By Marshall Auerback
Even on Wall Street and the City of London, not everybody has bought into the “green shoots” recovery story. Société Generale Cross Asset Research has just come out with a report entitled, “Worst case debt scenario – Protecting yourself against economic collapse; hope for the best, be prepared for the worst”
A lot of interesting asset allocation recommendations come out of the report including many of the usual favourites amongst the “we’re all going to hell and a hand-basket crowd”, such as gold, and basic agricultural commodities. Given the underlying deflationist theme in the report, bonds are also a big favourite, notably US government 10 year bonds (“10 YR bonds should perform well as long-term rates decline”), investment grade bonds, and a smaller portion in high yield bonds. Equities take a much lower percentage. So much for “stocks always go up over the longer term”.
All in all, some good ideas here, although the writers demonstrate an affliction common to many on Wall Street, who suffer from the “loanable funds theory” delusion, thereby lending the work some intellectual incoherence (much the same as our US policy makers). For example, they speak of a potential US dollar decline as the cost of “funding” its debt becomes “prohibitive” and posit a Japan-like analogy.
Here is where the problems start: Japan does not suffer from a “national solvency” problem and there has never been a default. The subsequent comparison of the US with emerging markets, which have high levels of foreign debt, or currency boards or exchange rate regimes is intellectually dishonest.
Although I have much sympathy with the bonds conclusion, I wouldn’t be happy investing in US dollar denominated asset if I truly believed the “loanable funds” theory. After all won’t the US have problems “funding” its debts if the dollar weakens and foreign investors demand a higher rate of return for their bonds?
You can see the incoherence here. That’s the beauty of a financial balances approach. It keeps you honest.
As for the other currencies, I have no problem with gold and think it could well explode if the market’s begin to refocus on the EU’s national solvency issues.
But the euro and yen? Let’s get serious here. As Randy Wray says in his book, “Understanding Modern Money”:
“Government spending is financed through the issue of currency, taxes generate demand for that currency that results in sales to government, bond sales merely substitute bonds for cash, and central bank operations determine interest rates and defensively add or subtract reserves. The relation of member countries to the European Monetary Union (EMU) is more similar to the relation of the treasuries of member states of the United States to the Fed than it is of the US Treasury to the Fed. In the US, states have no power to create currency; in this circumstance, taxes really do ‘finance’ state spending and states really do have to borrow (sell bonds to the markets) in order to spend in excess of tax receipts. Purchasers of state bonds do worry about the creditworthiness of states, and the ability of American states to run deficits depends at least in part on the perception of creditworthiness. While it is certainly true that an individual state can always fall back on US government help when required (although the recent experience of California makes that assumption less secure), it is not so clear that the individual countries in the euro zone are as fortunate. Functionally, each nation state operates the way individual American states do, but with ONLY individual state treasuries.”
Wray highlights that the euro dilemma is somewhat akin to the Latin American dilemma, such as countries like Argentina regularly experienced. Deficit spending in effect requires borrowing in a “foreign currency”, according to the dictates of private markets and the nation states are externally constrained. That’s why Iceland and Latvia are in a mess and suffer from solvency issues. It’s also why California suffers from a solvency issue or Italy or Spain. Not the US or Japan.
In many respects, the EMU policy makers desired this, particularly the Teutonic bloc. They hated (and still despise) the notion of “crass Keynesianism” (in the words of Axel Weber, the President of the German Bundesbank). But the absence of a “United States of Europe” entity that could conduct fiscal policy on a supranational scale means that regional disparities (which have been present since the inception of the euro) remain in force and have been exacerbated by the recent credit crisis. It’s Wilhem Buiter’s blind spot. He always used to argue that operating under a common monetary regime would lead increasingly to economic convergence, but this is crap in the absence of a supra-national fiscal policy. This is why credit spreads between the so-called PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) have expanded so dramatically vis a vis Germany, even though all are part of the euro zone. Yes, they’ve come down from the peak, but still well above pre-crisis levels.
By the same token, for the euro to act as a viable reserve currency alternative to the dollar, the euro zone countries would have to tolerate running sustained current account deficits, thereby facilitating the ability of foreigners to hold euro denominated financial claims. Unfortunately, given the fiscal constraint and resultant national solvency issues, the euro zone nations feel compelled to run current account surpluses (this is a particularly prevalent view in Germany), so that questions of national solvency never arise. There is certainly a compelling economic logic for Germany’s desire to run significant trade surpluses (even if left unsaid), but it does undermine the objective of the euro ever emerging as a serious reserve currency alternative to the dollar, assuming the maintenance of this odd bifurcated fiscal/monetary structure within the EU.
