Tuesday, March 15, 2011

Another cup of cappuccino?

What is it with human beings? Of all the creatures on the planet we seem to have the greatest propensity to repeat mistakes. Yet, we have the greatest ability to record, review and analyse history to avoid them. Doing the same thing over and over again and expecting a different outcome is the classic definition of insanity.

Knowing that alone should make us more sceptical of the solutions we often implement in the belief that they are novel answers to a seemingly new problem. That’s one of the advantages of having us “oldies” around. We have often lived through the “same old, same old” and know that there really is nothing new in this world except history not uncovered or simply misunderstood.

This week, as I reflected over my weekly cappuccino at the Rolandale roadside restaurant next to the N2 to George, I thought of one of the first articles I wrote for this column and whether the financial froth that was evident at that time had been reduced. Derivatives expert and author Satjayit Das had estimated that only about 30% of world liquidity had tangible value based on the production and supply of goods and services. The remaining 70%, he calculated, was based on speculation in the form of financial instruments such as derivatives. The implication was that you could not solve this problem by simply using tax-payers money to save those financial institutions with too much froth in their coffee. You cannot change a cappuccino into an espresso.

Immediately after the 2007 financial meltdown, prospects of a recovery were dismal and many believed that with the fallout on the real economy there would be a repeat of the great depression, widespread unemployment and deprivation. We arguably have not had that. Indeed while some are still holding on to the belief of a “double dip” down the line, there is a far greater level of comfort that the worst is over and that the world economy is on a path of recovery, albeit slow and fragile. Stock markets have largely recovered and this has always been a classic barometer of future prospects.

We could argue that if the price we had to pay for decades of excess up to 2007 was a few year’s brake on growth with some elevated levels of unemployment, a large increase in public and external debt in the developed countries, and some concerns about recurring inflation as Felicity Duncan reported this week, then we have done pretty well.

Or have we? Have the original band-aids, which became bandages and then plaster casts, not covered a festering wound that is becoming gangrenous? Take the confusing picture that has been emerging from the United States, where the economic woes were both set up and triggered in the first place.

As with most of the developed world, its response to the crunch was to use government money to rescue teetering financial institutions, both in the form of loans and buying equity. It slackened monetary policy and reduced interest rates to near zero. Added to this, it pushed more money into the economy through “quantitative easing”, or buying back its own securities to convert them into cash. Up to October last year, this had released $2trn into the economy. The intended effect was to reduce the value of the dollar and make American exports more competitive, encourage Americans to spend and to boost confidence on Wall Street which in turn would encourage investment, employment and economic growth.

clip_image002Federal Reserve Chairman, Ben Bernanke certainly has his critics who believe the whole package is fraught with danger, not least of which is runaway inflation or even a severe bout of stagflation. Will Bernanke repeat his predecessor Alan Greenspan’s mistake of misjudging the human response thereby unleashing unintended consequences? It’s perhaps early days, but so far there’s been little impact on American unemployment or housing. This makes sense. With the average American citizen carrying a personal debt of $52000 and facing a still uncertain future, they would rather reduce debt than spend money.

More frightening, if not amazing, is a recent report by Mike Whitney who writes that the Fed’s programme has sparked “an orgy of speculation” with the hedge funds again at the forefront. Borrowing very cheap money they invest on Wall Street on the anticipation that the rally will continue and in high risk paper that caused the problem in the first place. But there’s not much from companies to indicate that the stock market recovery is based on anything else but pure speculation. Companies have about $2trn that “they refuse to invest because they don’t see growing demand for their products”, says Whitney. This represents about 11% of the assets of non financial companies and a sixty year high in savings. Asset manager Robert Doll points out that high cash levels generate dividend increases, share buybacks and mergers and acquisitions, which are all shareholder friendly but do not affect the real economy or create jobs.

The only way out for Americans unable to face real austerity, is the unthinkable to many: a substantial increase in the Federal deficit, tax cuts and bigger government spending on job creating ventures. As unpalatable as this may appear (and probably is) it is certainly a better option than merely serving another cup of frothy cappuccino.

America’s woes underscore the contrast with the emerging economies. While the latter have obviously felt the effects of the general slump, they have been largely unaffected by the “froth” that overwhelmed the developed economies. Also there is more room to manoeuvre in government spending on infra-structure and employment creating ventures.

Perhaps the high level of unemployment in a country like South Africa is a blessing in disguise. It has to focus all its efforts and marshal real support from the private sector in tackling the problem. The improvement in business confidence reported by RMB in the past week or so is therefore probably more tangible and sustainable.

Of course, there is much work to be done in terms of making the country employment friendly, reversing the shrinking tax base against an expanding social dependence and ensuring efficient allocation of state expenditure. But these are practical issues thwarted only by stubborn ideologists and politicians.

The American story shows again the folly of making major decisions based on personal assumptions of how human beings will respond. It should tell us all that you cannot create lasting prosperity or base a recovery on monetary manipulations and speculation.

The hair of the dog is never an answer to a hangover – only a postponement of the inevitable.

10 comments:

  1. Whitney's orgy of speculation endorses Richard Bach's contentions i.r.o what he labels the breakfast flock mentality, and he suggests an easy alternative to those who seek true riches way beyond imaginings and can still power dive regularly for an adrenalin boost.
    The fund managers continue to receive their grossly inflated bomuses by virtue of a single factor,... fear. Fear of the ultimate financial meltdown lurking just around the corner, hence the puppet masters simply cannot let go of the reins.
    A vicious circle that will engulf us yet, unless natural attrition is allowed free rein.
    As much as a plant will struggle on in barren soil with scant nutrition, so man can endure and manage if he lets go of the absurdities he pursues.
    I'm sure this strikes home to you Jerry, as you sit sipping that cappuccino refill in paradise.
    For the rest,... just read JLS, by Richard Bach, and get a life beyond the fund managers.

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