Why something's got to give in the global economy

At times, I find it useful to forget about acquired academic knowledge and just look at events from a commonsense point of view. For instance, it is well accepted that people who drive large cars pay higher taxes on their vehicles than owners of smaller cars, and that people who eat and drink with abandon in a restaurant will be charged more than those who are watching their waistlines.

I also understand that airline passengers with excess luggage will have to pay extra. However, what I don't understand is why passengers who are themselves overweight don't have to pay more than passengers of normal weight. To be fair, airlines should weigh both passengers and their luggage at the same time. Then, if the total weight exceeds the limit per person, they should charge for the excess weight irrespective of whether it comes from the passenger or from their luggage.

In the same way, if I look at the current economic expansion around the world, which began in the United States in November 2001 and increasingly looks like a global boom, the following features strike me as being unusual. Expansionary monetary policies have led to high debt growth in the US, which exceeds nominal GDP growth by a wide margin. Is this sustainable in the long run?

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Just as corporate profits cannot grow at a higher rate than nominal GDP for the very long term, debt growth cannot exceed nominal GDP growth forever. At some point, either debt growth will slow down to the rate of nominal GDP growth or nominal GDP growth will accelerate to the rate of growth in credit. The latter can be achieved by real GDP growth or by inflation accelerating sharply.

Since it is unlikely that the US economy can grow in real terms by far more than 3% per annum, at some point debt growth will have to slow down or inflation will pick up considerably. If debt growth were to slow down sharply and join nominal GDP growth rates, I suppose that some kind of a deflationary recession would follow - an outcome Mr. Bernanke wants to avoid with the money printing press he controls.

Therefore, it would seem to me that the more likely scenario will be for inflation to accelerate in future. If one uses common sense - and not the statistics published by the Bureau of Labor Statistics - it is surely apparent that our cost of living increases are far higher than the published CPI figures.

The second unusual feature of the current expansion is that China and, increasingly, India are for the first time in modern history a factor in the global economy. No one paid any attention to these two economies in the 1975, 1982, and 1991 economic recoveries. But today, the Chinese economy has great significance, both as a supplier of goods and in terms of its demand for natural resources.

In fact, the incremental demand from China for natural resources has shifted the demand curve for commodities to the right, resulting in a higher equilibrium price.

In last month's report, I argued that of all the emerging economies India had by far the highest economic potential, both because of its size and because, in terms of economic development, it had lagged so far behind the other emerging economies until very recently. Matt Fernley, an analyst at UBS, has just published a highly interesting study entitled, 'What if India Grows Like China?'

In this report, Matt makes the case that, from a macroeconomic perspective, India has numerous similarities with the China of the 1980s and 1990s, and that if India realizes its potential, its demand for key materials may treble by 2015. So, if in recent years the incremental demand for commodities from China has shifted the demand curve to the right, then under the scenario outlined by Matt Fernley it is almost a certainty that India, with its billion people and still growing population, would do the same going forward. (Note that India has a far younger population than China.)

This should cheer the commodity bulls, as the demand-driven commodity bull market would extend far beyond 2015 (though, naturally, interrupted by intermediate correction phases).

Related to China, and now also India, driving the demand for commodities higher is also the emergence - for the first time in modern history - of commodities as a distinctive asset class. I am aware that some distinguished economists might dispute the fact that commodities are an 'asset class', but common sense would suggest that assets, for which shortages exist and, I may add, may persist for a long time, are likely to be more rewarding investments than assets for which the supply is limitless (such as US dollars).

Also, while we had a commodities boom in the 1970s, financial institutions at that time didn't consider commodities to be a separate asset class, and certainly didn't invest in a basket of commodities or in physical natural resources. (I suppose that commodities, and especially precious metals, become an asset class in an environment where paper money is continuously diluted in value through a rapid increase in its quantity.)

The third unusual feature of the current economic expansion is that it is accompanied by significant imbalances. Rapid debt growth in the US has led to rising asset prices (notably, homes) and sustained strong consumption growth in excess of income gains. In turn, high consumption in the US has led to an expanding trade and current account deficit whose growth in the long term, as a percentage of GDP, isn't sustainable either.

It may be that the current account deficit, which has soared from 2% of GDP in 1998 to over 7% of GDP, will rise to 10% - or even 20% - of GDP, but it should be obvious that it cannot expand forever. My common sense, however, isn't convinced that those academics, with their sophisticated mathematical and econometrical models, who claim that 'the current account deficit doesn't matter', realize that the current account deficit cannot reach 100% or 200% of GDP!

So, in order to stabilize the trade deficit, either US exports will have to rise very rapidly at some point (at twice the rate of imports in order to stabilize the trade deficit at the current level), or consumption in the US will have to slow down sharply (in order to reduce import growth).

Moreover, while, as just indicated, the learned economists will tell you that these external deficits don't matter, common sense suggests that we are in the midst of a huge shift of wealth from the US to Asia, a theme I have expounded upon on numerous occasions. Simply put, if the US consumes, and Asia invests and produces, it will lead for a large segment of the Asian population to higher per capita income increases than in the US.

