The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (7 page)

The fact that the economics profession has failed so miserably is a key part of the reason we are in this current economic mess and, more importantly, it will be a key part of the reason we will have so much trouble getting out of this mess after the Aftershock hits. Moving economics into a much more sensible direction is so important that we devoted a whole chapter to this issue in
Aftershock
, Second Edition (Chapter 9).

One issue that is not terribly important in the current economy, which was discussed in great detail in
Aftershock
, Second Edition, is inflation. Hence, we are often asked why past money printing hasn’t created inflation. Of course, we point out that we do have higher inflation, but, admittedly, it has not been high enough to increase interest rates, which is the key negative effect of inflation in a bubble economy. And it likely won’t be high enough to increase interest rates for at least the rest of 2012. So, why isn’t inflation higher? It’s due to what are called lag factors. There is always a lag between printing money and inflation. We discussed lag factors in detail in
Aftershock
, Second Edition (Chapter 3).

The easiest way to understand lag factors is the “fool in the shower” analogy used by Nobel Prize–winning monetarist economist Milton Friedman. The fool walks into a shower and turns on the hot water. At first, all he gets is very cold water. So he turns the knob higher to get hot water, and still nothing, so he keeps turning it up. Then, all of a sudden, the hot water hits and scalds him.

That’s what happens with inflation and lag factors. We don’t get inflation immediately, so we see no harm in “turning up the hot water” by increasing the money supply. All we see are the short-term benefits, and we keep printing more money without getting burnt. In fact, as we have said before, the reason inflation could be very high in the future is not because of the money we have already printed, but, more importantly, because of the money we will likely print in the future. More money printing will go from being somewhat discretionary to being more mandatory due to the need for increasing support for financial markets here and abroad. Since we are simply trying to support falling bubbles in housing, stocks, private credit, and consumer spending, there will be a continuing need to print money. Not that the money we have already printed won’t create inflation—it will. But the greatest contributor to future inflation will be future money printing.

However, even with massive money printing, a lot can go wrong long before we get high inflation. Printed money helps to solve some of our economic problems short term, but it doesn’t work perfectly and it isn’t a one-stop cure-all. Governments can print money, but that doesn’t mean they have an economic steering wheel, accelerator, and brake that allows them to drive the economy perfectly. Much of the economy is entirely out of their control. So even if we don’t have high inflation, we can still have financial crises, falling stock markets, and very sluggish real estate markets.

In all fairness, it is true that if we were really willing to open the money-printing spigot, we probably could solve all our problems short term ($10 trillion would likely do the trick). But few people would support it. And, that tells you that they actually know more than they are saying—they know that printing lots of money will create inflation—otherwise, why not print $10 trillion right now? They know full well the dangers; they are just hoping beyond hope that somehow $2 trillion dollars won’t be dangerous and won’t cause future inflation.

There are many possible situations that could accelerate a downturn in the economy. Some are more likely than others and some are less probable but are still possible, depending on unpredictable wildcard events. Potential triggers include:

• Greece
  
• China
  
• Iran
  
• The passage of time
  

Part of the bullish feeling in the stock market currently is a result of the “resolution” of the Greek crisis. Like the economic “recovery,” the Greek “resolution” is likely not for the long term. The Greek economy is still in serious trouble. Only an immediate default has been avoided through the bailout and another round of loans. More importantly, the spread of the Greek debt crisis to Spain and Italy has been temporarily stopped. As we have said all along, the Greek crisis is really a Spanish and Italian crisis. The European banking system can withstand a Greek default, but it can’t weather a Spanish and/or Italian default. So the ECB’s move to buy Spanish and Italian bonds with printed money and also to provide over 500 billion euros in loans to European banks in late 2011 (known as a long-term refinancing operation [LTRO]) and another 500 billion euros in March has helped keep the Greek problem from spreading to Italy and Spain in a catastrophic way.

But, fundamentally, the problem remains severe. Greece’s economy has continued to spiral down, with unemployment now over 22 percent, up from 7 percent in 2007. There is simply no way it can pay off or pay down its debt. Even optimistic projections show Greece’s debt to gross domestic product (GDP) ratio being at 120 percent eight years from now. Needless to say, those optimistic projections are likely to be very optimistic. The real numbers will probably be far worse.

This also shows a fundamental dilemma that many economies face, including the U.S. economy. Government austerity hurts growth. Lots of government borrowing helps economic growth, short term. If that is cut, the economy heads down. Now, if we weren’t in a bubble economy, the fundamental long-term drivers of real growth would ultimately help move the economy toward recovery. Argentina defaulted on its debt and, due to strong growth in the world economy, especially in the United States and China, its strong exports helped the Argentine economy to recover to a large degree. But if there are no fundamental drivers of growth and past growth was based on a rising bubble economy that has popped, then austerity simply becomes part of a vicious downward spiral. In the past decade, the Greek economy has been propelled by a rising bubble of debt that financed its spending. Now that debt bubble has popped and there is nothing to replace it to propel their economy. Plus, there is no strong growth in the European economy or the rest of the world to lift it up.

The situation in the United States is similar. Most of the growth from 2000 to 2010 was due to bubbles, not fundamental growth. So, once those bubbles have popped, there aren’t any growth drivers left. The lack of fundamental growth is evidenced in the job creation numbers. Between 2000 and 2010, there were
zero
net new jobs created. In fact, we actually lost about 200,000 jobs.

