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Despite India's horrendous bureaucracy, entrepreneurs have thrived, says marc faber. Faber: entrepreneurs can mutate rather quickly in order to take advantage of opportunities. He says the world's largest economy is suffering from a lack of investment in infrastructure.
Despite India's horrendous bureaucracy, entrepreneurs have thrived, says marc faber. Faber: entrepreneurs can mutate rather quickly in order to take advantage of opportunities. He says the world's largest economy is suffering from a lack of investment in infrastructure.
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Despite India's horrendous bureaucracy, entrepreneurs have thrived, says marc faber. Faber: entrepreneurs can mutate rather quickly in order to take advantage of opportunities. He says the world's largest economy is suffering from a lack of investment in infrastructure.
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Attribution Non-Commercial (BY-NC)
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ISSN 1017-1371 A PUBLICATION OF MARC FABER LIMITED NOVEMBER 23, 2001
Long Live Deflationary Shocks,
and Down with Central Bankers Who Want to Prevent Them! he inherited an apartment building in immunity to these unfavourable In all the more advanced the city for whose apartments he is conditions. Moreover, entrepreneurs communities the great collecting a rent of less than US$1 a can mutate rather quickly in order to month! This lack of any property take advantage of opportunities in majority of things are worse development over the last 25 years, sectors such as software, for which done by intervention of unlike elsewhere in Asia, is also there were no government government, than the interesting given that economic impediments or regulations in India. individuals most interested activity is shifting to the outskirts of Such is the power of free markets over in the matter would do the city and to other regions of the bad governments and governments’ them, or cause them to be country, where India’s totally interventions in the economy. Yet it is done, if left to themselves. incompetent government is unable to discouraging to see Mumbai, the hamper economic development to the business capital of the world’s second- extent that it has in Mumbai’s inner most populated country, lacking a John Stuart Mill (1806–1873), city. I can do no better, in describing large foreign business community, Principles of Political Economy the Indian bureaucracy, than quote such as we find in New York, London, the 11th-century Chinese poet Su Tokyo, Singapore, and Hong Kong, INTRODUCTION Tung P’o, who wrote: because of the government’s inability to provide an efficient infrastructure I have just returned from visiting Families when a child is born, and a more conducive business Delhi, Mumbai, Singapore, Shanghai, Want it to be intelligent. environment. (Even more and Dubai. Mumbai and Shanghai are I through intelligence discouraging is the virtually non- both impressive cities from an Having wrecked my life existent nightlife in India’s capital, economic development point of view. Only hope the baby will prove Delhi!) In the case of Mumbai’s inner city, the Ignorant and stupid. The Indian tragedy is that, in the remarkable feature is that little has Then he will crown a tranquil life absence of its bureaucracy and with, to changed since my first visit to the By becoming a Cabinet Minister. paraphrase Adam Smith, a tolerable metropolis in 1973, except that its administration of justice (an efficient buildings are now even more Still, what is reassuring about India legal system with straightforward dilapidated. The reason for this lack of is that, despite its horrendous commercial laws and property rights), development of the infrastructure in bureaucracy, entrepreneurs have the country could easily grow at the inner city is a maze of totally thrived and India is now home to around 8–10% per annum — antiquated property laws that have many very promising companies doing admittedly from a low base — and prevented landlords increasing the business in all kinds of sectors, but boost per capita incomes significantly rents on the premises they let out, especially in the fields of compared to the present environment, with the result that they have no pharmaceuticals and software. The which allows the economy to grow at incentive to maintain their properties good news, not only for India but for only around 5% per annum while per in good condition. Furthermore, the entire global economy, is that capita incomes hardly budge. Still, this tenants have the right to stay in their entrepreneurs are like rats who may be an opportune time for apartments for as long as they wish, manage to survive in just about any investors to purchase Indian shares. and the children of tenants can even environment, no matter how difficult, The Indian stock market, which inherit the leases taken out by their and that they show an impressive shouldn’t have a meaningful parents, many of which date back to ability to adapt to even the harshest correlation to foreign markets since before the Second World War. A commercial and legal infrastructures India’s economy doesn’t depend much friend of mine told me that years ago by developing a high degree of on foreign trade and foreign portfolio flows (exports amount to just 10% of GDP), is at present extremely Figure 1 India 12-Month Forward P/E, 1993–2001 depressed and is, in my opinion, discounting to a large extent the country’s problems (see Figure 1). In addition, time deposits as a percentage of total market capitalisation, which has declined to just 21% of GDP, are now at an all-time high (see Figure 2). The various listed India Funds, such as the Jardine Fleming India Fund (JFI), the MSDW India Investment Fund (IIF — see Figure 3), and the India Fund (IFN), all sell at discounts of around 20% from net asset value and might be a suitable vehicle for investors wishing to participate in the Source: ABN-AMRO Indian corporate sector. For an investment in a fund with a stronger bias towards a bottom-up approach to stock selection, our readers might Figure 2 Time