Guest blogger – Roger Nighingale
Saint Augustine—and, in things like credit availability, much more dangerous!
Economics activity progresses cyclically: relative to a fairly stable underlying trend, GDP tends to advance and retreat according to a regularly recurring chronology. Central Banks acknowledge the cycle, and try to dampen it. They know that inflation is likely to rise in the second half of an upswing, and unemployment in the comparable part of a downturn.
To avoid both Scylla and Charybdis, Central Banks have to steer a middle course. Monetary policy has to be counter-cyclical. Credit must be curbed when activity is high and quickening; enhanced when it’s low and slowing.
But, sometimes, arguably far too often, the authorities get things back to front. They tighten when it’s appropriate to be loosening; and loosen when it’s appropriate to be tightening. Instead of dampening the cycle, they exacerbate it. Instead of reducing the risks of unemployment or inflation, they increase them.
How come? It’s partly because they mis-analyse the cycle, but mainly because they’re thrown off course by unforeseen “events.” In the recent past, for instance, there was a hiccup (a banking crisis) in the second half of 2008. Had it not happened at that time, the authorities would probably have started to tighten credit in advance of the anticipated cyclical recovery.
Instead, they persuaded themselves to stay in a loosening mode. They judged it more important to stabilise the banks than the cycle. They argued that equilibrium in the latter was impossible unless it occurred also in the former.
But they had underestimated the extent of the problem. Though the transfer of resources from non-banks to banks had been mind-bogglingly huge, it failed to restore equilibrium. Indeed, it made things worse: banks weren’t saved, but many non-banks were destroyed.
In the years following the crisis, the extent of the authorities’ miscalculation gradually became apparent. Overall liquidity had been persistently excessive, but the condition of banks’ balance sheets deteriorated. Their lending to the wealth-creating parts of the economy was hopelessly inadequate; but their payment of bonuses to themselves, unconscionable.
The non-bank economy, meanwhile, was unbalanced. In sectors in which activity was progressing moderately satisfactorily, there was a risk of inflation. In those in which inflation was satisfactory, there was a risk of recession.
It began to dawn on a fretful world that the course being steered by the Central Bankers would not avoid both monsters; it might instead encounter both. Unemployment might rise concurrently with inflation. It had happened already in parts of the EZ; it might become commonplace in 2011.
And politics was beginning to be unhelpful. Elected legislators didn’t usually say much about credit policy, but these were unusual times. In the US, for instance, the Republican Party was doing very strange things. Sarah Palin got all the publicity, but Ron Paul wielded the bigger stick. He wanted the fiscal deficit slashed and credit curtailed. If he got his way, the policy might be implemented just as the economy hit the skids at the end of 2011!
Chancellor Merkel likewise. She’d now realised that the single currency was doomed. Monetary union required political union. It’d work in Europe only if Germany were prepared to pick up the tab for the debts for all the other countries. It wasn’t.
Ms Merkel was the paymaster. And her man at the Bundesbank, Axel Weber, was about to become the effective boss of the ECB. He’d say money must be tightened. It probably would be, and might coincide with a similar trend in the States. If so, and if China acted similarly (to contain inflation), the world could find credit scarce and expensive in the latter part of next year—at precisely the time that the cyclical downswing was getting under way.
That’s what happened in the States in the early thirties. It’s what happened also in Japan in the early nineties. Could it happen on a global basis next year? If it did, economies would suffer severely, and asset valuations significantly.
Which would suffer most? A lot would depend on how protectionist the world had become by then, but, as a general rule, it’d be sensible to lower the weightings attach-ed to the high betas (economies as well as stock markets). Investment skill would lie in avoiding losses rather than making gains.
To read more of Roger’s insights click here.