Only when the risk to our currencies is eliminated can we afford easier credit....
MARKET BUBBLES never quite pop. They hiss a bit, reflate a little, and then hiss a bit more.
This gives those who can think clearly the chance to act, and usually on favorable terms. But it's all very confusing, and only experience and deep understanding allows smarter investors to ignore the widespread tendency to sloppy thinking.
"Perhaps never before or since have so many people taken the measure of economic prospects and found them so favorable as in the two days following the Thursday [24th October 1929] disaster," wrote J.K.Galbraith in The Great Crash.
But then, "On Monday the real disaster began."
The disaster of 1929 began to rumble in September, but the storm really hit in October. The market continued down, then up...in horror, then hope, then in horror again...for six months. It stayed dead for 5 years.
If the day of reckoning for our Western markets is now approaching then the end-game looks like being the collapse of our developed-world currencies. The US Dollar will lead the way, the others will follow.
That's because modern central bankers cannot stand aside and watch while a shortage of credit – for both business investment and consumer demand – damages their beloved economic growth. They will make borrowed money artificially cheap, acting in the belief that the failure to do this caused the Great Depression, which it probably did.
But the famous "dead hand" of the market will respond, seeking out the inevitable flaws in strategies designed to contain the ebb and flow of economics. Money will become almost as cheap to buy as the central bankers make it cheap to borrow.
How will this happen? Savers will realize that their return – after artificially low interest, offset by tax and inflation – is being deliberately held in negative territory. They will understand that with a deeply damaged economy this is a long-term condition, and not the six-month fix of most minor recessions. With a long-term negative outlook for their Dollars, they will refuse to hold wealth in either cash deposits or bonds.
This is rational behavior, and it is beyond the power of central bankers to control. Ben Bernanke simply cannot expect people to store their wealth in Dollars while simultaneously undermining its value with artificially low interest rates. If the economy has become so weak that long-term low rates are needed to sustain demand and production at the levels we have become used to, then nature's self-correcting mechanisms will grind into gear.
The Dollar has held its international value for as long as the rate of new Dollars issued has remained slightly below the rate at which the world wished to acquire them. It's been like this for a long time, because an invested Dollar has tended to grow its real value through investment in an American economy experiencing real growth.
But after repeated rescues, the US economy is now over-supplied with all sorts of junk products and pointless services. Americans are well able to cut back on them in response to their shrinking personal balance sheets. In other words, the US economy is now classically over-developed.
Domestic producers are only capable of offering high-cost domestic services because they cannot compete with foreign competition on cost. That's why the US is annually bleeding $700 billion of reserves abroad (about $7,000 per family).
America's working and middle classes do not feel like their economy is growing. They know that their earnings are moribund; they know their job is increasingly at risk; they know that their houses are falling in value. They are unimpressed by growth based on the consumption of foreign goods.
Moreover, that last step up in American growth was fuelled by an annual transfer of $1 trillion in housing equity into increased consumer demand (about $10,000 per family). Now that prop has been removed and its effect has been turned negative by today's falling house prices.
This produces the worst future prospect for non-inflationary US growth in a generation. The absence of real growth underlying the world's favorite reserve currency is a world-changing event. It ends the period where international demand for Dollars just exceeded an increasingly free supply.
Expect the Dollar to start behaving like plums do when there is 5% more of them than can be eaten. The problem of plum gluts is that plums rot – decreasing in value through age – which means you must sell, not wait.
That is the new status of the Dollar, and it means Ben Bernanke cannot now safely cut US rates. Without real underlying potential for economic growth, the value of Dollars could drop 30%...40%...50% or more in a vicious circle in which we see faster depreciation create faster liquidation.
If a financial rescue is to be successful then pumped money needs to be rationed – by price – such that it only goes to genuinely profitable enterprises able to bid up for the new funds, and these enterprises must be carefully examined by bankers before being trusted. The process will filter out feeble businesses. But this sort of discipline has been weakened, and now is not even attempted. Under increasing political pressure, the objective of the central bankers is simply to dole out cash and stop the wailing.
The financial markets currently don't get this. The rate cuts they anticipate have already been priced into strangely calm markets. After a lifetime of rescues, the major institutions think we are headed for one of our regular periods of easy credit at low rates; and that this is all there is to it.
This complacency is behind the rally which the markets have experienced since late August – and this is your opportunity.
Listen carefully and you will hear the hiss. Underneath, the sub-prime meltdown is continuing to weaken the USA's ability to grow. The scale of the problem is frightening. It's looking much larger than any crisis to hit since the Second World War, which makes it increasingly unlikely that a printing press intervention is going to do anything other than trash the Dollar.
If we, here in the West, want to stay on top of the economic heap we need to take our medicine. We need independent central bankers, like Paul Volcker, who are prepared to be hated for throwing us into recession by holding rates high, and sacrificing both our weakest businesses and millions of jobs, so as to ensure we do not see the rest of our wealth entirely dissipated.
Then, after a deep recession and a dose of economic reality, the opportunities for genuinely profitable businesses will start to seed our future with a chance for real growth.
Only when the risk to our currencies is eliminated can we afford easier credit.
Yes, it would be very painful. But it's the price we must now pay for the celebrity of our recent central bankers. Nobody wants to be hated when they can be heroes – for a while – by nurturing twenty years of super-growth.
Unfortunately there is little chance of the correct course of action being taken. Our central bankers are already leaning in the wrong direction. They are trying to avoid the mistakes which led to the 1930s' Great Depression, whereas we are facing something even more serious – the permanent loss of the Western world's position at the top of the economic heap.
Don't dare to believe this is impossible. Stop to think, and you will appreciate that productive output – if measured in circuit boards, rather than Dollars – would already see Pacific Rim countries out-producing the United States. Yet their per capita GDP figures are tiny by comparison.
What is the source of this anomaly? It's the exchange rate; the Dollar needs to lose most of its value to re-balance the equation – and it will do so, sooner or later. It looks like we have the set of circumstances telling us the time is now.
As the longstanding reserve of choice there are an estimated $45 trillion bound up in the international bond market – which is about 50 times more than there are Dollars in circulation as money. These bonds are internationally owned and set for steady redemption over the coming years.
Hold on to your hats!