Deposits as Percentage of India’s Total Market contact Jon Thorn Capitalisation, 1993–2001 (jon@indiacapfund.com) who manages the Indian Capital Fund, of which I am the chairman. Jon Thorn has, in the past, written about India for this report. (See his contribution entitled “The Best of Times, The Worst of Times” in GBD report of July 20, 2001.) There could hardly be a stronger contrast than travelling to Shanghai after Mumbai: whereas inner-city Mumbai has stagnated in terms of infrastructure and real estate development, Shanghai has emerged Source: ABN-AMRO as a modern and impressive city over the last decade. In fact, the rapid development of its physical and commercial infrastructure is unprecedented in history. Figure 3 Morgan Stanley India Investment Fund (IIF), 1994–2001 Furthermore, as an Indian minister pointed out to me, although it was achieved at a certain price in terms of human rights, the success Shanghai has achieved in improving people’s standard of living and per capita incomes far outweighs those shortcomings. I have been visiting Shanghai regularly since 1989, and on each visit I am struck anew by its continuously changing skyline and the extent and speed of its modernisation. And this is the same city that, ten Volume years ago when I first began to write about its impending emergence as Asia’s most important commercial and financial metropolis, businessmen in Source: BigCharts.com Hong Kong dismissed as being far too
2 The Gloom, Boom & Doom Report November 2001
bureaucratic and lacking the necessary worth visiting just to see the Burj Al despite the fact that the emerging educational infrastructure to develop! Arab Hotel, the world’s only seven- markets have grossly underperformed I also visited Suzhou, a city I star hotel, whose stunning the Western developed markets since hadn’t visited for over three years. At architectural structure rises to more 1990 (see Figure 4), impressive that time, there were just two than 40 storeys from a man-made economic progress has taken place in industrial parks under construction on island in the Persian Gulf. most developing economies over the the outskirts of the city; now there are Admittedly, one could argue that the last ten years. Who, ten years ago, factories everywhere, with trucks Middle Eastern economies are had heard of Bangalore and of India’s continuously moving goods to and “artificial”, since they depend largely now famous software and from Shanghai’s port along a newly on the price of just one commodity — pharmaceutical companies, or spoke at built highway. While I am fully aware oil. But what is the difference between dinner parties about Shanghai’s of the problems that are endemic to the Middle Eastern economic system, stunning development and China’s the Chinese economy, including the which depends on the price of oil, and large trade surplus with the United difficulties facing foreign companies the Western industrialised nations, States? And who at that time was wanting to make money (due largely which over the last few years have aware of Emirates Airlines, an airline to the tremendous overcapacities in increasingly become dependent on the that is now certainly better managed all industrial sectors and the inevitable price of their stock markets for than Swissair or Sabena in recent “speed-bumps” the Chinese economy economic growth? And on what years, or of the Emirates Tower Hotel will periodically hit), the changes that would you rather bet your future: oil, Group, which owns and manages have occurred in China in the last few whose price is now rather depressed several luxury properties in Dubai years are simply extraordinary. (And (at least in real terms); or Western (among them the Burj Al Arab Hotel) you may recall that I am rather well stock markets, which by any valuation and now also runs the Carlton Tower known for my somewhat cautious standard still appear to be expensive? Hotel on London’s Cadogan Square? views about the health of China’s The purpose of this brief While I am aware of all the social and financial system.) While description of my recent trip is not, shortcomings of globalisation, it would seated comfortably, on my way back to however, to draw any conclusions seem to me that, over the last ten Hong Kong, in a business class seat on about the relative investment merits years or so, whole regions that in the China Eastern Airlines with of emerging economies compared to past were absent from our Western significantly more legroom than in the Western industrialised nations. market economy and which shunned any first class seat of a US air carrier, (For such an analysis, see GBD reports our capitalistic system as a result of not to mention the far friendlier of May 16, 2001, entitled “Emerging their adherence to socialist ideologies service, I mused how in the future Markets: An Unpopular but Depressed and to the ideas of self-reliance and airlines such as China Eastern and Asset Class”, and of July 20, 2001, hostility towards foreign investments China Southern would dominate the entitled “If the Purchase of Emerging have ºnow been fairly well integrated skies, while the Swissairs of this world, Stock Markets is ‘Financial Suicide’, into a “global economic system”. with their high cost structures, would What Then is the Buying of US Moreover, there is no doubt in my become extinct. Equities?”.) Rather, it is to note that, mind that over the same period, an My visit to the United Arab Emirates also held some surprises. As in the case of Shanghai, both Abu Dhabi and Dubai have developed Figure 4 Performance of Asian and Japanese Markets Relative to rapidly in the last few years and have the United States, 1991–2001 now become far more cosmopolitan than in the past. In particular, Dubai has emerged as an important trading centre, being the gateway to a large number of Middle Eastern, Central Asia ex Japan/US stock market index Asian, and North African nations, as [index 1994, MVM=Mean, RT=Effective, FC=standard)
well as an enjoyable entertainment
