“History does not repeat itself, but it rhymes.”
If this be true, it would be a good idea to recount the history of The Great Depression and the subsequent monetary evolution of currencies and markets, to understand where we stand today, if history were to ‘rhyme’. I will try and explain why we should be feeling optimistic just after the recent earthquake.
Parallels with the Great Depression
The story of the Great Depression starts with the creation of the US Fed in 1918, shortly after World War I. The reflation and money-printing policies of the new Fed led to unprecedented infrastructure spending, which set off parallel booms in the steel, construction and auto industries. At one time, there were 108 car companies in the US, of which about three survived after the Depression.
The current parallel is with the similar booms over 1998-2002 in IT & Communications first, followed by a housing boom, which was a purely monetary phenomenon, created by an excess supply of money meant to fight the dotcom bust. The whole thing took a decade.
In 1929, this led to a collapse in asset prices, led by a mistaken squeeze in liquidity, which converted a bad recession into a full blown banking crisis and a depression. This created a currency crisis in 1933, with the pound sterling going off the gold standard.
A currency crisis has been avoided this time, with the various TARP programmes, which (at least in the US) have worked surprisingly well. If the new European TARP works similarly, it will be the best outcome possible, under the circumstances. But the 2008 crisis still created a currency crisis in Europe, because of their internal banking crisis caused by a crisis of confidence in sovereign debt cross-holdings. But it took the same three to four years for an asset price collapse in one part of the world to expose a currency/monetary crisis in another part of the world.
After Britain took the pound off the gold standard, the world economy had no reserve currency for 11 years, till 1944. In between came the World War, which forced some countries to print currency, run up huge deficits, and lose their gold reserves. A parallel development was the loss of some ships carrying gold from Europe to the US. This led to the emergence of the US Fort Knox as the “custodian of the world’s gold”, creating the ground for its subsequent emergence as a reserve currency. At Bretton Woods in 1944, this was given a formal shape under the Bretton Woods Agreement.
If we assume that we are now in 1933 equivalent, we have to look out for this evolution, and this is what should set our long-term strategy.The new reserve currency will not be the USD; it could be any one of the following :
* A strong (but post-division) euro made up of Germany, the other AAA countries (Finland, Netherlands, Austria, Denmark, France, etc, now downgraded to a still decent AA+). This currency may not be large enough to replace to USD.
* The Chinese yuan , but this is unlikely, given the lack of maturity of the Chinese financial system. They will have to convince the world that they will not monetise their coming banking crisis.
* A currency evolved by a new Bretton Woods, which considers a composite currency that takes its value from gold, silver , USD and euro, perhaps. This will be a possible return to some kind of gold standard, reducing the panic in currency markets.
Right now, we have seen that in a panic, people rush into the USD. Even gold is not the safe haven that it used to be; silver has proved positively dangerous for many people. But this may not continue. In fact, I would want to bet on the fact that silver will go into a long-term (relative) decline to both gold and currencies. Technicals suggest that this is eminently possible.
So one should be long-term bearish the USD, long-term bullish the (post-division) euro, long-term bearish silver. I am unable to give an opinion on gold, which has already fallen 20 per cent from its dollar peak. Silver has dropped 40 per cent. But while the USD has not yet started its (long-term) decline, silver is already half-way through its long-term decline. The CNY will appreciate in relative terms, as will the rupee and other major emerging market (EM) currencies.
Between 1944 and 1971, there were no banking crises, despite a long-term boom starting in 1955. The big change happened after the oil crisis, when Nixon took the USD off its gold peg. Immediately, this started off the run-up to the Latin American debt crisis, followed by the Plaza Accord in 1985. The resultant increase in the (relative) purchasing power of the Yen led to the Japanese asset bubble of 1989 (when the palace of the Japanese Emperor was worth more than the whole of Manhattan). The subsequent bubble collapse, combined with their demographic decline, has created the only deflationary crisis we have seen in the last century.
Where is the US headed?
It is now pretty clear that the US does not have the demographic decline that Japan has, nor did it leave its reflationary policies till too late. The deleveraging of US households should get completed in about four to seven years, while the US corporate sector has already reached stability (as seen by the very shallow decline in the US Dow Jones Index, despite such a cataclysmic decline across the world). The only problem left over will be government indebtedness, which might follow the same pattern as in Japan, i.e., everyone will keep talking about a coming crisis of confidence, but since most borrowings will be held by domestic savers, this crisis of confidence will be pushed back almost indefinitely.
One should bet on the fact that once the damage from the deleveraging of the US consumer stops short of creating another recession, the US economy will coast along at 2-3 per cent growth, 8 per cent budget deficit (with 2.5 per cent current account deficit) and a regular drop in consumer and mortgage credit of 5 per cent per annum, savings rate of 6 per cent and a Velocity of Money of around five. This will create $1 trillion of investible surpluses in the hands of US banks every year, which will no longer go to Europe or Japan or other developed countries. One very likely place this will go into is the emerging markets energy sector, hopefully solar and renewables. Right now the cash holdings of US banks (and the Fed) stand at $1.6 trillion.
Politics will create a lot of bad volatility. However, if we assume that the gridlock will always continue, things will eventually sort themselves out. The current unemployment downtick has come despite drops in government employment, which is a very good sign. Another 1 per cent drop from the current 8.6 per cent will leave the US in very good shape. As explained above, the only long-term problem, the huge public debt ratio, will exist because of large and persistent budget deficits in an economy with low growth and low inflation. Something will have to change: either growth will accelerate or inflation will go up. The latter is most likely (especially if the velocity of money starts to go up). This will cause currency ($) depreciation, and later, a hardening of interest rates.
Tectonic shift
Finally, how will things sort themselves out, as far as the public debt ratio is concerned? Here, we have to give up linear thinking and try and imagine some tectonic (technological?) shift in the global economy, that takes down a particular cost (maybe energy) to zero. This will create an economic boom of unimaginable proportions, raising both growth (and taxes) to levels where the old government debt is forgotten. It happened in the 1950s in the developed world, and in India post-1991. Remember the 16 per cent NPA ratios of banks after the Indira + CK Jaffer Sharief loan mela years? They withered away because of the subsequent growth that we saw, post 1991.
This boom will trigger huge poverty reduction in Asia and Africa, bringing large masses of people into mainstream consumer markets. The developed world will export itself out of its mess; the only way that public debt ratios can be brought down is if they start to run current account surpluses, without increases in welfare spending (a.k.a. budget deficits).
To conclude, we should bet on the long-term (relative) decline of the USD, long-term appreciation of some other ( gold) standard currency, shallow and long-term decline of silver, with a lot of uncertainty about whether gold will also follow silver.
This article was originally published on February 25, 2012.
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