. Stocks should thus be purchased on down days and not chased on up days. A few takeovers would help underpin the bullish view that our own market has reached the value stage. However, prosperity in the economy is not easily recognisable as the small business sector is struggling under the weight of a poor government, and high interest rates.
At the moment we consider the Reserve Bank to be acting appropriately in relation to interest rates as monetary policy cannot be expected to overcome or offset the cascading effects of bad fiscal policy. Mr Bernanke has recently admitted this reality and has now called upon the US Congress to do their part. It appears that Uncle Ben is threatening the recession scenario believing that Congress will only act at the point of actual or perceived crisis.
With world growth slowing, disequilibrium has morphed into a bizarre loss of historical perspective of the cycle of boom and bust. There is a universal loss of faith in fundamentals. Confidence is clearly not in abundance. In an August 12 Wall Street Journal survey of 46 economists 13% said the USA is already in recession and 29% said recession is coming.
THE TRIPLE MISERY INDEX (TMI)
The TMI is our simple concoction and adds together 3 aggregates – the unemployment rate, plus the domestic deficit and the current account deficit as percentages of GDP. Out of the 16 countries selected Australia is well positioned with its TMI around 10. Above 15 we have Italy, France, India and the United Kingdom. Most worrying of all we have the USA, Spain and Greece above 20. Europe will not sort out its problems quickly, nor will America. But we believe that America will sort out its problems more quickly than Europe if it elects a wise and economically and commercially literate president.
‘Leadership’ is very important to the American economic and market psyche and it has relied on celebrity presidents far too often…. Reagan, George W Bush and Obama fit decisively into this category. It is a good thing that Donald Trump, Sarah Palin and Mr Huckabee will not be running in the 2012 presidential race. Ronald Reagan sowed the seeds of fiscal recklessness into the fabric of the American dream and it has been there ever since reflected in intransigent domestic deficits, except for a brief respite under the Clinton-Newt Ginrich ‘contract with America’ period.
Improvements: China, Germany, Russia
Mild Improvements: USA, Brazil, Canada, France, Indonesia, Italy, Spain, UK
Worsening: Australia, Greece, India, Japan, Turkey
CHINESE INDUSTRIAL PRODUCTION
Although the emergence of the Chinese middle class is an amazing phenomenon, China at the margin has gained its prosperity and enormous currency reserves from becoming the major exporter to the world – Europe, Asia, America, and Australia. Australia has not been terribly disadvantaged, on balance, as China has become our major export market in natural resources. But China industrial production is slowing as world growth slows and domestic imbalances have emerged, mainly in property markets. This will impact on Australia in the short term. As Europe and America learn to reflate efficiently and non-recklessly, then the world can begin to normalise, China can resume above-trend growth and Australia will recover that much faster.
What does ‘normalise’ mean?
In our view it includes the following –
- A stronger US dollar.
- A cessation of Congressional hostilities leading to an outbreak of fiscal responsibility.
- The election of a thoughtful and economically literate US president (Mitt Romney seems to have the appropriate CV)
- Tax reform in America… probably a national GST/ sales tax.
- Institutional reform leading to institutional accountability.
- A reduction of European welfare.
- Recapitalisation of European banks.
- Cessation or extreme modification of the European Union and a return to sovereign states allowing some states to use their own currency alongside the Euro. Additionally beneficial trade treaties can be negotiated… not ‘free’ trade agreements, there is no such thing as ‘free’.
- Relative peace in the Middle East aided by a European-Arab reconstruction fund.
- In China we need to see the continued emergence of the middle class and certain safety nets for workers which will increase Chinese production costs and re-balance their trade to some extent. Safety nets.. superannuation, minimum wages, less exploitation, workers comp insurance etc.
- The Chinese Communist Party should change its name to ‘The China Central People’s Party’ to indicate a deper engagement with the west and acknowledgement that it has become a free enterprise economy. China is not yet ready for democracy.
FIAT MONEY AND REFLATION
The great thing about paper money is that it is easy to print. In a global economy where there is excess capacity increasing the money supply does not need to be inflationary IF the increased money supply is spent and invested wisely. Putting more people to work and having less people at war should be good for global prosperity.
"Clearly the central bank of Zimbabwe has overdone it. But if the central bank of the USA has overdone it few seem aware of it. The secret is to give people more money, but not so much more that they realize all they’re getting is pieces of paper. Paper money may be a fraud, but it still represents purchasing power. When more units of it appear, people assume they have more purchasing power. And when they spend more the merchants think there is more demand and increase production. Pretty soon there is a boom." (Bill Bonner, author of "The New Empire of Debt", with Addison Wiggin 2009.)