and tourist centre for well-to-do people from around the region. Whereas Shanghai is impressive Japanese index/US stock market index [index 1994, MVM=Mean, RT=Effective, FC=standard) because of its size and rising economic power, Abu Dhabi and Dubai impress the visitor because of the money the ruling families have spent over the last few years on building extravagant gardens and parks, as well as Source: Gaveco monumental hotels. In fact, Dubai is
November 2001 The Gloom, Boom & Doom Report 3
unprecedented amount of knowledge, new ideas, technology, management Figure 5 Wholesale Prices in France, Germany, and the United techniques, and capital was transferred States, 1820–1896 to these developing economies. However, such a major and rapid change for the global economy — the integration of close to three billion people into the world’s economy who, until the late 1980s, were participating only on the periphery of the capitalistic market economy — also brings about a state of lasting disequilibrium. Following an initial boom that lasted from the mid-1980s to the mid-1990s, the emerging economies experienced severe crises in Source: David Hackett Fischer, The Great Wave the late 1990s. These crises were accompanied by significant currency devaluations or, in the case of China, by a deflationary environment, which inventions led to the opening of new were removed around the world and a in aggregate badly deflated the price territories. The combination of these global capital market permitted the level of the emerging world. In turn, two factors in turn increased the easy and speedy transfer of funds into the emerging world is now exporting supply of agricultural products, which regions that promised high returns. their deflated price level to the were then the world’s most important Thus, when the ideology of socialism Western world and contributing to a commodities and largely drove the came to an end and numerous structural “deflationary shock” in the business cycle. (Simply put, countries such as China became global economy, very much in the agricultural commodities were then to increasingly integrated into the same way the opening of the western the world what oil is today to the market economy, several new territories in the US and the opening Middle Eastern economies, with rising technologies and a global financial of Australia to the production of grain prices leading to periods of economic market were in place to facilitate and in the second half of the 19th century expansion and falling prices to speed up the process of led to a deflationary period that lasted recessions or below trend-line industrialisation, with the result that from the mid-1860s to 1900 (see growth.) the world is now faced with enormous Figure 5). Compare this to the current new sources of supplies of environment. The opening salvo to manufactured goods and tradable DEFLATIONARY SHOCKS the current deflationary shock was services, in the same way that Western fired as long ago as 1956, when Europe was inundated in the second In a free market economy, prices will Malcolm McLean (the founder of Sea- half of the 19th century by agricultural rise and fall depending on demand Land) introduced the first container products coming from the American and supply. A deflationary shock is ship. The container was one of the West, which led to the fall in prices brought about by supply rising much greatest inventions ever, because it referred to above. faster than demand, a condition that allowed for efficient and speedy That deflation is being exported, is usually brought about by some major transportation and avoided the costly in the case of manufactured goods and technological breakthrough. The and time-consuming process of commodities, from emerging application of a new innovation leads stevedores loading and unloading, and economies to the industrialised to greater efficiencies of production or stowing cargo from ships to trucks, and nations, including Japan, is evident to new sources of production, or to a vice versa. It is difficult to imagine from declining import prices (see combination of both. In the second that world trade could have expanded Figure 6) and, in the case of services, half of the 19th century, the earlier by as much as it has over the last 50 from the growing trend to outsource construction of canals and railroads years or so without containers. Then all kinds of accounting, and the emergence of efficient trans- came the Boeing 747, which lowered communication, and information ocean steamships lowered the cost of air travel and air-freight; functions to countries such as the transportation costs by around 90% the fax machine in the early 1980s, Caribbean Islands, Mexico, and India. and allowed grain grown in the which significantly boosted the In fact, the current deflationary shock western territories of the US and in efficiency of transmitting information; would reach far greater proportions if, Australia to reach Europe, leading to and later the PC and the Internet, along with the free flow of goods and declining agricultural prices which brought down the cost of capital, labour could move freely from throughout the world. Thus, we can communication to almost zero. At the one region of the world to another. say that the application of new same time, foreign exchange controls One could even argue that there was
4 The Gloom, Boom & Doom Report November 2001
