msn money
A new era of bad money
As countries continue to create money out of thin air to dodge debt
crises, where will this all end? And how can investors prepare?
So how does this end?
I don't mean the current Spanish debt crisis or even the euro debt crisis.
I think we know what the "solution" will be to that.
And I don't even mean the U.S. debt crisis or the Chinese debt crisis. I
think we know what the "solutions" for those will be as well.
But what about the meta crisis? The one that's been created by the current
round of "solutions." How does that end?
I'd suggest that we all brush up on _Gresham's Law_
(http://www.bing.com/search?q=gresham's+law&qs=n&form=money6) , the
16th-century description of
what happens to strong currencies when they meet up with bad money. In a
nutshell, Gresham's Law says that the bad currencies win. Figuring out what to
do about that is important as investors head into era of bad money as far as
the eye can see.
Creating new money
I think it's clear by this point in the aftermath of the global financial
crisis that all the various local crises have been "solved" to date by the
creation of vast sums of money essentially out of thin air on the official
balance sheets of central banks such as the Federal Reserve and the European
Central Bank and on the unofficial balance sheets of, say, China's banking
system. I think it's equally clear that, for all the talk about economic
reforms creating growth, or austerity creating growth, or financial market
confidence creating growth, the most likely "solution" going forward is the
continued creation of vast sums of money essentially out of thin air.
It's still an open question if the "solution" will work. In the case of
Spain, for example, the European Central Bank fixed the crisis for a while by
giving banks access to 1 trillion euros in three-year loans in December and
February. But by late March the crisis was back, and the yields on Spanish
and Italian government bonds had started to rise again. Now we're looking
at another program of bond buying by the central bank to lower yields or
another program of three-year loans to banks to give them the money to buy
more bonds in order to lower yields.
To condense what I wrote in my Friday, April 13, column, "_Why Spain
scares the market_
(http://money.msn.com/investing/why-spain-scares-the-market-jubak.aspx) ," on
the current state of the art in the Spanish crisis, Spain
and the eurozone are likely to fall back on a series of increasingly
desperate work-arounds by the European Central Bank, other global central
banks
and, finally, the International Monetary Fund. Each of those fixes would
require that somebody print money -- either the European Central Bank, the
International Monetary Fund or some combination of the Federal Reserve, the
Bank of Japan and the People's Bank of China. Print enough and the immediate
Spanish crisis goes away again as bond yields sink and governments get more
breathing space to propose economic reforms and budget cuts.
At some point, though, the bill for these solutions comes due. I hope that
point comes after some semblance of economic order has returned to the
eurozone and when growth has recovered in the United States and China. But
even
if Spain -- and Italy, Portugal and Ireland -- win back enough confidence
to be able to sell bonds in the financial markets again, the world will
still be looking at the bill for this crisis. And we'll still be looking at
unsolved budget and balance-sheet problems in the United States and China.
How big is the bill?
The grand total depends on how many central banks we want to include in our
reckoning.
At the least we should count the balance sheets of national central banks.
For example, the Banco de España, Spain's central bank, showed an increase
in its balance sheet for net lending to 228 billion euros in March from 152
billion in February. The March 2012 lending total was up from just 42
billion euros in March 2011.
Go up another level to the balance sheet of the European Central Bank. At
the beginning of March, that bank's balance sheet hit a record 3.02 trillion
euros (roughly $4 trillion). That was nearly one-third bigger than the
German economy.
The only thing good about the rapid expansion of the European Central
Bank's balance sheet is that it makes the Federal Reserve's balance sheet, at
$2.9 trillion, look positively conservative.
Deleveraging those balance sheets will be extremely dangerous. Central
banks will have to sell bonds and other assets back into the financial markets
to reduce the size of their balance sheets. That will reduce the money
supply and cut into growth. At the same time, governments that haven't yet
dealt with their outsize budget deficits and their own debt will have to raise
taxes, cut spending or both. The two-track effort, even if successful, will
be a huge drag on national economies and on the total global economy.
I think we can assume, however, from the behavior of national governments
and central banks during the crisis so far that they will do all they can to
put off any significant deleveraging.
