As the financial crisis continues, a lot of people are asking a lot of questions and a lot of people are trying to answer them. I have yet not heard one account of what will happen that has left me feeling sure about what's going on. I've written a few times on this blog about some of my different takes on what's going on - still I'm pretty much in the dark as everyone else and I'm constantly re-evaluating the situation.

By far the most common thing talked about is the great depression. A lot of people seem to think that this is just another depression with a possible inflationary twist - I would count myself as one of those people - from time to time. Just recently I wrote a piece partly covering the IT-bubble, where I was trying to point out that it was overcome fairly painlessly; and from some recent considerations I think that this crisis could actually be overcome with far less pain than what many are saying.

I've mentioned it myself before (as have many others), that the debt-GDP ratio in particularly USA has risen a lot since the late 70's. This is generally the argument to show that this has basically the same premise as the great depression (GD). But the debts causing the GD had come about in only a few years time (roaring 20's), whereas the debts of today have come about over the course of 30 years. When comparing the debt-GDP graph to the one of interest rates it looks pretty clear that the two follow each other. When things crashed in the beginnings of the GD (or during it's entire course) - there were certainly never zero interest rates like today.

The debt that preceded and made the GD come about was created in a financial environment that was very different than the one of today. The loan-economy, if you will, was something new and the people in charge of interest rates were unfamiliar with the impact that too high interest rates would have. Today pretty much everyone has loans and most of us see loans as a great way to afford things that we want and that we will be able to pay off during the course of our lives. It's all very simple - if it is possible to borrow a lot of money without it ever becoming too expensive to maintain, then people will be doing so - it's a very handy way to get cars, houses and so on, without having to save all that money first.

So, what might be passing most people by is that this could be a new type of economy, where a very large part of the population want to use loans to make their lives better and easier; Therefore, one might actually have to adjust economic thinking to a new healthy level of debts in society that runs much higher than it used to back in the early 1900's. To me it's a bit annoying reading these constant comparisons of what happened at a specific time in history and how todays events seem to follow the same pattern - almost as if it is the exact same thing - which it never is.

It's no big secret that the current financial crisis started with too high interest rates which then created the housing crash which in turn gave us the derivatives meltdown (which may or may not be over). All these problems have given a large contraction in demand and a loss of asset values. Still it is possible that all this is temporary and that lending and the world economy will resume pretty much as it did after the IT-bubble. There are real imbalances and deficits that need to be sorted out as well, but that does not have to mean that people will be loosing their jobs (for example read my investing in china or america posts).

Will things resume as normal, or is this debt-hype for real? I know this contradicts what I've said before, but there's a real possibility that things could resume as before, even though things look very gloomy. If people can borrow almost for free, I strongly suspect that they will begin to do so sooner or later - they can't really hold out forever. One should neither discount the generally much higher accumulations of wealth in the world today as compared to the days of the GD. All that money could easily be put to use in still plentiful opportunities of wealth creation.

I could be very wrong here and it's possible that I had it right in my first assessments. Maybe things are falling so hard that they cannot start leveling out or turning up at this point, perhaps we have to suffer a very long time of low economic activity (while people pay off their loans) and perhaps the imbalances created by free trade are too big. Or maybe the real pull-back has already happened and the smart money is already moving back into good stocks that have dropped heavily and are now beginning a long period of appreciation - while 'contrarians' and all the scared analysts are saying that this is just a dead cat bounce...

And perhaps further 'toxic assets' will be paid for by monetization - furthering the inflationary scenario, under an otherwise fairly normal economy. I've talked about the derivatives meltdown before and the AIG-linked milking of US-taxpayers - this thing is perhaps not so much anymore a financial bomb, but really a political one... I urge everyone to watch this interview:

Around the beginning of the new millenium the world suffered huge losses in stock markets, mostly attributable to the speculative boom of the IT-sector. There are a lot of people around today who are still mentally scarred over the incredible losses that they suffered there. We all know of the response to this contraction - a strong lowering of interest rates that created a housing bubble in most of the west.