transportation service industry could Figure 6 US Import Price Index (yearly percent change), be taken over by emerging economies 1990–2001 with their low wages. It should be evident that while European airlines with their high wage costs and poor management will fail, Asian airlines with their low labour costs will take over their business. The same is occurring in the shipping and cruise line industry, where most crew members originate nowadays from developing countries. Similarly, in the trucking industry, Mexican drivers with their lower wages will increasingly ship cargo between Mexico and the US at the expense of their American counterparts. Then there is the retirement and health-care industry. In the same way that there was a huge migration of Source: yardeni.com well-heeled elderly northern Europeans to lower-cost and climatically more appealing places far more freedom of movement a terms — and benefit people living in such as the Canary Islands, Majorca, century ago than there is today, poorer countries, where even those and Ibiza, and along the entire because of much tighter migration people who didn’t migrate would have Spanish coast, which has contributed policies now. But if there was a a better chance of finding to these regions’ economic growth in completely free movement of labour employment. Unfortunately, the the last 20 years, I can see that, in in our times, we would see millions of current strict migration policies in time, more and more people from the people from poor countries migrating industrialised nations are unlikely to industrialised countries will retire in to countries with high price levels and change (especially given the events of developing countries where the costs seeking employment at high wages in September 11), but even so, emerging of living are just a fraction of what countries such as Japan, the US, and economies are in a position to export they are at home. Naturally, this trend Western Europe, and temporarily deflation. In the manufacturing sector would accelerate significantly if depressing wages in the manufacturing this trend is already well under way government officials in the developing and service sectors of those and will accelerate, as, given the countries had the sense to refrain from economies. However, totally free current recessionary environment, their continuous anti-foreign rhetoric movement of people would not companies in high-cost countries (the and allowed foreigners to own necessarily damage these economies in developed countries) will shift far property. (The retirement industry the long run, but rather would benefit more production to emerging will only really take off in emerging them. This is so because if current economies in order to cut costs. And economies if foreigners have the right tight migration laws are maintained, since emerging economies with their to own landed property. This is, more and more businesses will simply low wages and, frequently, the absence however, a thorny issue in most migrate to low-cost countries such as of property rights can put developing countries, because their China, Mexico, and India (for infrastructure, such as roads, bridges, false sense of patriotism or, even services), leading to above trend-line tunnels, power plants, airports, worse, their nationalistic bias makes growth in these countries and below harbours, and so on in place at a far them think that the foreign, trend-line growth in the industrialised lower cost than the industrialised ownership of land amounts to selling nations. Just imagine the effect of free countries, and given their almost out their precious nation to evil and migration on Japan’s economy! The unlimited reservoir of cheap labour, barbaric foreign intruders, when in unfavourable demographic trends countries such as China will in future fact, as a percentage of their total would be reversed and, with pressure further increase their competitive property market, foreigners would be on wages, the country’s competitive manufacturing advantage over the unlikely ever to own more than 1%.) position would improve. A borderless developed countries. But just think how the money spent world, which would consist not only However, the service sector isn’t by 100,000 retirees would boost the of the free movement of goods and immune from this trend, as we have economy of a country such as the capital, but also of labour, would seen in the case of India’s software, Philippines, Thailand, Indonesia, or almost certainly increase the world’s call-centre, and accounting industries. Malaysia. Assuming, very GDP significantly — at least in real The entire international conservatively, an annual spending of
November 2001 The Gloom, Boom & Doom Report 5
US$20,000 per foreigner (but more in the suburbs or even the countryside, to raise prices in those countries that likely US$30,000), US$2 billion (or how great a step is it in a highly cost- receive these more affluent migrants. US$3 billion) would flow to these conscious world to move at least some Just have a look at how prices have countries’ bottom line right away, not processing functions to places such as moved up in southern Spain, and in to mention the know-how and skills India, the Philippines, Russia, or the Balearic and Canary Islands, over these retirees would bring with them, China? Moreover, it should be the last ten to 20 years. In this respect, and the estates their soft hearts would understood that there are businesses in a quick look at the Hong Kong leave behind to their new-found the service industry that create economy might shed some light on communities! Yet, while this wealth, as well as those that have the subject of the phenomenon of a migration trend is well under way stepped in to perform the work deflationary shock. within Europe (from north to south) formerly performed by housewives Manufacturing has already almost and in the US (from everywhere to who are now working women entirely left Hong Kong for locations Florida, Arizona, and Nevada), it still supporting their families. Thus, I can across the border in China. Even represents only a trickle towards see the positive contribution to services are increasingly moving across developing countries. Still, younger economic growth that service sector the border, not only for the export/ people, who by the time they retire companies such as temporary work import-related service sector, but also will have travelled widely and perhaps agencies and courier services like DHL for some functions in the financial lived in several different countries, and Federal Express are making. Less sector. And while Hong Kong people will be far more likely to adopt new clear is the benefit to the economy of don’t travel to China for a haircut, homes in foreign countries than their having to eat breakfast, lunch, and they do go there for shopping and for parents who grew up, lived, and dinner in a coffee shop, of spending entertainment. Moreover, on long worked in the same city all their lives hours each day driving your children weekends Hong Kong