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THE NEW ECONOMIC REALITY – PART III

THE NEW ECONOMIC REALITY – PART III

In Part I, we discussed the history behind the current worldwide de-leveraging, which is the primary factor determining today’s economic landscape. In Part II, we explored the reasons for the current market volatility, and discussed the current game of tug-o-war between two contesting sides; those who anticipate a deflationary depression and those who anticipate inflation. As the contestants pull the rope in one direction and then the other, the market becomes volatile and fear spreads as both sides shout their views from bullhorns. Both Part I and Part II are available below.

Today’s installment, we will discuss potential influences which may tilt the playing field allowing one side or other to gain an advantage in the tug of war.

ONCOMING POSSIBLE INFLUENCES

There are many, but today, let us discuss three that are inflationary and three that are deflationary.
INFLATIONARY

Quantitative Easing by many member countries of the European community and other developed countries.
A new wave of stimulus spending by the U.S. government as it panics and pumps even more money into a banking system (a banking system that is not distributing the money to borrowers).
Continued strong growth seen in China, India, and other leading growth countries. These countries do not depend upon exports to the stalling economies of the world. Much of their economic growth is being powered by their infrastructure and consumer sectors.
DEFLATIONARY

Many over-levered local, provincial, or national governments will be unable to refinance or float new debt.
The oncoming failure of governments and pensions to pay the full amounts that have been promised, resulting in changes of retirement age, pension, and forcing austerity.
At present, the most important deflationary factor is the large cross-holdings of European sovereign debt by the large European banks, thus causing failures in the European banking system. This could cause a major deflationary impact as these countries are less likely to be able to repay the debt held by their own banks.
IN OUR OPINION, IT IS TOO EARLY TO KNOW WHICH EVENTUALITY WILL OCCUR

Our opinion is based on historical analysis and the principle that humans usually choose to avoid problems rather than confront them, especially when that human is a politician whose re-election campaign is at risk.
Historically, the U.S., Japan, and Europe (with the exception of Germany) have all opted for a Keynesian approach to counteracting depression. In other words, they prefer to spend their way to prosperity; running big budget deficits during difficult economic times. Politicians find it much easier to promise gifts to voters than to take them away. Because of this truism, we expect much more quantitative easing (QE) or money printing.
We agree with the prescient Jim Sinclair, who has said that we will have “…Quantitative Easing to infinity”. Quantitative Easing causes currency debasement and currency debasement leads to inflation. Ultimately, a destructive hyper-inflation may develop over the next few years if politicians do not rein in their spending impulses soon.
The alternative policy is to allow a banking system collapse which would be very deflationary, and therefore politically unpalatable.
THE MECHANICS OF CURRENCY DEBASEMENT

How has currency debasement developed in the many countries that have suffered from it over the centuries, and how will it work this time?
To put it simply, Europe and the U.S. are in the habit of spending more than they can raise in taxes, and more even than they are able to borrow. When spending on social programs is cut to rein in expenses, voters object. Fearing for their political future, politicians expand money printing to allow the programs to continue. (Over time, this causes much greater damage to the economy than a cut in spending would cause).
The supply of money increases but the demand for that currency stays constant, causing the value or purchasing power of the money to fall. This is called currency debasement. In recent years, both Europe and the U.S. have begun the process of currency debasement by their money printing exercises. This leads to a downward revaluation of a country’s currency and the increased impoverishment of those who hold long-term bonds and cash over time.
In our mind, the primary question for investors is how long will it take for the value of the currency to collapse?
WHICH INVESTMENTS PROTECT FROM CURRENCY DEBASEMENT?

Historically, gold and income-earning real estate have been the best hedges against currency debasement. In an inflationary economic expansion, fast growing companies, non-precious metals that are used for industrial purposes like steel and copper, or energy sources such as oil, coal, and natural gas, and investments in fixed assets which will rise in value, such as timber and farmland will do well.
Currency debasement is a monetary event that can accompany either a depression in economic activity or a growth in economic activity. An inflationary depression is much trickier and we will discuss that in future letters.
WHAT CAN ONE DO IN A BANKING SYSTEM COLLAPSE?

Even a partial banking system collapse is deflationary.
In our opinion, the biggest risk for European investors today is the collapse of his or her banking institution. Even the fear of this can be deflationary.
We cannot stress enough that depositors should be sure that their assets that exceed amounts insured by government sponsored bank insurance programs (whether they are bank deposits, stocks, bonds, currencies, cash, etc.) are held in a custodial relationship that is by law segregated from the assets of other investors and the assets of the institution itself. Further, depositors should make sure that the contents of that legal structure are audited by an independent auditor at least once a year.
THE BIG PROBLEM AHEAD IS THE THREAT OF A MAJOR EUROPEAN BANKING CRISIS

We anticipate that this event might look something like:
1. Banks are holding bonds of sovereign governments that cannot be repaid. This decreases the value of the banks’ capital, making them bankrupt, and the banks will have to get new capital to survive.
2. The only source of new capital will be their home governments (private and institutional investors will not be willing to participate).
3. Fear will cause runs on deposit institutions. Eventually, banks will be nationalized by their respective countries.
4. Then, in order to raise the capital for the banks, the countries which cannot sell any of their own bonds (for lack of buyers) will print money (QE).
5. The QE will expand the national balance sheet of these countries many times over.
6. Although these countries have printed a huge new supply of money, there will be no increase in the demand for the money, which will lead to a fall in the value of the money (the buying power of the currency falls).
Eventually, this devaluation of the currency (though good for exports) is highly inflationary. This inflation will cause the currency to fall further and a vicious cycle will take hold. This cycle will only end with the successful formation of a new currency partially backed by gold or some other fixed assets like land, real estate, etc.
WHO SUFFERS?

Bond holders, holders of the currencies which have been devalued suffer in any kind of inflation. A banking crisis that leads to a deflation helps bonds at first, but only if the issuer has the wherewithal to pay.
WHO CAN BENEFIT?

Those who hold assets that a failing bank cannot touch (assets that are separate form the banks assets even if held at a bank).
In our opinion, inflation can be experienced both in an economic expansion or an economic depression. In either case GOLD, CURRENCIES of countries with conservative financial management and stable banking systems, REAL ESTATE, and other real assets can do well.
In an inflationary expansion fast growing companies and producers of commodities will also do well. In a deflation, bonds will do well if the issuer can make the payments. Gold often holds its value in terms of buying power even in a depression.
In addition to taking steps to preserve capital during a deflation, there are other opportunities available to investors who have the ability to sell short or find ways to hedge. In coming letters, we will discuss some of these opportunities in more detail. In the meantime, we continue to watch the markets and political events closely to determine how and when the new economic reality will become clearer.
Thanks for listening.


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