Global aging isn't helping
Yes, there will be budget cuts and/or higher taxes even in the United
States, but as in the eurozone debt crisis, each plan is likely to run far
behind events. That's not surprising, since the post-Lehman Brothers financial
crisis is running parallel to unprecedented global population aging. That
demographic shift by itself would stress the budgets of every government in
the world, because national budgets have been built on assumptions of a much
younger world. National politicians will have a tough time staying ahead
of demographic and fiscal trends.
As the eurozone crisis has demonstrated over and over, politicians will do
what they think is the minimum necessary to defuse any acute crisis while
attempting to minimize the political pain. Even if the governments of the
world gradually are forced to act by the financial markets and by the
constraints of the real economy, any progress is likely to be very, very slow
and
punctuated by crises in some part of the world.
What are the consequences?
Here's where Gresham's Law comes in, both in its popular and in its more
accurate forms.
The popular form goes "Bad money drives out good." People tend to hold good
money, money that isn't going to depreciate rapidly, and therefore remove
it from circulation. They tend to use any readily available money -- even
if they don't trust its value in the long run -- because in the short run,
availability of the currency counts for more than its ability to hold value.
A more exact reading of Gresham's Law runs "Bad money drives out good if
the exchange rate is set by law." (During Gresham's lifetime in Tudor
England, he had the repeated opportunity to observe what happened when the
government tried to set the value of money by declaration.)
This part of Gresham's Law argues for the long-term failure of efforts to
set the value of currencies by government decree. In our century, we don't
do that by royal proclamation but by central bank intervention.
What does all this mean practically? It means that we can expect the
extreme pressure that has led countries to abandon strong currency policies to
become irresistible over time.
The decision by the Swiss National Bank, for example, to link the _franc_
(http://www.bing.com/search?q=swiss+franc+currency&qs=n&form=money6) to the
euro to limit the pain that a strong currency was inflicting on national
exporters is an example of things to come. The Swedish central bank,
Sveriges Riksbank, faces similar pressure from exporters to depress the value
of
the _krona_
(http://www.bing.com/search?q=swedish+krona+currency&qs=n&form=money6) .
It also means that such efforts aren't likely to succeed in the long term.
As long as the Swiss and Swedish national budgets and deficits don't look
like those of the eurozone, there will be continued upward pressure on
those currencies, and the central banks in those countries won't be able to
indefinitely keep their currencies from appreciating. It also suggests that
efforts like those of Brazil to depress its currency also won't succeed in
the long term, unless Brazil is willing to slap on currency restrictions that
resemble those on the _Chinese yuan_
(http://www.bing.com/search?q=yuan+currency&qs=n&form=money6) .
That would be extraordinarily perverse, since the Chinese are moving with
accelerating speed to ease controls on the yuan in order to make it into a
global currency that would let China reduce its dependency on the dollar,
euro and yen.
In the long term I don't know how all this plays out -- although I suspect
the outcome is rather ugly, with the odds pointing toward another global
financial and economic crisis not too far down the road, touched off by some
combination of deleveraging of central bank balance sheets, economic
slowing in developed economies (especially the United States) and budget
crises
set off by the consequences of aging populations.
But in the medium term -- which is the one that investors live in --
Gresham's Law suggests that we can count on further appreciation of the sounder
currencies of the world -- despite attempts by central banks to depress the
value of those currencies. That could well slow growth in economies such as
Sweden, Canada, Australia, Brazil and China as those governments gradually
lose the fight against currency appreciation.
For U.S.-based investors, the appreciation in those currencies against the
dollar could well make up for any underperformance of those strong-currency
economies. (The same would hold true for investors based in the euro and
the yen.) In a world where growth from other sources looks as if it will be
hard to find over the medium term, the continued appreciation of strong
currencies is a source of gains that investors shouldn't overlook. (This same
logic argues for portfolio exposure to gold and other commodities that go
up in price as the dollar falls in value.)
One caveat, though. Any long-term trend in currencies or commodities will
be punctuated with retreats that may tempt you to sell. If you think the
long-term trends that I've described are indeed strongly in place, try to
adopt a measured strategy that has you buying during those retreats instead of
selling.
--
Centroids: The Center of the Radical Centrist Community
<[email protected]>
Google Group: http://groups.google.com/group/RadicalCentrism
Radical Centrism website and blog: http://RadicalCentrism.org