almost empties and travelled abroad only to daycare centres, and of having a itself, as people from Hong Kong find infrequently. (This trend will also be cleaner come daily to your house it cheaper and more pleasant to go to reinforced by the rising number of because your wife works at a Thailand, the Philippines, or China multiracial families.) McDonald’s outlet and earns less than for a couple of days than to stay at The other service sector that is the value added if she had stayed home in expensive Hong Kong. increasingly becoming tradable is home and looked after the household! Moreover, increasing numbers of health care. There are a growing But under the influence of vocal Hong Kong people are moving their number of people who travel from feminists, many women have come to homes to nearby places in China Europe to Singapore for dental care believe that staying at home and because of the huge accommodation (much cheaper) and to Bangkok for raising their children is a demeaning cost savings — a trend that would all kinds of bizarre operations. In job, while earning a salary for one’s certainly accelerate if the Hong Kong countries such as India, the work — even if it is associated with government decided to open the Philippines, and Thailand there are high transportation costs in addition border to adjacent Shenzhen 24 hours excellent health-care facilities that to income taxes — is personally far a day. (At present, the border closes at cost a fraction of what they cost in more rewarding and glamorous. In 11 pm and reopens at 5 am, because Western countries. general, I believe that services that the parasitic Hong Kong property Sceptics of this deflationary shock add significant value to an economy, developers, who basically run Hong scenario will, of course, argue that as compared to those which simply Kong, fear that a totally open border while some deflationary pressures do serve as substitutes for the old would depress real estate prices in exist in the manufacturing sector, “household” economy, can be more Hong Kong even further.) In addition there will be no problem for most easily outsourced to other countries. to the increasing numbers of Hong services, as people simply wouldn’t (If the US government was a profit- Kong Chinese who are living in or travel from a high-cost country to, say, driven corporation, it would outsource retiring to China, retiring expatriates Thailand just for a comparatively the entire social security are leaving Hong Kong for less- inexpensive meal or to, say, Burundi administration and the IRS to India.) expensive places offering a higher for a cheap haircut. Moreover, they While it is true that there are far quality of life, such as can be found in would be correct in pointing out that more migrants from less-developed Europe, Australia, New Zealand, or at present the migration flows still countries into the developed countries Southeast Asia. In the meantime, favour the developed countries, with than the other way around, the Hong Kong is host to a large flow of far more people from poor countries incoming migrants have the tendency migrants from China, who have, in moving to rich countries than vice to keep wages in the industrialised recent years, kept wages from rising versa. But consider the following. If so countries from rising much — in some and are therefore a thorn in the side of many large companies have already cases, they can even depress them — the local labour unions. Thus, at least found it advantageous to move their as a large flow of migrants increases in Hong Kong, a structural back-office, and occasionally their the supply of labour. Conversely, the deflationary shock from the opening front-office, functions from expensive flow of migrants from rich countries to of China is clearly evident and this downtown areas to cheaper locations countries with a low price level tends deflationary trend will, in my
6 The Gloom, Boom & Doom Report November 2001
opinion, continue to depress the the exploitation of the American such as in Shanghai and Beijing could territory’s asset prices, including continent and other new regions and perform well after the more than 50% shares and real estate. catapulted America into the role of capital value decline they have The questions we have now to the world’s leading industrial power, experienced since the end of 1995. address regarding this deflationary resembled far more a deflationary The 1873–1900 period was also shock scenario are whether such a boom than a shock! Moreover, while highly beneficial to holders of fixed condition is something to be owners of agricultural land in Europe interest securities who reaped large concerned about, and whether performed poorly, real estate in cities gains from deflation. The yield on monetary policies can reverse this rose again after the 1873–1878 crisis, British Consols fell from a high of deflationary trend. because of the accelerating process of 3.41% in 1866 to a low of 2.21% in urbanisation. This was particularly 1897, and in the US the yield on THE ECONOMIC true of the US, where real estate in higher-grade railroad bonds declined CONSEQUENCES OF A southern California soared in the years from 6.49% in 1861 to 3.07% in DEFLATIONARY SHOCK preceding 1886. Thus, while real 1899. Deflation was obviously not estate may not be particularly particularly favourable for corporate American economists such as Paul attractive in the present deflationary profits, and bonds therefore out- Krugman and economic policy period (certainly not in financial performed equities after 1876 (see decision makers such as we find in the centres), selected real estate markets Figure 8). US Treasury and the Fed would do anything to avoid a deflationary shock, fearing that deflation means Figure 7 The Rise of Real Wages, 1800–1896 depression. But let’s look at the evidence. It is true that the period between 1873 and 1900 wasn’t a golden era of prosperity. Grain farmers, particularly in Europe, were in deep trouble. with political consequences that included the Populist movement in the US, the “revolt of the field” in Britain, and rural unrest in Europe and Russia. Returns on