5 October 2011

Market Update:   Is protectionism the only way forward?

Unlike at other financial institutions, at Vision Finance, we only write market updates when we either actually have something new to write, or when our view changes.  This way it is easier for our readers not to be flooded with essentially research spam and to be able to revisit our past commentaries.

Indeed most things that are happening recently, including debt crisis, sovereign downgrades, double dip, was totally anticipated by Vision Finance many years back (easy to verify – just read our past research), and even forecasted by our own Vision Finance Sovereign Ratings (www.financewithvision.com/ratings), so pretty much everything has been said about this topic (accrual accounting, Greece not being Greek problem, overleverage, etc).  Our regular readers will know our view, and rest assured, we will write an update when the situation warrants one.  Otherwise we all have much better things to do; your on your work and us on our work.

So the double dip is now all but certain, and the only surprise is the ability of the global economy, mainly the investment banks, to convince the world for the last two years that recovery was likely.  It never was likely, as the real problems were and still are are still out there.  What appeared like the early shots of the recovery was nothing more than the spin, engineered by yet more collective greed of bankers, money injection and pretending to do something.   Indeed little has improved in the last two years, and if anything, the situation is only more serious, with more record deficits, faltering budget revenues, bad statistics and lack of any realistic policy options (from current bag of options available).   Daily meetings of ministers do not yield results, and even if we were to put all the ministers in one room for a month, they would not come out with the solution to the problem.   Indeed we think that it is very worrying that in the world of 21st century there is a need for all these Ministers to meet in different City on the daily basis, alone an evidence that there is something significantly wrong with the world, almost as if there is collective desire to show action, but lack of any single person to be able to actually do something. 

The world goes on of course, but there are few important lessons that emerge:

1.       We maintain our view that the only way out to deleverage the system is via inflation, that will need to at least total 100% over the next 5-10 years.  This inflation can be gradual (we advocated this and suggest further and globally coordinated QE programmes, or it can be sudden (via hyperinflation which no developed country is ready to face), which will happen if the Ministers continue to talk and not to act.

2.       We recently took this view from opinion to that of mathematical certainty.  To understand more please read the analysis of Greg Pytel  http://gregpytel.blogspot.com/ , who in essence states that mathematically there are three solutions to the problem:  (i) inflation, (ii) write offs, (iii) double digit gdp growth.  We agree with this, and naturally see the inflation as the only way forward.  Write offs, like wages, are simply sticky and impossible to implement in the coordinated manner.  GDP is hardly a choice.  Inflation is hence the only way forward.

3.       When thinking about the long term, we see that the current financial problem, has a nice analogy, that of the working parent and the unemployed child who is now a grown up.  In this analogy, the parent is paying the child regular maintenance, almost enabling the child to do nothing, not to seek work, not to learn.  Warren Buffet said that “one should leave their children enough to do anything, and not enough to do nothing”.  In many ways China and other producing nations are enabling America and Europe to do nothing, to pretend to be in good shape while yet more factories down, less is produced, new technologies are praised as the sole answer to the problem, there is focus on consumption rather than production, imports rather than exports.    Afterall what good does this child has to offer apart from the promise of recovery and that it will get the job in the future?  In many ways every year the situation actually becomes worst, as the lost generation emerges.  Strikes in Athens are now a daily routine, other countries appear similar, and many are on the boarderline.


New element in our analysis:  protectionism

This is something new at Vision Finance. What we have realised is that inflation alone will possibly not be enough to save the developed world, as even though it will correct the current leverage and debt imbalances, it will still leave the same problems in place.  In essence it is very much possible that the currency depreciation will simply not happen, or will be resisted, as with the increased QE of the “bankrupt countries”, China, Russia and other developing exporting countries will also print money to maintain the current status quo, of production, of local stability.  Take China; it is growing, perhaps not as fast as before, but it is still the manufacturing hub of the world, and it simply cannot afford to revalue its currency, due to the fear of internal cooling what could potentially lead to the upset in local population, and subsequently maybe even to attempts to replace the government there.  It might sound bit “conspiracy theory”, but there is no accident that China is the biggest importer of armoured vehicles, in essence trying to prepare itself against the middle east style uprising that could be coordinated by the likes of  facebook.  Any such uprising is likely to be triggered  by the economic slowdown.  In many ways the situation in Russia is similar.  One of VF bankers has been actively involved with trying to issue Tier I and Tier II instruments for the Russian banks, discussing its advantages with the Russian Central Bank, stating that in order to enable the Russian Banking system to grow, new capital is needed, and that this capital can either come from abroad via foreign ownership of banks, or from abroad via Tier I and Tier II instruments that will enable the Russians to remain the owners of the banking sector.  To his surprise the reaction of the Central Bank was that it was in essence not interested in developing the banking sector, raising its asset ratios to the levels seen in Kazakhstan, as any collapse of the banking system was seen as the biggest single risk to the power change in Russia.   In essence, should the local banks default, people would take to the streets demanding the power change, and greed for money will always be a much more powerful stimuli than the demand for free press.   Russia has actually experienced many problems of potential power change during the Russian crisis of 1998.   As the result the Russian banking system going forward remained widely underleveraged, what proved to the right thing to do post 2008.   As the result, in many ways the Chinese by protecting the weak value of their currency are doing the same trick, and they will object in every way possible to rebalancing this power away from.


In the situation that the FX market will be unable to provide the proper balance in the global markets, there will be very little choice for USA and Europe to start to implement serious protectionist policies, like that of 500% tax on imported cars, electronics and other manufactured consumer goods.  This will in essence enable the local producers to flourish, manufacturing to grow, economy to became more closed off, but also more independent.  Consequences to Chinese and other EM countries would be significant, but the benefits to the people of USA and Europe large.  In many ways at Vision Finance we expect that one things go very bad, some new leaders will emerge, and they will openly speak out about this alternative, even though today it is widely assumed by the mainstream economists that “protectionism is pure anti market evil”.   They are unfortunately wrong in many ways.

In order to understand protectionism better, lets look at its effects.  Yes it limits the flow of goods and probably also the capital, yes it decreases efficiency, and in general it is a step in the wrong direction for the global economy, disabling the Adam’s Smith’s principle of relative and absolute advantage and the impact of the invisible hand, however lets accept that in many ways protectionism already exists.  Take labour markets.  Within European Union it is illegal to offer someone from non –EU country a job without a proper reason for doing so, including identifying special skills or running an advertisement to show that nobody local was available.  However from economic perspective what is the difference between hiring a Chinese worker in UK to build the TVs for UK people, or buying a TV that is made in China and exported to UK?  None.   A tax of say 500% on TVs would in essence mean of course more expensive TVs, but it would also mean that this factory would need to be relocated back from China to the UK, employ UK people, pay them economies and stimulate the local economy rather than that of Shanghai or Beijing.  The same concept applies to cars and any manufacturing effectively.  Services are bit trickier and more difficult to control (will someone monitor email?), but the concept is the same, and even though we at Vision Finance are clear that we are not in support of protectionism, and actually if anything we would prefer that the UK labour market opens up to every Chinese that would like to move there, we are also real, and as some point when unemployment is at high double digits, the “new wave of politicians” will start to implement significant protectionist measures, which frankly in many ways we understand.

In many ways returning to our analogy of the working parent and unemployed adult child, at some point, the Child might actually realise that he or she will be better of without the money from mummy and daddy, and that the time has come to actually do some work, learn and one day make this money by themselves.