Prolonged Global Winter - By Martin Hutchinson
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Prolonged Global Winter - By Martin Hutchinson

Posted by ProjectC 
"In the current global unpleasantness, there are alas no world leaders with Liverpool's economic grasp (having David Ricardo as economic advisor doubtless helped). Even compared with other recessions within living memory, such as 1974 and 1982, the reaction from the global political class has been notably panicky and hysterical. Five trillion dollars of global stimulus programs, largely consisting of public spending, are unlikely to increase the stability of the global economy, and nor are the moves by three of the world's four most important central banks to "quantitative easing'' – the monetary policy of the early Weimar Republic.


Under Weimar, the profits from "seigniorage" – the issue of new money – financed around 50% of public spending in 1919-23. Notoriously, this resulted in a trillion-fold devaluation of the mark by November 1923. In the United States today, around 15% of public spending is being financed through seigniorage – the Fed is purchasing $300 billion of Treasury bonds over six months, an annual rate of $600 billion per annum, 15% of 2009 federal spending of $4 trillion.

The U.S. may still be the right side of the Weimar dividing line, but in Britain the figures are more alarming. The Bank of England is purchasing 75 billion pounds of gilts over three months, an annual rate of 300 billion pounds per year, more than 65% of Britain's projected 2009 central government expenditure of 454.6 billion pounds. Of course, the Bank of England may not repeat its gilt purchases every three months, but at least in the short term it is disturbing that Britain is currently "printing money" faster than Weimar Germany.
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Prolonged Global Winter

By Martin Hutchinson
April 06, 2009
Source

With increasing frequency over the last few weeks, economic statistics have emerged suggesting that the first shoots of economic spring are emerging and that the bottom of the U.S. and global recession is only just round the corner. Higher vehicle sales and factory orders, the Institute of Supply Management monthly index and slightly higher personal income and retail sales figures have all burgeoned like early crocuses, suggesting that the slope into economic decline has turned shallower, so we may reach bottom about mid-year.

Had we not been afflicted with a global epidemic of panicking governments, those modest green shoots might indeed have blossomed into a genuine spring. However, governments' misguided activities have darkened the global outlook. Far from entering spring, we are still in the opening stages of a winter that has become nuclear and will blight the world for the best part of a decade.

There is no necessity for a severe recession, such as the present one, to be excessively long; it depends on the government policies pursued. At one extreme are the Great Depression, both severe and lengthy, and the Japanese rolling recession of the 1990s, appallingly lengthy but at no time particularly severe. As is generally agreed, both these downturns were artificially prolonged by misguided government action.

At the other extreme, we can examine the British recession of 1816-17, after the end of the Napoleonic Wars. This would have been severe in any case, because of the transition to peace after 20 years of war and the immense financing difficulties and investment "crowding out" effect caused by Britain's 1815 public debt burden of over 250% of Gross Domestic Product (GDP), 50% larger than Japan's today and double Italy's.

However, the downturn was made much worse by the April 12, 1815, eruption of Indonesia's Mount Tambora, the largest volcanic eruption in recorded history. This deposited 100 billion tons of volcanic ash (more than the volume of Lake Geneva) over the world's surface and caused in 1816 the "Year without a Summer" – with fairly mild effects in southern climates and the United States, but causing the entire British harvest to rot in the fields. More serious than a mere banking crisis, therefore.

Lord Liverpool, Britain's prime minister, implemented only one policy to fight recession. In February 1817, with parliamentary approval, he suspended the operation of the Habeas Corpus Act, in order that any impending riots could be efficiently quelled. This well-designed "stimulus package" proved remarkably successful. Only one small disturbance occurred and by December, 1817, after a bountiful 1817 harvest, Liverpool was able to end the suspension, as the recession was over and the threat to public order gone. Total recession duration: about a year, though there was a second "dip" in 1819 because of the 20% deflation needed to put Britain back on the Gold Standard.

In the current global unpleasantness, there are alas no world leaders with Liverpool's economic grasp (having David Ricardo as economic advisor doubtless helped). Even compared with other recessions within living memory, such as 1974 and 1982, the reaction from the global political class has been notably panicky and hysterical. Five trillion dollars of global stimulus programs, largely consisting of public spending, are unlikely to increase the stability of the global economy, and nor are the moves by three of the world's four most important central banks to "quantitative easing'' – the monetary policy of the early Weimar Republic.

Under Weimar, the profits from "seigniorage" – the issue of new money – financed around 50% of public spending in 1919-23. Notoriously, this resulted in a trillion-fold devaluation of the mark by November 1923. In the United States today, around 15% of public spending is being financed through seigniorage – the Fed is purchasing $300 billion of Treasury bonds over six months, an annual rate of $600 billion per annum, 15% of 2009 federal spending of $4 trillion.