agricultural land, both in terms of real estate prices and rents, fell. But on the other hand, real wages rose practically everywhere more rapidly than in the first three-quarters Source: David Hackett Fischer, The Great Wave of the 19th century (see Figure 7), as a result of meaningful productivity improvements in agriculture and manufacturing. Thus, the European Figure 8 Relative Strength of US Stock Prices vs Railroad Bond landowning class lost out, as they not Prices, 1857–1899 only faced declining rents and agricultural prices but also rising real wages. However, we should not forget that the economic development of many new regions which led to exports of Mississippi cotton, Argentine beef, Australian wheat, New Zealand mutton, African ore, and Canadian timber, combined with declining transportation costs (the Suez Canal opened in 1869), created an integrated global market for commodities, boosted world trade, and brought about large economies of scale. Thus, landowners aside, the deflationary shock that had been 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99
brought about by new technologies Source: The International Institute for Economic Research and inventions, and which permitted
November 2001 The Gloom, Boom & Doom Report 7
In sum, I would argue that while terms or adjusted for the US dollar easier monetary policies would in no the entire 19th century was exchange rate), the Japanese way have reduced the production of characterised by a deflationary trend deflation following 1989, and the agricultural commodities or retarded (commodity prices and interest rates Asian crisis after 1997. Therefore, the process of industrialisation, which in 1900 were half those of 1800), it given the current high level of with its productivity improvements was a century during which enormous consumer and corporate debts in the led to a fall in prices for steel, coal, economic progress took place US, there is a serious risk of a transportation, and so on. Also, accompanied by strong population deflationary bust. Moreover, even if would Japan be worse off today had growth. Therefore, there is, in a deflationary bust can be avoided interest rates not been reduced to principle, nothing to fear from and some kind of deflationary boom almost zero? It’s unlikely, since deflation. However, the reason so were to occur in the years to come, almost-zero interest rates, combined many economists fear deflationary we should not forget that the with large fiscal deficits, allowed the periods is that they only look back at deflationary boom of the 1873– debt levels in Japan to grow in the the Depression years of the 1930s, 1900 period led to a huge 1990s to unprecedented levels for an which were truly a deflationary bust. geopolitical change, with Britain industrialised nation. Had, instead, However, instead of analysing the being a relative loser while the US the Japanese government let the various causes of the bust following became the world’s leading post-1989 crisis run its course and not 1929, they focus on the devastation industrialised and political power. intervened, more pain would have the deflationary bust brought about, Whether in the years to come China been incurred in 1992, but Japan when, in fact, the Depression was will challenge the economic today would be in a far healthier only a consequence of the previous hegemony of the US remains to be financial and economic position. In speculative credit-driven boom that seen, but having witnessed with my fact, I would argue that Japan’s led to the excesses of the 1920s. Had own eyes what China has achieved in problem is that it didn’t have enough these economists studied the 1920s’ the last ten years, it is possible that, deflation, which would have brought speculative boom more carefully, they in the manufacturing sector at least, its price level more in line with those might have implemented economic China could overtake the US within of other Asian countries, shut down policies during the 1990s that could the next ten to 20 years (with the excess capacity, and bankrupted weak have reduced the risk of a similar proviso that there is social stability). companies, which are now going — occurrence in the years to come. In Also, in terms of investment strategy, or will eventually go — out of his book Booms and Depressions, investors should not forget that in business anyway, but with a much published in 1932, Irving Fisher made the period from 1873 to 1900 and, larger debt burden than would have the “over-indebtedness” responsible even more so, from 1929 to 1941, been the case five or eight years ago! for the Depression, meaning “that bonds significantly outperformed As to whether the 1930s’ debts are out-of-line with, are too big equities. Depression could have been avoided relative to other economic factors”. with easier monetary policies is a According to Fisher, over- THE EFFECTIVENESS OF much-debated subject, with indebtedness is brought about by MONETARY POLICIES IN A economists such as Milton Friedman “new opportunities to invest at a big DEFLATIONARY arguing that economic policy profit … such as through new ENVIRONMENT mistakes post-1929 were the cause of inventions, new industries, the Depression, while the Austrian development of new resources, Assume that, in the years following school of economists maintains that opening of new lands or new markets. the boom of 1866–1873, the world the crisis was brought about by easy Easy money is the greatest cause of had cut interest rates as rapidly, and monetary policies prior to 1929, over-borrowing” (Irving Fisher, The eased monetary conditions by as which led to over-investments and Debt Deflation Theory of the Great much, as was recently done in the “over-indebtedness”, as well as to Depression, London, 1933). US. Do you really think that, under speculative excesses in the stock Therefore, whether deflation leads to such conditions, the opening of the market, which in turn brought about a deflationary boom, as in the latter American West to agriculture and the subsequent deflationary slump. years of the 19th century, or to a the subsequent glut of agricultural Also, in the case of Latin