Is This the Beginning of the Next Crisis?
Recent market developments have attracted substantial attention from those who are anticipating another financial crisis ahead. Credit spreads are widening as liquidity conditions tighten. Equity markets around the globe have corrected meaningfully and the technical picture looks increasingly dangerous. Is this the beginning of the next crisis?
No, it is the next round of the same crisis that began in 2007, when numerous mortgage-backed securities suddenly became illiquid as did numerous funds investing in them. That set off a chain of events which culminated in the failure of Lehman Brothers and subsequent run on money-market accounts. Policymakers, in particular the US Treasury and the Fed, struggled to keep up with the pace of events. It was only when Fannie and Freddie were nationalised and the Treasury extended a guarantee to all US money-market funds that things began to stabilise. Credit markets began to thaw and by March 2009 the equity market took notice and began one of the greatest rallies in history.
But we would argue that, notwithstanding the re-opening of credit markets and strong recovery in equity markets, the crisis never ended. Rather, it changed form. When public authorities stepped in to prevent a further deleveraging of the financial system, they explicitly or implicitly assumed responsibility for much of the debt that was collapsing in value. In doing so, they issued more of their own and also raised expectations for future issuance. Thus, government deficits in many cases are now in the double-digits as percentages of GDP and are adding to debt levels which in some cases are already in the triple digits as percentages of GDP.
It is obvious that this is unsustainable. No realistic real growth assumption would allow this debt to be paid back at its present value. Some estimates suggest that, even if governments were to raise marginal tax rates to record high levels, this would merely stabilise rather than reduce the national debt. In practice, such policies would probably discourage investment and depress economic growth longer-term such that they would only exacerbate the underlying problem of unserviceable debt burdens. They might also lead to a political backlash. No, it is not realistic for most governments to tax their way out. Their debts are going to be devalued either by inflation or some form of default. The exact mix of the two will vary from country to country but the end results are going to be similar.
Some might argue that, with the exception of Greece and a handful of other countries with triple-digit debt burdens, that a general global sovereign debt crisis, if unavoidable, is at least many years away. Well, it is nice to think so. We all like to sleep at night. But get real folks: Are policymakers taking the sort of actions which build confidence in the ability to service debt? In the US, the government is extending its reach not only into the health care and automotive industries but into many areas, implying a degree of centralised economic micro-management never before seen. What does this imply for economic efficiency and potential growth going forward? In the euro-area, there is serious talk of explicit cross-border debt guarantees and of creating a fiscal union to centralise deficit financing, both of which would discourage serious attempts at national debt consolidation. In Japan, the government continues to spend, spend, spend, alongside an aging population and shrinking private capital stock, implying both a rising debt burden and a declining ability to service it in future.
Far from building investors' confidence in their ability to pay down their national debts, policymakers in general are doing quite the opposite. And the problem is that, if confidence erodes sufficiently, the long run becomes the short run very quickly: Investors demand a higher risk premium, which increases borrowing costs, which saps economic strength, which depresses tax revenues, which leads investors to demand a higher risk premium, which increases borrowing costs... You get the picture.
If they find themselves caught in a vicious circle of rising risk premiums and refinancing costs, governments may suddenly face an overwhelming temptation to print money and permanently monetise some portion of the debt. This can be done in principle if the debt is denominated in the domestic currency. As a result of its membership in EMU, Greece doesn't have this option. The UK, by contrast, has seen its debt burden decline substantially. Sterling devalued by nearly 30% in trade-weighted terms in 2008. Unfortunately, the UK has subsequently been running a deficit of around 15% pa, so in another year or so the real debt burden will be right back where it was prior to the devaluation.
The bottom line is that the temptation to devalue and inflate is large and it is growing in the UK, the US, the euro-area, Japan and anywhere the real debt burden has grown to unsustainable levels. Even the Swiss are resisting currency strength through central bank intervention notwithstanding a far lower domestic debt burden. In this environment, should we be confident that any major currency or government bond market is a reliable store of value? Some might be better than others, to be sure, but are we confident that we can pick the right one, at the right time, during a period of general currency debasement which might last for years, or which might suddenly morph into outright default? And even if we are, does that fully protect us from the real and growing risk that ALL major currencies decline in value versus real assets generally? It happened in the 1920s-30s following the unsustainable run-up of debts to pay for WWI and subsequent rebuilding and it is going to happen again, following the unsustainable run-up of debts to pay for bloated, inefficient, unsustainable and, in the US, rapidly growing, welfare states.
