How money lost its true purpose

Hopes that we were embarking on a big Christmas rally took a bit of a pounding yesterday. Stock markets around the world dived.

And little wonder. The National Bureau of Economic Research the US body which officially decides if the country is in recession announced its decision. The US is indeed in recession, and it started in December 2007.

Now that's nothing most of us didn't already know. But for the bulls still out there, it must have come as a bit of a shock to see it in black and white.

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After all, that means that the recession has lasted for a full year. If this was just the little V-shaped blip that many of them were expecting, there should at least be some light at the end of the tunnel by now. Yet things just seem to be getting worse by the day

Economic outlooks around the world are terrible

It wasn't just the official confirmation of a US recession that rattled markets of course. Economic data from around the world was terrible. Data from Purchasing Managers' Index surveys for November showed that manufacturing activity shrunk by the most on record in China, Britain and Russia.

In the UK, the PMI showed that manufacturing activity shrunk more rapidly in November than at any time since records began in 1992. The headline figure fell to 34.4 from October's 40.7 reading (a figure below 50 indicates the sector is contracting).

Meanwhile, Bank of England data showed that new home loan approvals fell again in October, to 32,000. That was the same level as in August, which in turn was a 15-year low. From the peak in 2007, approvals are down 72%.

The grim data saw the pound experience its biggest one-day fall against a basket of major currencies since sterling was kicked out of the European Exchange Rate Mechanism in 1992. (For more on why the pound is among the world's weakest currencies, see our recent cover story: The great currency crisis and what to do about it).

Traders are betting that the Bank of England will now cut interest rates by a full percentage point on Thursday, after its Monetary Policy Committee meeting, which doesn't seem at all unlikely. But this won't address the core problem that we're facing.

Pumping money into the economy won't solve the problem

The trouble is, global economic growth has been dependent on US consumers for too long. So when they stop spending, the people who make things to sell to them suffer. And in turn, the people who dig up the raw materials, to supply the people who make things, also feel the pain.

One way or another, most of the economies in the world, if not all of them, have become heavily geared to one of these three things consumption, manufacturing, or production of raw materials. And unfortunately it's very difficult for an unbalanced economy to rebalance. It requires a whole new way of thinking, and a fair amount of social upheaval. Which is why most governments and at least a chunk of their populations would rather wind the clock back to the way things were before the big bust.

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That's why we have central banks across the world slashing interest rates, and governments across the world pumping money into their economies to prop up ailing industries. In the States, the Federal Reserve has now embarked on full-blown money-printing to try to fend off deflation. The technical term for this is "quantitative easing". We'll be looking at this and deflation in more detail in the next issue of MoneyWeek, out on Friday (if you're not already a subscriber, subscribe to MoneyWeek magazine).

But we can't wind the clock back. Rebalancing has to happen. We got into this mess in the first place because the world was flooded with money. We won't make it better by trying to flood it with more.

Money is losing its power

At a very basic level, money is just a method of keeping score. Money is only valuable to society when it performs its function, which is to reward the most productive use of capital. When it's working as it should, it helps us to decide where best to direct limited resources, such as our time and labour.

But money's usefulness has been blunted by central bankers continually focusing on preventing bad investments from going wrong. Former Fed chief Alan Greenspan, the man they once called the 'Maestro', was the main culprit behind this school of central banking. Any time Wall Street looked like losing money on a duff bet, Mr Greenspan was there to bail them out.

But that means money loses its power to help people differentiate between good and bad investments. The biggest rewards tend to go with the riskiest projects, until you reach the point where essentially you're just gambling. The problem is, if you remove risk from the equation, all you're left with is reward.

We've not seen the bottom of the market yet

In other words, the world's central banks have been aiding and abetting rampant speculation, which has sucked money away from productive projects, to be tossed away at the roulette table.

And so we end up with builders who build, not roads, or decent housing, but buy-to-let flats and condos for speculators to 'flip' to each other. We see China left with a glut of factories because it's been relying on US consumers to keep buying plastic rubbish with their property profits.

All of these bad investments are being revealed for the terrible mistakes they were. That's the upside of the recession. The downside is that the boom went on for so long that the unwinding of the bust will be very painful indeed. And there's every chance that the actions of the Fed, and our own government and central banks, will simply draw the process out.

What does that mean for investors? It means we're unlikely to have seen the bottom of the market yet. And it also means that the rush for perceived 'safe havens' will continue. For the time being certainly, gilt yields look set to fall further.

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