Got a crisis? Roll the printing press--get ready for the age of bad money
04/17/2012 8:30 am EST
I don’t mean the current Spanish debt crisis or even the euro debt crisis. I think we know what the “solution” will be to that.
And I don’t even mean the U.S. debt crisis or the Chinese debt crisis. I think we know what the “solutions” for those will be as well.
But what about the meta crisis? The one that’s been created by the current round of “solutions?” How does that end?
I’d suggest that we all brush up on Gresham’s Law, the 16th-century description of what happens to strong currencies when they meet up with bad money. In a nutshell Gresham’s Law says that the bad currencies win. Figuring out what to do about that is important as investors head into an era of bad money as far as the eye can see.
I think it’s clear by this point in the aftermath of the global financial crisis that all the various local crises have been “solved” to date by the creation of vast sums of money essentially out of thin air on the official balance sheets of central banks such as the Federal Reserve and the European Central Bank and on the unofficial balance sheets of, say, China’s banking system. And I think it’s equally clear that, for all the talk about economic reforms creating growth or austerity creating growth or financial market confidence creating growth, the most likely “solution” going forward is the creation of vast sums of money essentially out of thin air.
It’s still an open question if the “solution” will work. In the case of Spain, for example, the European Central Bank fixed the crisis for a while by giving banks access to 1 trillion euros in 3-year loans in December and February, but by late March the crisis was back and the yields on Spanish and Italian government bonds have started to rise again. And now we’re looking at another program of bond buying by the central bank to lower yields or another program of 3-year loans to banks to give them the money to buy more bonds in order to lower yields.
To condense what I wrote in my Friday, April 13 post on the current state-of-the-art in the Spanish crisis http://jubakpicks.com/2012/04/13/the-spanish-debt-crisis-combines-the-worst-of-the-greek-and-irish-crises-in-a-too-big-to-fail-package/ Spain and the EuroZone are likely to fall back on a series of increasingly desperate kludges by the European Central Bank, other global central banks, and finally the International Monetary Fund. Each of those fixes would require somebody to print money—either the European Central Bank, or the International Monetary Fund, or some combination of the Federal Reserve, the Bank of Japan, and the People’s Bank of China. Print enough and the immediate Spanish crisis goes away again as bond yields sink and governments get another breathing space to propose economic reforms and budget cuts.
At some point, though, the bill for these solutions comes due. I hope that point comes after some semblance of economic order has returned to the EuroZone, and when growth has recovered—to whatever degree it’s going to recover--in the United States and China. But even if Spain, and Italy, Portugal, and Ireland do win back the confidence of the financial markets and are again able to sell bonds in the financial markets, that will still leave the world looking at bill for this crisis. And we’ll still be looking at unsolved budget and balance sheet problems in the United States and China.
Exactly how big is the bill for all this? Well, that depends on many central banks we want to include in our reckoning.
At the least we should count the balance sheets of national central banks. For example, the Banco de Espana, Spain’s central bank, showed an increase in its balance sheet for net lending to 228 billion euros in March from 152 billion in February. The March 2012 lending total was up from just 42 billion euros in March 2011.
Go up another level to the balance sheet of the European Central Bank. At the beginning of March the European Central Bank’s balance sheet hit a record 3.02 trillion euros (or roughly $4 trillion.) That was nearly one-third bigger than the 2.3 trillion German economy.
The only thing good about the rapid expansion of the European Central Bank’s balance sheet is that it makes the Federal Reserve’s balance sheet at $2.9 trillion look positively conservative.
Deleveraging those balance sheets will be extremely dangerous. Central banks will have to sell bonds and other assets back into the financial markets in order to reduce the size of their balance sheets. That will reduce the money supply and cut into growth. At the same time governments that haven’t yet dealt with their outsize budget deficits and their own debt will have to raise taxes or cut spending or both. The two-track effort, even if successful, will be a huge drag on national economies and on the total global economy.
I think we can assume, however, from the behavior of national governments and central banks during the crisis so far that they will do all that they can to put off any significant deleveraging.