Investors who share this concern, that the long run could become the short run surprisingly quickly and thus no longer regard major currencies as reliable stores of value, need to find an alternative.
REAR-VIEW MIRROR MYOPIA
Historically, gold has been the pre-eminent alternative store of value. Given the ongoing rise in the gold price amidst high economic uncertainty, this appears to remain the case today. But there are those who believe that the price of gold has risen so far that it is now a “bubble”. They point out that gold has recently featured on the front pages of many major financial publications and is now a regularly discussed topic on financial news channels. By this facile logic, most financial assets must also be overvalued. A more sophisticated argument is that the gold price looks high in a historical comparison with financial asset prices generally. For example, the gold/S&P ratio, at around 1:1, is well above where it has been during the past 20 years. This problem with this argument, however, is that, prior to those past 20 years, the ratio was well above 1:1, in particular during times of financial crisis, such as in the 1970s / early 1980s and, not surprisingly, in the 1930s and 1940s. Given that the risks of a general global sovereign debt and fiat currency crisis are without doubt the highest they have been for many decades, to focus only on the past 20 years is to demonstrate severe rear-view mirror myopia.
There is also growing talk of increased financial “speculation” in commodities. Does this imply that commodities generally could now be overvalued? Well, we would ask, overvalued relative to what? To the fiat currencies and government bonds that are at increasingly at risk of devaluation and/or default? You can't have it both ways. Imagine that, as these commodity “bubble” bears maintain, that commodity prices crash by 50% as a result of another general deleveraging of the financial system along the lines of H2 2008. Are we to believe that, if we enter another such episode, policymakers are just going to sit on their hands and do nothing? Or it is more likely that they jump right back into the fray, throwing yet more debt at the problem? But won't that just bring forward the day of default and/or devaluation? Or are the too big to fail banks actually not too big to fail? Was fundamental financial reform implemented when we weren't paying attention? Were banks suddenly recapitalised?
No, we didn't think so. To believe that fiat currencies are going to re-establish themselves as reliable stores of value requires investors to have confidence that governments are sorting out the fundamental weaknesses with their financial systems and economies. Most important is to encourage savings over consumption as this will encourage investment, thereby creating more economic resources to devote to future debt service. Examples of such action might include:
- Government spending cuts, in particular on economically unproductive programmes such as entitlements (which are just wealth transfers and, as such, discourage saving) and defence
- Tax code simplification and broadening of the tax base (eg fewer loopholes)
- A move away from indirect to direct taxation (ie from savings to consumption taxes)
- A move away from corporate to individual taxation (ie from investment to consumption taxes)
- Labour market deregulation (to encourage workforce participation and broaden the tax base)
This list could be much longer and more specific depending on the country in question. However, at first glance, notice that, at present, in nearly all major economies, not only are governments not seriously considering the sorts of policies listed above, in some cases they are doing almost the exact opposite! And instead of trying to fundamentally reform their financial systems in ways which will reduce the risks of financial crises in future, they are instead laying a vast accounting and regulatory smokescreen to ensure that assets of questionable value need not be marked to anything other than make-believe and instead can be gradually monetised over a period of years as banks earn 4% yields on government bonds with near 0% central bank funding. This is a great deal for the banks, to be sure. But there is no “free-lunch”. Somebody has to pay. In this case, it is the holders of the devaluing currency in question. No wonder that some of these folks are seeking to reduce their exposure to the currency in favour of alternatives. Based on the continuing rise in the gold price, it may well be the preferred choice.
IS GOLD ALL THAT GLITTERS?
While gold may indeed be the preferred alternative in the present circumstances, it presents two potential drawbacks as an investment. First, and most straightforward, gold is only one asset. Basic investment principles dictate that we never put all of our investment eggs in one basket but rather seek ways to take advantage of diversification, the only “free-lunch” in economics. Second, the fact that gold is an obvious potential alternative store of value implies that at certain times it could become overvalued relative to other, less obvious alternatives.
Take silver for example. Historically a monetary substitute for gold, it is considered by many to this day to compete with gold as a potential alternative store of value. When the price of gold began to surge in 2006, the price of silver followed right along. However, when the financial crisis hit in 2008, the price of silver collapsed along with most commodities, leaving gold looking historically expensive in relative terms. The ratio has subsequently corrected back toward the long-term average even as the gold price has continued to rise, providing a good example of how other alternative stores of value can be attractive at times.
Much the same pattern has been observed with platinum which has emerged in recent years as an important precious metal, increasingly popular in jewellery. Platinum was closely following the uptrend in the gold price from 2006 into 2008, rising to over $2,000/oz at one point, but then collapsed in value to only $800/oz, leaving gold looking historically expensive in relative terms. It has subsequently risen back to $1,600/oz, more in line with the long-term average ratio to the gold price.
