ICangles Investment Post…
For the current secular bear market asset inflation trouble comes in threes. Too much liquidity in the global economy in the late 90’s fueled the Internet bubble of bad corporate investments that popped in 2000. To avoid the necessary restructuring pain around a recession, more liquidity was injected into the global economy leading to unsustainable growth around the residential real estate bubble that popped along with related credit markets in 2007. In another attempt to avoid restructuring pain and alleviate the following recession more liquidity is being injected into the global economy notably by the U.S. and Chinese governments. Today that capital is fueling more unsustainable price appreciation or levels in bonds, emerging markets and commodities.
To fully appreciate the nature of the trouble brewing a basic understanding of the genesis of this current cycle’s bubbles is essential. I’ve argued in previous posts that the global economy’s growth potential is largely determined by a multi-decade cycle of disruptive technologies. When electricity, the internal combustion engine and most recently the semiconductor were in their growth phases a large amount of capital was necessary to create surrounding infrastructure and could be productively employed. As the respective technologies entered maturity and less capital was required, excess liquidity fueled asset bubbles in stock, real estate and commodity markets. Secular bull markets in the beginning, middle and end of the twentieth century were followed by secular bear markets and tough economic times.
But this is only half an explanation around asset inflation. It explains the timing of when the global economy has the lowest requirements for growth in the monetary base and is most likely to brew asset inflation. It does not explain why central bankers provide the excess liquidity in the first place. Part of that reason is the human tendency towards optimism and trend extrapolation. Smart people convincingly argued that innovation around the microprocessor in the late nineties fundamentally changed the economy allowing for a permanently high growth, low employment paradigm—the Internet was seen as a new beginning of innovation, rather than the last truly big spurt around the microprocessor. Smart people again made strong arguments for why the global trend of rising residential real estate prices was sustainable. And smarter ones figured out ways to insure against the risks in the credit markets. Today, the same experts are making similarly clever arguments about why bonds, emerging markets and commodities are all good investments for the foreseeable future.
The second half to the explanation of central banker behavior is there over reliance on classroom models. Asset inflation is difficult to measure and their models rely on measurements. Making matters worse the cyclical nature of disruptive technologies means the growth potential of the economy continually changes making modeling all the more difficult. They pour liquidity into the global economy as if caring for house plants—the solution for a lack of growth is nearly always to provide liquidity. And charged with not just monetary stability, but creating growth, bankers nearly always turn on the monetary spigots to cultivate said growth (so expected were Fed loose money policies that the moniker the Greenspan Put was coined at one point and the nickname Helicopter Ben).
The real world however, is as different from classroom models as a simple houseplant is from farmland. And while supplying liquidity almost always fuels measurable growth, in less measurable terms such growth is not always sustainable and sometimes leads to unwarranted troubles later. So, aware of the benefits of liquidity, but partly blind to its risks, central bankers will nearly always err on the side of more liquidity. That is if they are not constrained by the monetary system they operate within. Yet, today’s monetary system rather than constraining money creation through a mechanism, such as a gold standard, actually encourages excess liquidity. And partly because of that, the system is breaking down.
Such a breakdown is consistent with the last two secular bear markets. The Great Depression saw the world actually break into distinct trading and currency blocks as the global monetary system crumbled. Then in the seventies the Bretton Woods system ended as the U.S. was forced to abandon the gold standard. The new system that arose was nicknamed Bretton Woods II, and today having helped fuel today’s asset bubble it has sown the seeds of its own destruction. Under Bretton Woods II the U.S. dollar remained the currency of global trade only instead of being backed by trade surpluses and gold it was supported by foreign purchases of debt that funded trade deficits.
Countries, like Japan and China, grew their economies via export lead growth strategies, involving the buying of billions in U.S. government debt. This helped keep U.S. borrowing costs low and the dollar stronger than the Yen and Yuan, thereby enabling borrowing by American consumers to purchase artificially cheap Japanese and Chinese goods. Under Bretton Woods II, Japan, China and other countries grew their economies by selling goods and the U.S. sold them debt in return. The Euro experienced a similar dynamic as Germans sold goods and nations, like Greece, sold debt in return under the auspices of a single European monetary policy, amidst uncoordinated fiscal strategies. But the selling of debt in exchange for goods is obviously not a viable long-term monetary system. It is now in its last act, and the current asset inflation could fuel a final series of asset bubbles.
Today, corporate America having repaired its balance sheet after the dotcom bubble is in no mood for increased borrowing, U.S. consumers are looking to repair their own balance sheets after the real estate bubble and American government borrowing would already be at unsustainable levels if not for atypical financing rates. There are no more asset bubbles to blow in the U.S. So, like saturated ground when liquidity is poured into the U.S. economy by central bankers it now flows elsewhere. (The above chart courtesy of NowAndFutures.com shows the recent sharp decline for money growth in the U.S.) Nevertheless the Federal Reserve of the U.S. is doing everything it can to grow the monetary base in America resistant to the idea that America’s economy is predisposed at this point to deleveraging, rather than releveraging, debt.
The same is not the case for China, and although it could keep that money from flowing onto its shores by allowing the Yuan to appreciate against the dollar, its commitment to creating jobs by selling exports means it is still trying to preserve Bretton Woods II through the buying of American debt that keeps its currency artificially low. Chinese goods and assets remain artificially cheap in currency terms versus U.S. dollar denominated ones. And the resulting flow of cheap money into China is compounded by its own stimulus plan and loaning by its government controlled entities.
Government debt is fueling this last series of asset inflation. Because of the continuation of Bretton Woods II U.S. bonds are being unsustainably priced. In the Eurozone the acronym PIIGS has been coined to label the debt problems of Portugal, Italy, Ireland, Greece and Spain. The cheap money is also fueling an asset bubble in Chinese real estate, while the monetary regime and stimulative government lending is fueling unsustainable growth and inflation in the Chinese economy at large. In turn increased commodity appreciation related to the growth of China and the need for investors to find somewhere to park their money is fueling asset inflation in commodities markets. And emerging markets often linked to commodities or export-led currency policies are also entering dangerous territory. Events are conspiring for a nasty turn in the future.
Much of the future growth in the world’s economy, including the Chinese miracle going forward, will prove as unsustainable as the wealth creation around residential real estate proved. Yet, it is also worth keeping in mind that there were several years of such growth between the dotcom bubble bursting in 2000 and real estate bursting in 2007. To perceive when the end is near an eye should be kept on the monetary spigot and for a change in Federal Reserve policy and the currency policies of countries, like China and Japan. A central bank “managed” change is most likely to instead become a disaster of popping bubbles and the demise of the current global monetary system. Few people recognize that it was the historical norm for a secular bear market to experience the collapse of the global monetary system in the twentieth century. We should not expect this time to be any different.
UPDATE on January 13, 2011 Investor’s Business Daily posted an editorial “Has Fed Lit Inflation Fuse?” with further information on this topic and a reference to the growth in the adjusted monetary base per the following chart; and on January 17, 2011 the Wall Street Journal reported that China’s President predicted the end of the current monetary system.
UPDATE on March, 2011 the title of this blog post was changed and a few edits made to the body of the text.