International Co-Operation is required
03/31/09
Empires are frequently envisioned organically: they are born, they live and prosper for a while, and then they decline and eventually perish. Edward Gibbon's 1776 "Decline and Fall of the Roman Empire" was influential because of its depth and the use of scientific methods and served as a model for many historians afterwards. A similar, more philosophical course of thinking was promoted by the German Spengler with his 1918 work "The decline of the West". While the former was an English historian in the modern sense, the later probably influenced more people, especially in Europe. Both, however, provide philosophical cover to this day to all kinds of political agendas. One very popular conventional wisdom is that the United States is following the path of the Roman Empire into oblivion. When proposed in polite company, one rarely escapes the sense of inevitability that the proponent is trying to convey along with the historical certainty that righteous punishment must follow every decadent deed in its footsteps. Thus, many proponents mix historical facts with religious concepts like "good" and "evil" (yes, just like our previous President), ornament the product with some "rational" arguments, and present the result as this country's destiny. Chinese central bank governor Zhou Xiaochuan has joined this illustrious club, when he published his editorial last week in which he claimed that the time has come to replace the U.S. dollar as the global reserve currency. The issue is important to Beijing since it holds over $750 billion in T-Bills alone. China, however, does not purchase U.S. debt out of choice, but out of a lack of choice, as Stratfor said so succinctly in one of its recent Geopolitical Diaries. China is a state with serious social stability issues that needs economic intervention by the government to maintain mass employment. I really do not want go dialectic on you, so I spare you the three step disproval about the decline of the dollar. You know where I stand, anyway. Nuts!
The two charts above show you that we are all in the same boat. The left chart shows the German business climate survey, conducted by the IFO Institute and to the right you see the U.S. ISM survey. The charts on both continents look atrocious. I could have picked other charts, but the economic picture remains the same. The Group of 20, or G-20, is meeting in London this Thursday. Its members - 19 countries with some of the world's biggest industrial and emerging economies, plus the European Union - represent about 90 percent of the world's gross national product, 80 percent of world trade (including trade within the European Union) and two-thirds of the global population. Needless to say, many of the 19 members blame the US for this synchronized global downturn.
Unfortunately, no consensus exists on how to escape from it. The US and UK agree that the excesses of the financial sectors have their roots not just in excessive deregulation, but also in the massive excess supply of goods from surplus countries, namely China, Germany and Japan (with 2007 current account surpluses of $372, $253 and $211 billion respectively). But China and the continental European countries, led by Germany, argue it is all the fault of profligate deficit countries. Angela Merkel said in a recent Financial Times interview: "The German economy is very reliant on exports, and this is not something you can change in two years." One can not even be sure that they want to change that. So what happens when the three main exporting countries of this world with a combined current account surplus of $835 billion are unwilling to promote private consumption in their own countries, because thriftiness is a source of considerable pride to them? The rest of the world, most of the deficit countries need to consume that much more than their incomes. The problem is that these countries can only spend on the excess supply by borrowing the difference. Furthermore, deficit countries have run out of willing and creditworthy private borrowers. How can the world overcome this conflict of interests?
This is exactly the crossroads, where history, philosophy, and even morals come into play. Deficit spending had led to sad extremes in the past so history forbids it, especially when you speak German. Pumping money into the economy smacks of the Weimar Republic and hyperinflation and thus the European Central bank, which is dominated by German bankers, fights inflation and nothing else. It is their philosophic raison d'etre. Surplus countries do not just come about. They are being built by high savings rates and the view of their citizenry that debt is decadent or immoral. There is your trifecta. I know my German compatriots, they are proud of their thrift and they hate deficits. Call them fiscally conservative. I would venture to guess that the same can be said about Japan and China. These surplus countries relied on the private sectors of deficit countries to do their irresponsible borrowing for them. Those times, however, are over and if they would like to sell their goods overseas, they need to find new markets, or lower their prices or ... produce less.
This is the crossroads of the global financial system. External imbalances between countries can no longer be ignored much less maintained. Yet Germany, Japan and China hope that the world will soon be able to absorb its excess supply again. At the same time however, they refuse to follow the example of the US and Britain by refusing to promote private consumption in their own domestic economies. Granted, it all takes time, but we already know that it is more a philosophical difference than time, that is standing in the way. They already are getting their exporting sectors ready to produce more stuff even more efficiently so that they can sell even more stuff to the world and gain more market share from this crisis. This is exactly not what this world needs. What we need is more balance, not more stuff. The world is drowning in overcapacity already, yet everybody hopes that it is going to kill the next guy, not their own factories. The charts above show you the state of the US economy. Quantitative easing has lowered 30-year conventional mortgage rates to the lowest level ever. The problem is that many potential buyers are either scared or do not qualify because of stricter lending standards. Thus bank lending has contracted anyway, as the second chart shows. The non-bank part of the financial system, the private and unregulated lenders, have closed shop, liquidated their holdings or otherwise disappeared. Paul McCulley called it the "Shadow Banking System". It provided more than half of private financing in the US. Europe has the same problem. The US government is trying to substitute this missing leg of the financial system by pumping money into the economy at a rapid pace. Inflationary concerns have been the result in many quarters. I do not believe that inflation poses a significant risk in the coming 12 to 18 months. Global overcapacity virtually guarantees that prices, inflation and GDP growth will stay low for the foreseeable future. I fear that too little liquidity injection poses a greater risk than to much. Barton Biggs called it the global ice age in 2001. The G 20 need to realize that we are all sitting in the same boat. The time for moralistic finger wagging is past.
Hermann Vohs
"A government that is big enough to give you all you want is big enough to take it all away."
Barry Goldwater
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
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