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What's on the Other Side of Austerity?


And should asset managers count on central bankers repeating the mistakes of the past, or look for actual change?

European policy makers are continuing to digest the grim economic reports from the assorted countries within the eurozone, and the news is not good. Stalwarts like Germany and the UK are showing signs of reversion towards zero or negative growth, while France, Italy, and Spain face mounting unemployment. And don't forget, the smaller countries like Greece, Portugal, Ireland, and even tiny Cyprus are mired in a morass of hurt. In contrast, the US seems to be lumbering towards slow growth as a standard expectation. Asia continues to drive towards improvement with headwinds blowing; India, China, and Japan have announced expansionary activities over the past months. In the midst of this globally sanguine news, the US equity markets continue their march upward, with the US dollar even showing some pep in its step. So, what's a normal investor to make of all these contradictions? And importantly, what happens to the current stasis if Europe moves towards a true growth stance?

How can Europe drive growth?

This is a question that has been bedeviling the policy wonks in Brussels for some time. There are two factions, and the past four years have seen dominance by the austerity budget camp. The austerity proponents have garnered a strange partnership with the deeply socialist democrats. Together, these camps have aligned to impose cuts in government spending and concurrent increases in taxes on the wealthy. Add in a dash of conspiracy for offshore tax havens and global tax cheats, and you have the everyday news coming out of Europe. The mix of cut and tax isn't working, according to economic indicators such as GDP, employment, and budget deficit accounting. In response, elections have shifted power towards those espousing a "growth" platform. What does that exactly mean? Does it mean lower taxes? More spending? Increased deficits in the short term? In my humble opinion, the answer is likely to be currency devaluation, inflation, and perhaps a rally in gold prices.

My conclusion may seem abrupt, and here are the factors leading to such a brief conclusion:
  • Debt to GDP ratios throughout Europe are already high. Europe has had 20 years of deficit spending to support itself, and the world finally cried 'stop' in the sovereign debt crisis. And while the crash has been slowed by the European Union acting as a supranational issuer of debt, the trend of excessive debt, and debt service crowding out spending, has only grown. In other words, the markets won't let Europe gear up another 10 or 20% of its GDP in new debt.
  • Tax regimes can generate sensational headlines, but everyone knows that the middle class pays the most taxes. We can soak the rich, we can name and shame the rich offshore tax cheats, and we can badmouth the big rich corporations, but all these payers combined will not close the gaps in the budget deficits. Some may explain that these are the folks who provide jobs anyway, so if you press them too hard, they will simply go inside their shells and hide out for a decade or more. Rich people are patient, they can wait out political storms – that's why they maintain "tax havens."
  • Since Europe cannot issue meaningfully more debt, and it cannot tax its way to growth, there are only two other possibilities – miraculous organic growth, or inflation/devaluation/default.
Let's start with the positive scenario – "miraculous organic growth." It sounds nice, because it is nice. It is also unlikely, but should not be dismissed in its entirety. If one ascribes to the theory that economies are collections of individuals, aspirations, attitudes, and philosophies, and that these interactions make up our real economic activity, then a recession can be interpreted as a scenario where a preponderance of the individuals in the real economy have lowered aspirations and bad attitudes. They may be scared, unemployed, or feeling that the government should be taking care of them in their distress, so they become paralyzed and do not act. The result is a recession, or even a depression, and it can last for years as it takes a toll on the nation's psyche. Fortunately, as we all know, attitudes can change, and people can become happy. Better yet, social science tells us that happiness is contagious, and it can lead people to feel more confident, to invest, and to take on risk. Collectively, this happiness will make the economy stronger, and can promote growth – happiness is the opposite of depression, economically and spiritually. What can drive this kind of happiness? No one knows for sure, but here are some examples: good weather, increased birth rates, social harmony, plentiful harvests, and innovation. Sounds squishy, I know, but these are psychological drivers that can translate into growth, and they are all outside of the reach of policy makers – let's call them 'acts of God' – and hence this kind of organic growth would be indeed 'miraculous' and the corresponding virtuous growth cycle would be a welcome relief to a troubled world.

While the miraculous growth scenario is appealing, there is really nothing that one can do about making it occur…other than to pray…and policy makers are not likely to go down that path. Therefore, we should assume that policy makers will use the tools at their disposal – the worldly tools like tax policy, regulation, market interventions, and government spending. Sometimes one can look at non-obvious indicators of devaluation – the ones that seem to make no sense. In point in fact, the new $100 bill. Have you seen it? It is colored, like monopoly money. Does that matter? Maybe. Pesos are colored…it's all just fancy paper, and its only value is social confidence. Admittedly, this is non-traditional thinking, but why are the policy makers fabricating our currency to be more decorative? Another anecdote – have you gotten takeout food recently? Now, I'm an accountant by profession, so I have a thing for numbers, and I seem to be the only one in my household who spends change. You see, I give cashiers the actual amount so that our house doesn't fill up with jars of coins. An some places are ideal for exact change, like the grocery store and takeout food, where a tip isn't really expected. One word…freak…that's how I felt at the restaurant when I counted out $0.91 to pay up my bill. People stared at me, they laughed; you see, anything below 1$ doesn't even count, especially when it costs $100 to fill up my F150. Our currency has already been debased. And of course, there are the more concrete examples of monetary devaluation and anti-austerity behavior:
  • Japanese intervention in the markets to increase deficits and drive down the yen while increasing their stock market performance;
  • Janet Yellen at the Federal Reserve espouses the benefits of 2% inflation expectations;
  • The Fed continues to load up on debt instruments and monetize our debt;
  • A poll from "Eurobarometer" identifies that trust in the EU is at an all-time low;
  • Anti-austerity protests in Europe are a common occurrence, they don't even make headlines any more;
  • The BBC reports that "China is likely to continue…easy monetary policies to sustain growth, and would not raise rates or look to limit access to capital";
  • Reserve Bank of India lowered its key interest rate for the second time in three months in an attempt to revive the economy.
So, around the world, there is a push to lower rates and to hope that the rate reduction and the increased deficit spending will drive up growth. And while nominal growth should indeed perk up, we should remember that there is never a 'free lunch.' One potential impact of low interest rates and increased debt and deficits are future drags on economic activity – in other words, if economic growth proves to be fleeting, the debt cannot be paid off without devaluation or outright default on debt. So, let's hope that the growth strategies generate positive and sustainable growth, because we have seen in Europe that default is not acceptable. And that leaves one option – slow motion default by currency devaluation and inflation – and this devaluation should be supportive of the price of gold.

In conclusion, we should all work towards making organic growth happen – do good deeds, be happy and take risks. If we all do this, miracles can happen. In the meanwhile, our investment patterns may be well-served by taking into account that policy makers will most likely repeat the mistakes of the past, albeit in slow motion, and set off a wave of currency wars, competitive devaluations, and inflation – all in an attempt to debase the currencies in which their unsustainable debts are denominated. In such times, investors have been rewarded by holding real assets and commodities… hold them for a while. Don't put all your eggs in one basket, but remember to diversify into real assets and metals – no huge bets, but don't ignore these asset classes.
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