Moralist or Visionary?

You only need to look at the graph below and it becomes fairly clear that the US economy has become much less volatile in the past fifteen years or so.

Growth did slow down in 2001, after the stock market “tech” bubble burst. However, while this officially qualified as a recession, the year-to-year rate of change of real Gross Domestic Product barely touched the zero-growth line. Altogether, the graph seems to paint the picture of a fairly stable economy.

Why this unusual stability? And can it last? The implications for global investors are momentous.

There are today two very distinct schools of thought on the subject: I’ll call them the Moralists and the Visionaries.

THE MORALISTS

The Moralists take the economy’s unusual resilience with a grain of salt. They point out that the global economic, boom of the last fifteen years or so was built on a mountain of debt; that US consumers and the nation as a whole have been spending more than they earned; and that, while a splurging America did keep the rest of the world from recession and deflation, the imbalances that have been created in the process are unsustainable.

In other words, they believe that the United States and, in its footsteps, the global economy, have stolen growth from the future, so that a period of adjustment to sub-par growth or a recession is inevitable.

They further point out that Federal Reserve policy has been asymmetrical: stimulative when recession, deflation or a financial crisis threatened, but merely neutral, rather than counter-cyclical, when the economy was more buoyant. This has resulted in “printing” so many dollars that a global surplus of the US currency has been created. Were it not for the intervention of foreign central banks (principally in Asia), the US currency would have declined much more precipitously than it so far has.

But, despite their professed ability to “neutralize” such intervention, when foreign central banks buy dollars, they issue local currencies in exchange, thereby further increasing the global supply of money and credit.

The supply of money has traditionally been a leading indicator of inflation. But “money” has become increasingly hard to define, and certainly to measure. Financial innovation has allowed many non-bank financial institutions to create credit through debt securitization and other instruments, increasingly with the assistance of leverage-hungry hedge funds and their “carry-trade” practices. What is certain is that a mountain of debt and credit has been created globally.

So, where has inflation been?

It has been suppressed in the averages. China and some other Asian economies, in their race to develop by capturing export markets previously served by a diversity of international suppliers, have contributed to severe global overcapacity and declining prices in a number of major manufacturing industries.

In the process, they also have become huge and destabilizing buyers of many raw materials and some other industrial components, leading to a price explosion in commodities.

To simplify, what we have today is “biflation”: the price of what China buys goes up and the price of what it sells goes down. Meanwhile, “average” inflation, as reflected in popular indices, seems to go nowhere.

Historically, inflation has been a well-documented process:

· Too much money is created compared to an economy’s productive capacity;

· Normally, this will eventually result in the prices of goods and services going up;

· But excessive money creation usually starts in the midst of a recession, when demand for credit is subdued, as individuals and companies are still busy repaying old debts.

· The new money supply thus goes into “saving” instruments such as Treasury bills,stocks and, often, real estate. Bond and stock markets go up, as do house prices.

· Only later, when demand for goods and services approaches productive capacity, does true price inflation show up.

But that last shoe hasn’t dropped yet.

The US Federal Reserve has been pumping money into the global economy for a long time, now. With “biflation” averaging out at low levels, in recent years, there has been little pressure on central banks to raise interest rates to fight inflation. In fact, occasional fears of deflation (Japan for years and the United States more recently) or financial crises (too numerous to list) have led central bankers to continue encouraging credit creation.

For the Moralists, things are clear. A global money or, at least, credit bubble has been created, which has found its way in financial assets and housing, but not yet into the prices for goods and services. However, “what cannot last forever, seldom does”. The next step will either be inflation in the price of goods and services, which will force central banks to adopt severely restrictive policies, or deflation, as the credit bubble bursts on its own, precipitated by some “accident”, and carries economies down with it. There is no escaping a day of reckoning.

It is no secret that I have sympathized with the Moralists’ view. Probably because of my education (I have never believed in free lunches), but also because this camp is populated by many older investors, who are supposed to be wiser and more experienced.

Still, the Moralists have a monopoly on neither age nor brains.

THE VISIONARIES

Even though, over time, the Visionaries have had a tendency to identify more future trends than have actually materialized, a few have seen and articulated important changes just as they were shaping up. Some are even old and wise enough to be suspicious of “TTID” theories (This Time It’s Different).

This is why it would be mindless to totally ignore their claim today that recent revolutions in communications, computing and other technologies, together with the accelerated globalization of the world economy, have ushered in a “Brave New World”.

