2010: Another year, another crisis

December 21, 2009

copeland1- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

If the financial crisis were a theatre production of Hamlet, we would now be at the end of Act III.

But look . . . the audience is already standing up, applauding wildly and putting on their coats. They obviously think it’s all over. Little do they know how much blood remains to be spilled . . .
Look at the facts.

The FTSE is up by nearly 50 percent since March, so that it is now more or less back to where it started 2006.  The same is true of gilts, corporate debt, and more or less every other financial asset on both sides of the Atlantic and across the globe. Even the housing market, where it all began, seems to be reviving.

So the crisis must be over, right?

But the jubilation may be premature, because, since Lehman Brothers collapsed in September 2008, policymakers have used every conceivable tool of monetary and fiscal policy so as to restore the status quo ante. Indeed, the success or failure of these policies has largely been judged by the criterion of how far the numbers look normal – where the norm has been redefined to mean “similar to the levels of 2005 and 2006”.

In these terms, the policies, especially quantitative easing, have been extremely successful. In many respects (not just bankers’ bonuses), the clock has indeed been turned back to 2005.

The trouble is we know how this story ends. The world economy is locked into a cycle which will repeat itself as long as the fundamentals remain unchanged. The sequence that culminated in the crisis of 2007-8 is being repeated like a film in fast-forward.

The authorities keep printing money so as to stimulate the economy, secure in the confidence that inflation is no problem. On the contrary, there may even be a threat of Japanese-style deflation, which would disastrously increase the real burden of debt.

But why is inflation so tame? How can the U.S. money supply increase by 20 percent without affecting consumer prices? Of course, much of the new money has simply remained in bank tills, helping to rebuild reserve ratios ravaged by debt write-offs, and with relatively high U.S. unemployment of labour and capital, inflations is bound to be muted.

But all the signs are that markets are not even expecting much inflation in the future. Why not?  Look East for the answer. As long as there are underemployed peasants in the interior of China waiting to stream into its booming cities to produce the goods that Western consumers crave, inflation is never going to return.

In short, it is a rerun of  the 1930’s, but with the unemployed spread throughout the global economy, not just hanging around on the street corners of our own cities.

If the flood of newly-printed money is not absorbed by higher goods prices, there is only one alternative. Excess money balances and rock-bottom interest rates cause a stampede into higher-yielding assets, driving up their prices and reinflating the bubbles we know and love.

The nightmare is recurring, and will continue to recur until we in the West stop printing money and/or the Chinese allow the RMB to float upwards and start to spend their hoard of dollars on the schools, hospitals, roads and railways they so obviously need.

So what are the prospects for 2010? In the 2008 crisis, almost every asset class which wasn’t actually toxic became blessed as a safe haven. So while anything to do with banks or real estate were untouchable, Government securities, especially US Treasuries, dollar assets, commodities, emerging markets were all seen as safe. This time around, some of last year’s saints will be added to the list of sinners.

Three asset classes look particularly vulnerable. One, commercial real estate, is already in crisis in most countries. (Note that the Dubai fiasco is ultimately about commercial property).

Secondly, the realisation has dawned in recent months that some Government securities are actually extremely risky. Bond market investors are becoming increasingly selective, and there is a danger of a flight from the debt of the riskier Eurozone Governments.

Since the list of heavy borrowers includes not only the ClubMed countries, but Italy and Belgium too, there is a distinct danger of an EU bailout crisis with threats and counter-threats, bluster and brinkmanship as the Germans baulk at footing the bill.

Thirdly, the condition of the sickly dollar has not worsened in the last year, but nor has it improved. Americans are saving a higher proportion of their income – but their incomes are lower, and their debts are growing in real terms.

The Federal Government is still borrowing, and has added near-bankrupt state Governments and a newly-inflated healthcare budget to its existing list of commitments.

Of course, if any of these crises materialise, the short term consequences for the stock market will be negative. And even if we can avoid a crisis, we are likely to manage only insipid growth in the UK and US, given the debt burdens we carry, which would still suggest stock markets are overvalued.

So what is left? Like most economists, I share the view attributed to Keynes that gold is nothing but a barbarous relic . . .  but, as the Romans found out, sometimes the barbarians win.


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