Monday, December 1, 2008

Canada's Opportunity in Crisis

Below is a copy of a letter I sent to my member of parliament, Andrew Saxton of North Vancouver. To be clear, these are not policies that I would say are acceptable from an Austrian Economics perspective. However, given the political situation in Canada, we are faced with making less than perfect decisions or having a socialist coalition takeover of the country's legislature. Gun to head, I choose the former.

I also want to point out that these policies would most definitely not work for larger economies like the US or EU. But Canada's unique position as a resource based economy enable them to take these bold measures without the disastrous effects of its potential failure.

Canada's Opportunity in Crisis

Albert Einstein once wrote that the definition of "insanity" was doing the same thing over and over again, while expecting different results.

If he were alive today, he would have to look at the collective actions taken by governments around the world to stem the financial crisis, as nothing other than insanity. Most economists seem to agree on one thing: individual people and governments were too heavily indebted for their own good. And the "credit crisis" is the economy's way of saying "please, no more."

Yet nearly every mainstream economist's "solution" to this problem is for government to provide "stimulus." They feel that if banks would lend to each other and then to businesses and individuals, the economy will reignite itself. This is akin to a drug addict in withdrawal claiming one last hit will make him better again. Since August 16th, 2007, the United States Federal Reserve has been lowering interest rates. The Bank of Canada and other foreign central banks were quick to follow suit. Since then, central banks have created an alphabet soup of lending facilities. The US Treasury and foreign governments have conducted trillions worth of bailouts of financial firms. And now, like clockwork, other failing industries are lining up at the doors of government for their own bailouts. All of this is being done in the name of "getting credit to flow again." Yet, dozens of initiatives notwithstanding, credit markets worldwide remain closed to most, prohibitively expensive to the rest.

It is clearly not working.

The Credit Crisis is a Symptom of a Greater Disease

The reasons for this "failure to reignite" are many. To start, people and businesses have become psychologically averse to debt. Catchphrases of the past few decades like "utilizing economies of scale," and "leveraged ideas," have become ancient relics of a bygone era. And it has happened seemingly overnight. The principles of economics taught in the best business schools of the world over the last few decades have ceased to function. Commonly believed investment mottos like, "buy and hold for the long term," or "over time, real estate always goes up," have evaporated. In response, policy makers and economists, are asking the wrong questions. Instead of asking "why?" They are asking, "how can it be made better again?"

What if they were to ask "why?" They would find that the answers are far less complex. Asset prices worldwide are falling in tandem for the first time in nearly 80 years. In other words, they are perplexed by a phenomenon only ever experienced by geriatrics: Deflation. Who in their right mind would borrow money to buy an asset that most believe will be falling in value over the near to intermediate future? What bank in their right mind would lend to a person or business with such an ambition? Deflation is at the heart of why current monetary policy has been a miserable failure.

At the root of deflation is more than just falling asset prices. Falling prices are yet another symptom. The total supply of all money and credit in the world, despite the re-inflation efforts of central banks, is declining. And the velocity of that money being deployed in the economy is decelerating, as holders of capital elect to "hoard" rather than "deploy" their savings.

There is yet another deflationary force at work that is beyond the control of any monetary policy maker. And that is the force of demographics. Collectively, the "Baby Boom" generation (defined by most as being born between 1942 and 1961) are entering retirement all across the western world - accounting for half of world GDP. It is likely not a matter of coincidence that the first of this generation hit retirement age (65 years old) the same year our present crisis began in 2007. This entire generation had planned to liquidate their savings of stock, bonds and real estate over the next 15-20 years. And it should have come as no surprise to us that at the first hint of falling asset prices, this generation greeted us with panic selling.

Unfortunately, our younger generations are not only less numerous but they are in poorer financial condition (burdened by student debts) than their parents and are in no position to pick up the slack in terms of asset accumulation or consumption. Additionally, there are socionomic signals suggesting our younger generations are rejecting the materialistic values that have buoyed our economy for decades. One such blatant example would be the international "Buy Nothing Day" scheduled for November 29, 2008. Whether this kind of event makes any impact is irrelevant. It is the overall trend that is important, and that trend shows that consumption is progressively becoming "less cool" in the minds of our younger generations. Considering most western economies depend upon consumption for anywhere between 60-70% of GDP, this is a trend we would be wise to note seriously.

If the reader is to have any remaining doubts that we are in the grasp of an enormous deflationary spiral, let me communicate it on some other terms. As of May, 2008 the total world market capitalization of stock markets was US$57.5 Trillion. By the middle of November of 2008 that total had fallen to nearly $30 Trillion. Conservative estimates put total "developed economy" residential real estate assets close to US$80 Trillion. This would not include the massive property bubbles seen in the BRIC economies. Conservative estimates of "developed economy" commercial real estate assets are near $30 Trillion, corporate bond issuance near $20 Trillion, etc. It is not unreasonable to conclude that the current crisis has wiped out many dozens of Trillions in assets worldwide. Yet most economists and policy makers persist in believing that just a few more hundred billion in "stimulus" will make everything better. They all amount to mere drops in the proverbial bucket. The only things being "stimulated" are the egos of their proponents.

