Economics 101 and the State of the World Economy By Navin Doshi

Economics 101 and the State of the World Economy
By Navin Doshi, February 23, 2010

A good image for the state of the world economy is a giant bathtub whose water tap is controlled by the central banks of countries around the world. The water level in the bathtub represents the overall strength of the economy. The banks are keeping the taps open at this time by printing money to stimulate slumping economies. This giant bathtub also has several large unplugged holes through which the water is gushing out uncontrollably. Each hole is created by a mini-explosion due to an economic event like a jump in the mortgage default rate or a rise in the number of unemployed. The world’s fundamental economic problems created by banks will not disappear simply by keeping the printing presses running nonstop. One “hole” was created by Greece, which deviated from the Euro-imposed discipline of keeping the government deficit below 3% of GDP, and another was created due to the implosion of the Dubai economy caused by excessive debt. In the U.S.A. the increasing deficit, now over 9 % of GDP, due to bail out and stimulus packages, decreasing tax revenue and sagging demand seems to be a perennial hole. When they plug one hole, another is created. Please note that we have not addressed in this image the long term leaks such as transfer of wealth due to consumption much greater than production.

Central bankers insist on quantitative easing by increasing the money supply or printing money as a short-term solution, which is analogous to pouring water into the bathtub, but at the same time the water is gushing out due to the holes at the bottom. Deflationary pressure, due to the oversupply of goods and services and decreasing employment, also causes the water level in the bathtub to fall. When asset prices keep declining due to the oversupply of goods and services and insufficient demand, the water level falls, thanks to Adam Smith’s supreme law of demand and supply. Falling bank lending at the fastest rate in history is another deflationary hole that can be plugged only when the rise in economic growth accelerates. Total bank lending has dropped by about three quarter of a trillion dollars in the last 12 months. The broadest money supply measure, M3, a leading indicator of the state of the economy, has been contracting at a rate of 5.6 % over the last three months. The risk of a double-dip recession or even worse is growing by the day.

Economists’ perception of the current state of the world economy is divided. Those who look at the top of the bathtub see this as an inflationary situation as they focus on the abundance of paper money in the form of stimulus packages to jumpstart the economic engine. Those who dare to look at the bottom of the bathtub recognize the fundamental problems and see uncontrolled deflation in our future. Currently no one knows for sure what will happen in the future due to the uniqueness of the current state of the economy. In March 2009, the market crashed, and the inflationary pressure since then has been marginal. The water level seems to rise when the taps are opened, and on the surface the markets seem to stabilize. However, when a new crisis arises due to fundamental economic issues, new holes emerge and the water level starts falling once again. European countries like Portugal, Italy, England, and Spain, or even troubled states in the U.S. including California, New York and Illinois, also have the same problem: the deficit as a % of GDP is far greater than the acceptable level of 3%. Until the underlying inadequacies are addressed, this systematic pattern will continue to plague the world economies.

In the long term, central bankers tend to err on the inflationary side as they had during the 2002-2007 period after the recession of 2000 and the 9/11 event. Economic history has always been on the side of inflation. In fact, 3% inflation rate is the current acceptable level central bankers shoot for. Olivier Blanchard, IMF’s chief economist, now recommends that central bankers should raise their target to 4% inflation rate (Economist, February 20th, 2010 issue). Even staunch ultra free-market economist F.A. Hayek, whose views come from the Austrian school of economics, and are the opposite of those of John Maynard Keynes, a strong proponent of government intervention, agree that when the economy falls off the cliff, the intervention of central bankers in creating more credit and money is essential to avoid catastrophic depression.

Now more than ever before, all the markets in the world are interconnected. It is indeed a reversal of fortune that the Western countries now prefer that the emerging economies of China, India and Brazil increase their GDP growth rate. The Western countries would like to see stronger emerging market economies that will generate a demand for the export of goods and services from Western countries. Sooner or later, the holes of the bathtub will get plugged and the water level will rise and even overflow, bringing the economy to an inflationary domain. I do hope they get plugged sooner than later.

So how does one invest when the treasury yields are near zero with high stock market volatility? I would prefer a mixed asset allocation that includes short-term (five years and shorter) investment grade bonds, precious metals, substantial cash, and a bit invested in very stable growth stocks. Those who are willing to take some risk can consider shorting U.S. treasury bonds. The logic of short-selling U.S. treasury bonds is very simple. America is drowning in a sea of debt at a near-zero interest rate. Essentially, there is no upside other than the belief in the strength of the dollar. Undoubtedly, there will be inflation at some point in the future. Currently the decreasing money supply M3 shows deflationary pressure. Only when most of the holes of the bathtub are plugged, meaning M3 and employment starts rising and the real estate markets are stabilized, will the equity markets perform better. However, if the rate of inflation goes out of control and keeps rising, the long bonds will get slaughtered while precious metals will probably out-perform almost all other asset classes. I do emphasize that one needs to be nimble and agile in this highly volatile market.

(Mr. Doshi is a writer, trader, and a philanthropist and his articles are posted at http://www.nalandainternational.org)

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