America bust, as after 1929, would seem to commodities on the world’s markets post-1981, easy monetary policies depend very much on the level of that led to their price declines would combined with large fiscal deficits debt in the economic system prior to not have occurred? In my opinion, brought about the worst of all the deflation. This observation seems such monetary policies would possible worlds: hyperinflation and to have been confirmed by the actually have accelerated this process, depression. And in the case of Asia deflation in Latin America in the since even more railroads would have post the 1997 crisis, I could make the 1980s following the petrodollar boom been built and the American case that easy monetary policies have (in nominal terms there was continent would have been opened at had the effect of badly retarding the inflation, but because of the currency an even faster rate. One point ought necessary reforms and of leaving the collapse there was deflation in real to be obvious: lower interest rates and debt overhang problems largely
8 The Gloom, Boom & Doom Report November 2001
unresolved. Thus, it is by no means particular importance. In particular, impressive than the 1995 or 1998 certain that current monetary with increased frequency of usage, bull phases that followed the Fed’s policies in the US will be effective in the effectiveness of drugs tends to easing on these occasions.) reviving the economy. diminish and occasionally disappears Now, compare this to the present. There are some more points to altogether as bacteria and viruses Liquidity has been pouring into the consider. In his highly recommended develop immunity. In this respect, it system, with the Fed fund rate having book, Manias, Panics, and Crashes is interesting to note that when the been cut by 450 basis points since the (Basic Books, 1978), Charles tightening cycle ended in the final beginning of the year! But what was Kindleberger devotes a chapter to months of 1994, the stock market the result? The stock market has “the lender of last resort”, which soared in 1995 by more than 40% to rallied recently, but whereas in the “stands ready to halt a run out of real new highs. Then, in 1998, following past such massive easing moves and illiquid financial assets into the LTCM debacle, monetary produced new highs in the stock money, by making more money conditions were eased once again and market within months, today the available”. According to Professor within a few months the market stock market averages and its leading Kindleberger, “How much? To made new highs (see Figure 9). Later, constituents such as Cisco (see Figure whom? On what terms? When? These in the final months of 1999, 10) still remain well below their year constitute some of the dilemmas of monetary conditions were massively 2000 highs. In other words, monetary the lender of last resort, after it is eased once again because of the interventions seem to have become determined, first, whether there unfounded concerns about the larger in size, but at the same time should be one, and second, who it problems associated with Y2K and less effective in boosting or should be. All these issues derive the market again made new highs. supporting the stock market and, from the basic dilemma that if the (Given the huge liquidity injection at along with it, the economy. market knows it is to be supported by the time, the rise was far less Moreover, if these monetary a lender of last resort, it will feel less (little? no?) responsibility for the effective functioning of money and Figure 9 S&P 500, 1997–2001 capital markets during the next boom. The public good of the lender of last resort weakens the private responsibility of ‘sound’ banking.” Kindleberger then goes on to give examples of where interventions by the lender of last resort (usually the central bank) worked and occasions when they failed. In particular, he emphasises the importance of the timing of the intervention. “‘Too Source: BigChar ts.com Exchange provides no volume data little, and too late’ is one of the saddest phrases in the lexicon not only of central banking but of all activity. ‘Too much, too early’ is not an evident improvement. Enough at Figure 10 the right moment is better than Cisco Systems, Inc., either. But how much is enough? 1995–2001 When is the right time?” Kindleberger further states: “If, then, one admits the necessity for a lender of last resort after a speculative boom, and believes that it is impossible for restrictive measures to slow down the boom at the optimal rate without precipitating collapse, the lender of last resort faces dilemmas of amount and timing … As for timing, it is an art. That says nothing — and everything.” Therefore, as is well known in the medical field, dosage and timing of Source: The Stock Picture the administration of drugs are of
November 2001 The Gloom, Boom & Doom Report 9
interventions are as timely as the US Treasury’s decision to halt the sale of Figure 11 US Mortgage Refinancing Applications Index, 30-year Treasury bonds when yields 1997–2001 are relatively low (why did the US Treasury not discontinue such sales in 1981, when long-term Treasury bond yields reached 15%?), then we may be in for some nasty surprises. In fact, I believe that the Fed’s intervention in the market will make matters worse in the long run, because any intervention in the free market leads to unintended consequences. One of these is, undoubtedly, the refinancing boom in the housing market (see Figure 11) and zero interest rate auto loans, both of Source: ABN-AMRO which simply borrow demand from the future. Once interest rates no longer decline, and it wouldn’t surprise me if the Treasury’s decision couple of years, equities could return corporate bonds, which in such a to halt the sale of 30-year bonds has less than ten-year Treasury bond deflationary scenario would put a top in place for US government yields, which at present are hovering continuously suffer from a bonds and marked the low of interest a tad below 4.4%. And as to the deteriorating credit quality. Finally, I rates, the refinancing boom will come deflationary scenario I have outlined also