However, unlike Greece, we have the ability to create two more bubbles to help pull us out of trouble temporarily—the government debt and dollar bubbles. To the extent we try to reduce the government debt or dollar bubbles, our growth will fall. Hence, we are between a rock and a hard place, just like Greece. Either we embrace austerity and let the bubbles fall, or we try to pump up more bubbles, which will temporarily keep the other bubbles from popping but make the final pop much worse. We think this is an easy choice for politicians—pump up the bubbles! This is also why there will be more and more discussion about how government debt and money printing isn’t so bad, but actually very good. Of course, this is nuts, but when times get tough, people tend to go a bit nuts.

What’s the solution? That’s easy—don’t blow up the bubbles in the first place. Once you have one, there is no easy way out of a bubble, no soft landing. After you have a bubble, the only choices are pop it now or pop it later. Both are painful. One is painful now; the other is even more painful later. These bubbles were a mistake to begin with and, unfortunately, there is no easy way to correct that mistake now. Ultimately, we will have to focus on increasing productivity to grow the economy rather than blowing bubbles. Increasing productivity is not just the best way to grow an economy; it is the
only
way to grow an economy in the long term.

Since Greece doesn’t have the ability to pump up two more bubbles, it is facing a vicious downward spiral in its economy. Its unemployment could jump far higher than it is today—maybe even 30 percent within the next 12 to 18 months. Fueled by growing joblessness, businesses will lack confidence to invest and consumers will lack confidence to spend. It’s a bad downward spiral that doesn’t end quickly.

A Greek default on its debt won’t solve the problem either. Much more is hurting the Greek economy than having too much debt. The big problem is the inability to borrow as they did before to pump up the debt-fueled spending bubble that was so critical to their growth. Without a bubble to drive growth, the only option is increasing productivity. And, for Greece, that is likely to be a very slow process.

China’s construction boom is unprecedented in human history. By some estimates, as much as 50 percent of their GDP is now driven by fixed investment, a large part of which is construction. Far from encouraging a more consumer-driven economy rather than export-driven, consumer spending as a percentage of the economy has actually decreased while the construction part of the economy has become absolutely dominant. Even at the height of our housing bubble, construction was only 17 percent of our economy. At its height during Spain’s housing bubble it was 23 percent, and in Dubai it approached 30 percent at the peak of its speculative construction boom.

Some people feel this construction bubble is unsustainable, although not surprisingly most people do not see it as unsustainable and think it can go on for many more years. For those who think it will slow down, a lot of the discussion surrounding the fall of this construction boom revolves around whether it will have a soft landing or a hard landing. Massive state-controlled and -directed bank lending, which was fueled in part by printed money, has been the driver for all these construction projects. Hence, many believe that it is well within the government’s ability to control the slowdown.

However, there is also the possibility that the Chinese government can’t so easily control economic growth, especially if the growth is based on an economically unsustainable driver. In fact, using nonmarket methods, such as forced bank lending, to create construction projects for which there is no market demand could easily make a downturn even harder for the government to control when it begins to go bad—as it inevitably will.

China’s growth over the past couple of decades has been driven by the government’s opening up the Chinese economy increasingly to market competition and market forces. However, its growth in the past few years has come from just the opposite—government-controlled nonmarket intervention. And, we might add, the only reason they have the financial power to do something so unwise as massive forced bank lending for construction is the enormous economic gains made from their move toward a more free-market-driven economy.

So, we think the possibility arises for China to endure not just a hard landing, but an economic meltdown due to a collapse in construction compounded by slowing exports. At the very least, it seems highly unlikely that China’s government can navigate an exit out of this construction bubble any more carefully than the United States or Spain. Just maintaining their current growth rates means maintaining the unbelievable amount of construction they are currently doing and then doing even more every year, plus not having any downturn in exports—in fact, they need continuous increases in exports. It all sounds highly unlikely and very much like the Japanese export- and construction-fueled economy of the 1970s and 1980s that finally popped in a most spectacular fashion.

Yes, some cheerleaders might be able to tell us why China is so well managed that it can avoid what happened to the United States, Japan, and Spain, but it seems like pure cheerleading at its best. Not only do we not believe China is better managed but that China’s non-market economic management—the massive government intervention to circumvent market forces—is actually going to result in a far bigger collapse than that faced by any of those countries when their construction bubbles popped. The best comparison is Japan, since, like China, it was fueled by massive export growth as well as massive internal construction-related growth. The Japanese story ended in great turmoil, even though it was a much more advanced and capably managed economy than China when its bubbles popped.

For the world’s bubble economy, a meltdown by China would have unusually harsh consequences. That is part of the reason so many people are cheerleaders for China’s construction bubble, even though they wouldn’t normally support such extreme nonmarket intervention in the economy in their own country. China is not only the second biggest economy in the world; it is providing almost all of the growth in the world since the financial crisis. So it is having an outsized impact on the United States and world economy. It is also important psychologically to the financial markets, giving them some real teeth behind the belief that high economic growth will continue, just not driven by the United States anymore. If it pops, it will be a big disappointment, especially if the hard landing becomes a meltdown.

Like so much about China and the economy in general, it is hard to know exactly when such a meltdown could occur because it is so dependent on government actions (Chinese government) and psychology. But it is likely we will see a more pronounced slowdown than we are already seeing in the second half of this year, and 2013 will be the first real chance for a meltdown to occur. Like our own government, the Chinese government will fight this with money printing, but they have been doing this for some time and, at some point, it simply won’t work. China is already a huge economy, and maintaining its high growth rates will become increasingly difficult under any circumstances. And when that growth stops, it won’t go gently into the night, but rather will likely go from dream straight to nightmare.