Is It Possible to Fix the World?
As we look at the world after a week where equities around the globe lost roughly 6%, bond yields in the US and Germany hit lows not seen since the depths of 2008, gold and silver took massive losses, credit spreads widened dramatically (although not as badly as equities which wasn’t the case earlier this month) and currency traders sold everything to revert to the safety of the US dollar, we can only ask ourselves: Is this world fixable? We think the answer is YES but with a caveat or two that we will get to later.
Let’s first look at economic conditions in the U.S., Europe and China, given these are the most important economic zones in the world. We could include Japan but if we were to try and make the case that economic growth will save the day, including a country that has been in a deflation-induced depression for 22 years probably wouldn’t be credible. We raise the issue of growth because we have spent much time studying how Canada (and New Zealand and Sweden) lowered the debt/GDP ratios from crisis levels coming out of the 1990/91 recession. The results of the analysis show that growth can solve a debt problem. Perhaps more importantly, non-inflationary growth has proven to be very effective in allowing overly indebted nations to recover from debt/GDP ratios that so often have ended in default. Canada raised taxes and cut spending (note to the US political leaders of both parties – history does not suggest success can be achieved by one or the other – you must do both) but it was the economic environment during the 1990’s that was responsible for most of the deleveraging. US economic growth in the 1990’s averaged well above long term trends while at the same time inflation and interest rates fell continuously through the decade. The breakdown of the Soviet Union and the resulting kick start of globalization were very disinflationary events, while the productivity gains from the invention of personal computers, the internet and cell phones allowed inflation to continue falling while growth was still strong. We have concluded that Canada’s success in recovering from a debt crisis was more to do with strong, non-inflationary growth than cutting spending and raising taxes. But of course both are necessary. A final side note on Canada – the political will to cut spending and raise taxes did not materialize until the Government of Canada bond market reached a state of crisis as foreign investors refused to buy bonds denominated in Canadian dollars, rightly fearing devaluation. And that is exactly what Canada did. The Canadian dollar fell from above 90₵ US to near 60₵ US during the decade. Furthermore, the political party which introduced the consumption value-added tax and initiated spending cuts was immediately sent packing in favour of the party who campaigned on rescinding the tax hikes.
If we look at the world today and overlaid the macro economic conditions of the 1990’s, it is very unlikely that markets would be experiencing these levels of volatility. If the US and Europe grow at 4-5% for the next 10 years without a recession and interest rates and inflation fall every year, today’s debt levels will surely be materially lower and equity markets would be at levels predicted in 1999 and early 2000. Everybody can assign their own probably to this happening but we have it at virtually zero.
Now let’s return to today’s economic climate. First the US: industrial production and capacity utilization are slowly improving but remain at levels consistent with the end of a recession, not three years into a recovery; retail sales are steady at relatively weak levels; unemployment is above 9% with no sustainable downward trend; jobless claims seem stuck above 400,000; housing prices continue to decline and lower mortgage rates are not helping as very few people can qualify under the new tougher loan to value rules to refinance despite meeting all the income tests. Our take on the US economy is that it is weak but not currently in recession. We see the US as still in “muddle through” mode, although recession in 2012 is likely.
Moving to Europe, there are very few positive signs anywhere. If there is anything to be optimistic about, it is that the core largest economies are doing the best. Germany and France are barely positive and weakening; Italy is flat and weakening, while the PIIGS are all in negative growth. Perhaps the Eurozone composite data may still be positive but we think Europe is definitely in recession. Whether we are technically correct or not really doesn’t matter. Growth in Europe is certainly not strong enough to lower debt/GDP ratios and won’t be for the foreseeable future.
As for China, we acknowledge having little firsthand experience in evaluating its economy. We also have little faith in the data released by China and believe that growth is lower than the official numbers released and that inflation is probably 2 to 3 times higher than the 6% data China sends to the rest of the world. China is a powerful economic force and no doubt, the marginal pricer of commodities including oil. It is, however, the largest export economy and Europe is its largest customer. We don’t think China is developed enough yet to grow at double digit rates while the rest of the world is in recession. Can China save the world economy? We don’t think so and given the performance of energy and mining stocks this week, a lot of other people see it the same way.
If growth isn’t going to solve the world’s debt problems, policies and strategies that increase debt levels in the hope that growth will eventually save us probably aren’t the answer either. Europe is the immediate problem. Can Europe be saved from a 1930’s depression-like scenario? As we said earlier, we believe this is possible if they adopt the following measures:
1. European TARP
Financial markets are not fearing government defaults because history shows the post-default economic growth is very positive. Markets fear the impact on the European banking system, because without a solvent banking system, depression scenarios are likely. Greece, Portugal and Ireland need to default and large percentages of their debt needs to be written off if they are going to have any hope of reasonable economic growth. The European TARP program must be large enough to handle all three countries – not just Greece.
2. EU Finance Minister
The architects of the European Union recognized that the monetary union requires some form of fiscal cooperation to be successful. Each country was required to meet two fiscal tests: a maximum deficit of 3% of GDP and maximum debt of 60% of GDP. Unfortunately, these were entrance tests and were ignored once the Euro was deployed. It was also highly questionable whether Greece, Italy and perhaps Belgium ever met the criteria. It is clear from where we sit today that a more formal process to maintain broad fiscal equality is necessary for monetary union to work in the long term.
3. EU Area Bond Program
We think this is inevitable and necessary to fund the maturing debt of Italy and Spain over the next 2 to 3 years. We don’t think Germany will agree to this without the appointment of an EU Finance Minister (probably a German). The TARP program can deal with the three smaller countries that need to default. Italy, however, cannot because, as the world’s third largest bond market, it is simply too large to default. Unless a credible plan is in place to support Italian debt maturities, Europe’s problem will persist as the fear of an Italian default will dominate markets until a solution is found. We are unsure whether the structure of an EU zone bond would be a joint or joint and several liability. Politically, a joint only structure would be easier but whether the markets and (unfortunately) the rating agencies find it acceptable remains to be seen.
If you accept that our blueprint is a feasible plan to deal with the European sovereign debt problems, you must then ask if there is the political will to institute such a plan. Given the fractious nature of Eurozone politics, the easy answer is no. If we go back to our analysis of countries that have survived debt crises (Canada, New Zealand and Sweden) and look at how the political will was created, the answer is clear – and unpleasant. In Canada’s case, the political will came from a bond market that refused to finance deficits any longer. In the early 1990’s, Canadian rates were approximately 6 percentage points higher than the US despite the similar inflation levels and weaker growth. The market didn’t want to buy Canadian government debt in Canadian dollars because of a fear of currency devaluation – which is exactly what happened. The lesson here is that bond market crises create political will. Our conclusion is that this plan, or something similar, will be enacted – precipitated by a market crisis or perhaps a bigger market crisis than we have now.
We look for very high levels of volatility while this process unfolds. If Europe enacts a large TARP program to recapitalize the European banks (including the raising of capital from public markets), it is likely there will be a substantial relief rally. If history is a reliable guide, the equity markets, Euro/US dollar and US treasury yields will be much lower and credit spreads much wider before this happens. The interesting case will be gold. Will gold prices fall as the US dollar rallies or will gold investors look past Europe to what must occur in the US to solve its debt problems. We are in the camp that gold has further downside despite the massive move in the past week. However, we see it trading in a sideways range before moving substantially higher once the market ultimately focuses on the US debt situation.
We view the US similar to every other country. The political will to enact policies leading to lower debt/GDP ratios will come from the US treasury market not from within the political process. Bill Clinton’s famous line that he wished to be reincarnated as the bond market may be replayed endlessly on the internet.