Can we dodge the next bullet?

We have missed 'Great Depression 2' thanks to massive global stimulus packages. But the problem now is, how do we keep these titanic packages afloat? And this is where it gets a little murky.

These days a lot of people are expressing concerns over the direction of both the economy and the markets. And it is not hard to see why. First the local market tanks 50-plus per cent, then it rises 30 per cent. They're confused. What’s going on?

In answering this question my starting point is the government stimulus actions that have occurred around the world in the last 18-plus months. Yes this crisis started in August 2007, and continues. But back to the stimuli. They have been massive. The US government alone has committed $US12.8 billion in spending, loans and guarantees to stop their economy sinking into an abyss. Let’s put that in perspective. Its 3.5 times the 'real' cost (i.e. inflation adjusted) of the US war fighting effort in the second World War. Folks, stimulus efforts do not come bigger. The US effort is bigger than anything else they have ever tried before, by multiples. The message is clear – global governments will do everything they can to stop the global financial crisis.

I have no doubt that had global governments not undertaken these massive stimulus efforts we would be in the midst of a depression worse than anything we could ever contemplate. Worse than the thirties. Why? For one simple reason. Leading into this crisis US debt levels as a percentage of GDP were far higher than anything that existed in 1929. And that is not a good recipe at a time of falling asset prices. Forced asset sales would have led to further declines in asset prices. Just like any natural calamity that fails to differentiate between the righteous and the sinful, this financial tsunami would have dragged down the good with the bad. It would have been ugly. In fact the word 'fugly' comes to mind!

But in my opinion that bullet has been ducked. We have missed 'Great Depression 2' thanks to the massive global stimulus packages. A lesson learned from the suffering of the thirties. Well done global governments. The problem now is, how do we fund these massive packages? And this is where it gets a little more murky.

Debt deluge

"When I die I want to come back as the bond market” President Clinton’s advisor James Carville

Governments have a number of funding mechanisms. Raising overt taxation is one, but is electorally unpopular. Asset sales are tough in an environment of falling asset prices, so tapping the bond market is probably the first choice. But for that market to continue its primary role of supplying cash to government’s, it has to maintain its confidence it will one day get repaid. When bond yields start rising it’s a sign bond markets are losing that confidence. It’s as simple as supply and demand. If the government floods a market with a supply of new bonds, the price of those bonds would collapse and yield’s rise. I’m pleased to see President Obama has publicly recognised this risk by warning the US they cannot indefinitely continue to borrow from China. So at least the risk is recognised.

Quantitative easing

Sometimes government funding needs are so great that not even the bond market is up for it – like in times of war. So an alternative funding mechanism is 'quantitative easing'. This is the quaint name given by central bankers which the rest of us would call 'printing money'. Central bankers coined the euphemism presumably because they didn’t want to panic the masses; and popular media.

The problem with printing money is that it increases supply, without any commensurate increase in demand. The process usually starts with best intentions e.g. it’s a temporary measure and the stimulus will be withdrawn before it gets out of hand. But that’s a bit like saying you’ll provide drugs to an addict, but only to the point they are almost 'high'. The reality is that once the public works out the market is being flooded with rapidly depreciating paper currency, inflation breaks out.

Most famously the Weimar Republic in Germany tried quantitative easing in the twenties in the face of huge WWI reparations. It didn’t work out well. The isolated Mugabe regime in Zimbabwe also tried it over the last several years with exactly the same experience as the Germans. Quantitative easing when taken to its extreme as in those two cases, leaves a nation impoverished. The currency becomes worthless. Debase a currency enough and you are left with a barter economy. In the ensuing inflation or in worst cases hyper inflation, fixed rate lenders and savers are wiped out. Relative winners are fixed-rate borrowers and those with hard assets.

The risk of rampant inflation worries me most now. Much more concerning than a depression. History tells us inflation starts slowly and builds to a point where if not contained, inflationary expectations explode. At that point some really hard medicine – like exorbitant interest rates – are needed to control it.

This is why I like hard assets like gold. Even other commodities look attractive as the Chinese re-build stockpiles (see China's stockpile solution). Inflation boosts nominal property values. All the property doomsayers may be right in real terms but in nominal terms property values generally increase. Interest rates also rise. So borrowers, the time to fix your rates is approaching.

Mike Mangan is a portfolio manager at 2MG Asset Management whose performance was ranked top decile amongst all Australian Equity managers for the 12 months till April 2009 by the respected Mercer survey

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