Yes, there will be budget cuts and/or higher taxes even in the United States but as in the Eurozone debt crisis each plan is likely to run far behind events. That’s not surprising since the post-Lehman financial crisis is running parallel to unprecedented global aging. That demographic shift by itself would stress the budgets of every government in the world since all existing national budgets have been built on the assumptions of a much younger world. Even with the best will in the world, national politicians would have a tough time staying ahead of demographic and fiscal trends.
But as the EuroZone crisis has demonstrated over and over again, politicians are unlikely to operate with the best will in the world. They will do what they think is the minimum necessary to defuse any acute crisis while attempting to minimize the political pain. Even if the governments of the world will gradually be forced to act by the financial markets and by the constraints of the real economy, any progress is likely to be very, very slow and punctuated by crises in some part of the world or other.
What are the consequences of this?
Here’s where Gresham’s Law comes in both in its popular and in its more accurate form.
The popular form goes "Bad money drives out good." People tend to hold good money, money that isn’t going to depreciate rapidly, and therefore remove it from circulation. They tend to use any readily available money—even if they don’t trust its value in the long run—because in the short run it’s the availability of the currency and not its ability to hold value that counts. You can see this popular form of Gresham’s law at work in the preference during the crisis for yen and dollars as a medium of exchange and for the tendency of currencies that are likely to be sounder in the long run—the Swiss franc and the Swedish krone—to appreciate during each stage of the crisis as people expressed a preference for these currencies—by buying them—as a more reliable store of value.
A more exact reading of Gresham’s Law runs "Bad money drives out good if their exchange rate is set by law." (During Gresham’s lifetime in Tudor England he had the repeated opportunity to observe what happened when the government tried to set the value of money by declaration.)
This part of Gresham’s Law argues for the long-term failure of efforts to set the value of currencies by government decree. In our century we don’t do that by royal proclamation but by central bank intervention to buy and sell currencies in an attempt to influence value.
What does all this mean practically?
That we can expect the extreme pressure that has led countries to abandon strong currency policies to be irresistible over time. The decision by the Swiss National Bank, for example, to link the franc to the euro to limit the pain that a strong currency was inflicting on national exporters is an example of things to come. The Swedish central bank, Sveriges Riksbank, faces similar pressure from exporters to depress the value of the krone.
It also means that such efforts aren’t likely to succeed in the long-term. As long as the Swiss and Swedish national budget and deficits don’t look like those of the Eurozone, there will be continued upward pressure on those currencies and the central banks in those countries won’t be able to spend money indefinitely selling their currencies to keep them from appreciating. It also suggests that efforts like those of Brazil to depress its currency also won’t succeed in the long-term unless Brazil is willing to slap on currency restrictions that resemble those on the Chinese yuan.
Which would be extraordinarily perverse since the Chinese are moving with accelerating speed to ease controls on the yuan in order to make it into a global currency that would let China reduce its dependency on the dollar, euro, and yen.
In the long-term I don’t know how all this plays out—although I suspect the outcome is rather ugly with the odds pointing toward another global financial and economic crisis not too far down the road touched off by some combination of deleveraging of central bank balance sheets, economic slowing in developed economies (especially the United States), and budget crises set off by the consequences of aging populations.
In the medium term, however—which is the one that investors live in—Gresham’s Law suggests that we can count on further appreciation of the sounder currencies of the world—despite attempts by central banks to depress the value of those currencies. That could well slow growth in economies such as Sweden, Canada, Australia, Brazil, and China as those governments gradually lose the fight against currency appreciation.
For U.S. based investors, though, the appreciation in those currencies against the dollar could well make up for any underperformance of those strong currency economies. (The same would hold true for investors based in the euro and the yen.) In a world where growth from other sources looks like it will be hard to find over the medium term, the continued appreciation of strong currencies is a source of gain that investors shouldn’t over look. (This same logic, by the way, argues for portfolio exposure to gold and other commodities that go up in price as the dollar falls in value.)
One caveat, though. Any long-term trend in currencies or commodities will be punctuated with retreats that will tempt you to sell. If you think the long-term trends that I’ve described are indeed strongly in place, try to adopt a measured strategy that has you buying during those retreats instead of selling.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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