For readers in the middle of this conversation, we are in a series on the debate held at a London restaurant between Charles and Louis-Vincent Gave (father and son) and Bill Bonner.
The Gaves openly declared that 'This time it's different,' much to Bill's amusement. We all know that it almost never, ever is. They make their argument in a book called 'Our Brave New World'.
The next thing that GaveKal argues is that monetary policy no longer works like it used to. 'In the wake of the Asian Crisis, lower rates are more stimulative to supply than demand while it used to be that lower rates were more stimulative to demand.'
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This is a subtle argument, but part of an overall theme that we are in a deflationary world. Bonner would agree, but where he sees a negative aspect of deflation, they see a deflationary boom. Readers of Gary Shilling would recognise this position. Shilling has maintained for years that we will enter a period of what he calls good deflation.
At its roots, a deflationary boom exists when supply is structurally ahead of demand. Prices drop, and in a classic world, when prices drop, demand rises, thus stimulating even more supply.
This, they point out, makes it easy for central bankers, if you assume the job of central bankers is to keep inflation under control. They do not have to worry about the supply side of the inflation model. Inflation can be created by not enough supply to meet demand. But when there is always 'more stuff' coming into the market, inflation does not result from supply side problems.
That means that central bankers need only worry about the demand side of the equation causing inflation. Thus, raising rates will lower demand, taking away the demand driven inflation. If they need to stimulate demand, as they wanted to in 2001-02, they simply lower rates. But here is the GaveKal twist:
'In terms of managing demand, the Fed may have overdone the demand stimulation in 2001-04, but an important lesson was learned: low rates not only stimulate consumption in the US, but capacity expansion abroad even more. For a while, we get a window where demand surges (i.e.: US housing cycle, energy) and people believe we have entered an inflationary boom. For a brief period, it appears that demand has caught up with supply. But, monetary demand stimulation at the core also creates supply stimulation at the periphery. And while this is going on, investment in capacity looks like demand.
'At some point however, the rise in commodity and house prices we have witnessed in recent years will likely be viewed more as a reflection of capacity growth around the world, not true demand.
'Because low rates are a reflection of the deflationary backdrop, not the cause, the Fed simply can not lean into demand too hard by raising rates aggressively; otherwise they risk a real deflationary bust. The Fed thus has to raise rates gingerly and talk tough - walk hard, but carry a small stick. And since prices don't structurally take off, core inflation measures around the world stay tame.
'Whatever central bankers want to do, they cannot change the reality that supply is in excess of demand. So the complexion of activity is decent volume growth but muted prices. This likely means that the next time the Fed has to lower rates aggressively, the curve won't be as steep as the last go around. In our old MV=PQ framework, when curves are steep, currencies fall, and deficits widen, companies can monetise higher prices. Income statements are inflation pass-throughs. However, investors usually don't like to pay a lot for that (which is why multiples have fallen over the last few years).
'Today, those forces are in reverse. Companies cannot rely on the crutch of price; companies have to monetise volumes. This is much harder to do; and investors are willing to pay a premium (i.e.: Apple) for companies that can do it.'
By 'relying on the crutch of price,' GaveKal means that companies simply cannot raise prices to increase profits. They have to sell more 'stuff' at lower prices to increase total profits.
This is the chicken-and-egg analogy, but an important distinction. Yes, the Fed did want to stimulate demand when they lowered rates. But they also made cheap money (with the help of other central banks, and especially Japan) available WORLDWIDE for increasing production.
Thus, China has some 1,000 ball bearing companies when it needs, maybe, 10. Each day, the managers of those 1,000 companies wake up trying to figure out how to get to be big enough to be one of the 10 who will survive.
And that means growing even more capacity, which is not really needed. They do this by borrowing money, getting foreign investment, offering lever lower prices, etc.
And since rates are low and the money is easy to come by, they have every incentive to do so.
It is the same for chips and copper wire and appliances and, well, just about everything. And the developed world responds by letting the developing world (not just China!!!) do the low profit manufacturing and keeps the profitable design and marketing parts of the business. And this results in a trade deficit.
We shall see that Bonner, et al, do not like the dollar asset standard. Good old gold is what we need as a basis for money. Yet GaveKal not only asserts that a dollar asset standard is developing, but that it is superior to gold. Quite simply, they argue that since gold cannot grow at a fast enough pace to maintain global growth, it has to be replaced, otherwise we revert to a world where consumers lose and governments dominate by their power of controlling gold flows. Now, let's turn to page 109 in our hymnbook and let them explain how they see their Brave New World developing:
'If we assume that a new part of the world is getting richer (China, India, Russia, Brazil, etc.), then we should probably assume that some entrepreneurs in those countries are making it big. This assumption is not a stretch; there is enough anecdotal evidence to support it (if you doubt that some new entrepreneurs are making it big, go to the Louis Vuitton store in Shanghai on a weekend). If we further assume that, in the countries getting richer, we will start to witness the emergence of institutional savings (pension funds, mutual funds, family offices, etc.), then we should expect big 'savings flows' from the rapidly growing developing world into the Western world.
