Crank up the printing presses

Published 18 August 2011 05:01, Updated 26 August 2011 12:29

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I remember studying excessive spending and the US debt issue (not a crisis at that stage) when I was at uni. To put that in perspective for the IT savvy among you, people were still running around with punch cards and there was talk of phasing out COBOL as a computer language.

Of course everyone needs a scapegoat when it comes to disasters and the US President makes a big target. Hence the bad press around his role in the tortured debt ceiling negotiation that eventually delivered a “solution”. The reality is this problem has been building since the post-WWII period. Defence spending, the Cold War, the space race, Iraq and Afganistan, the welfare state – none of this stuff is cheap. Or sustainable.

The point is the US debt crisis is not particularly new. It was just that no one knew when the bomb would go off.

One thing that perhaps was surprising was the trigger. It wasn’t that S&P downgraded the US government credit rating, it was that it occurred so soon following the resolution to raise the debt ceiling. I guess the US government needs a new lobbyist because it would have liked this to have been delayed for as long as possible to give markets a chance to digest the “good news” of a political solution.

It is fast becoming conventional wisdom that most of the developed world has begun what will be a prolonged deleveraging cycle. What will this mean for economic growth and the ability of the US in particular to reclaim its former glory? Despite a positive, patriotic television poll of US citizens I saw last weekend, I doubt it will happen any time soon.

The slow downward drift of the US is a bit of a recurring theme of mine but I think we can safely say another step along the path towards a brave new world was taken recently, with US Federal Reserve chairman Ben Bernake saying US interest rates will stay close to zero for the next two years. This is an unprecedented admission for the head of the world’s most powerful central bank. With unemployment stubbornly above 9 per cent, consumer debt totally tapped out and housing still in the doldrums, the long march has begun.

Europe won’t escape the new world order either. The euro zone is likely to shrink as some of the peripheral countries are ultimately forced out. The real game plan is to delay this as long as possible to allow the major European banks to restructure their balance sheets so as to be able to absorb the ultimate default hit that inevitably must come.

With so little ammunition left in the locker, what will authorities do to deal with the massive debt issues in Europe and the US?

Their primary concern is to restore health to the real economy, but government spending is working in the opposite direction as austerity measures ramp up to reign in public sector debt. That throws all the weight on monetary policy. But clearly not conventional monetary policy – there is no room to cut interest rates further. This means further large scale quantitative easing is extremely likely.

Whether this policy can be successful in restoring economic health is questionable but the initial market reaction last week assumes the world is heading into another global financial crisis. The evidence for that is simply not there. But make no mistake, with the global debt problem appearing so intractable, central banks will have to recant on inflation targeting and crank up the printing presses. Already done that, you say? You ain’t seen nothing yet. It is time for a tried and true (if whimpy) way out – inflate the debt away.

The difference this time around is with consumers so overloaded with debt, the type of inflation generated is unlikely to be concentrated in the CPI basket. It is far more likely to manifest itself in asset price inflation.

One of the unintended byproducts of excess liquidity in the past has been a bull market in equities and a bear market in bonds. It is unlikely to happen overnight, or be a smooth ride, so caution remains the key. But having minimal equity exposure in your portfolio right now may turn out to be extremely costly down the track.

One more thought: As an Australian investor, the recent decline in the Australian dollar helps protect against the recent market fall in global stocks in your portfolio. If you find it difficult to believe that an exchange rate above parity with the US dollar represents fair value, then historically this still represents a good buying opportunity.

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