I HAVE NOW spent very close to a month sidelined from the markets that have been at the centre of my life for the best part of the past 35 years. It’s not only given me time to do a bit of thinking but, when picking up the papers, looking into the screens again and beginning to talk to market mates, I find a world floundering.
Endless free money in any quantity desired has come and, in some economies, gone again. And yet, when push comes to shove, we are going nowhere in a hurry and most of the financial wizards who engineered us into the mess and then, supposedly, out of it again are stumped.
But where’s the quiz? From time to time, Wilkins Micawber, a character from the 1850 Charles Dickens novel David Copperfield, is dragged up and quoted for his simple analysis that “Annual income twenty pounds, annual expenditure nineteen [pounds] nineteen [shillings] and six [pence], result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” The line is usually immediately dismissed as a bit of arcane nonsense that has no place in the 21st century. Not surprisingly, I somewhat disagree with the detractors.
CREDIT OILS THE wheels of commerce. Leverage drives the desire to take risk and to invest. So far, so good. But what of persistent public sector deficits? It is a simple fact that the number of countries not running structural nor cyclical deficits can more or less be added up on the fingers of one hand.
Deficits work very well in times of inflation. Once a year, at the end of the fiscal period, the accrued deficit moves from the “current account” – that being the annual budget – to the “deposit account”, which is the national debt pile. As long as Mr Inflation is busily eroding the current value of the debt mountain, all is well and although the debt pile is growing by the deficit, the inflation erosion of the national debt covers most of the money involved.
Take inflation out of the system and persistent deficits begin to pose a problem. We are, however, burdened – if burdened is the word – with a socio-economic model that needs to make up the shortfall between fiscal revenues and citizens’ expectations by deficit finance. It has been like that for the best part of 2-1/2 generations and it is not something that anyone wants to give up on, least of all those who get elected in order to provide the goodies.
Between 1945 and 2008, US CPI averaged 4.1%. Since then, the average has been a mere 1.7%. I know there are lots of arguments about interim periods of low inflation, not least of all in the early 1960s, but the charts tell nothing of how different the situation was then to now. The early 60s were a period of massive productivity gains in both the primary and secondary sectors of the economy when the US economy was growing in the way China was in the past decade. In the five-year period from June 1961 to June 1966, US GDP growth averaged 6.1% while CPI was at 1.4% for the period. I digress.
We are drawing to the end of a cycle that has cost us all a lot of money but which has not moved us decisively forward
THE SIMPLE FACT is that the excess credit and excess leverage that had generated utterly unsustainable growth and consumption patterns blew up the global financial system in 2007/2008. Facing the ruins, we were offered a chance to rethink and rebuild from scratch. Instead, we chose to reflate at any cost. Now, no more than eight years on, the system is stumbling again. Despite all the stimulus, the US economy hasn’t really achieved unstick speed, the UK is scared of its own shadow, Europe remains unbalanced and China, bless it, is producing output figures as credible as those of Greece before the fall.
Aficionados of the late Michael Flanders (father of the financial journalist Stephanie Flanders) and Donald Swann might recall their song “Misalliance” and will remember the lines: “Poor little sucker, how will it learn, when it is climbing, which way to turn? Left, right, what a disgrace, or it may go straight up and fall flat on its face”. The great reflation game looks as though it might be coming to an end and without the benefit of inflation, which is sorely needed in order to erode the debt mountain, the cost of borrowing, when it begins to rise, will place extraordinary burdens on fiscal households. A GDP growth of 6.1% and 1.4% inflation simply isn’t going to happen.
Austerity isn’t a ski-jump. Austerity doesn’t “work” by creating new growth. Austerity is about cutting one’s suit to match one’s cloth. It is about bringing one’s expenditure in line with one’s income. For the past eight years, governments and central banks have tried to pump up GDP in the hope of generating enough fiscal income in order to meet the existing outgoings … and they have manifestly failed. The hard work has been done in Greece, Portugal, Ireland and to a significant extent in Spain too. Germany is a special case and I’ll leave it at that. But what is clear is that the heavy lifting hasn’t even begun in the US, the UK and in France. Japan ran out of firepower years ago and even China will eventually struggle.
Markets are confused and that, to me, is no surprise. US corporate earnings for Q2 were disappointing. The air is getting thin for cheap borrowing and share buybacks. QE has, by and large, failed. Yes, it kept the wheels oiled but it didn’t, as many had expected, catapult the economy back into hyper-drive. Price action clearly displays that investors haven’t got a clue what is ahead of them and that they are no more than busily shuffling their feet in an attempt not to be caught on the wrong side of the next big move.
From where I am sitting, it looks as though we are drawing to the end of a cycle that has cost us all a lot of money but which has not moved us decisively forward. I read of some analysts forecasting a 65% probability of a 40% correction of stock markets before the end of 2015. I think I’ve read that or something very similar every year for the past five years and sooner or later one of them might be right. The next big decision has to come from the side of government and if balancing the books has to be called austerity, so be it. But anybody who looks at austerity and muses on whether it works or not might, Fed tightening or no Fed tightening, be advised to go back and re-read Accounting 1.0.1.