Moreover, what this academic crowd overlooks is that US financial assets have been falling in value relative to financial assets overseas. According to Bob Prince and Jason Rotenberg of Bridgewater Associates, this repricing of U.S. financial assets is necessary because the U.S. need for foreign capital is huge and continues to increase.

Attracting this incremental capital requires an increasingly favorable relative expected return. And the fastest way to raise the expected return is by lowering the price. Sometimes it happens through a higher interest rate, sometimes through a lower stock price, sometimes through a falling currency.

Some observers have been puzzled by the outperformance of emerging markets, and of the stock markets of Japan and Europe compared to the US, but it makes perfect sense that where the liquidity accumulates as a result of current account surpluses, asset prices rise more than in those countries that are over-consuming and are plagued by a current account deficit.

According to Bridgewater Associates, 'U.S. assets have consistently fallen in value relative to those abroad by a cumulative value of over 35% in four years [see Figure 1]. This will continue until the dollar falls sufficiently to shift the pricing of U.S. goods and services enough to reduce the need for capital. Until then, the price of U.S. capital will fall in relation to abroad.'

In fact, I wouldn't rule out that within the next ten years bond yields in Brazil or Russia could decline below US bond yields as they have already done in many newly industrialized economies. Moreover, whereas US financial assets have, over the last four years, declined by a cumulative 35% relative to assets overseas, the underperformance of US financial assets compared to gold and silver is even more striking.

Against gold, US bonds and stocks have lost more than half their value since 2001. As explained in the past, I expect this underperformance to persist for many years to come. US home prices have also begun to decline sharply against gold. As Ned Schmidt, publisher of the Value View Gold Report (valueviewgoldreport@earthlink.net) points out, since July 2005, the prices of single-family homes in the US, as measured by the gold price, have declined by 25%. (A year ago, 440 ounces of gold would buy the typical house, whereas today only 380 ounces of gold are required.)

The massive shift in wealth to Asia - most notably to China - has also meant that, for many countries, China has displaced the US as the engine of growth. From Figure 3, courtesy of the Bank Credit Analyst, we can see that whereas China has a huge trade surplus with the US, it has a large trade deficit with the rest of Asia.

In fact, some Asian countries now have larger exports to China, which are still growing rapidly, than to the US. Moreover, in countries where exports to China are still smaller than to the US (such as Latin American and African countries), they are growing far more rapidly than to the US and, therefore, have a highly stimulative impact on their economies.

That this shift of wealth from the US to Asia will also have important geopolitical consequences ought to be clear. (Angola has become China's largest supplier of oil.)

This shift of wealth from the US to the emerging economies has led to a bizarre situation in the history of capitalism. In modern economic development it was always the rich countries that financed economic development in the emerging economies. European capital financed the construction of canals and railroads in the emerging American economy of the 19th century.

Then, in the 20th century, European and American capital financed economic development in Latin America, Australia, Asia and Russia (until the Russian Revolution). But now, it is not the rich US that is financing the emerging economies, but the poor countries, mostly from Asia (notably China), that are financing US consumption through the purchase of US dollar fixed-interest securities with their bulging foreign exchange reserves.

This situation is truly unique in economic history and one has to wonder how sustainable the condition will be. (A symptom of this shift in wealth to emerging economies is the disappearance of Brady bonds. Governments that issued them in the early 1990s, in order to help resolve defaulted commercial bank loans, are now buying them back.)

The final unusual feature of the present global economic expansion is that, so far, the Fed's busy money printing press has lifted in value all asset classes, including stocks and bonds in developed and emerging economies, industrial commodities and precious metals, real estate, art, collectibles, and even bonds (until very recently).

Common sense would argue that it is impossible for all asset classes to move up forever in concert. In particular, rising property and commodity prices are a symptom of some inflation in the system and can themselves cause, in time, consumer prices to increase at an accelerating rate. Therefore, it should be clear to anyone that sooner or later commodity prices or bond prices will tumble.

If monetary policies become really tight, commodities, including precious metals, will fall hard. Conversely, if monetary policies remain expansionary, interest rates are likely to rise for far longer and bonds to decline much further.

We can see that since the early 1980s gold and interest rates moved down in concert until 2001. But since then, gold has more than doubled in price, while interest rates fell further into 2003. Since then, interest rates have hardened modestly.

Some economists will argue that rising gold prices and low, or even declining, interest rates are entirely compatible amid the ongoing globalization. But I don't buy such reasoning. Something will undoubtedly give in a very big way and lead to far higher volatility in the asset markets.

In my opinion, the precious metal markets are signalling high rates of inflation in the future, while the bond market is saying that inflation won't be a problem. Someone will pay dearly for being on the wrong side of the trade and I suspect it will be the bondholders.

By Marc Faber for Whiskey and Gunpowder

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