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CHAN AKYA Keynesian bomb is ticking By Chan Akya
Keynesian spending that is being unleashed upon an unsuspecting world takes the role of a stereotypical Hitchcock moment: after first beguiling audiences into believing that danger lurks around the corner, the master movie maker usually displays an anticlimactic result such as a harmless mewing cat; but before the comic relief can fully set in he reveals a nasty turn as the real villain enters from the other side of the screen.
For all the sounds and fury associated with the current meltdown in the global economy, the outburst of Keynesian spending will likely create a far worse result, namely hyperinflation that could
well take hold before the year is over. There are a number of factors leading up to this, on both the supply and demand sides of the equation.
To the cynically minded few, there is a simple enough reason for this, namely that inflation is usually the best cure for all debt overhang situations. To explain that further using the example of the US economy, the overall "stock" of private, government and corporate debt at the end of 2007 was around US$25 trillion, about double the country's annual gross domestic product. Against this, there have been some $25 trillion of asset value reduction from $50 trillion in the value of stocks, homes and future pension values to around $25 trillion by the end of 2008.
According to Bloomberg (the professional service, not the mayor of New York city), financial institutions have written off about $1.1 trillion between banks ($800 billion), insurers ($150 billion) and US federal agencies ($120 billion). The gap between the write-offs of banks and those of insurers probably requires a study unto itself; however it suffices to say here that altering actuarial assumptions and differences in accounting logic help point to a significant pile of undeclared losses at various insurance companies as well as banks in Europe and Asia.
Even as the scale of this loss appears overwhelming, it stands at a mere 4% when considered against the total debt figure quoted in the previous paragraph. To paraphrase the old joke about Russian communists [1], surely the world economy cannot have stopped spinning just because banks lost 4% of their assets? The answer is most certainly that the actual scale of losses is more likely to be in the region of 30-40%. Not to put too fine a point to the proceedings, this is the developed world bankrupt many times over, but that statement has an implicit assumption on the maintenance of purchasing power on the part of the US dollar or indeed other "hard" currencies such as the euro and yen.
Governments ranging from those in Britain and Germany all the way to the US have already injected hundreds of billions into their banking systems; guaranteeing capital positions and even asset quality in the process; all this in reaction to these institutions wiping out barely 2% of their total assets. To say that their ability to take further losses is fairly limited would be the exaggeration of the day. Much like the understated losses of insurance companies and pension funds, the rest of the system will also have to absorb the losses of the "zombie" companies and individuals in one fashion or another.
The honest way to do this would be to write off the debt and the capital of all financial companies and start all over again with vastly shrunk monetary bases: however no liberal democracy - much less autocratic dictators - can withstand wave upon wave of deflation that this entails. The opposite therefore must be true: a burst of inflation that helps to reduce the purchasing power of money while effectively reducing the difficulty associated with servicing mountains of debt. This is all good for the people who have to repay their borrowings, but what about those who own the assets, that is, the lenders?
The "cure" of inflation would be a whole lot worse than the "disease" of the credit crunch as far as Asian savers are concerned. It is well nigh time to junk all financial assets belonging to the Group of Seven leading industrialized countries and re-embrace the historic investment of choice for the region: gold.
Doing all this in the context of a new US government, geopolitical imbalances and the Nash equilibrium I described in a recent article (see Capitalism at the crossroads, Asia Times Online, January 16, 2009) means that unprecedented changes could occur on both the demand and supply sides; both pointing to inflationary shocks.
Demand shocks: On the demand side, there are a number of factors that could produce an artificial stability in consumption. 1. Keynesian spending - the biggest culprit of all in this respect would be government spending on infamous bridges to nowhere in the manner that Japan indulged in during its own crisis. Government spending is wasteful enough on its own but when combined with endemic irresponsibility, we could easily see the mother of all pork barrels being rolled out. 2. Asian consumption - losing money on their savings by the day, Asians could well start substituting consumption for savings even if their governments haven't thus far embraced the idea. Failing to export their way out of the industrial decline in China and Southeast Asia, governments would be forced to indulge in handouts as well as dead-letter projects. 3. Rising debt forgiveness actually works to increase the pain for lenders but more importantly puts the deadbeats back into the economic system. In countries ranging from the US to Europe, the new mantra is to forgive debt, with banks writing off large portions of debt particularly borrowed by individuals and "important" companies. With people all too willing to blame others for their own debt ("it was Wall Street’s fault for making me borrow the $3 million, honest"), the result is a one-off resumption of purchases by poor people but at the cost of higher cost credit / unavailability of debt for those with better credit records. 4. The lack of credit available to deserving companies and individuals means that the process of upgrading efficiency has come to a quick stop. Much like the Cubans who continue to use 50-year-old American cars because of a lack of alternatives, it will soon be common to see middle-class Americans (hardest hit by the downturn in wealth terms) using 10-year-old cars, avoiding home improvements and so on. In effect, this pushes up consumption of products such as oil.
Supply shocks: Then there are the inevitable supply shocks, some of which are better understood than others: 1. Cuts in credit that produce falling inefficiency (in demand shocks above) also adversely affect the ability of companies to improve their operations, increase production or provide adequate industrial security. All of this translates to the world of supply shocks as companies using outdated and old equipment find it all the more difficult to sustain or rebuild lost production. 2. Geopolitical forces are also going out of control, as shown in the example of Russia reacting to an impending decline of hundreds of billions of dollars in lost revenue from falling oil prices. Much like Russia needs higher oil prices to keep prime minister Vladimir Putin in power, so do the likes of Venezuela and Saudi Arabia to keep their existing rulers in place. That argues for an increase in geopolitical risks; which has always proved inflationary. 3. Weather disruptions are increasing around the world. Records from the beginning of December point to sharp increases in both the variance and averages for winter rainfall in much of the Northern Hemisphere; the outlook for similar events in the Southern Hemisphere appears to have worsened equally all along the Pacific coasts. That would in turn curb agricultural production in vast areas of the world - Brazil, Argentina, Australia to name a few - in turn producing severe shortages of agricultural commodities in months to come. 4. Adding insult to injury, much of the "hedging" mechanisms for avoiding the problem of rising prices are now impossible to effect due to the paucity of credit. Thus farmers cannot get credit to upgrade their lands or to introduce new irrigation systems; industrial users cannot buy raw materials in advance to offset a potential rise in prices later on.
Paper money's worth It is thus almost a dead certainty that the combination of wasteful Keynesian spending (if you will ignore the tautology) and supply-side effects would produce a sharp spike in inflation that is designed to buttress the ability of borrowers to repay their obligations while rendering the value of their payments almost moot for lenders.
Asians have saved a lot since the end of the Asian financial crisis, but will find an acceleration of wealth diminution upon them in months to come. Their only defense against this course of action that the G-7 countries have embarked on would be to boycott all debt issuances from the US and Europe over the near-term until yields rise fast and far enough to compensate for inflationary risks. Unless this can be pushed through, the only safe assets would be those that can hold a degree of their purchasing power,namely physical commodities and, of course, precious metals such as gold.
Note: 1. This one has it the dead tsar met with Lenin in hell (surely a communist couldn't have gone to heaven anyway) and asked him how things were in Russia. Lenin admitted the bread queues were equally long, inflation was still a problem, Russians were still lazy and unreliable but that alcohol content in vodka had increased by 2% under the communists. To this, the venerable tsar replied: so you killed me and my family for that extra 2% alcohol content?
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