Damn the Torpedoes, Full Speed Ahead! Destination: Japan or Zimbabwe?
By Tony Allison, January 5, 2009
The famous quotation above comes from the Battle of Mobile Bay in 1864 during the Civil War. Union Admiral David Farragut needed to capture Mobile Bay and Fort Morgan, but was facing a bay strewn with mines (called “torpedo fields” back then) that had already taken down the USS Tecumseh with all 94 men going down with the ship. Coming under fire from both the Confederate fleet and Fort Morgan, Farragut had to decide between retreat or taking on the minefield. Farragut issued his now historic order, eluded the minefield and emerged victorious.
The Federal Reserve and the incoming Obama Administration today face an economic minefield more treacherous than even that faced by Admiral Farragut. They must either charge ahead aggressively with unprecedented spending programs, or retreat and be accused of letting the economy fall off a cliff. One can easily guess which way they will go. Full speed ahead!
The Japanese experience
Ben Bernanke, our current Federal Reserve chairman, seems terrified of letting the US repeat the “lost decade” experience of Japan in the 1990’s, or even worse, the Great Depression experience of the 1930’s. Many economists, including Bernanke, believe that Japan was too incremental with monetary policy and often pursued a cautious economic road that was viewed as “too little too late.” They believe this helped keep Japan mired in an economic morass from which it has yet to fully emerge.
It appears fairly certain that the Fed and the new administration will not be incremental. They will “go big” with both monetary and fiscal policy, and not be the least concerned about inflationary effects down the line. The Fed seems to believe it can handle that situation should it arise by draining liquidity out of the economy. We shall see. Economic stimulus and money creation of this massive and historic nature has never been attempted. In a complex global economy, unintended consequences are always a potential risk lurking around the bend. Clearly the Fed is more concerned about the deflationary effects of debt and deleveraging. The Fed has already “leveraged up” its balance sheet to the tune of $1.2 trillion in 2008 and appears to be just getting warmed up. Expect many trillions of new dollars (borrowed or printed) to be thrown into the fray in 2009. This road could eventually lead to Zimbabwe-like inflation.
Creative destruction on hold
Another problem that added to Japan’s long economic malaise was the propping up of “zombie” companies that should have been allowed to die. The US is now facing the same issue, having bailed out the banking and auto industries. Many other zombie companies figure to be lining up in 2009, desperate for similar treatment. “Creative destruction” will be put on hold, as intense political and societal pressure to save jobs will rule the day. This road will likely prolong the agony, much as it did in Japan.
Bold action on the way
A “damn the torpedoes, full speed ahead” approach may or may not be successful in 2009, but it has overwhelming political support. The populace is demanding action, and the Fed and the new administration will certainly oblige. The tepid approach by the Japanese has been duly noted. The Obama Administration has already stated that in times of crisis, doing too little is more dangerous than doing too much. No politician wants to be accused of not taking bold action, even if the risks and consequences are unknown.
The Fed has already started its bold “quantitative easing” program. Buying massive quantities of Treasury bonds outright seems to be next in the quantitative easing playbook. The Fed clearly wants to drive down all interest rates and force cash hoarders back into productive lending and investing. The outcome for 2009 is unclear, but the “full speed ahead” approach is quite clear. One can only hope the Fed is successful in both reviving the economy and then preventing a nasty bout of hyperinflation from arriving on our shores.
Will extraordinary measures work?
It is possible, but far from certain, that our “damn the torpedoes” approach may lead us down both roads. We might first succumb to Japan-style deflation through continued deleveraging and widespread fear, leading to little or no economic traction, and then suffer the fate of Zimbabwe as the “extraordinary measures” eventually lead to unleashing the hounds of hyperinflation. Although if we are to suffer inflation, it will hopefully not be in the same galaxy as Zimbabwe’s 231,000,000% inflation rate (as of summer 2008). After all, who can afford a $100 billion dollar omelet?
In an ironic Alice-in-Wonderland twist, Zimbabwe is now praising the Federal Reserve’s new “flexibility.” The Reserve Bank of Zimbabwe recently released the following unsolicited endorsement:
“Banks, including those in the USA and the UK, are now not just talking of, but also actually implementing flexible and pragmatic central bank support programmes where these are deemed necessary in their national interests. That is precisely the path that we began over 4 years ago in pursuit of our own national interest and we have not wavered on that critical path despite the untold misunderstanding, vilification and demonization we have endured from across the political divide.”