In what Kiril Sokolov of 13D Research Inc. has called “The Ultimate Contagion”, most formerly closed or Marxist economies have embraced or are on the way to embracing free enterprise. As a result, in the past fifteen years, nearly THREE BILLION NEW WORKERS have potentially been added to the global labor force, who previously did not meaningfully participate in the world economy (China, India, Russia, etc.).

At the same time, say Charles Gave and his team at GaveKal Research Limited, “a technological revolution is multiplying man’s intellectual strength just as the first industrial revolution multiplied man’s physical strength. Resources that, until recently, had been locked away in the world’s best libraries are now open for all to see; facts and figures which just ten years ago took dozens of hours to gather are now no further than a mouse-click away. Information can be shared almost instantaneously at no cost across any distance.”

To date, the most visible impact of these two concurrent revolutions has been an explosion in “offshoring”, e.g. the re-location in countries with cheap labor of tasks that previously where performed within companies’ home countries.

This is part of what Schumpeter called “creative destruction” whereby, as innovation gives birth to some new industries or businesses, it also kills some older ones. But, with the scale and scope of the revolutions mentioned above, it had the potential, this time, to be particularly disruptive.

Indeed, within a very short time, major segments of traditional industries in mature economies have been displaced -- “outsourced” to China and other developing countries. It is almost miraculous that the United States, for example, has been able to maintain nearly full employment in the face of these destructive influences.

But this also is a tribute to the creative forces of globalization and innovation. The three billion new workers added to the global labor force over the last fifteen years are also potential consumers. As globalization brings them jobs and boosts their incomes (even from very low levels), they are already having an impact on the demand, not only for oil and other commodities, but also for new technologies and some consumer goods. “Emerging market countries are finally emerging.”

Meanwhile, corporate profits in “old economies” are boosted by rising productivity and lower (foreign) manufacturing costs. Amazingly, this has so far been achieved without ballooning unemployment, even though many traditional jobs have been transferred to cheaper locations. There is little doubt that some workers are suffering, but there also is no evidence that the new jobs that are being created are lower paying than those they are replacing.

THE MINSKY FACTOR

The views of the Moralists and the Visionaries are not necessarily irreconcilable.

The Visionaries tend to concentrate on demographics, technological innovation, social or geopolitical evolution, for example – the trends they foresee usually remain in force for decades.

The Moralists, on the other hand, believe that economies are fundamentally cyclical and that they have a tendency to “revert to the mean”: when economic factors have been growing above trend, they eventually return to trend or, temporarily, below it – usually in a matter of years.

It is therefore possible that the two groups’ differing views about where we stand today are merely a matter of time horizon. The global economy may have changed long-term course (for the better) as a result of globalization and recent technological revolutions, but that does not mean that traditional cyclical influences and patterns have been eradicated.

This brings us to Hyman Minsky. This famous economist believed that it is financial cycles that drive economies. “The financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles." He also documented how financial systems naturally evolve from being dominated by hedge (risk-averse) positions, to ones where speculation reigns and finally to a “Ponzi” (bubble) stage. And he argued that these swings, and the booms and busts that can accompany them, are inevitable in a free market economy.

But he also issued a warning that seems very timely at a time when so many potentially harmful cross-currents have in fact added up to a sort of equilibrium for the global economy.

Minsky warned that stability is inherently unstable. The longer you live in a stable environment, the more likely you are, as the years go by, to accept this environment as being riskless and therefore to become more venturesome, to accept more leverage, etc. As more people adopt this (really speculative) attitude, conditions are progressively created for the next crisis.

As I have argued in the beginning, we have, in fact, enjoyed a surprisingly stable economic environment for about fifteen years, even if this has been punctuated by occasional financial road bumps. Until the last few weeks, nobody seriously prepared for the possibility of recession, and talk of inflation that never materialized increasingly sounded like the “Peter and the wolf” tale. Opinions may now be changing.

In our global environment of unprecedented leverage, there is no lack of candidates to precipitate the next financial crisis and, in a weakening economy, very possibly a recession. But, as Warren Buffet reportedly said: “you don’t know who’s swimming naked until the tide goes out”.

We may actually have entered a “Brave New World”, but it is a safe bet that it will still have tides. For the moment, I would rather stay onshore and fully dressed.

François Sicart (in Mexico)
August 28, 2006