We live and work in a fiat money system. We produce goods and services and we are paid in cash or a cash equivalent, such as a direct credit to our bank account which may be met out of the payee’s cash or a bank credit facility. Companies borrow from investors via various forms of debt, but mostly from the banking system who provide credit from their borrowings from a central bank, or other commercial banks deploying the savings of depositors.
Paper currency is not new. It existed in 1716 in France, fell into disuse, and then re-emerged in 1791. Paper money found its way to America in 1862 when Abraham Lincoln passed the Legal Tender Act. The Federal Reserve System was put in place in 1913. After World War ll Germany became a massive printer of money. In 1934 President Roosevelt revalued gold from its official price of $20.67 to $35 to enable the printing of more paper money with the hope of lifting America out of The Great Depression. In 1944 The Bretton Woods Agreement was made to treat the dollar as a substitute for gold. At the official price of $1 for gold pegged at $35 an ounce, countries holding gold or US dollars could print money up to that limit. In 1971 President Nixon ended the gold standard, ending convertibility of dollars into gold.
Paper money has generally preceded outbreaks of rampant inflation as a large quantum of dollars chases a limited supply of desired goods and services. Hence inflation has to be monitored and controlled, and above all, anticipated.
INFLATION
There are three faces of inflation. Firstly, a general rise in the cost of goods and services. Secondly a rise in asset prices. Thirdly, a rise in the current account deficit as imports exceed exports via the trade balance as countries find it cheaper to import than to produce goods and services themselves. An easy example is the outsourcing of call-centre jobs to Bangalore and Malaysia etc. Another easy example is Wal-Mart where on a store visit our editor found that only the toy department stocked ‘made in America’ goods.
However, in a money printing environment such as that pursued by Alan Greenspan and then by Hank Paulson and Ben Bernanke, having too much money chasing too many goods and services is not an inflationary problem, because we have excess money supply chasing excess capacity. And this increased supply is mainly to do with the emergence of Asia where technological abilities, skill sets and an over-abundance of cheap labour enable goods and services to be produced cheaply for export to the idle and indolent west. And this is not a political statement, it is simply economic fact.
WHAT MAKES UP THE SHORTFALL?
In the good old days classical economics taught us that consumption and investment were funded from savings. But the phenomenon of excess consumption that began in the 30’s has survived with but occasional interruption, and over the past decade or so, with increased momentum. That process became the debt funded boom that we are currently exiting. People consume today out of borrowings. In a real sense savings is spending forgone. The latest manifestation of this debt phenomenon is the transfer of debt from the private sector to the public sector. The private sector has de-leveraged and the public sector has re-leveraged. Public debt tends to be inefficient and frequently mis-allocated.
BUT GOVERNMENTS HAVE NO MONEY!
Governments get their money from three principal sources – taxation, borrowings, and running a few public utility-type businesses. An example of businesses formerly run by governments would be Commonwealth Serum Laboratories (now CSL), Commonwealth Bank, and Telstra. Government budgets are just cash-flow statements – money in and money out. Little or no distinction is made between discretionary and recurring expenditures, and capital items. There is no Profit and Loss Statement, and there is not a Balance Sheet. If governments discourage private investment then the alternative is to increase our level of imports. This reduces job creation at home, increases unemployment, increases unemployment benefits and other forms of welfare (such as ‘free’ health). Pretty soon the budget surplus turns into a budget deficit.
But governments should run budget deficits at appropriate times PROVIDED the expenditures that contribute to that deficit are well targeted. What is happening though in the Western world is that fewer and fewer producers are servicing a growing number of welfare recipients. The Henry Tax Review recommended the creation of a super-welfare agency so that welfare could be properly monitored and controlled. The Australian (and American system) with active welfare states and activist Federal welfare leads to substantial abuse and waste.
So the fear and the problem is that over time we all veer towards being Greece where the government in effect had to borrow money to employ public servants who did very little. When we then impose ‘austerity’ there are riots and lootings, anger and mayhem.
WHY THEN PRINT MONEY?
Simple. Inflation is better than deflation, depression, or even a slow-down. Keynesian economics has reached its illogical conclusions, its zenith of idiocy. Fortunately in a fiat money system it will not matter until one day we finally reach the levels of our own misunderstandings and delusions. Even wars can be financed on credit provided China, a surplus country, is prepared to lend money to a deficit country like the United States of America.
IS THE ANSWER TO GO BACK TO THE GOLD STANDARD?
The answer is no. The economic debacle of the 30’s spelled the end of the gold standard. Modern economics has finally melded with modern politics. It is highly unlikely that an ounce of gold will be legal tender at Harvey Norman, Woolworths, David Jones or McDonalds. Our belief is that the fiat money system has travelled and prevailed for far too long to revert to the gold standard.