Friday, October 31, 2014

Beyond market jitters.

Are we still vulnerable to a global economic collapse?

My father was born a few years before the 1st world war; survived the global flu pandemic before his 10th birthday; lived through the great depression and fought in World War II. It was the depression that drove him and many of his peers to seek their fortunes elsewhere than Europe. They were of an age group poised to find meaning in life, carve their own paths and seek opportunities in a world that had little to offer after the collapse of the New York Stock exchange in late October 1929, and precipitating the longest, deepest and most extensive global depression in history.

As one interested in both history and economics, I would often encourage my father to share his thoughts and experiences of that time. They may have lacked some academic and scientific insights, but they gave me a much deeper understanding of human conduct so often ignored in our economic discourse but that was so profound in those events. It was during one of those exchanges that in my zeal to demonstrate my intellectual prowess, I explained to him that the depression was caused not by panic, but by a crude banking system unable to back the volumes of transactions and a fiscal policy that should have allowed greater deficit spending to counter an inevitable cooling off of the economy.

“Rubbish!” he said. “Everyone in an instant said: ‘Oh shit!’”.

That was it. A miner’s logic that brooked no further discussion; a belief in a single consciousness of man that in that case could trigger a collective response in unison with two words reflecting panic and dismay. Of course, there was some truth to that. Although there had been “market corrections” for some days from September 4th 1929, no one could predict the 40% fall over a few “black” days in late October. Just as surprising were four runs on banks within a year. Consumer confidence evaporated; spending fell leading to a sharp fall in business activity, bankruptcies, job losses and a fall in wages, all of which accelerated the vortex of a perfect storm.

I may not share my father’s assessment of economic booms and busts, but since that conversation, those two words come to mind each time we are confronted with market volatility. Can we really be confident that with all of the modern financial engineering tools at our disposal we can avoid a repeat of that cataclysmic event? Was the 2008 “great recession” not simply a warning light that faded behind the subsequent financial and stock market hype that in turn belied a much deeper malaise and an ailing real economy? Are the old economic postulates governing the relationship between consumption, production, money, debt and investment no longer relevant? Is everything so rationally secure that we cannot expect spontaneous irrational behaviour?

In short, with adjustment especially in the financial markets inevitable, the question is simply whether it will be a correction or a crash, a creep or a leap.

One thing is certain: the structure of the global economy is vastly different today and while this era has produced new disciplines of knowledge and experts, not one seems to have captured an absolute truth. Evidence of this can be found in contradictions in reputable responses: from pushing more money into the system to increasing interest rates; and from government austerity to increasing deficits and perhaps even writing off sovereign debts. Despite having armed ourselves with incredible technology to rationalise; to gather and process information and perform nano-second trades or responses across the globe, the whole system is underpinned more than ever by two profoundly irrational forces – greed and fear.

The side effects of a new Prozac for economic depression are still mostly unknown. The Atlas juggler has three spinning clubs in the air: a financial system; government intervention and the real, productive economy. Each has its own high level of complexity and intricacy, with the interaction between them being even more uncharted and complex. Even a highly condensed treatment of all the factors involved is way beyond the scope of an article such as this. Unfortunately the devil is in the detail so at best I can present an over-simplified analysis of some key issues and focus on the global perspective which impacts on South Africa.

The financial system is awash with debt – approaching $200 trillion or some 300% of total global GDP. This has been the result of a post-depression banking system that can multiply credit and advance it to the productive economy – in other words increase the money supply. Cheap credit should encourage both consumption and production and therefore economic growth, which in turn enables a repayment of debt.

But this has not happened. Consumers are insecure, debt weary (see Moneyweb article here), and generally income besieged; business is reluctant to invest in productive expansion and declining interest rates encourage widespread incestuous speculation in financial instruments including stock markets and derivatives which at an estimated $700 trillion is 10 times larger than global GDP.

Any talk, therefore, of increasing interest rates sends these “markets” into a tail spin, spilling over into stock markets and the real economy by further dampening consumer enthusiasm. Paradoxically interest rates are the primary weapon against price inflation.

Governments are the biggest “debtors” (about half of the total) and encourage low interest rates not only because of the impact on their own budgets but on the same theory that cheap money promotes economic growth. In addition, increasing government deficit spending should translate into higher economic growth and more jobs. So with few exceptions they continue to run deficits constantly shifting norms of prudence. But for the most part in the developed world this spending has gone into propping up financial institutions, and not on job creating government projects such as building infra-structure.

Yet, the most important constituent of all, the real productive economy remains as capricious, perhaps even as unfathomable as ever. It is here where we capture the very essence of our economic co-existence, adding value to each other in the provision of goods and services; where we explore and innovate, transact and exchange; where we freely express our moods, fears, hopes, aspirations and expectations.

In our desire to control the uncontrollable we have created a massive imbalance between the juggler’s three clubs. By their very nature the financial and government constituents are largely parasitic, adding very little value or creating little tangible wealth in their own right and feeding off the host of the real economy. But they are needed in creating the conditions in which others: entrepreneurs; the creators and builders of business, value based investors and workers can get on with the value-adding process and create prosperity and abundance. The current malaise is simply repeating history’s lesson that the force of the real productive economy is powerful, inexorable and with a mind of its own that sometimes simply wants to blow off steam.

Restoring equilibrium could take years, maybe decades. Yet, a collapse of the size of 1930 is unlikely. That was particularly severe because the pendulum swung from inordinate euphoria to widespread doom and in an economic car with no brakes. In addition, while we may still lack the expertise in appropriately using all the levers, switches and buttons of the fiscal and monetary machines, we are getting to understand them better.

Can we abseil down the cliff or will we run out of rope? Hopefully the bottom is not too far, but what is self-evident is that greed and fear are totally inappropriate in such a pursuit. We need patience, prudence and fortitude – attributes that sustained my father’s generation in an age of deprivation.

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