It has been a long and trying summer. Like everyone, I have been transfixed by the market’s wrenching descent, along with the political mayhem that has accompanied the decline.
I was stunned that brinksmanship put the U.S. on the verge of default; I felt disbelief as I witnessed the first-ever downgrade of U.S. credit; and though the Eurozone’s economic woes were no surprise, I was astonished that such grave problems were met with so little clarity and even less resolve.
I’ll stop discussing the past, and instead focus on the future. A caveat, first: as a rule, I avoid writing thematic pieces about the “macro” environment. I find that most commentaries of the sort are overbroad, heavy on unsubstantiated opinions and jargon, and light on facts. Yet given present circumstances, the “macro” landscape is unavoidable, so I will address it here.
As markets have collapsed, I have been struck by how many pundits have focused their attention on the gross dysfunctions of Washington and Brussels. Stimulus, bailouts and the indebtedness of nations have become heated, emotional issues; everyone across the political spectrum has found someone else to blame for the mess.
I hold no illusions about the gravity of the current sovereign crisis. The intractable nature of such large debts has sapped confidence. Most of Europe is saddled with unsustainable obligations, and a decade of fiscal profligacy has put the U.S. on a trajectory to match Europe’s worst. The West must put its fiscal house in order.
All that stated, I want to be clear about what I view as our central problem today: the world is not growing fast enough. The challenge we face is, first and foremost, one of growth, and not necessarily one of debt.
The idea that the world is growing at a sub-par rate is patently obvious. Nevertheless, it is important to recognize the primacy of the growth problem, especially because so much of the current rhetoric presumes that excessive debt is the cause of our woes. Most economies are now growing at rates well below their potential, and it is that sluggishness which transforms a challenging debt problem into a crushing burden. With better growth, sovereign debts could be restructured, terms lengthened, and solvency preserved. Enhanced growth would lift millions out of the ranks of unemployment, and the resulting gains in output would help “pay for” the accumulated debts of sovereign nations. The world needs to focus its efforts on restoring growth, rather than orchestrating massive bailouts or taming massive debts.
Why isn’t the world growing? What’s at the root of the problem? A heated debate is underway between academics, policymakers and pundits. Some believe that disastrous monetary policy and fiscal imprudence have destabilized the world, ushering in hyperinflation and the end of fiat currencies. Others cling to a wholly separate view, where misguided austerity measures – intended to rein in debt – will instead push the world into a “liquidity trap,” where deflation and recession are inescapable.
Flexibility is Essential
I do not pretend to posses the economic prowess necessary to address either view. However, I would like to make one basic observation: the global economy suffers from far too many rigidities, and it is these rigidities that stifle growth. In my experience, flexibility and adaptation are the hallmarks of a vital economy. Yet instead of flexibility, the world’s economy is staggering under the weight of too many fixed policies, artificial markets, and dated economic constructs.
What do I mean by “rigidities?” I mean any major policy or market structure that suspends natural economic forces to advance political goals. Unfortunately, many examples exist in the world today. In the U.S., asset values in a key national market – residential housing – have been supported by stimulus and artificial means. This rigidity – the refusal to let markets find a natural bottom – has meant that growth has not resumed, and recovery remains elusive.1
A second major rigidity exists in the global financial system. Large, “too-big-to-fail” banks have stubbornly insisted on the quality of assets on their balance sheets, despite growing evidence to the contrary. Regulators have acquiesced, afraid that realistic valuations would push their local banking systems into shock.2 Major banks have thus been able to avoid painful write-offs and losses; yet because their balance sheets have not been rehabilitated, the world now suffers episodic liquidity panics and rolling credit crunches.
A Failed Union
The third and most detrimental rigidity is located in the global currency markets. The Eurozone represents a grand economic project; only time will tell whether it will be a lasting one. However, it is already apparent that the project’s broadest ambitions have failed: “peripheral countries” such as Greece and Portugal are not well suited to the union. Much of European politics is now devoted to the search for a bailout that will preserve the union. Some have recently suggested that the Eurozone will remain intact mainly because the cost of a breakup (estimated $800 billion) outweighs the cost of a bailout.
Yet even as breakup costs are high, I believe they pale in comparison to the long-run costs of sustaining the present union. Greece, Portugal and possibly other peripheral countries are neither solvent nor competitive under the euro. They must exit – hopefully in an orderly fashion – in order to rebase their economies without invoking crippling deflation and austerity. The countries that remain in the union would be better off for it: the residual Eurozone would avoid the prolonged economic downturn that would surely follow a bailout.