The losses suffered from the housing bubble are much greater and at the same time we've had huge bank-losses from derivatives and bad loans along with a very broad stock market crash. Now jobs are starting to disappear and people who are deep in debt stop spending money - furthering the fall in demand. This outlook is indeed grim - but the responses this time have been much more dramatic.

Just the other day the G-20 promised to throw another tsunami of money at this thing and with zero interest-rates and yet more money being thrown around - how can we not 'recuperate'? I know that I've said that things are bad - and they are - but by the looks of it, the crazy spenders in the governments and central banks could yet prolong this from being a total crash by another couple of years.

Very often during the last year there have been comparisons made with the great depression, where some have claimed that the actions taken back then were no good, since they didn't put a stop to the depression. Well, the situation is very different - back then the interest rates were never at zero, only briefly did they touch 2% and then stayed around 3-4% most of the time. Governments did not throw money around like today - one big reason for that would be the basis of money in gold.

Pretty much all governments of the world have vowed to spend money until this thing is over with. And why doubt them? They really have no restraints - except for the belief in the value of paper money. And this is where inflation comes in. As people become more and more aware that the boom is created falsely out of the printing presses, then as confidence in the money wanes, inflation will begin hitting us hard.

As paper money becomes more worthless everyone will finally be even more broke than they would have been if the governments would not have started throwing money around. But by then the problems will be so huge that the world would have to somehow start over - monetarily speaking.

Can anything stop the inflating depression from happening? Well, as I mentioned - the politicians might notice the danger in loss of confidence in the paper money; so the thing to worry about would really be if they actually start to show restraint - as paradoxical as that is! Because then they'll be doing what they did during the great depression, that is, just prolonging the agony. If we want to get this thing over with somewhat quickly it is either through severe inflation or severe deflation - not something in between. The politicians have taken the inflation road already, and although its certainly not good - it would be better if they would stick with it.

So, unless they show restraint - which I doubt - we will see an artificial boom in all assets in the coming years that will be followed by severe inflation and finally a complete break down of the system. I guess one important signal to watch closely would be if the auto industry will be bailed out - if not, then bunker down for a great depression deja vu!

People in the US are angry becuase the bailed-out gang at AIG got a few million dollars in bonuses. At the same time the government has thrown away millions of millions of dollars (trillions, that is), subsidising total incompetence and corruption, without expecting any of that money back.

Now the Obama administration is declaring its intent to buy up all the remaining toxic assets to finally put a stop to the crisis. It's been estimated that this would cost the tax-payers/government another trillion dollars - but this is getting a little old, isn't it? One trillion here, another trillion there, a third trillion, a fourth... and so on. And the message is always the same - we have to bail them out because they're too big to fail, besides, we're the government, we have infinite resources, so why not share it with our buddies at the big banks?

It's no big secret that big banks were among the top of Obama's contributors, besides this is true for most 'major' US-politicians. If the Obama-administration really is serious about buying ALL the toxic assets from the banks, then the dollar really is dead, and the US-government will go bankrupt. The economy of a nation is no different from a personal economy, it's only politicians and a joke of an educational system that makes people think differently (which is true for all western countries).

If you've borrowed so much money that you can't pay the interest, do you keep borrowing more? If you've lent your neighbour a few thousand bucks and then he turns out to be a few million deep in debt from the bank, do you pay his bank-debt in order to get your borrowed money back? If you and your friend are broke, do you take out a loan to have him build you a bridge that you don't need?

You might say I'm presenting a very skewed image here, but if you consider that a personal economy is more short-term and a national economy is more long-term, it actually makes sense. You might argue that a nation can lower interest-rates; yes it can, but only in the short-term! Money wasted, is always money wasted, no matter on what scale. And borrowed money is also always borrowed money, no matter on what scale. The same goes for productivity and consumption. Therefore, if a nation is acting like an insane person, it is going to go broke, probably piss off it's neighbours and eventually end up in the asylum - or the morgue.

A final analogy: If you've made bad decisions in the past, and you stand around chanting "change!" and "hope!" on your front lawn - will your neighbours think "this is change we can beleive in!" or will they call the police?

