Japanese Vision for Growth Gets a Poke in the Eye

For four decades the Japanese economy secured more than its fair share of coverage in the financial press. Dominating the economic headlines were the manufacturing and export expansion of the 60’s and 70’s and the phenomenal market rally that took the Nikkei to almost 40,000 during the 80’s. Thereafter commentators focused on the lost decade of the 90’s caused by the property market crash, bank balance sheet shrinkage and the death of Japanese equity wealth by a thousand cuts.

This decade has seen the rise of China’s economic profile, with the PRC now destined to replace Japan as the world’s second largest economy. Such is the dominance of Chinese related articles it’s easy to forget Japan is still an economic goliath, albeit in relative decline. And the cause of that decline can be summed up in one word; deflation.

There’s something deeply embedded in the Japanese economy and psyche of Japanese businesses and consumers that has caused deflation to be a secular and persistent challenge for the Bank of Japan for the past 20 years. The problem with deflation is that it maintains the real value and burden of debt, whereas a healthy rate of inflation, 2-3%, over the years gently erodes the real economic cost of borrowed capital. It is inflation that has given the western economies the luxury of consuming more in the present, with debt in nominal terms eroded by the passage of time. Deflation throws another spanner in the works of economic growth. Why buy a new car, or new machinery, in fact why buy anything today that will be cheaper in a few months? The result is structurally weak demand, an interest rate so low it’s barely visible to the naked eye and a flight of capital to higher yielding currencies (the New Zealand and Australian dollars have been a favoured destination for retail and institutional investors for years). Deflation is a nasty poke in the eye for demand, capital investment and growth.

In fact Japanese interest rates have been so low for so long, the Yen has been systematically sold (shorted) not just by Japanese investors but by a legion of hedge fund managers for years with the proceeds placed just about anywhere that offered a higher return. Admittedly that carry-trade, along with most risk embracing investment strategies, grew to bubble proportions and burst in 2008 but with investors embracing risk again, greed replacing fear, that transaction (short Yen, long anything else that moves) is likely to re-surface.

Investors unsure about the viability of continued Japanese deflation, preferring to focus on the unprecedented global stimulus measures, that should be inflationary, should look closely at the latest Japanese consumer prices data. Prices fell 1.7% in the year to June, prolonging the sequence of deflationary months (year-on-year) to four in row. The main contributor to the decline in prices is energy, with oil settling into $60-$70 channel compared to last years roller-coaster ride to $147.

Investors could suggest that the global economic recovery could re-inflate energy and commodity prices, prompting inflation and thus curing the Japanese “I’ll buy it later when it’s cheaper” philosophy. Unfortunately, higher energy costs are paramount to poking the Japanese economy in the other eye. Japanese energy imports can peak to 97% of its oil and 96% of its gas needs. Japan is similarly deficient in other key energy and mineral related commodities. Higher energy and commodity prices just leave Japanese consumers with less to spend on domestic goods, further hurting demand.

Welcome Back John Maynard Keynes

An understanding of economics is greatly enhanced by the study of great economists, men who formed original and ground-breaking theories regarding economic management, foreign exchange mechanisms and monetary and fiscal policy.

If Adam Smith was the founder of economic theory as we understand it today (The Wealth of Nations, 1776) then John Maynard Keynes was the father of modern monetary and fiscal policy. His brilliance, soon to be obvious, went largely unnoticed in his formative years of study and examination. “The examiners presumably knew less than I did”, he famously remarked.

Later, in the years between the two great wars, his work focused on developing theories better able to achieve full employment – in response to the deflation and poverty caused by the global depression. His work relating to interest rate controls and government led stimulus, obvious and accepted now as a cure for recessions, were at the time revolutionary, misunderstood and unproven.

Morally robust, he resigned in protest against the First World War reparations policy, a thorn in the side of Europe for 20 years and a key grievance which led to the rise of militarism across Europe, and the Second World War.

In 1943 Keynes was fundamental to the original proposal for an international monetary authority. In 1944 he led the British delegation in the Bretton Woods Agreement. Late in 1945 he was accredited with almost single-handedly negotiating the American Loan Agreement which helped rebuild Britain, bankrupt in all but name, following six years of war.

The stress and burden of the US loan negotiations contributed to the demise of his health. Americans found Keynes to be “irritatingly brilliant”. But the war, Britain’s earlier guarantee for financial help, was already over. Military cooperation had been replaced with a new economic order. Keynes secured a loan for $3.75bn agreed at a 2% rate of interest. Any other man would have returned to the UK empty-handed. The final loan repayments were made 61 years later by Tony Blair’s government.