'In simple words, the emerging markets' newly rich will feel like investing a part of their newly created wealth in regions of the world where property rights are well protected and where there is a rule of law. The excess trade balances earned by the 'industrial world' have, in fact, little choice but to be reinvested in the assets of the 'creative world'. The pension funds of the 'industrial world' will buy the companies which give their countries work. The successful individuals in the 'industrial world' will also buy real estate in the 'creative world' (because it also happens to be the 'fun world').
'This implies that the assets in the 'creative world,' and especially the prestige assets will always border on the overvalued. Similarly, given the ability to change a producer if he becomes a little bit too demanding, asset prices in the industrial world will remain a little bit undervalued at all times...Which brings us to the following point: balance of payments consists of two parts:
'1. The Capital Balance: if the above holds true, that part will always be positive for countries with well developed financial markets.
'2. The Current Account: since the two parts add to zero (by construction) it means that the current account in countries with well developed financial markets (US, UK, HK etc.) should always be in deficit, and massively so...
'Taking this a step further, we can assume that, as a result of the constant capital flows, the countries with a well-developed capital market will have an overvalued currency and a very low level of long rates. Which in turn leads to robust real estate markets (see chapter 8) and higher asset prices.
'We call this 'the dollar asset standard'. Basically, diversified and safe assets in the Western world replace gold as the standard of value in the eyes of new savers in Asia, Latin America or Eastern Europe.
'The first implication of this new 'dollar asset standard' is that overvalued currencies, combined with a low cost of money (i.e. low barriers to entry), will prevent anybody in the 'developed financial market world' from making any money in industrial goods. In turn, this development will ultimately force companies in the developed financial market world to move to the 'platform company' business model, specialising in design and in marketing, and letting someone else produce the goods.
'But this is where it gets interesting: once they make the switch to the 'platform company' model, a number of companies will likely realise that they should domicile their research and marketing activities in countries with low marginal tax rates, both for their shareholders and their employees.
'To some extent, this has already happened in the financial industry. On any given day, the biggest foreign net buyer or seller of US Treasuries is the Caribbean Islands. Now needless to say, the Caribbean islanders are not amongst the world's largest investors; but the hedge funds domiciled there most definitely are.
So the 'efficiency capital' of the world, which used to be domiciled in big investment banks in the world's financial centres (whether London, New York, Frankfurt, Tokyo...) has now re-domiciled itself in hedge funds whose legal structures are in the Caymans, Bermuda, the British Virgin Islands etc. The tax revenue on the 'efficiency capital' is now lost for the US, the UK and others...and there is little they can do to gain it back.
'And it's not just in finance that this is happening. Hong Kong Land, a property developer is incorporated in Bermuda. Electronic Arts, one of the world's biggest video game designers is incorporated in the Caymans...As an increasing number of companies move to the 'platform- company' model, it is likely that the top talent will want to work, or at least be taxed, in low tax environments. This will lead to a collapse in tax receipts in countries that do not adjust to this new model. In the new world towards which we are rapidly moving, income taxes will becoming increasingly voluntary and governments will have to get their pound of flesh through property and consumption taxes instead. This should lead to more efficient (i.e. downsized) governments all over the Western World. The platform companies might end up killing off the Welfare State.'
This sounds like James Dale Davidson and Lord Rees-Mogg in their important book written a few years back called 'The Sovereign Individual', although GaveKal comes to the same end from a different road.
And it is an idea to which I subscribe, though for different reasons. It will not just be the pressure from platform companies wanting to avoid taxes that will precipitate that change. I would make the argument that the current generation (in nearly every country in the developed world) and our forebears have written a check in the names of our children, which they will not be able to pay. By this I mean our social security and pension programs. And if they cannot pay it, they won't.
The social contract between generations and governments is going to be re-written in the next 20 years.
We live in interesting times.
By John Mauldin for The Daily Reckoning
P.S. Today, we concluded the GaveKal arguments in 'Our Brave New World'. Next, we will turn to Empire of Debt, looking at Bill's and Addison's arguments. Then I will share my view on the topic. It will surprise no one that I think the truth is somewhere in the middle.
Things are in fact different, yet we will have to find a balance. That a balance and a squaring of the balance sheet may come from new and different forces than in the past will make things seem both different and the same.
It is a rhyme, not a repeat. It is Muddle Through, not a depression, soft or otherwise.
You can purchase the GaveKal book, Our Brave New World, directly from www.GaveKal.com.
John Mauldin is the creative force behind the Millennium Wave investment theory, author of the weekly economic e-mail Thoughts from the Frontline, JohnMauldin.com, and a private letter for accredited investors. His latest book is due out in December.
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