Very often when I read about the prospects of the US economy, it seems to be from the perspective of a debtor that can't repay his debts, and therefore must fail. Otherwise the perspective is one where the analyst pretends that the debt-situation is not that bad. Well, the debt-levels are bad (just look at these graphs!) and the derivatives market with its huge uncertainties along with constant government bailouts is not exactly making things better. I've heard estimates for total derivatives losses from only a few billion (in the very beginning) up to over hundreds of trillions of dollars. Whatever the total losses will be, we basically have two scenarios of how it will end; either the losses stop coming fairly soon or the government is going to keep bailing out the banks and eventually the bailouts will have become so many that everyone is going to start asking questions and then we'll have a great public indignation which would force the government to declare an end to bailouts and let the banks and the financial system finally crash, or the government will have to somehow quench the uproar. The bailout and stimulus-packages already in place and the potential coming ones are going to be funded by monetization, cause there's no way that the rest of the world will lend those kind of sums of money; this will inevitably devalue the dollar, which brings us to the lenders...
For the last couple of years (decades really) all they've done is to accumulate IOU's like crazy, when the reasonable thing would have been to spend those IOU's in exchange for things from the US. Now they're sitting on these huge mountains of IOU's and they're getting worried because of the bail-outs and the possible devaluation of the IOU's (or: the dollar). What would be the reasonable thing to do here? Would you throw the dollars away, keep sitting on them or would you start giving them back to the debtor in exchange for something useful?
I think the answer is pretty obvious. The countries that have huge holdings of dollars will have to start spending them, and this can only mean that a lot of business is coming to American companies. If you look at the trend, it tells you that more and more dollars are pouring back into American companies. Take GE for example, they're sucking up five billion dollars a year from China today and that number is growing. It's all very simple: If the foreigners don't spend these dollars, they're just getting into more trouble - as will the American people because they will have to default, and/or inflate away parts of the debt.

So, does this all mean that things will be honky dory? Well, one should definitely not disregard the huge importance that the US consumers have for American companies, and to rebuild wealth will take some time. It really depends on how stupid the lenders and the US government are, if the lenders start spending dollars then the rebuilding of wealth (or destruction of debt) will go a lot faster and things may well stabilize (stop going down) within two years - this assuming that the derivatives market will have stopped imploding (!) - and that really is the huge wild card here, in fact the very thing that will determine the future of the global economy. Again, if you look at the trend, the derivatives losses are not slowing down and nobody knows where it will end. But when these losses stop coming or when the government stops paying for this garbage, then I beleive it will be a good time to invest in America. But beware, not until the black hole of derivatives has gone away completely is it safe to really invest in anything related - and by related I mean economies with financial sectors exposed to these instruments. Even a company like GE, mentioned just above, has taken credit losses although they may see great growth in places like China. So, until the green light comes up... let's focus on precious metals, perhaps energy and perhaps some more independent economies.

From the viewpoint just expressed I think it looks reasonable that things may well not go so bad as some have predicted; government can really only put the people in so much debt. I doubt that we really will see more than, at the most, another five trillion of bailout or stimulus money (which in itself is obviously a humongous lot of money). But then the US government has to cut down on a lot of other spending as well, which may prove difficult - but they would not be the first country in history to have run up a huge public debt, and others in that position have prevailed. Big problems are on the horizon and the government of the US really has to do things right in order for this crisis to be resolved (globally, as well) - so far they haven't. Hopefully even they may start to see that the bailouts are not sustainable and that the spending has got to be cut. I may seem naive to say that politicians like the Obama-gang might actually learn something, but stranger things have happened, and we should all hope that they do learn... unless you happen to really like things post-apocalyptic?

China's worried...

I got a lot of positive response on the post I wrote on Russia, so I figure there is a lot of curiosity out there about the state of some of these more exotic growth-economies. There is undoubtedly a lot that is unclear and uncertain about how things might shape up in these countries that are low in BNP per capita, that have low debt levels and strong growth. I feel that China is, just like Russia, one of the most elusive countires on the planet, not just economically. For the past couple of years I've unknowingly dismissed China as simply a country that is nothing more than - as the title says - an export driven slave camp. And I've held the position that as things start to go bad, and chinese exports go down, they're gona be left with nothing - because all they have is a huge population that is willing to work at slave-type conditions. After having done some well-needed reading on the subject, I'm gona try to give a more nuanced picture.