It is a grand illusion that this deflation can be stopped. And the only other excuse for these wasteful actions are that to believe if confidence is restored, all can be well again. Knowing the above uncontrollable contributors to the situation, we can only conclude that such hopes are misguided at best, foolhardy at worst.

How Did it Come to This?

The origin of all financial cycles stem from the environment in which it's oldest generation was raised. For us, that generation is what is known as the "Silent Generation." Silent because they grew up during the Great Depression and WWII with very little ability to complain. Their fathers often jobless, then sent overseas to war. But what is often referred to as the cause of this crisis, US Subprime Lending, is once again little more than another symptom of a process that was set in motion during our last major crisis - the Great Depression. In the desperation to stem the depression, numerous entities were created by the Hoover and Roosevelt administrations in the US, the Bennett and King governments in Canada. Most notable among these entities was Fannie Mae in the US (1938). Fannie Mae was created to stimulate home ownership and it did just that. Artificially increasing the demand for houses, prices naturally rose. This was done on a fairly small scale for decades as cautious lenders were loathe to make the same mistakes they had in the late 20's.

But once the Silent Generation, the only remaining generation with remembrance of that era, moved out of government and out of the front offices of financial institutions, the same reckless type of financial engineering that led to the Great Depression began anew. Of course, this time it was different - but it was the same. What were the trust holding companies of holding companies like the Shenandoah Trust Co. in the late 20's became derivatives like Credit Default Swaps (CDS) of today, and what was 10:1 leverage on stocks in the late 20's became the Subprime Lending for Real Estate of earlier this decade. Only the names are different. The concept was the same. Insane amounts of leverage backed by an asset with little or no intrinsic value.

What would lead lenders and borrowers to such reckless pursuit of high returns on their capital? Greed? Partially, yes. But that is the easy answer. The real motive for this is far more multifarious. Primarily, the urge to attain such large gains at any risk is due to the effects of inflation. The constant pumping of the money supply by central banks discourages people from saving and encourages them to buy things that they perceive to be perpetually rising in value - real estate, stocks, fine art, etc. Government mandated inflation targets are what cause fits of speculation. For if your money is simply sitting in a bank account, you are losing purchasing power. This process has a long perceived illusion of prosperity attached to it. For if my net worth, diversified among asset classes, is rising by a few percent every year, I will "feel" richer, even if my money is able to buy less and less. But eventually, this cycle reaches a peak. Prices can no longer rise because of any number of reasons - demographics being one of them.

The solution to this problem is pretty self-evident. Eliminate the mandated inflation targets set by central banks, and the magnitude of the boom/bust cycle will be dramatically reduced. But this is only a partial solution, and there are many more which I will spare the reader of right now. Policy makers are very disinclined to be thinking of preventing an economic crisis 30 years from now, while there is a crisis now, begging for attention.

The Entire Concept of "Money" Has Changed

Starting in 1971, in conjunction with President Nixon's closing of the gold window and the Bretton Woods agreement, there was a major shift in government's views toward their own domestic currencies. No longer did a strong currency translate to a strong economy. In fact, the opposite became true. Central banks began competitively devaluing their currencies to gain an advantage in the markets for global exports. This process has accelerated over the last few decades to the extent that many large economies have simply resorted to "pegging" their currencies to the US dollar to prevent a rise in the value of their own currency.

The US has had the luxury of being able to issue their currency and have it accepted as the "reserve" currency all over the world. But this may change. As the US accumulates more and more debt, and their unfunded liabilities on the future remain unfunded, their reserve status may be lost, which would set off a domino effect of unknown consequences.

How foreign policy makers prepare themselves for such a potential currency crisis, along with their methods of dealing with the current credit crisis, will determine what nations will lead the way during the next global economic expansion.

So now that we have discussed the nature of this crisis, how we got here, and the policies which have been unsuccessfully taken by governments and central banks worldwide, what can Canada do to weather this storm and position itself for a strong recovery?

The Black Sheep Strategy

The Chinese symbol for "Crisis" is the same as the symbol for "Opportunity."

Although they are not saying it outright, Canadian and most other foreign policy makers have been engaging in a type of trade protectionism. Their method of doing so is not with tariffs as it was during the Great Depression, but rather with interest rates. We are purposely weakening our currency by lowering interest rates as a way of protecting our export driven economy. I think in the intermediate to long term, this is a very self-destructive strategy. Much of our manufacturing sector has already been wiped out in the last 4 years as the Canadian Dollar rose against the US Dollar. What survived were the strong and unique exporters that were providing a service or product that was not able to be found elsewhere. Producers of raw materials (our major export) actually benefited from this strength in the Loonie, as their costs of acquiring equipment was reduced. The value of their products is determined on the international marketplace, therefore, it did not raise the cost to our major export market.

As has been noted frequently, the Canadian banking system has been less harmed than most others, but there is significant risk that our banks will also start having greater issues when the inevitable real estate declines accelerate in our major markets.

