13 February 2009

Wen Jiabao on Confidence

In a rare interview with Western media, Wen Jiabao, the Chinese premier, told the Financial Times: "Confidence is the most important thing, more important than gold or currency."

Why is it that such wisdom comes from the leader of China, but is absent from the leaders of other countries? Do other presidents and prime ministers intentionally play a backstage role, letting their Treasury secretaries or finance ministers communicate with the public to avert blame when policies fail?

That suggests that the leadership may not have all that much confidence in the programs they are promoting; or more likely, the leadership does not understand the issues.

Investors and entrepreneurs take risks in search of profit opportunities. In contrast, in times of crisis, many avoid risks and hoard cash in an effort not to lose money. Except, of course, if your bank, or the currency you hold the cash in, goes down the drain. When confidence even in cash erodes, gold thrives.

The slogan for crisis investing so dreaded by governments is: "Gold is the most important thing, more important than confidence or currency."

Governments dread investors flocking to gold because it shows a lack of confidence in riskier alternatives available. Gold's attraction is that its value cannot go to zero; it has no counter-party risk; gold over the millennia has shown to be a store of value. But economies do not grow when gold is hoarded: capitalism requires risk seekers.

What do rational market participants, what do entrepreneurs, what do investors need? Do they need bailouts? Do they need stimulus packages? Do they need low interest rates? No. The top priority for any reasonable person to put capital at risk is confidence. It's the confidence that the market will provide fair prices and that one has a fair chance to be fairly compensated for the risks one takes.
Capitalism does not require low prices, low interest rates, easy access to credit; capitalism requires fair prices, fair interest rates and fair access to credit.

In a rational market, the cost of borrowing skyrockets for those who borrow too much. Consumers, businesses and governments are all subject to the same forces. However, policymakers seem to want none of that; they argue that requiring homeowners to pay 5%-6% on a mortgage is too much, that the government must intervene to lower the cost of borrowing.

Five percent is too much for someone who cannot make a large down-payment and may lose his or her job; 5% is too much for someone who has maxed out his or her credit card. But historically, 5% for a mortgage is a fantastic deal.

Confidence does not come back to markets because the government subsidizes mortgages. Confidence comes back when private lenders and borrowers agree on the terms of a mortgage; this may take some time as a lot of confidence has been destroyed by both irresponsible lenders and borrowers. The government may provide a temporary "feel-good" effect by buying agency securities of Fannie Mae and Freddie Mac, lowering the cost for subsidized mortgages.

However, by buying these securities, they will have a label on them: "agency securities are intentionally overpriced". What rational buyer would want to buy such securities if they are not fairly compensated for the risks they are taking on? Never mind private buyers, so the government thinks, as the Federal Reserve will step in to buy the securities. When we have the Fed, who needs the private sector? The Fed is so much more efficient at printing money. To name just three problems with this approach:
First, the government replaces rather than encourages private sector participation.
Second, the government is increasingly engaged in specific credit allocation. Picking specific industries or firms to subsidize is something better left to planned economies. When governments start picking industries and companies to subsidize, inefficiencies are created, leading to higher costs, lower competitiveness and ultimately a loss of jobs.
Third, given that the US is dependent on foreigners buying US debt, it may be rather hazardous to the value of the US dollar when the government intentionally overprices US debt.

The Chinese especially must be excused for ramping down their appetite of US debt: the securities they purchase are artificially inflated through Fed purchase programs; the Chinese need their foreign currency reserves to prop up their domestic economy; and ironically, the US can't think of anything better than to insult the Chinese by labeling them currency manipulators! Contrast that with Wen Jiabao, who holds out an olive branch, telling the world they will use their reserves to buy technology in Europe and the US.

The concept that devaluing your currency will jump-start economic growth is simply a baffling one. Say you own US$90,000, worth 100 ounces of gold; or let it be the value of a piece of land. You devalue your currency, so now the $90,000 will buy only 50 ounces of gold or a fraction of the land. The economy may now be "jump started" as people feverishly work to make up the loss again; it will take years of economic growth to be able to afford the missing 50 ounces of gold or the remainder of the piece of land yet again.

Somehow policy makers have it backward. Many of us like our jobs, but not so much that we love to give up half our net worth for the opportunity to go back to work.

But what about all those folks who need to have a bailout? Something obviously went wrong as individuals and businesses took on too much credit. The solution, however, is not to prop up a broken system by stuffing even more credit down the throat of those who couldn't handle the credit in the first place. The solution is to allow an orderly write-off of investments and loans that have gone wrong. Most mortgages are non-recourse loans, meaning homeowners could simply hand over the keys to their homes and walk away from their debt. As a result, financial institutions would in the future think twice before making a loan to such borrowers.

What it comes down to is that just about all policies proposed deal with propping up a broken system rather than initiating the reforms necessary. Credit plays an important role in modern economies, but throwing more credit at those who are over-extended is not the solution. Quite the contrary: by not allowing consumers to reduce their debt levels, allowing them to "de-leverage" as we prefer to say, it will make the exit strategy all but impossible.

Assuming that some of the money from the stimulus and the easy money will stick at some point, what happens when interest rates will need to be raised to fight the inflation that's being firmly implanted into the pipeline? The Fed thinks it knows how to fight inflation, but raising interest rates to anything close to what we saw in the early 1980s is simply not realistic unless one wants to cause a revolution.

Similarly, the spending programs initiated will likely ramp up by the time the economy shows signs of recovering; how on earth will one be able to scale them back again? It may not be possible for the dollar to remain the world's reserve currency; ultimately, those wishing for a weaker dollar to boost economic growth may get much more than they are bargaining for as far as the dollar is concerned. No country has ever depreciated itself into prosperity and the US is unlikely to be the first.

The optimistic scenario is that the US will emerge from the crisis through inflationary growth. While confidence in business will come back in this scenario, the confidence in the dollar may be shattered.

Present government policies are aimed at coercing the public into taking risky investments so that they don't lose the purchasing power of their hard-earned cash. The reason that's done is so that all the debt can be served. We can do better than that. If we had less debt, we would be more concerned about preservation of purchasing power. But because the government also has tremendous debt, the interests of governments and savers are not aligned.

Governments should provide a fair playing field that fosters savings and investments. In China, it's not that consumers want to save so much, but that there are not enough investment opportunities available. A healthy level of spending will result when consumers have strong balance sheets. Spending driven by excessively low interest rates is not the approach.

China has understood much of this, but, in our assessment, could play a greater role in fostering entrepreneurial activity; there's a tremendous opportunity to build a more balanced economy in China, not by encouraging private spending but by encouraging private investment. Infrastructure projects play a role in that, but China should go far beyond that, providing its people a vision that depends less on exports, but more on building a strong domestic economy.

Europe has chosen a more modest path where a deep recession may weed out the weak players. Europe can afford to take this approach as consumers have less debt. The European Central Bank, in our assessment, prefers this path over the US approach that may lead to inflation, possibly even hyperinflation down the road.

The US economy has attracted investment for so long because it has been a fair place to conduct business in. Gaining the confidence of investors takes decades to build, but is easily destroyed. The US must focus on reform to avoid some of the excesses from happening again; not simply prop up a broken system.

So far, all we see is governments throwing money at the problem. We may be able to sum up our current policies as: "We don't know what we are doing, but we are doing a lot of it ... "

Axel Merk is manager of the Merk Hard and Asian Currency Funds, www.merkfund.com. Merk Insights provide the Merk perspective on currencies, global imbalances, the trade deficit, the socio-economic impact of the US administration's policies and more.

(Copyright 2009 Axel Merk.)

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