want to make the case here that to an abrupt end, while auto sales will above, which may be reinforced by if the world had had no central banks collapse once the zero interest rate easy monetary policies and at the over the last 20 years and monetary auto loans policy is discontinued (not same time a relatively poor growth had been kept constant at, to mention that zero interest rate performance of bonds, the answer say, 3% per annum, it is likely that loans will eat badly into the may be found in the movement of the the wild swings we have experienced automakers’ profits). At the same US dollar against foreign currencies, in the global economy since 1990 time, low interest rates will especially against the Chinese would have been avoided. Without temporarily ensure the “survival of renminbi, and commodities. In time, central banks, market forces would the weakest”, not the “survival of the the expansionary monetary policies have contained the speculative fittest”, and prevent excess capacities of the Fed are likely to weaken the booms and the colossal busts that being shut down. In addition, easy US dollar, if not against the Yen, followed them far better than the monetary conditions will lead to then against the Euro and, sometime central bankers have managed to do. further capacity expansion in Eastern in the future, against the Chinese As John Stuart Mill observed, “the Europe, Russia, and especially China, renminbi and commodity prices. great majority of things are worse thus reinforcing the over-capacity Moreover, I would make the case done by intervention of government” problem and the deflationary that had the Fed not intervened than the market would do them if left corporate profit environment. aggressively in the money market and alone. But, don’t I contradict myself? On pushed down interest rates by 450 the one hand I believe that the US basis points since the beginning of CONCLUSION Treasury bond market has reached or the year, interest rates on long-term is close to a top, and on the other bonds might very well be lower than In the same way that the opening of hand I believe that the deflationary they are now. The injection of too the American continent in the 19th forces will be exacerbated by easy much liquidity into the system keeps century led to a deflationary boom, monetary conditions. Moreover, I inflationary expectations artificially the rise of China and other emerging explained earlier that, in previous high; therefore, while interest rates economies is spreading deflation periods of a deflationary shock, bonds do decline, real rates (interest rates around the world. A mild form of outperformed equities. However, it is adjusted for inflation) remain high or deflation, such as we had under the possible that in order for bonds to even rise. Thus, even under my gold standard of the 19th century, is outperform equities, bond prices deflationary shock scenario, coming probably desirable. It ensures the wouldn’t necessarily have to rally largely from the rise of China’s survival of the most efficient much, but could either remain just manufacturing sector and new entrepreneurs and producers, while around the current level or decline technologies, interest rates could rapidly eliminating weak companies less than equities. In other words, remain very high in real terms. This and inefficient market participants. A under this scenario, for the next would particularly be the case for deflationary environment also forces
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companies to continuously look for but in the same way that agricultural resolution on the downside is very new methods of production in order to commodity prices would have likely, with stocks bottoming out at boost productivity and lower costs. declined in the 19th century even far lower levels. I also doubt that real Moreover, deflation forces a more under extremely loose monetary estate will perform well, and the now conservative approach towards conditions, the deflationary shock for ongoing deflation for commercial borrowings and investments by the the manufacturing sector brought properties (see enclosure on next corporate sector, as the real cost of about by the opening of China and page) will eventually also spread into money remains relatively high. Lastly, other regions in the world cannot be the residential sector. Long-term US in deflationary periods, real income avoided. Moreover, it would appear government bonds are unlikely to gains by wage earners are usually that the Fed has implemented larger rally much further, but in a higher than in inflationary periods. and larger monetary interventions, deflationary environment for The problem with deflation is not but successively with less and less corporate profits a 4% return will be deflation, but the preceding inflation, impact on economic activity. high compared to the returns I expect which is usually exacerbated by In terms of investment strategy, I for US stocks. In addition, high-grade monetary policies and during which am afraid that investors will have to corporate bonds yielding above 6% debts are out of line with and “are too become accustomed to far lower are relatively attractive for tax- big relative to other economic returns in the next few years than exempt accounts. factors” (Irving Fisher). As Fisher they enjoyed during the 1982–2000 The recent rally that began on pointed out, “Easy money is the bull market for bonds and stocks. September 21 is likely to fizzle out, as greatest cause of over-borrowing.” As previously stated, I believe that at corporate profits will continue to I very much doubt that current very best the stock market will disappoint. A test of the September US monetary policies will be fluctuate (wildly) in a trading range lows, and more likely a break of effective in combating deflation. The of between 950 and 1,250 for the these lows, should therefore be process of deflation may be retarded, S&P 500, but that eventually a expected next year.
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November 2001 The Gloom, Boom & Doom Report 11
Source: Financial Times, October 8, 2001 Marc Faber Limited Enclosure 1