Of the major industrial metals, copper is the one that historically was most commonly used as money, although for relatively small, everyday transactions. During the 2008 crisis, the price of copper and of industrial metals generally collapsed. Notwithstanding a strong recovery in 2009, industrial metals prices in general remain below the levels seen prior to the crisis. Relative to gold, the current copper price of around $300/lb looks low in a historical comparison, although hardly extreme.
By far the largest globally traded commodity by value is crude oil. As the world's single most important source of energy, crude oil serves as the global benchmark for energy prices generally. As is the case with copper and industrial metals generally, the price of crude oil has also failed to keep up with the price of gold in the past few years. In any case, both copper and oil are hugely volatile in price, with a strong correlation to business cycles, calling into question their suitability as stores of value.
Agricultural and other “soft” commodities also trade widely and represent the basic input costs for food and clothing, which still comprise a substantial portion of the household budget in much of the developing world. Notwithstanding rapid population growth, however, food prices have not risen by much in recent years and in some cases have declined. The US price index for crude foodstuffs has risen by around 50% since the early 2000s, trailing far behind the 300% rise in the gold price over the same period. This suggests that, perhaps, gold is gradually becoming expensive relative to a wide range of basic consumer goods.
Relative to commodities generally gold has risen quite substantially in price in recent years. This can be seen by comparing the price of gold to the broad CRB commodities index. Back in the 1970s, the ratio of the gold price to the CRB index was generally below one until the dollar started to weaken dramatically in the late 1970s. In 1980, when the price of gold soared to $850/tr. oz. amidst fears of a dollar crisis, the ratio briefly reached 2.5. Currently it stands at nearly 5, twice as high.
As the pre-eminent historical alternative store of value it seems to us completely reasonable that the price of gold has been rising steadily amidst a growing risk of a general sovereign debt and fiat currency crisis. But as we have seen, the outperformance of gold relative to many other commodities has gone a fair distance. Regardless of how exactly the sovereign debt crisis is eventually resolved, how much debt is defaulted on and how much fiat currencies in general are going to devalue, those investing in gold today are going to need to purchase food, clothing and shelter tomorrow. No matter how far the gold price rises in the meantime, it is unrealistic to expect a permanent disconnect between the price of gold and of all those goods out there that we know are going to be consumed someday. The gap is almost certain to begin to close again at some point, although that might be some time yet.
While we like to think that we are clever enough to know when and under what circumstances to take profits in gold and move into other alternative stores of value, it makes basic financial sense to take advantage of the diversification that a broader basket of commodities can provide as a matter of course. But given that the growth outlook is deteriorating as various forms of fiscal and monetary stimulus run their course and also as inflation in various countries leads to rising interest rates, defensive, relatively non-cyclical commodities are likely to fare better than cyclical, industrial ones over the coming year. Indeed, given the huge imbalances in the global economy, the massive debt overhang and the overwhelming evidence that policymakers remain on the wrong track, it may be several years before a strong, sustainable, global economic recovery becomes possible. Those seeking an effective store of value for such an environment should not only reduce their exposure to fiat currencies generally and consider holding some gold; they should diversify across a range of relatively non-cyclical, defensive commodities. The Amphora Liquid Value Index, a diversified basket of primarily defensive commodities, is designed to provide a benchmark for alternative stores of value.
Source: Bloomberg LP
The Tax Foundation, a US think-tank, claims that a top marginal federal income tax rate of 85% would be required to hold the deficit down to 3% of GDP in the coming years. Figuring in state and local taxes, this implies top marginal tax rates approaching 100% for certain individuals. For the complete analysis, please see http://www.taxfoundation.org/publications/show/25984
Unlike the sterling ERM crisis of 1992, this was by no means an “official” devaluation, in that sterling is not officially pegged to any currency. But had the UK wanted to defend sterling, they would have needed to raise interest rates sharply. Given that several major UK banks were on the brink of failure at the time, higher interest rates would almost certainly have resulted in massive private sector debt defaults and probable general failure of the financial system. As such, the UK provides a good example of a government preferring a sharply devalued currency to general debt default.
All major participants in WWI, the victors and the vanquished, devalued their currencies versus gold by a substantial amount in the 1920s with the exception of the US, which did so in 1934. Previously fixed at $20.67/tr. oz., the government reset the dollar peg to $35, where it would remain until the US abandoned the gold standard in 1971.
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John Butler Archive
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