Keynes remains famous for his theories tackling monetary deflation and trade depression. His policies embraced the economy as a whole. His understanding of the relationships between money supply, fiscal intervention, investment and job creation were unrivalled. His suggestion that increased economic activity could be best achieved via centralised intervention and sponsorship of capital projects was proved successful during the 1930’s.

During the process of financial market de-regulation from the 1980’s to 2007 the policies of John Maynard Keynes were increasingly viewed as out-dated, too interventionist. Economists cited the modern free market economy to be self-controlling, self-moderating and a capitalistic self-fulfilling prophecy of wealth creation. The past year has seen a return to centralised intervention, all-encompassing economic policies and a return to the theories that were first realised by Keynes 75 years ago.

Born on 5th June 1883, a student of Eton and Cambridge, a renowned teacher committed to helping others learn and a reputation for speed of mind that few could cope with, Keynes’ theories again form the bed-rock of solutions used to resolve recessions and stimulate economic growth.

Only 2 Assets Classes: Cash, & Everything Else

We are in truly unique times. The depression of the 1930’s shares the most traits with the current recession. Both periods suffered systematic failures, rather than just being ‘bubble’ recessions, but there are key differences. Over the past 75 years ago, financial instruments have increased exponentially both in terms of their complexity and breadth of international distribution. Risky assets such as equities, corporate bonds, property, commodities, higher yielding currencies and the infinite number of alternative investments were previously thought to offer strong diversification benefits, when combined, through all stages of the economic cycle. The past year has proved that theory wrong.

The correlation (similarity in performance and volatility) of all risky assets increases substantially in periods of systematic stress. It always has. Also the correlation of risky assets has increased generally since the mid 1990’s, through all stages of the economic cycle due to globalisation and the ability to trade any asset class online from any location. The efficient circulation of information also means buyers and sellers can act simultaneously creating additional momentum in price volatility across all markets.

Add into this high-correlation equation the lack of liquidity suffered by investors in times of turmoil, particularly those exposed to more exotic instruments previously marketed as having absolute return characteristics, and I would suggest in times of recession and economic turmoil, there are not a plethora of asset classes, there are two: risk free assets and all risky assets. If you really pressed, I would be sympathetic to the view that gold can represent a third asset class in such times.

I would also suggest future recessions are inevitable. Governments and central banks are committed to using monetary policy as the primary tool to stimulate or cool down the economy. This blunt instrument distorts the nominal supply of money relative to the real economic wealth of society. During periods of monetary easing a large proportion of this excess supply of money is consistently misallocated to consumption and financial transactions. Inflation and asset price bubbles are the result. Higher interest rates follow, confidence weakens, demand falls, prices collapse, liquidity fades and the circle of boom-bust remains intact.

In summary:

1. The performance characteristics of constituents within risky asset portfolios are increasing in correlation over time.
2. That correlation jumps higher when the benefits of diversification are most needed, in times of market turmoil.
3. Traditional diversification techniques used today do not work.
4. We will suffer more recessions and renewed market turmoil in the future.

Is it fair to conclude the current framework of the investment industry is therefore flawed?

Banks: Always the Problem, Never the Solution

Imagine for just a few moments an economy with no debt. You have no ability to borrow or lend, nor does any other participant in the economy. There is also no mechanism to print money and therefore to create additional nominal paper wealth. The only assets you own were purchased with the fruits of your labour and enterprise. The only money you have is from the proceeds of assets you previously sold or income from labour and enterprise, yet unspent. Also in this fictional land, the nominal supply of money, coins and bank notes, exactly equals the true nominal and economic value of society’s wealth, This wealth consists of ready to use commodities (grown coffee, mined coal, etc) and real, not paper, assets. If the rate of saving increases, or the holding period between transactions lengthens, the velocity of money and real economic activity decreases. If through natural disaster or war, assets are destroyed, the nominal value of paper money would be greater than the economic value of real assets. In this environment of fixed money supply with no ability to lend, borrow or print money, society can only theoretically accumulate more assets in future periods, than it did in the past, by improving the efficiency of commodity growth and extraction or by inventing new products of economic value. But unless money supply is increased, or the circulation of money accelerates, the prices of assets and commodities would have to fall, due to the increased supply of commodities and assets relative to fixed paper money supply. Furthermore, you could not increase your personal real economic wealth by working longer hours unless another participant was willing to work less hours as your increased output would also create excess supply that the fixed monetary base could only purchase through deflation of asset prices.

