Spain, the Gold Standard, Eurobearishness, and the Impoverished Dwarf Army
For someone who gleefully dove in at the bottom of the bear markets in late ’08 and early ’09, you’d think I might be more optimistic about Europe right now. Unfortunately, I am not convinced. The more the crisis goes on, the greater my level of fear becomes. This is almost a complete reversal from the deep market plunges of late ’08 and early ’09, where I was buying in like a mad man.
Maybe my fears are completely irrational and I should see the “deep value” screaming out at me from back in the “Old World.” Then again, maybe there are all kinds of warning signs that should be flashing to all investors right now.
It’s been a long time since the Great Depression and an even longer time since the major panic events of the Gilded Age / Belle Epoque. Most people don't even have an awareness of the Long Depression any more.
The general public and even major policymakers have seemingly discounted knowledge from previous eras that suggests inflexible monetary policy can create major economic instability. So I want to explore the gold standard and the Eurozone under this prism. Moreover, I want to look at China’s dollar peg and how it affects the American consumer.
The Gold Standard
We’re seeing many people advocate a return to the gold standard. This would be very ill-advised, not to mention highly impractical. It would have a devastating effect on world economies.
The reason the gold standard can be so economically destructive is that it links a nation’s currency to a highly volatile commodity. Money supply then becomes completely dependent on the supply of this precious metal, thereby linking money inextricably to shifts in commodity markets. When a new low-cost gold resource is discovered and mined, this increases money supply, creates implied inflation, and stimulates economic growth (due to a weakening currency).
However, when gold becomes more scarce and the implied prices push upward, this creates extremely strong money, which then functions as an “investment” rather than a medium to exchange goods and services. Once “money” is no longer “money”, investment in the economy suffers dramatically (with the exception of gold mining, which becomes the only profitable enterprise), and the economy contracts dramatically. This situation is exacerbated in a world with rapidly increasing population and a dwindling supply of gold.
Price stability is theoretically one of the major reasons behind the gold standard, but in actuality, the underlying volatility of gold creates price swings that undermine stability, creating periods of both high inflation and severe deflation. This makes banking crises much more likely under a gold standard and might even create higher market interest rates (due to this volatility risk).
No wonder the gold standard was thrown out the window during the Great Depression. Not surprisingly, there was a strong correlation between economic recovery and going off the gold standard.
A return to the gold standard would not only be ill advised, but completely impractical. Moreover, it would be extremely economically inefficient. Think about all the labor, resources, and expenses needed to mine gold. Instead of being used to develop new technologies and create new products to improve people’s lives, we would have to waste billions per year to discover “money.”
I am now officially the least popular person in the entire Land of Foolery, but I am willing to live with this distinction if it brings us any closer to the truth.
You might wonder what the gold standard has to do with the Eurozone. The answer is that the Eurozone’s structure is not much more flexible than the gold standard. The Eurozone is a bizarre entity, because it deprives every nation within of monetary flexibility. This might not be an issue if the Eurozone were able to enact fiscal policy, but it cannot. So the Euro becomes somewhat similar to the gold peg. The two situations are far from 100% analogous, but they still have a lot in common.
From this perspective, the Eurozone crisis is not a fiscal crisis; so much as it is a monetary crisis. This is why austerity will likely not work; at least not on a grand scale. Yet, austerity has been the solution of Germany and France (i.e. the major powers behind the Eurozone).
This is not to suggest I am advocating reckless deficit spending. Rather, I’m suggesting that the Eurozone nations are caught in a Catch-22 right now. If they cut their budgets, they exacerbate their economic contraction, which lowers GDP, and increases their budget deficits, rather than eliminating them. On the other hand, if they continue to spend, their debt load continues to move upwards and their GDP might stay level or grow by a small amount.
In a way, the Greek crisis was not that big of a deal. Greece accounts for only a small percentage of world production, but the scary thing about the crisis is that it has showcased the Eurozone’s flawed design in dramatic fashion. Greece does not scare me; it’s Spain that scares me.
