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.