Canada has an opportunity to express to the world that our currency, banking system and economy will be a bastion of stability in a time of world economic turmoil. We have a very unique ability to provide ourselves with sufficient energy, sufficient water resources, sufficient food crops, and a wide variety of other natural resources. At the same time, we have a population far smaller and far more educated than the only other nation able to claim the same advantages (Russia). This fact alone makes Canada a prime destination for world capital to find a safe and secure home. But our current policies are driving those same holders of capital away.

The Bank of Canada needs to be raising interest rates, not lowering them. And our treasury department needs to be increasing it's holdings of gold reserves to further bolster the strength of our currency in the minds of world investors. These two acts combined would dramatically increase the value of our currency and the perceived safety of holding Canadian Dollar denominated assets.

It is my belief that the substantial influx of foreign capital that would ensue would not only provide us with the money needed to address our enormous infrastructure deficit, but it would increase the deposit bases of our major banks, giving them a cushion to falling collateral prices on their debt securities. Currently, the remaining savings of the world are rushing into short-term US Treasury notes for their perceived safety. Investors in these securities are receiving almost zero return on their capital. There is certainly a large amount of capital looking for a home.

A rise in interest rates would prove problematic for already struggling businesses, however, the ensuing unemployment would be easily dealt with by infrastructure hiring, re-education programs for workers in old and dying industries, and by the subsequent rush of foreign firms to set up offices in Canada.

Other arguments against higher interest rates are that it would, as it has historically, stifle economic growth. But this assumes that the credit markets are functioning as "normal." They are not. People and businesses are not willing to borrow money at any rate, and banks are not willing to lend to them anyway. Banks are already requiring higher down payments, and higher credit ratings. So higher interest rates will not necessarily have the same effect on the economic growth rates, as one would automatically assume.

Lastly, it goes against common logic that in a time of heightened risk, that borrowing rates be lower. Banks may be more willing to lend at a higher rate of interest, which offsets some of their risk. Without question, if the market were left to be determining rates of interest - without minding the policies at the Bank of Canada, rates would be higher. We are fighting an uphill battle by lowering rates when the market clearly wants them to be higher. And as has been noted, the side-effects of too low rates far outweigh the benefits. Canada could become a top destination for carry trades if international investors were paid to take the risk. Why not welcome them?

Summary

- Offering cheap capital to failing banks and businesses is not working because of the uncontrollable forces of deflation - we are pushing on a string
- Policy makers are continuing to throw good money after bad, while confusing symptoms of the crisis with the disease
- Mandated inflation is the root cause of our boom/bust economy
- Competitively devaluing our currency against the US Dollar is having little positive effect on our export economy
- Raising interest rates and increasing holdings of gold to back our currency will boost confidence of foreign investors
- Foreign capital can be used to invest in infrastructure, re-education programs, and new high-tech industries like resource efficiency, and health-care
- A strong currency and stable banking system would effectively pronounce to the world that "Canada is open for business."

It is my hope that Canadian policy makers will look past the already disgraced "solutions" attempted to stem this crisis, and will instead think outside of the box. The policy adjustments I mention here are non-partisan in nature. They should satisfy legislators on both sides of the aisle, while ensuring we do not leave our younger generations with an economy in tatters for decades to come.

"It was the best of times, it was the worst of times; it was the age of wisdom, it was the age of foolishness; it was the epoch of belief, it was the epoch of incredulity; it was the season of Light, it was the season of Darkness; it was the spring of hope, it was the winter of despair; we had everything before us, we had nothing before us; we were all going directly to Heaven, we were all going the other way." - Charles Dickens, A Tale of Two Cities


I am open to hearing other's opinions on this matter (as always). Please leave your comments - even if you think such a plan would be nuts. I'd like to hear why.

5 comments:

rick said...

Very nice work.

You are completely correct. Unfortunately, politicians will try anything to save us. I'm a little frightened by the new socialist coalition and their promise of a stimulus package. Using our money, forcing us into deficit. Once again, punishing the savers.

As you say, deflation is inevitable. It's just part of the natural cycle. Cheap money made this correction even more painful than necessary. Trying to stop it is simply impossible. Prolonging it seems to be in fashion. Perhaps the only thing more damaging than the length of the recession is the uncertainty and volatility.

Anonymous said...

TL;DR

Matt Stiles said...

thanks for the comment, rick

dmy said...

At last some valid points in all the babble of the current panic.
I would say that many of your ideas deserve to be tried in Canada.
One thing that you haven't mentioned and that is apparent to me is as follows:
1. What is a bubble? Answer: a period of temporary financial insanity where we lose all notion of value.
2. We're now in what looks like a long painful period of correction. Fine, but value is not a purely financial notion. We live in a society where all notion of value has been undermined for decades. To get out of the current crisis, we're going to have to reinstate the idea that work creates value. Surprise, surprise, we can't go on forever making money out of wheeler dealing. That's what's got us into the current mess.

One last point: I'm afraid you don't know what socialism in all its horror is. Come to France (where I live and work), you'll find out, and until you do, you haven't got any idea.

Best regards,

dmydmy

Anonymous said...

What a fantastic, educational piece!


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