The U.S. may still be the right side of the Weimar dividing line, but in Britain the figures are more alarming. The Bank of England is purchasing 75 billion pounds of gilts over three months, an annual rate of 300 billion pounds per year, more than 65% of Britain's projected 2009 central government expenditure of 454.6 billion pounds. Of course, the Bank of England may not repeat its gilt purchases every three months, but at least in the short term it is disturbing that Britain is currently "printing money" faster than Weimar Germany.

On the fiscal side, the figures are equally exciting. The United States, Britain and Japan are all running fiscal deficits of more than 10% of GDP in 2009. Once you factor in the newly released Organization for Economic Cooperation and Development's more pessimistic economic forecasts, they will run even larger deficits in 2010. Furthermore, if recovery is at all sluggish, the "output gaps" between those countries' actual GDP and their increasingly theoretical "full employment" GDP are likely to produce fiscal deficits close to the same level in 2011 and possibly thereafter.

There seems to be no recognition among policymakers of how dangerous these profligate policies are. Only last week, at the G20 meeting, the world agreed to provide yet another $1 trillion of capital to the international bureaucrats of the International Monetary Fund and the World Bank, who will on past form divert it almost entirely to governments of the countries most devoted to overspending.

Deserving countries, in Latin America and East Asia, which have managed their affairs properly without excessive balance of payments or budget deficits will see little of this money, and nor will the beleaguered emerging markets private sector. Like the world's other fiscal deficits, the IMF and World Bank funding will have to be borrowed, and in being borrowed will create either inflation or "crowding out" of truly productive Western and emerging market corporations, whose funding needs will become more desperate as the global recession drags on.

Except in a few countries such as Germany and China, which had previously been fiscally conservative with low or negative budget deficits, the correct amount of "fiscal stimulus" in this downturn was zero or negative. Most countries were already running substantial budget deficits in the boom, and the automatic stabilizers in all big-government economies would anyway have widened budget deficits beyond all past peacetime records, even without stimulus.

Similarly, the global economy has been bedeviled for the last decade by excessive money creation. The correct policy in the downturn would have been to hold monetary policy tight, in order to fight the inflation threatened through past excesses and the budget deficits, providing only the minimum liquidity needed to ensure that the money markets continued functioning.

Given the marginal short-term benefits of current global policies and their huge long-term costs, one would imagine that the world's politicians were all running for election this year, perhaps about August, after the bottoming out of the initial recession has become fully apparent but before the long-term disasters of inflation and sluggish recovery are fully manifest. However this theory doesn't quite work. Germany's Angela Merkel is running for re-election, but has been notably cautious on both fiscal and monetary policy, while France's Nicolas Sarkozy, Russia's Dmitry Medvedev and Barack Obama are with us until 2012.

Nevertheless imminent re-election is certainly a factor with the enthusiastic expansionists Taro Aso of Japan, Manmohan Singh of India and Gordon Brown of Britain. In all three countries, near-term fiscal disaster is close enough and unpleasant enough that rational people would prefer retirement to having to face it after winning re-election – but these people are politicians!

While the current downturn may reach bottom by the summer, therefore, recovery is likely to be very slow indeed. Government borrowing will crowd out much private investment, reducing the potential of the global economy as funding is diverted from new investment into less productive courses. At the same time, inflation, caused by excessively stimulative monetary and fiscal policies, will return to plague the global economy as in the 1970s, forcing a return to restrictive monetary and fiscal policies if a global repeat of the Weimar disaster is to be avoided. (Chinese central bankers seeking to invest their reserves in something sound will find no available outlet other than gold). Political panic may have marginally reduced the depth of the recession, but it will enormously increase its duration.

It therefore follows that the sharp recoveries in global stock markets in the last few weeks are wildly premature. At current levels, U.S. stocks are only marginally above their equilibrium value, based on U.S. economic performance in the decades to 2007, but there is now no certainty that we are in the economy of 2007, or anything like it. With higher taxes and a large "output gap" such as is appearing between actual and potential GDP, which will remain with us for many years, the profitability and growth of U.S. industry will be permanently damaged, so stock prices should in equilibrium be correspondingly lower.

There is thus likely to be another downward "leg" in the U.S. stock market's long decline from its bubble-induced euphoria of 1995-2007, taking it to around the historical low valuations of periods such as 1949 when the cult of the equity was dead and buried. Taking "normalized" post-recession earnings on the Standard and Poor's 500 as being around $60, and applying a 1949 multiple of about 7 times earnings, would give a bottom for the S&P500 of about 420, equivalent to below 4,000 on the Dow. In other words, the likely market bottom is at about half its current level.

The global economic climate, far from bursting into bloom, is likely to endure a prolonged winter, extending over several years, as if nuclear war or a volcano larger than Tambora had struck the world in 2008. For the global economy, it will be the White Witch's Narnia – always winter and never Christmas.