What's gone wrong - my view - and some predictions

For the past couple of months, whenever I've heard some financial pundit asked about the possibilities of another depression, they have tended to give a chuckle and say words to the effect, "No, no, no - I think that very unlikely. We know so much more now about how economies work. They made such mistakes in the depression - we know better now."

But there's a reason why they call economics "the dismal science". It's worth remembering that in the Depression, too, they believed they had capitalism pretty much worked out. They were wrong. They always turn out to be wrong, eventually. In the seventies, they were sure that you couldn't have recession and inflation at the same time... whoops. World, meet stagflation.

Since then the consensus has been that Reserve Banks should smooth out economic cycles with the tool of interest rates - increase them to cool things off when the economy is overheating, decrease them to stimulate the economy. And that governments should increase their spending in downturns, by borrowing and deficit spending if neccessary, and curtail its spending in upswings. And that - so goes the theory - is why we don't have depressions anymore. The cycle can be smoothed out with interest rates. We can stimulate when it starts to look bad.

But... I can't help but wonder if the goal of "continuous economic growth" is really achievable. Over the past ten years, the United States has faced increased competition from the likes of China and India, and while this grows the global economy, I can't help but wonder if the US economy, when separated from the artificial growth of low interest rates, has truly been increasing very much over that time period.

What we've seen in the US is very, very low interest rates - constant stimulation to the economy - ever since Greenspan's time. Whenever anything has gone wrong - the economy tanking under Bush Snr, the dot com bubble bursting, September 11, and in the current crisis - they just cut interest rates, squeezing a bit more bubble and boom out of an economy that in truth was going nowhere.

The problem is that you can't keep cutting interest rates forever. Eventually, you run up against the ultimate wall of 0% rates. You can't keep stimulating forever, and particularly not with borrowed money, although the US seems prepared to try.

What has been forgotten, I think, is that a loan is in essence a bet, at very short odds. You are betting that you will be paid back. When the interest rate is very low, you are saying "it is very, very likely that I will be paid back." If the true risk is greater than what you are making from the interest, then you are going to lose your money, eventually, as surely as a gambler will eventually go broke trying to beat the house in the casino.

The US has been pumping out cheap money to banks, at interest rates that didn't represent the real chance of default. The banks have thus been able to pass that money out into the wider financial sector, again at rates that didn't reflect the real risk. The result? A long period of artificial "growth" that ultimately fails to reflect the underlying economic capabilities of the US - and possibly the rest of the developed world. The world's money flowing to sovereign wealth funds in China and the Middle-East, as Western countries borrowed to finance their booms (thankfully Australia is an exception to this, having genuinely done well out of the truly booming, developing economies through mining exports.)

Eventually, though, real world returns can't support the loans. It starts collapsing and defaulting back through the system, arriving inevitably at the Reserve Banks that shouldn't have lent money at those prices in the first place. In truth what they were doing was simply making bad bets with taxpayers' money.

My conclusions from this?

1. Everybody piling into US Treasuries is madness. Given the amount of debt the US has, and the pathetically low interest rates offered by US Treasuries, the risk to return ratio surely makes this a bad bet. The US is going to have to print money to pay off its debt - or increase taxes - or steal some other country's natural resources. I don't see how the US economy can grow its way out of this problem.

2. Following from this, I think a collapse in the value of the US dollar could happen very soon. Days or weeks. (You heard it here first).

3. The idea of governments giving boosts to their economies through the cutting of interest rates is going to come in for some scrutiny and re-evaluation soon. My feeling is that it creates unsustainable, false growth, if it becomes divorced from the true risk inherent in the loans. Central banks will have to start assessing whether the risks involved in such loans justify low interest rates, or if it is in fact better to let the economy slow, or even recede, than make potentially bad loans that lead to bubble economies.

4. Expect the world's power-centre to shift in the next few years increasingly towards China, Russia and India, in that order.

5. A really, really wild prediction: the Dow peaked for all time one year ago
at 14,168. It will never again get so high. (Today, it's 9,258.)

posted by Nicholas @ 1:10 PM