Sunday, October 14, 2012

We're Doomed!

During the last three weeks I have been traveling on business and at the same time finished a fantastic book called "The Lords of Finance" by a hedge fund manager, Liaquat Ahamed.  This is a book about the four heads of the main central banks at the time of the great 1929 crash but really is about the economic consequences of World War I and how these worthies, each trying their best, made a right royal hash of things triggering a global depression that only rampant nationalism and global conflict even worse than first time around brought to an end.

Taking a look at today and adding everything up, I can't see much difference. There's no escaping the fact that the world is in economic turmoil of such momentous size that it is difficult to see a way out.  Or as Private Fraser of Dad's Army would say: "We're doomed".

Private Fraser of Dad's Army
Back to the book, this is the situation.  WWI was largely funded by the British Empire and then when they/we ran out of money by the US.  At the end of the conflict France owed Britain $11 billion and Italy $6 billion (round numbers).  Britain owed the US around $8 billion.  Converting those 1918 numbers to 2012 numbers: France owed Britain $3-4 trillion, Italy owed Britain $2 trillion and Britain owed the US $4-5 trillion.  France and Italy also owed the US money directly.

Because the Germans had demanded the French pay for losing the 1870-71 war so catastrophically to them, they took Alsace and Lorraine as well, the French demanded and the 1919 Treaty of Versailles so disastrously embodied reparations from Germany in the amount of $31 billion which in 2012 terms was ... wait for it ... $12 trillion.

Germany unsurprisingly said from the get go that they couldn't pay.  France said they didn't care and promptly marched into the Rhineland and took over Germany's entire industrial capacity ensuring that Germany now couldn't earn enough to even cover the interest on this debt ... Oh yes, there was interest as well!  Britain told the US that if the French and Italians couldn't pay them then we couldn't pay the US and asked whether the US would agree to offset the French/Italian debt portion so therefore the US could simply go after them.  Realising that only Britain had never reneged on any debt, the US said no.

Factor in the straight jacket that was the gold standard to which Britain wanted to cling at pre-WWI levels making Sterling massively over valued and consequently Britain's exports massively expensive and Britain wasn't able to make ends meet.

German hyperinflation ensued wiping out the middle class's savings and any debtor setting the scene for the Nazis.

The French managed to devalue their currency in 1920 sparking an economic boom which resulted in a massive influx of gold so that by 1930 the vast bulk of the world's gold was in only the US and France.  Add to this the fact that the French resolutely refused to budge on any concession to Germany and you now had political impasse as well as financial mess.

Ultimately the US agreed to take a haircut on their debt from Britain (80% -- they were the first to agree), France (40% in 1926) and Italy (26% just after France) and then promptly turned their backs on Europe and the interminable squabbling.  Germany ultimately settled for 20% too, but that was years later.

Anyway, read the book.  It's better than my brief synopsis.  However there are parallels between then and now: massive government debt, economic fragility, banking sector crisis.  What happened then could happen now.

Debt forgiveness has already started with the Greeks forcing a big haircut on their debt.  The reality is that Greece today like Germany post-WWI cannot repay their debt.  Nor for that matter can Spain, Portugal, Ireland, Italy and many others.  Eurozone actions currently are simple band aid measures kicking the can down the road for someone else to fix later on.

Inflation is happening now, its just not being fully described in official statistics.  Official statistics in the US and many other nations quote CPI two ways -- core and headline. CPI means the Consumer Price Index and is calculated by taking a basket of items in current use and comparing price levels at different time periods.  'Core' excludes food and energy -- two of the main items that the consumer actually uses the most (remember the consumer accounts for 70% of GDP).  This is the number that governments use for their 'official' inflation index.  In the UK there is an older measure called the Retail Price Index (RPI) that is an even broader basket of items that in actuality better reflects what the consumer spends than either of the CPI measures.  Currently RPI is 5.5%, headline CPI is around 2% and core CPI is lower still.  Pick a number.

Now I don't feel that inflation is non-existent.  Last year my power bill was $300 per month.  This year it is $400.  I use no more and the price of oil has been pretty much flat year on year.  Yet that rise is excluded from official statistics.  The fact that I can buy an iPod for less than last year DOES reflect in the CPI numbers.  What do 'they' say about statistics, statistics and damn lies?

I worked in Brazil and Argentina in the last 1980's during their hyperinflation periods.  The first time I was in Argentina it was for a week.  When I arrived the exchange rate was 600 pesos to $1.  When I left a week later it was 1200 to $1.  In Brazil, the company I worked for had an accounting difference in local currency terms that was considered 'material' by the auditors.  At the end of the week, it became a rounding error.  The result there was the extinction of the middle classes and the destruction of their savings.  In both countries a tragedy that has taken years to fix.

The third thing is currency depreciation.

Consider the level of US government debt and the fact that wealth is being sucked out of the West (OECD nations) towards the East and you realize that at some point there must be a drastic change in the level of currencies.  20 years ago there were virtually no Emerging Markets (EM) nations whose government debt was considered to be Investment Grade.  Today more than 65% of EM nations are investment grade.  In fact overall EM aren't doing that badly at all right now.

Going back to the comparisons of then and now, there was one thing that really helped when all the dust settled and all of the nasty stuff had been scraped off the global fans and that was population growth.  After WWII, there was a huge surge in births in the West, the age of the Baby Boomer like myself.  Our parents had come through the rigors of war and wanted to get on with life and a better life than before.  Innovation helped of course and with it the drive for personal economic prosperity fostered by capitalism.  This also allowed that generation to save, the first generation to do it on a broad level.

Take a look at today's demographics in the West and you see that there's no such demographic boom on the horizon.  In fact countries in the West are actively seeking ways to limit immigration at the same time as birth rates are declining.  Any positive demographic trends that are going are in EM.

So in summary, we have broadly the same economic mess as before (but thankfully no gold standard but floating currencies) but the demographics aren't with us.  I'm concerned about this and hope that policy makers are as well and that the heads of the major central banks do better than last time around.

History brings great perspective.  Ben Bernanke of the Fed is supposed to be a keen student of the Depression and to this point has done the full Keynesian solution of throwing money at the problem hoping that fixes it.  In my estimation this is way better than nothing but the jury's still out on the unforeseen effects coming along in the future, whatever they may be.

When I was young there was a journalist in the UK that wrote under the name "Cassandra" for one of the dailies.  His voice was opinionated and always to the point.  Hitler had him on his death list had Germany won WWII.  He took his pen name from a Trojan lady, a great beauty who having spurned Apollo's affections was condemned to have perfect foresight but to have nobody believe her in eternity.  I can't imagine many worse things than that.  I hope people are looking at the same things I am and paying attention.  That's the only way I can see a way out of this mess.

Cassandra, daughter of King Priam of Troy.  They should have listened.

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