January 28, 2013
The other day, there was an arresting interview online from Davos. It featured a guy called Ray Dalio. This man manages a startling $140 billion and speculates in the markets. He started with $5 million, so evidently he is good at what he does.
While much of the coverage here was on Enda Kenny and what he was saying about how much the rest of the world loves us, the interview with Dalio was, for me, the standout one of the week – notwithstanding, of course, David Cameron’s move earlier that week(- more on that later).
Dalio said something quite straightforward about the state of the world financial system. When asked what he was going to do with his investments this year, he responded that, with so much cash about, he expected much of this money to leave cash deposits and buy “stuff”. He wasn’t so specific on what stuff exactly, but he said he felt that it made sense for people to use their cash, which is now not generating any return, to buy other stuff.
Is this the moment when the stock market and property markets and, frankly, markets for everything that isn’t cash, explode?
Dalio’s view of the world is straightforward. As the central banks of the world keep pumping more and more money into the economy to ensure that the recovery takes hold, the value of cash is plummeting. He is therefore not taking his cash off deposit, because he sees some great investments out there. Rather, he is taking his cash out of his deposit account because he is getting no return on it.
So the price of all assets is rising because a wall of money is pushing them up, not because the prospects of the economy have improved dramatically.
This explains quite a lot. Take for example the Irish bond market. It is rallying at a time when the ability of the economy to generate the growth necessary to validate that rally is not there. This means that the rally in assets is rented, not earned.
The rally is rented, not earned.
Let that sink in.
By this I mean the spike in Irish bond prices is a new bubble based on a huge amount on money looking for a home and finding its way into the Irish bond market. High-yield assets are rallying as investors like Dalio go in search of yield from ‘stuff’.
This implies that the rally in Europe and the sense that the worse of the European bond/debt/credit problem is over – as is being muttered in Brussels – is ludicrous. The bond herd is now buying up peripheral European bonds driven by the free money from the European Central Bank (ECB) rather than any change in the ability of the countries such as Italy, Spain and Ireland actually to service that debt.
We are in a classic six-stage cycle of how a bubble forms, driven yet again by cheap credit. These six stages were outlined by the brilliant US economist Hyman Minsky.
In the first phase, what happens is called displacement. This is when there is a change in policy which materially affects the economy.
This change in Europe occurred over the past 18 months when ECB boss Mario Draghi replaced Jean Claude Trichet and started printing money. He hasn’t stopped since. This is the same policy followed by the Fed. And, in recent days, the Japanese have gone one further and said they will print as much as is necessary to push up the rate of inflation.
The second phase of a Minsky cycle is the gearing phase. This is when the price of assets lurches upwards driven by the change in policy. Once this happens, the banks get involved and financiers like Dalio get on the bandwagon, buying stuff with borrowed money. This causes the boom in assets.
In the next phase, the boom phase, the herd gets involved and buys risky assets, driving the price ever upwards and, as the price goes up, more and more investors get into the asset.
The fourth phase is the euphoria phase when the investors are so ecstatic with the perceived returns on their assets that they forget there was ever a crisis in the first place. Even if they are now buying assets expensively, the very expense can be made legitimate by all sorts of new theories. The fact remains that countries in peripheral Europe haven’t a prayer of paying back money, even as yields fall to almost Germanic levels.
Then we get the fifth phase, which is the distress phase. Here we see canny investors getting out and taking their profits. The herd is still high-fiving each other while the smart ones sell and escape with their swag.
The final sixth phase is the panic phase when the herd realises that the countries in peripheral Europe could actually never pay their debts in the first place because the lifestyle they achieved with the borrowed money was a rented lifestyle, not an earned lifestyle. The herd panics and runs for the door. The house of cards comes tumbling down.
Then we move into what is called the Minsky moment where good assets have to be sold to pay for the losses in a portfolio caused by the fall in the value of bad assets. Because there was leverage, we go into another deleveraging cycle in Europe at higher levels of debt.
Obviously the only coherent way out of this is a default because, when debt can’t be paid, it won’t be.
However, the core of the central bank policy in Europe right now is to avoid this at all costs. Once you take capitalism out of the equation when non-repayment punishes stupid investment, you are in for a long-term cycle of repetitive booms and busts.
As the great British economist John Stuart Mill observed: “Credit busts don’t destroy wealth, they merely reflect the extent to which wealth has already been destroyed by stupid decisions made in the boom.”
When we hear moneymen saying indiscriminately that they are going to buy ‘stuff’, it is a small signal of a Minsky moment likely in the future.
This brings us nicely to David Cameron. Will he get what he wants from Europe? My hunch is that the EU will be convulsed by the ramifications of recurring bond crises in the years ahead. Crises are always met in Europe by more, not less, integration. Against that background, the EU is not likely to open up the prospect of an Ã la carte EU. Therefore, Cameron might not get what he says he wants.
In such a case, the in/out British referendum is carried by the “out” side. Middle Scotland is then in a conundrum and will move to a more separatist mode, even if the referendum on independence is defeated next year.
The real battle of Britain starts then as Scotland and Wales worry about being welded to English nationalism with no EU escape hatch.
What happens to us? Well, Ireland is like the jockey riding two horses, the British economic horse (our biggest trading/demographic/cultural partner) and the European horse (our political master). As long as the two horses are running in tandem, the jockey can manage.
However, when the two horses dart off in different directions, the jockey’s position becomes terribly uncomfortable.
David McWilliams’ new bookÂ The Good Room is out now