While many might point to Spain’s public debt, I’d be even more concerned about the level of private debt. It’s not that the Spanish government has been “fiscally irresponsible” as many assert. Rather, it’s that the private sector debt, coupled with inflexibility in monetary policy, has created a bad situation in Spain. As real estate prices continue to fall and Spanish consumers continue to de-leverage, deflationary pressures will continue to undermine the Spanish economy. These deflationary pressures reduce GDP, which then drive up the public debt, and create a greater likelihood of default.
I wouldn’t sleep on the situation either. There are too many skeletons in the closet in Spain right now. Over the weekend, the Bank of Spain has to bail out regional savings bank, Cajasur. Spanish banks could be sitting on more hidden losses, as well.
In essence, Spain may very well find itself in a deflationary spiral. It can’t escape its public debt without either increasing governmental revenues or decreasing governmental expenses. It can’t increase revenues without either spending more or lowering taxes in order to raise GDP. It can’t decrease expenses without lowering GDP, which then creates larger deficits.
Of course, it’s difficult to say how precisely this situation would play out in real-time. What does the ECB do? Are Germany and France forced to jump in again? I honestly don’t know the answer, and I’m not sure that many people do.
The Greece situation suggests, however, that the Eurozone needs dramatic reforms to remain viable in the long-term. Otherwise, it could fall victim to a deflationary trap that forces the break-up of the Eurozone. If several Eurozone nations are in default, there really seems to be no other option.
So, you might say I’m just a tad bit bearish on the Eurozone in spite of the declines of the past month. I am not convinced it is a viable entity at all and I am not convinced that Eurozone politicians completely understand the problem. Due to this, it’s completely unpredictable what will happen. Severe deflation? Hyperinflation? Both are possible. The former makes the latter more likely. Who wants to invest in that environment?
For those who follow me, you know that I’ve been bearish on China since the beginning of this year. I have never fully bought into the China growth story. When I heard about Jim Chanos’ major thesis on China contraction, I was even more convinced.
The other day, I came across Hugh Hendry’s analysis of China and it’s extremely thought provoking. Check out this article for more. I recommend Hendry’s newsletter, which you can download via a link in that article (I can’t link directly to the newsletter).
In Hendry’s analysis, he makes a few excellent arguments. First off, he acknowledges that China creates its Dollar peg in order to stimulate exports. The belief is that this will bring greater prosperity to China. However, Hendry disagrees with this and says it’s the exact opposite. By constantly weakening its currency, China is basically taking from its citizens in order to redistribute to its industries. The end result is not a wealthier China, but a poorer Chinese consumer.
Many people cite China’s extremely low consumer spending as evidence that Chinese culture promotes saving, but this simply isn’t true in any real sense. Rather, China’s Dollar peg simply takes away all power from Chinese consumers. Instead, Americans get lower cost goods, but it comes at a cost here, as well (America’s manufacturing).
Hendry is very bearish on China just like Chanos and I’m still in that same camp. This is not to say that one will not do well if they can find quality companies on the cheap right now --- but in general, I believe that China’s going to go through some extreme pain in the next few years.
Money supply growth is now starting to plummet (after skyrocketing upwards rapidly from 2008 – 2010) and there are signs of huge credit contraction. This will lead to recession. It’s unclear how China’s government will respond, but one way or another, they are being forced to choose between hyperinflation and economic contraction. Neither is appealing.
One has to wonder if Chinese policymakers will finally see the wisdom of letting their currency float, however, rather than try to play mercantalistic games.
That said, there are very attractive buys in China right now if you know where to look. I make no claim of "knowing where to look" in this case.
The Scariest Thing in the World
With all I’ve written about China and the Eurozone, it’s difficult to think that there’s something even more frightening out there, but there is. And maybe most of you know what I’m talking about.
It’s North Korea.
North Korea is a nation of impoverished dwarves. That’s not a joke. The average North Korean is almost half a foot smaller than his/her South Korean counterpart. This isn’t genetics, so much as it is diet. The poverty of North Korea strikes a dramatic contrast with the wealth of South Korea; one of Asia’s most successful economies. The Communist government in North functions more like Pharaohnic Egypt than a modern nation. Kim Jung-Il is hailed as a “God” and the masses starve.