Let's just look at some numbers first: Foreign exchange reserves ~$2trn, external debt ~$300bn. The surplus of imports-exports is somewhere around $300bn today, what is very interesting to note here is that although exports for the last few months have gone down ~2,2% (in nominal terms), the imports have actually gone down even more ~18%! This big decline really shows how great the import of commodities in China really is; with the big decline in prices for the last few months, China is actually benefiting.

What caught my attention most of all about China is the very overlooked public sector, which is estimated to represent about 60% of the economy. With all the attention that the private sector has been getting, one might almost get the impression that they have almost no public sector. If we just look at this in a workforce perspective - China has a workforce of ~800M, where only ~130M are export-oriented jobs.
Since not too long ago, communist China started to allow a private sector and foreing investments in the country, as a way to "speed up the path to the socialist dream". Well, whatever you think of China's commuist-capitalist system, I'd say it looks like it's working; poverty in the country is down greatly and the technological modernization has been quite strong as the private innovations spill over into the public sector. So, the backward technology and inefficiency that plagued China before privatization has been much improved, still much needs to be done - not least in the inner and western parts of the country that are less exposed to these innovations.

So, couldn't China just expand it's public sector to fill in the slack of the private sector? - after all, the privatization adventure has already given so much. Well, this is what they are actually doing, just recently they announced a $586bn stimulus program, and have also declared an intent to continue adding more stimulus-money to the economy, going forward. Most of this money so far has been aimed at infrastructure-projects. It's impossible to say now what effect this will have, but obviously it will ease the pain of some of the people that will lose their jobs in the export-sector.

The privatization in China has brought a lot of wealth and development into the country and I think that a strong public sector really can uphold employment for a few years if export-driven growth greatly decreases. But what does this mean for investors? I would think that the strong growth of China will definitely go down, however it might not necessarily turn negative and so the domestic market might very well continue growing even as western countries are crashing. I do not beleive that here will be a decoupling of the chinese economy, but considering their strong demand for commodities (which looks unlikely to slow down that much) they will probably take the role as a helping hand for those economies that are faring most ill.

Some have forecasted political problems in China (or a breaking up of the country) because of its great economic inequalities both regionally and on a per capita basis. I don't see this as too likely; the chinese government is working very hard to combat these issues and although many migrant workers are losing their jobs, the big public sector will probably be used to swoop these people up. For example the chinese military was expanded by ~17% last year and again by ~15% this year, I think that the chinese leaders can produce jobs quite easily - at least in the shorter term of a couple of years.

Now, I might be dead wrong about the ability of the public sector to swoop up unemployed people, but I really don't see how; China has huge reserves and still a political and economic structure that makes these things much easier than in more capitalist countries. With the stimulus-money going into infrastructure, the rest of the world will not be losing the chinese demand for commodities and although things go really bad all around us, I beleive that China will be able to maintain a fairly firm position. The problems that China faces are more long-term - because they really are dependent on exports of goods, just like Japan, where exports have been dropping insanely. Both these countries need commodities from the outside to exchange for whatever they can produce. And it is no secret that China has been going around the world lately doing what they can to secure the flow of commodities into the country. Many people are aware of the danger in this situation, and unless technology for a self-sustaining society in terms of (foremost) energy can be created there will be wars for natural resources in the future.

Wow, that ended on a bad note. But it may well be a scenario that never has to come true or it may well be far off into the future. The economic down-turn is probably going to make the developed world less hungry for energy and therefore ease the strain on oil-supplies and the competetiveness around it; therfore this isn't necessarily an issue in the coming years and with the financial strenght and 'special' structure of the chinese economy it should be fine for at least some time to come.
So finally, should one invest in China? Well, I think that companies for the domestic market might just make it fine in the coming years, but not those who are more export-oriented. Perhaps a small or mid-cap chinese fund is a good idea, but on the whole the economy will probably be growing very slowly, if at all.