DABERIAM XCV

22nd December 2015

After the horrendous events of November, December has, thank goodness, been largely uneventful on all fronts.  The world continues to trudge along in a marginally deflationary economic environment, something not experienced since the 19^th Century.  It is also an experience that worries current economic thinkers and governments as it makes it difficult to get rid of debt.  Inflation is superficially a painless way, as it quietly eats into people’s savings to the unjust benefit of borrowers.  This enables government to mitigate the need to balance budgets, an idea that seems to be regarded as very old fashioned.

In Europe we have had a year where “QE” has become a politically acceptable method of avoiding addressing the old banking crisis of 2008-9.  Europe is following Japan, which has been flooding its own market with cash for twenty or so years, taking the Bank of Japan’s balance sheet up to some 70% of GDP to the point basically where the banking system is running out of good assets to sell to the Central Bank.  The effect of this exercise has had little impact on the real economy but has enormously distorted the banking system to the point where it is virtually ceasing to function in the conventional sense.

Leaving aside Japan, Europe is working on the same snake oil solution. Both economies are piling up debt that is in reality unrepayable and can only be eliminated by default or rampant inflation.  The USA with its Central Bank balance sheet standing at around 25% of GDP is not in quite such a serious position, particularly as the banking system, and more importantly, the private economy has dramatically reduced its borrowing in the last ten to twelve years.  The Fed has, after endless prevarication, raised interest rates for the first time in seven years by 0.25%.  This movement is really no more than a change of sentiment.

The problem with all this monetary gushing is that it has created dangerous asset bubbles, financed by dubious debt instruments that have been taken up by the finance industry and sold into the savings markets, pension funds, insurance companies, etc.  Added to this the distortions have encouraged the movement of assets out of stock markets into “safer” debt instruments that become highly toxic, if and when interest rates start to rise, or confidence starts to be lost in overblown asset values.

It must be remembered that borrowing is always taking from the future to spend in the present.  Put more brutally, the policy of borrowing to finance deficits, whether government, corporate or individual, is robbing the future so to re-balance the books is likely to cause serious short-term pain.

Two important events that will have a long term impact on the world’s monetary system have been announced recently.  The IMF has admitted China to the SDR system, an acceptance by the world that China is critically important to trade and demonstrating that the Chinese Communist Party is serious about freeing up the exchange rate and interest rates to market forces.  Secondly, the ratification by the US Government of the restructuring of the IMF, allowing China a seat at the top table.  This will improve the financial world’s understanding of Chinese policies and help re-establish the US status as a pragmatic force for good in the world that had been severely dented by their obtuse blocking of IMF reform.

On the commodity front, cyclical oversupply of hard and soft commodities is driving down prices which is causing a large part of the deflationary pressure, but is of enormous benefit to Western consumers to the detriment of the commodity producing countries.  The reduction in oil prices, as I mentioned in November, has an immediate benefit to the general public and the reduction of the hard commodity prices will feed through into industrial profitability, provided there isn’t a blow up in the debt market, these changes auger well for US, European and indeed, the Chinese economies.

While oil is in very considerable oversupply, it is a market that is easily moved by events.  As well as the Civil War in the Middle East, another wildcard is Putin’s politics.  It is reported that he is building military bases in Syria and it is conceivable that a Russian tank division in Syria could be used to change the bargaining balance between Russia and Saudi on the question of oil production, causing a spike in oil prices.

Apart from the normal and incalculable unknown unknowns, a possible debt explosion or a Putin play, 2016 is likely to see a steady improvement in the economic environment.  2 to 3% growth with near zero inflation is really quite benign.  With Governments, albeit at glacial speed, working on reducing their deficits, this could mean stability and a general improvement in people’s incomes over the short to medium term.