Clearly, misery loves company.
It is always difficult to predict where asset prices are headed, especially in these uncharted waters. However, looking beyond the shorter term deleveraging and volatility, certain assets would seem well-positioned in this new world of central bank alchemy. Tangible assets such as oil and precious metals cannot be produced at the phenomenal rates at which paper currencies are expanding. Consequently, the value of these assets should continue to increase as the value of paper money continues to shrink.
To expand further, despite billions in exploration dollars and great technical expertise, the amount of oil and gold discovered each year is not growing. In the case of oil, severe supply problems loom ahead. To top it off, many oil and gold producers are slowing production around the globe due to uneconomical prices or lack of adequate financing. Thus, when limited supplies of tangible assets meet unlimited and aggressive currency creation, it is highly likely that the values of oil and precious metals, and the well-run companies that produce them, will trend higher, perhaps substantially, over the longer term.
The road less traveled
So much of the damage to our economy and that yet to come could have been avoided, by simply living within our means as a country. Once upon a time, the US actually did live this way. Once upon a time we were an industrial giant, a creditor nation and energy self-sufficient. And lastly, the entire global financial system was backed by gold, once upon a time.
However, governments (in particular) and individuals will always take the road most traveled (excessive debt and overspending) if given the opportunity. It has happened routinely throughout recorded history, and it is happening now to the US and much of the developed world.
One road that should be considered is some form of new gold standard. The beauty of past gold standards is that they automatically enforced spending limits on governments. The money supply growth could only expand at the rate of gold supply growth, perhaps 1-2% per year. A gold standard also limited governments from printing money for wars or for buying votes through deficit spending. This is one big reason why governments hate a gold standard. It is also why historically, countries have suspended their gold standard to finance and wage wars. Unfortunately, a gold standard can only be maintained by willing and ethical governments. And if the integrity of political leadership dissolves, so does the gold standard.
A disciplined global financial system
We have a desperate need today for a much more disciplined global financial system. Perhaps out of truly desperate times may come a common-sense solution. That might be the creation of a new global Reserve Currency Standard consisting of a gold-backed basket of major currencies. The mechanics of the system might have to be different from past gold standards, but the disciplining mechanism must be part of the solution. Any new currency agreement will likely not be seriously discussed until the global economy begins to recover first.
Healing self-inflicted wounds
A new gold standard would not solve the world’s problems, but it would at least give us a chance to heal our self-inflicted wounds and eventually forge a better world for our children and those generations yet to come. There would be many stumbling blocks to its implementation, the foremost being the human condition and the nature of politics. Do we have enough leaders of integrity and strength to pull it off? And more importantly, do we have leaders that can enforce the harsh spending discipline that a gold standard requires? The nature of politics today would seem to put that into serious question. I look at every new year with a sense of new hope and optimism, but I worry about our collective lack of common sense, even in desperate times.
Let us hope our leaders guide us safely past the torpedo fields that lay in front of us, and that our final destination is neither Japan nor Zimbabwe.
I wish a happy and peaceful New Year to all.
“I shall be telling this with a sigh. Somewhere ages and ages hence: two roads diverged in a wood, and I, I took the one less traveled by, and that has made all the difference.” Robert Frost (1874-1963)
U.S. stocks turned modestly lower on Monday afternoon after a short-lived attempt in positive territory as investors shifted through December sales results from automakers which, while poor, were not as awful as many had expected.
The Dow Jones Industrial Average fell 81.80 to close at 8952.89. The S&P 500 Index was down 4.35 to close at 927.45. The Nasdaq also closed lower, ending at 1628.03, down 4.18.
Crude-oil futures rallied Monday to the highest level in one month, as an escalating Israel-Hamas conflict triggered political tensions in the energy-rich Middle East and as President-elect Barack Obama's stimulus proposal raised hopes that oil demand will rise. Crude for February delivery rallied $2.47, or 5.3%, to end at $48.81 a barrel on the New York Mercantile Exchange, the highest closing level for a front-month contract since Dec. 1st.
Gold futures ended Monday's trading below $860 an ounce for the first time in more than a week as a rising U.S. dollar reduced the metal's investment appeal. Gold for February delivery closed down $21.70, or 2.5%, at $857.80 an ounce on the Comex division of the New York Mercantile Exchange, ending below $860 an ounce for the first time since Dec. 25th.
© 2009 Tony Allsion