Let’s build into this zero sum economic model, debt, the ability to lend and borrow. Again money supply is unchanged. The zero sum game is also unchanged. The flow of money is altered but no real economic growth is secured. The only change is the timing of consumption for each party. The borrower enjoys higher consumption now at the expense of future consumption. He is spending future income. The lender forsakes current consumption, preferring to consume later when the debt is repaid. The real economic asset base is unchanged. The borrower can purchase assets, employ more staff, pay higher wages but if the supply of money is unchanged every extra dollar he spends is directly offset by the decrease in economic activity of the lender.

So debt by itself, within a fixed money supply economy, is a financial transaction that creates no real economic growth. Progressing towards a more realistic scenario, closer to today’s economy let us introduce the concept of new and additional money supply. Not new economic wealth, just new paper money. The creator of this paper is seeking to stimulate the economy and decides to allocate a third each to Consumption, Lending and Investment. (By investment I am referring to the creation of new assets of economic value and the improvement of existing production efficiencies, not the purchase of assets already in circulation). Examining each of the three in isolation, if new money is added to an economy within a fixed asset base, purely to increase consumption, inflation is caused as demand increases whilst supply is constant. Nothing new of economic value has been created. Each unit of paper money is just worth less relative to the unchanged real economic asset base. Borrowing to purely consume creates inflation and has zero sustained economic benefits.

The second scenario relates to the share of printed money that is lent and borrowed. If the borrower uses his additional paper money to consume the economic impact is unchanged, as above. If the paper money is used to buy completed assets, again as discussed above, the only occurrence will be inflation in the price of assets. Debt used to increase consumption or purchase assets has zero sustained economic benefit, only the flow of money changes. There is no new real economic wealth, just inflation, or asset price bubbles, or both.

Therefore, only newly printed money that is invested into the process of building new assets of economic value has a positive impact on growth. Increases in consumption can only be sustained if it is the function of an enlarged asset base of economic value exactly matched by an increase in the supply of nominal paper wealth.

To achieve real economic growth, society must have a mechanism that increases money supply which both facilitates and mirrors real economic growth, (the increase in quantity of real assets). In the absence of this scenario when newly printed money is allocated to the purchase of completed assets, or consumption, rather than applied to investment in the production of new assets or invested to improve current output efficiencies, zero real economic growth occurs and asset price bubbles are created.

Applying this theory to the current stimulus policy and the new paper money printed by the Fed and other monetary authorities, every dollar spent on supporting consumption or used in the purchase of completed assets has zero true economic value and is today’s generation borrowing from the income of future generations. It’s fake growth, here-today-gone-tomorrow paper wealth. Therefore every dollar allocated to the balance sheets of failed banks, which is then lent to stimulate consumption or used in the acquisition of existing in-circulation assets represent transactions of no true economic value. Supporting financial institutions that profit from building fake wealth probably isn’t a great idea either.

In fact the stimulus package is quite successfully re-building the same myth of debt-fuelled economic growth and is deepening the embedded structural problems of a debt based society, which incorrectly allocates printed money to consumption and zero-sum financial transactions rather than into real economic investment.

If you persist with the same course of action, is it reasonable to expect a different outcome?

Does Gold Always Go Up in Recessions?

Gold Weekly to 18th June 09

By Robert Prechter, CMT. The following article is adapted from a brand-new eBook on gold and silver published by Robert Prechter, founder and CEO of the technical analysis and research firm Elliott Wave International.

I have often read, “Gold always goes up in recessions and depressions.” Is it true? Should you own gold because you think the economy is tanking? Whenever we hear some claim like this, we always do the same thing: We look at the data.

The first thing to point out is that gold did not make a nickel of U.S. money for anyone in any of the recessions and depressions from 1792, when the gold-based dollar was adopted, through 1969, a period of 177 years. Well, to be precise, there was a change in the valuation in 1900, when Congress changed the dollar’s value from 24.75 grains of gold, the amount established in 1792, to 23.22 grains, a devaluation of just six percent total over 108 years. The government did raise the fixed price from $20.67/oz. to $35/oz. in 1934, but that action occurred during an economic expansion, not during the Depression. In 1968, gold finally began trading away from the government’s fixed price. Even then, it slipped to a lower price of $34.95 on January 16 and 19, 1970. So the idea that gold always goes up in recessions and depressions is already shown to be wrong. It did not go up in terms of dollars in any of the (estimated) 35 recessions or three depressions during that period.

What almost always does happen during economic contractions is that the value of whatever people use as money goes up as prices for goods and services fall. When gold is used as money, its value in terms of goods and services goes up. But gold can’t go up in dollar terms when gold and dollars are equated. So no one “makes money” holding gold under these conditions. It is a fine point: What tends to go up relative to goods and services during economic contractions is money, and when gold is officially money, that’s how it behaves. What we want to know is how gold behaves in recessions and depressions when it is not officially accepted as money.