What about the yen? The yen might be the biggest basket-case currency of all. The credit expansion in China over the past year has been so great that there may well be strong growth (at least in a statistical sense) from China for several quarters to come. But this is not good for Japan. Look at the real trade weighted yen. It has appreciated because Japan has had deflation and everyone else inflation. Yet it has a zero trade surplus for the first time in decades. What happened? Japan was at the technological frontier. It dominated many export markets. The rest of mercantilist Asia was way behind, but progressively they have caught up. They have eaten Japan’s lunch, first in shipbuilding and steel and the like, now in consumer electronics and the like. To compete, Japan has had to move its production platform abroad. Now the worst will come from China. Chinas credit expansion means a giant investment boom in all the export sectors that mercantilist Asia is in. Chinas provinces do not conduct business with a profits’ agenda in mind. They continue to invest on an uneconomic basis. They will finance loss making enterprises. They will dump, steal market share, in effect do anything to keep the blind stupid duplicative factories running and exports from falling further. At whose expense? Above all at Japan’s. This troubling long term implications for the yen, especially if the analysis of Michael Pettis on China is correct. You ain’t seen nothing yet in terms of the competitive pressures they will unleash against Japan.
On balance, since I tend to share many of the gloomier predictions of the SocGen crowd (albeit for different reasons), I would be inclined to construct an investment portfolio geared toward deflation and Japanese style stagnation, as opposed to inflation and surprisingly high GDP growth. Obviously, I don’t tend to share the belief expressed by certain members of the Federal Reserve that a 10% official unemployment rate might be the “natural rate” in the US. The upshot is that a portfolio that has lots of 5 year treasuries, gold, some Norwegian Krona (although I’m not sure what happens to the Krona if the euro comes under a lot of strain) and stuff like natural gas stocks, and probably countries which own a lot of natural gas like Canada seem eminently rational to me. Natural gas is the perfect transitional green tech fuel. Not as sexy as solar or wind, but way more economic and a realistic alternative (Al Gore doesn’t seem to understand the laws of basic thermodynamics). My friend,
Robert Bryce ), (author of “Gusher of Lies: The Dangerous Delusions of ‘Energy Independence’) is writing a new follow-up book on this theme and and basically comes out with a “natural gas to nuclear” proposal, which is probably right if we’re serious about clean energy and less dependence on Middle Eastern oil (although I have my doubts about whether the latter is feasible, given oil’s fungibility). At the very least, it’s a more intelligent proposal than the Obama Administration’s horrible “cap and trade” policy, another boondoggle to Wall Street to ensure that our environmental policies are financialised as well.
Keeping on this theme, one other conspicuous omission by SocGen (surprising, given that it’s a French bank): nuclear energy related and uranium stocks. When the next market downdraft comes I’d load up on these types of companies as well, although tactically it’s probably advisable to start buying 5 year Treasuries now on the basis that I think the dollar is very oversold and, equally significant, oversold for the wrong reasons (i.e. the US is “going broke” and we’ll have to raise rates “to attract funding from the foreigners”). Of course if the stock market tanks (as I suspect it might soon given that the thrust of US policy has been great for banks and disastrous for everybody else) bonds could start doing well much sooner. In any event, given the extent to which we have hitherto misallocated our fiscal resources (virtually ensuring no growth surprise to the upside in my opinion), I’d much rather own bonds than stocks over the next 12 months. As I said earlier, US national solvency is not an issue.One final point. For those of you who think that a gold standard system of some form would create “honest money” I would recommend that you read a paper from Marc Lavoie from the University of Ottawa (“Credit, Interest Rates and the Open Economy”, Essays on Horizontalism, Ch. 10, “The Reflux Mechanism and the Open Economy”, Marc Lavoie, Edward Elgar Publishing, 2001) The paper highlights that when looking at year to year changes in the period before the First World War – the heyday of the gold standard – the foreign assets and domestic assets of central banks moved in opposite directions 60 per cent of the time. Foreign assets and domestic assets moved in the same direction only 34 per cent of the time for the 11 central banks under consideration. The prevalence of a negative correlation therefore demonstrates that the so-called Rules of the Game were violated more often than not, even during the heyday of the gold standard. Indeed, according to A.I. Bloomfield (“Monetary History under the International Gold Standard: 1880-1914″, Federal Reserve Bank of New York, 1959),”In the case of every central bank, the year-to-year changes in international and domestic assets were more often in the opposite than in the same direction.” To state the obvious, the “honest money” types believe that inflation is theft from savers, and by implication, anyone who is not for “sound” money is a pinko favoring redistribution. It’s a class warfare posture in disguise. But among the many disingenuous (or just plain wrong) aspects of their argument is that they contend that sound money = no inflation, meaning price stability. This essay by Marc explodes that myth. As anyone who has looked at the record knows, inflation was highly variable during the gold standard years, swinging from deflation to inflation, and in not trivial amounts to boot.