Imagine if Greece were rescued. Undoubtedly this would provide a temporary bolster to confidence, as happened in the spring of 2010. Yet the markets would invariably return to the same theme – doubting the union’s stability, and fretting over the moral hazard induced by the bailout. The solvency of more countries would be called into question, and the cumulative cost of the rescue package would balloon. Confidence would erode yet again, and with it, aggregate demand. This is a recipe for stagnation and decline. Is saving Greece worth consigning the $12.5 trillion Eurozone economy to an extended period of uncertainty and sub-par growth? I don’t think so.
A Construct Past Its Prime
Beyond the euro, there is one other major rigidity in currency markets: the Chinese renminbi’s link to the U.S. dollar. It is time for that tether to be cut. Those who have followed my past work would note that I have often discussed China’s side of the story: China’s decision to peg its currency to the dollar goes far beyond the desire to gain an “unfair” trade advantage, or to “steal jobs” from the West. Rather, the policy had far more to do with the country’s rickety domestic banking system. Two decades ago, China’s banks were impossibly weak and frail; pegging to the dollar offered a vital monetary anchor that helped the country introduce greater financial discipline. Then, the peg served a concrete purpose; it was born of sheer necessity rather than machination.
Yet even as I would acknowledge the original rationale for the peg, I now believe it is time for that link to cease.3 China no longer enjoys a dependable monetary anchor in the dollar: instead, the dollar has become a conduit through which China imports inflationary conditions and illicit capital flows (“hot money”) which chase speculative investments. Meanwhile, the rest of the world can no longer ignore the rigidity of the renminbi – its limitations and lack of liquidity have become an impediment to global growth and trade. It is astonishing that even as China enjoys the second largest economy on earth, its currency is tethered to the dollar as if the country were a third world nation. Fortunately, China appears to have recognized the problem, and it is gradually moving toward a convertible currency.4 The rigidity inherent in the current currency regime serves little constructive purpose anymore.
Tepid Growth and Range Bound Markets
In my view, such rigidities are stifling economic recovery, and I don’t believe current policies are helping much. Economic policy must stop distorting markets and propping up asset prices – whether for homes, bank balance sheets, or currencies. The Fed has adopted aggressive monetary stimulus, but this appears to have only fueled speculation in precious metals, which is of little help to anyone. Instead of stimulus, markets must be allowed to clear. Artificial prices on inflated balance sheets only delay the inevitable, and prolong the world’s stagnation, at great cost.
In the short run, greater flexibility (e.g., Greece leaving the euro) will induce volatility, and some economic pain. Economic activity may first deteriorate before it rebounds. Yet flexibility will allow markets to clear, and pave the way for the resumption of growth. For proof, contrast the cases of Japan versus East Asia. After its financial bubble burst in 1989, Japan propped up insolvent companies and stalled reform. The resulting rigidity induced two decades of deflation and anemic growth; even now the country suffers from entrenched unemployment, especially among the young. By comparison, East Asia met its 1997 financial crisis by embracing policies that emphasized flexibility and reform. The ensuing adjustment was painful but swift. The region returned to growth less than two years later, even as pundits predicted a decade of stagnation.
If the major rigidities I have described are not addressed, I fear that growth will become increasingly hard to find in the world. I would caution investors against hoping for material gains from broad market indices. Markets will most likely remain range bound – like Japan – unless the bulk of these rigidities are removed. Admittedly, valuations are now quite attractive, and this may limit the potential for further downside; and carefully selected individual investments may still prosper, even in a range bound world. But flexibility is essential to induce the sort of broad-based growth that acts as a tailwind to equity markets.
I hope I am wrong about all of this. I hope an unforeseen, exogenous event will nudge the global economy toward a sustainable recovery. I hope we will see a resumption in economic activity that puts the world’s unemployed – especially the legions of unemployed young people – back to work. Yet short of a small miracle of this sort, flexibility is the only way I know of to restore growth.Andrew Foster
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- Bloomberg News, “U.S. New-Home Sales Decline to Six-Month Low as Prices Fail to Lure Buyers,” 26 September 2011.
- Bloomberg News, “European Bank Stress Tests Compromised by Greek Non-Default, German Mutiny,” 15 July 2011, and “Local Government Debt Is China’s Subprime,” 16 September 2011.
- Technically speaking, the renminbi is no longer pegged to the dollar, but rather linked via a “managed float.”
- Bloomberg News, “Yuan Will Be Fully Convertible by 2015, Chinese Officials Tell EU Chamber,” 8 September 2011.