Many gold bugs say that because gold was a good investment during the Great Depression, it is a “deflation hedge.” We addressed this topic in At the Crest of a Tidal Wave (1995, p.357) and Conquer the Crash (2002, pp. 208-209). At the time, government fixed gold’s price, so it didn’t go up or down relative to dollars. Gold was a haven during that time, the same as the dollar was, since they were equated by law. But gold served as a haven because its price was fixed while everything else was crashing in price during the period of deflation. Gold bugs like to claim that gold would have gone up during that period had it not been fixed, but the crashing dollar prices for all other things suggest that in a free market gold, too, would have fallen. It would have fallen, however, from a higher level given the inflation of 1914-1929 following the creation of the Fed. So gold became worth more in dollar terms than it was in 1913, which is why it began flowing out of the country. In 1934, the government finally recognized the new reality by raising gold’s fixed price. Since 1970, markets have been in a large version of 1914-1930, except that gold has been allowed to float, so we can clearly see its inflation-related, pre-depression gains.

Observe that gold’s price remained the same for a Fibonacci 21 years after the Fed was created in 1913; it was revalued in 1934. [Ed. Note: For a full chapter on Fibonacci time considerations for gold, download the 40-page Gold and Silver eBook.] Then it held that value for 35 (a Fibonacci 34 + 1) years, through 1969. So aside from the revaluation of 1934, the inability to make money holding gold during recessions, depressions, or any time at all save for the day of the revaluation in 1934 held fast for 56 (a Fibonacci 55 + 1) years following the creation of the Fed. So even after Congress created the central bank, no one made money holding gold in a recession or depression for two generations.

In 1970, things changed dramatically. Investors lost interest in stocks and preferred owning gold instead, for a period of ten years. The same change occurred again in 2001, and so far it has lasted seven years. But, as we will see, recession had nothing to do with either of these periods of explosive price gain in the precious metals.

The period of time one chooses to collect data can make a huge difference to the outcome of a statistical study. If we were to show the entire track record from 1792, gold would show almost no movement on average during economic contractions. If we were to take only 1969 to the present, it would show much more fluctuation. To give a fairly balanced picture, combining some history with the entire modern, wild-gold era, I asked my colleague Dave Allman to compile statistics beginning at the end of World War II. This is what most economists do, because they believe “modern finance” began at that time and that things have been “normal” since then. It’s also when many data series begin. So our study fits the norm that most economists use. It also provides results entirely from the Fed era, making it relevant to current structural conditions.

[Ed. note: To study the six tables revealing gold's performance record vs. stocks and T-notes since WWII, download the 40-page Gold and Silver eBook.]

Table 1 shows the performance of gold during the 11 officially recognized recessions beginning in 1945. Although one could make a case for different start times, we took the 15th of the starting month and the 15th of the ending month as times to record the price of gold. The results speak for themselves. Even though it is accepted throughout most of the gold-bug community that gold rises in bad economic times, Table 1 shows that such is not the case.

The only reason that the average gain for gold shows a positive number at all is that gold rose significantly during one of these recessions, that of 11/73-3/75. The average gain for all ten of the other recessions is 0.16 percent, almost exactly zero. The median for all 11 recessions is also zero. If we omit the five recessions during which the price of gold was fixed, the median gain is 3.09 percent.

For long-term forecasts and more in-depth, historical analysis for precious metals, including the six revealing tables mentioned in this article, download Prechter’s FREE 40-page eBook on Gold and Silver.

The Global Economy – 29th May 2009

For some weeks now this weekly review has ‘called’ Q1 or Q2 2009 as the trough of the economic cycle. Initially there was much risk in the statement as the global and US recovery was by no means certain, but as the weeks have progressed the ongoing stream of economic data has increasingly supported this view. The consensus among market commentators has also moved towards our more optimistic pro-recovery stance and now a Q3/Q4 recovery is a mainstream prediction, rather than the hopeful rhetoric of the enlightened minority. Our view did of course fully consider the unusually bitter and sharp contraction in growth primarily caused by very poor leadership in the global banking sector, ineffective regulatory risk controls and appalling credit procedures in the mortgage and commercial lending market place. But whilst we accepted this scenario as depressingly and worryingly unique in modern times, with only the depression of the 1930’s having close similarities, we also reflected on the impact of the unprecedented wall of money flooding into the global economy via government and central bank stimulus packages and its effect on demand. The global economy has never enjoyed such internationally co-ordinated monetary easing or the simultaneous hard–cash injections by governments, to shore up the balance sheets of strategically important institutions. The consequences of this combined stimulus are already being seen in the price of commodities, including oil and gold. Looking beyond the current market-wide inflation data which does not yet fully reflect improving demand outside of the resource sector, we predict that deflation will not only fade from the vocabulary of pessimistic US economists, but that concerns over inflation will return with vengeance within 18 months. The real challenge for 2010 is not achieving stronger global economic growth, a scenario which looks inevitable relative to 2009, but how to restore stable economic growth without killing the US consumer spending recovery with sharp interest rate rises, the usual primitive remedy for rising inflation. We would stress this view is not implying the deep structural problems within capitalism are being fixed. A move away from a cyclical, debt based economic system would need to be implemented for that. Nor is it an equity market prediction, which is below. But we do think the US and global economy, in terms of Gross Domestic Product, is set for a significant improvement from its Q1/Q2 trough.