In short, North Korea is a disaster in every way. And the regime is well-armed, insane, and becoming increasingly desperate.
I am very afraid that conflict between North and South Korea will occur within the next few years. It almost has to happen at some point. North Korea can not survive. I’d rather see it go out with a whimper and a peaceful re-unification into the South Korea state. But the powers inside North Korea aren’t willing to go down without taking down a lot of people. Or so it seems.
China will soon experience a recession. The Eurozone has major issues. But the situation in Korea is just outright scary. Let’s hope for the best, but I would definitely prepare for the worst.
Given the Eurozone situation, coupled with my own bearish outlook on China, I would say that the U.S. might be the best place to invest right now. I will surely attract the ire of gloom-and-doomers and those with a political ax to grind.
Things aren’t perfect here, but the U.S. handled the credit crisis relatively well. Certainly some mistakes were made, but nothing major. The biggest error in my view was the nature of the stimulus (should have been more infrastructure-focused *or* should have entirely been made up of one-time tax cuts). TARP could’ve been designed better, but it wasn’t the disaster that many were predicting it to be. The Federal Reserve made a lot of missteps leading up to the crisis, but has mostly made reasonable decisions since late ’08.
Given this, the U.S. could see its economy grow over the next few years. Moreover, the China crash might actually help the U.S., by lowering prices for oil and commodities. That said, it’s also possible that the Eurozone situation adversely affects America. We’ll have to wait and see.
I’d keep an eye on both Europe and China, but for the moment, I’d content with U.S. investing.
The U.S. is Not Greece
The Pragmatic Capitalist wrote an excellent article on how the US is not Greece recently. This does not mean we are out of the woods; merely that our issues are of a different nature.
The scariest thing to me about the US fiscal burden isn’t so much the burden itself, so much as it is the political establishment’s indifference to it. When they do address it, it’s normally in an unhealthy way, or a misleading way (to paint themselves as a “deficit hawk” when in actuality, they are just as bad as everyone else --- see John McCain).
In actuality, however, we could get our deficit under control fairly easily if there were simply political will to accomplish it. Here are the steps I would take to improve the US’s fiscal situation:
(1) Cut military spending 5% for the next 5 years. We spend way too much on the military and American Presidents simply abuse its power.
(2) Phase out Social Security. It’s the most economically inefficient program devised by Washington. The private sector can handle it much more efficiently. Moreover, social security taxes are a huge drag on our economy. Of course, income taxes would probably have to be raised in the short-term to phase out social security, but it would be well worth it in the long-run and any tax increases could be made to sunset at some later date.
(3) End the Drug War, de-criminalize, tax, and regulate marijuana. From the statistics I’ve seen, we actually spend enough money on the Drug War so that eliminating it would probably cut a huge chunk of the budget deficit. Moreover, it would create a new revenue source, and increase GDP.
(4) Simplify the Tax Code. We waste billions per year in American wealth trying to comply with this nightmare of a system. Eliminate all deductions and just create flat rates. It’s fairer and simpler. Why should people who decide to have 8 children get tax advantages over people who have 2 children or chose to have no children anyway? Lower tax compliance costs mean greater GDP and more wealth can be pushed into innovative pursuits.
(5) Repeal Section 404 of Sarbanes-Oxley. This is another drag on our economy. Section 404 requires public companies to hire an external auditor to examine internal controls. It’s not that this information isn’t useful to investors; it’s that the costs of providing this information are overwhelming to small companies. One of the rules of auditing is that it should provide information only if it’s cost-effective and Section 404 is not. By eliminating it, smaller companies would have greater access to capital, which would allow them to grow and innovate. This increases American GDP in the long-run.
(6) Lower Taxes. This would be higher on my list, except we have too huge deficits right now for it to be practical. But if we were able to get the deficit under control, I would lower taxes. Lower taxes will help increase GDP. Higher GDP means higher governmental revenues. Moreover, our debt-to-GDP ratio falls.
No one in Washington is listening to me, but I do believe that with these six steps, our fiscal condition could be improved. As I’ve said, the problem isn’t that it wouldn’t work – it’s that there’s a lack of political will.
That’s all for now. Now, go ahead and berate me. ;)