Consequences & Cures

After the greatest credit bubble in history, hope for the best – but plan for the worst...

OSCAR WILDE's phrase "the triumph of hope over experience" could be applied to any investor assuming that equities will always prove sound in the long-term.

   Anyone with an eye for financial history knows that stock markets can stagnate and drift for decades at a time, especially when inflation is in the ascendant. Such episodes can also be tough for hedge funds; massive outflows were witnessed under similar conditions in the late 1960s.

   One should plan for bad times and black swans, in other words – and the great investors of the past have prepared themselves by wallowing in the worst-case scenario as a dress-rehearsal of what could go wrong. Those who make no plans will be buffeted by unexpected events and will inevitably join the ranks of the consensus hoard.

   Until recently we assumed that quant risk modeling would cover the bases, but Value at Risk may be a suspect measure of our vulnerability. When planning for possible economic problems one should contemplate their cause, effect and potential consequences. Right now that means:

• Cause: Post-9/11 stimulation & tax cuts, too much money created from too much debt;
• Effect: Inflation and debasement followed by deflation;
• Consequence: Property and equity slump, power shift from West to East.

Causal Credit

   The author John Gardner once wrote that "History never looks like history when you are living through it." The TMT crash of 2000 should have been the pre-cursor to a major recession, which over time would have brought the economy back into balance. Sadly, the terrorist attacks of 2001 made a recession politically unacceptable, and America was goaded into a state of artificial economic stimulation.

   We are now paying the price for what may prove to be the biggest bet in financial history in the form of a credit crisis. This term is really a misnomer, as what we face is a debt crisis, the kind of problem which undisciplined, developing countries have to endure. This sort of thing is not meant to happen to smart westerners like us.

   But we should take a hard look at the numbers. The US current account deficit could be confused with that of a banana republic, and it can be funded only as long as developing countries' currencies remain Dollar-pegged and commodities – such as crude oil and Gold Bullion – are Dollar-denominated, too.

   These assumptions may well have a shelf-life, however. Reserve currency status is a privilege of military might and a dominant trade status. As America's influence diminishes, its steady depreciation – coupled with asset freezing orders such as the Bush administration has imposed on subprime mortgages – is undermining the Dollar's desirability for the very people who subsidize America's tax and interest rate cuts.

   We can now appreciate the foresight of the Founding Fathers. They wrote America's Constitution in the same year as the French Revolution, but their currency was backed by precious metals to avoid economic turmoil. The trebling of silver and Gold Prices in the last 5 years versus a 40% decline in the trade-weighted Dollar is a graphic reminder of their wisdom.

Inflation Then Deflation

   As with many previous episodes where a currency is mass-produced to pay for wars or wastrel policies, the more that is created, the less it buys. Just as the road to hell is paved with good intentions, so the inflationary path is the most popular to pursue.

   While we have enjoyed the rising tide of liquidity through a pumped-up money supply, we cannot go on subsidizing our lifestyle with debt, leaving a lifetime of liabilities for our offspring.

   The same people who used to talk of market forces when they stood to benefit, now beg for rate reductions and bank bail-outs. If the problem is too much credit, how does making it cheaper help us? This is the question that Japan has wrestled with for two decades.

   In the late 1980s, Japanese interest rates were set too low for too long, inflating an equity and property bubble just when the population was ageing. As American baby-boomers begin to retire en masse in 2008, perhaps a similar fate awaits them.

   While deficits as a proportion of GDP understandably peaked at the height of the Great Depression, this time round we have breached even these extremes; only we've done so during the good times. When posterity turns to penury, we may remember the acumen of our agricultural ancestors, who stored in the good times to prepare for the bad.

Consequence & Cure

   The hangover from the consumer party is taking the form of soaring consumer prices. As debt-fuelled earnings evaporate then equity prices may be pole-axed, in spite of lower interest rates. Precious metals starting with silver and Gold Investment could once again provide one of the few bolt-holes for investors, just as they did in the 1930s and 1970s. They should be held unemotionally as an insurance policy to preserve purchasing power in the face of Dollar devaluation.

   While Gold Prices could offset declines elsewhere, however, we ultimately need to fix the monetary system now it's gone bad – and the longer-term threat we face is that of a power shift from West to East. We have accrued debt and outsourced our manufacturing while developing countries have accumulated cash and created an industrial base. They have also negotiated future supplies of raw material. In future, real wealth may well be access to real assets.

   But we should not fear a financial crisis, because western economies need to undergo a period of cleansing, of detoxification, after which they will (hopefully) rehabilitate. To come full circle, we may hope for the best while planning for the worst – and planning for the worst may be our best hope.