Looking at the most recent US economic news in more detail, revised data now indicates the US economy weakened less than initially estimated in Q1 contracting at a 5.7% annualised rate, rather than the 6.1% fall previously announced. Investor’s, prior to the announcement, had been even more optimistic and predicted on average, the figure to be revised to a 5.5% contraction. Also, for the first time in a year, US corporate profits after tax increased, albeit only by 1.1%. The figure is a vast improvement on the 10.7% slump seen in the prior quarter and surpassed the consensus Q1 forecast of a 7% fall. Dissecting the Q1 GDP figures more closely, weakness in exports more than off-set a stabilisation in consumer spending, which accounts for around 2/3rds of US economic activity. Interestingly, some very competent market analysts are putting their neck on the block and are predicting much shallower weakness in Q2 and a return to positive US GDP growth in Q3. Unfortunately, unemployment is a lagging indicator so the US economy is likely to suffer rising jobless claims for some time yet even when the wider economy has returned to growth. The current unemployment rate is 8.9% and looks set to reach 10%, with the car manufacturing sector and Michigan, its home, likely to suffer most.

The growing expectation of H2 2009 economic recovery, and the view that equities were grossly oversold, prompted the sharp appreciation of equity prices in the period from early March to mid-May. At the end of that 10 week rally we highlighted that in the short-term prices look stretched after such a short sharp spike and a pause in upward momentum was inevitable. 2 weeks later that pause appears to be coming to a conclusion and the next move in the S&P 500, the diversified large cap index, is imminent. Based on the current trend of improving economic data and index technical factors we suggest the next significant move is up. The S&P 500 is at 907 (at the time of writing) from a March low of sub 700 and a further rise to near 1,000 would likely complete the technical recovery from the manic depressive state in investor confidence that caused the oversold trough in prices seen in March. A summer lull in trading may interfere with the timing of this view, but the next major move for US equities, we believe, is up. Time will tell.

We briefly mentioned oil. It’s worth taking a closer look at the market as the recent price action, we suggest, is a fore-taste of further inflationary pressures to come in other areas of the global economy. Reflecting for a moment, a barrel of oil fell from $147 during mid-2008, to a little over $32 by December of the same year. Since then oil has pursued a near-relentless recovery to pass $65 on Friday, twice its cyclical low. Statements from OPEC members have reinforced the view that the current rally is not a false dawn for oil bulls. The Saudi Arabia Oil Minister, Ali al-Naimi, long respected for moderate and reasonable analysis of the sector commented the market is “ready” for $75-$80 per barrel prices later in 2009. His views are based on already firming Asian, Middle Eastern and Latin American demand, not pie-in-the-sky guess work. The start of the US holiday driving season also suggests we are more likely to see $80 than $50, next. From a technical view, the price of oil has crossed its 200 day moving average and a number of oil analysts are now suggesting $60 is the new floor in prices. Politicians who side-lined their pro-green sound bites through the worst of the recession will soon be marketing their renewable energy credentials again.

Before progressing on to the UK, let’s take a brief look at the Euro-Zone economy where investment ‘professionals’ are still talking about deflation following release of May’s data which showed prices flat at 0.0% compared to the same month a year earlier. Readers will be forgiven for being confused. “Haven’t I just read oil prices have doubled and the global recession is definitely easing?” You did. But the Euro-zone is different to the US and other economies because the European Central Bank executed a monetary easing plan that was so mistimed (late) you would be forgiven for thinking they were trying to pre-empt the next recession, not cure this one. Not only were the box-tickers at the ECB too late in cutting rates, they unbelievably were still raising interest rates in July 2008 when corporate confidence had already stalled and seasoned financial sector analysts were busting blood vessels in stress as we approached the near-collapse of the global banking industry.