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," 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 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.
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.
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.
