How the new normal works

The end of the western capitalistic system is approaching but this also means that there is a lot of money to be made and lost

By Sameer Sharma

Throughout human history empires have always risen and fallen. As your empire gets bigger and bigger, it becomes more difficult to maintain it and grow and then comes the competition too and their aim is to be numero uno. This logic can be applied to population analysis of various species and yes even to finance.

All corrections and rallies follow a certain pattern within a physical system. As we approach the end of that system, oscillations become more frequent while their magnitude falls. Eventually the system breaks up and a new system is born. This is the story of the world.

The slow decline of the American empire

The American empire is slowly but surely in decline after it peaked out in the mid 1990s. During that time, policy makers gambled that via globalization and the free trade that comes with it, it could move up the value chain where returns were higher while it would receive cheaper goods from countries that have a comparative advantage in producing that particular good. That way, as the US would move up the chain and innovate and get richer, it would also benefit from low inflation because the Chinese and Mexicans make shoes for almost nothing. Low inflation would yield low interest rates which would allow the empire to continue to prosper or so they thought.

There is nothing wrong with free trade as it does indeed come with enhanced productivity which is the only long-term determinant of sustainable growth. But where the Americans went wrong was that they failed to educate the majority of their population to compete with the emerging giants of tomorrow. The Indians and the Chinese, greedy to become what they once were, realized early on that they too could move up the value chain and make more money than just making shoes and t-shirts, something we in Mauritius are still working on.

The biggest problem for the United States today is that the labour force of developing economies is much more competitive than the majority of its labour force. The US political system is short-term in nature which creates longer term policy paralysis for the smooth running of such a large empire. Hence, while a small minority of Americans continues to benefit from the American dream, an increasing percentage no longer does. The Federal Reserve is not however bound by the limited shelf life of presidents, congressmen and senators. Policymakers in turn realize this. At the end of the day, you can only entertain the majority of the population with so many football games, so much rap and so many wrestling matches!

What you do then is that you keep interest rates artificially low, i.e. below inflation, you get them to lever up just like you would inject steroids in certain animals in order to get more out of them, and you make them consume like there is no tomorrow. No more money, no problem, get them to take equity out of their homes while at the same time lowering minimum home equity requirements. At the same time, checkmate China and others in the Middle East and control the sources of energy.

At the end of the day, China needs to go through the Indian Ocean to get to the Mid East and Africa. It needs to go through the Pacific in order to get to Brazil. The problem was that policymakers thought that they could contain internal bubbles that come with negative real interest rates, but that has not worked.

Uncle Ben prints money

If we take into account the unfunded liabilities of the US such as Medicare and add it to the debt load, we are looking at a 14 trillion dollar economy having a potential overhang almost three times that. Burst bubble or not, the Federal Reserve needs to achieve 5% nominal GDP growth in order to keep the economy from slipping into the abyss by hook or by crook. Considering the labour mismatches and the ongoing deleveraging process, the government cannot replace the consumer forever and make up for the fall in spending and so the only other alternative is to print money.

If the US does not get to the magic 5% figure via real growth, it can try to do so via inflation. This is why I constantly talk about how currency markets dictate how asset markets move these days because there is central bank tinkering there. Whenever markets fall, Uncle Ben Bernanke is right there with a quantitative easing speech. This week we will hear about QE2, yes another one so soon and no real growth to show for it and soon enough there will be QE3, 4…

Uncle Ben has been responsible for one of the biggest rallies in history during the month of September as he made sure the dollar depreciates versus key carry trade currencies. Commodities were the best performing asset class, especially agriculture commodities. Well done Ben! This is all artificial of course but it is a money making dream come true if you understand how the world works.

The future of the world lies in Asia but the Americans will not go down without a fight. If the markets are disappointed by QE2, a large correction will certainly come and Ben will eventually come around and promise more money printing. In sum, buying at the dips on any correction has been working like no tomorrow for the past year and a half.

The new normal can be defined as an environment where the US economy grows at a more moderate pace, austerity obsessed Europe continues to decline in importance while emerging giants continue their rise. The new normal will also witness currency wars and a rise on average of real assets and a potential bear run for bonds. The new normal is the prelude to a major crisis to come because money printing is never the solution. Debt monetization never works, just ask Dr Mugabe.

The end of the western capitalistic system is approaching but this also means that there is a lot of money to be made and lost. In finance, we need to understand long-term trends and find ways to profit out of it. I do not care if China is number one or some other country. I care about how much money I can make out of it.

Our schools are not creating the required human capital

Mauritius in turn needs to invest much more in education, not in arts or marketing courses but in mathematics and sciences. Rather than talking about cutting taxes here and there while giving zero compensation to the civil service, the country must have a more progressive tax system and spend that money on educating our future. The education system in Mauritius is too theoretical and based on vomiting what you memorize in the exams and thinking that you are intelligent because of it.

We need to teach our kids how to think and we need to make them believe that staying in Mauritius is worth it. Talk to almost any kid today and they will tell you that they want to leave. They fail to realize that the western economies are in decline and that Asia is becoming more important. They fail to realize that if we are able to increase the knowledge base of our children towards the math and sciences, we can grab a tiny but sufficient share of the business that flows in the Indian Ocean. Our schools are not creating the required human capital. Every time I go out, I hear about how many kids are studying finance and the CFA.

Five years back, all kids wanted to study law. Kids should try to understand longer term supply and demand dynamics. Policy makers in turn should realize that the Mauritian economy cannot keep on growing like it was before and nor are shopping malls and the duty free island concept the solution. Many of those malls will face significant problems over the next five years because the feasibility studies were comical and based on dreams as against realities. An economy can survive via depreciation of its currency and artificial tinkering, but it cannot prosper while not being productive. 

Sameer Sharma, a chartered alternative investment analyst, is the Head of International Funds at IPRO Investment Professionals 

– Conjoncture Nov-Dec 2010

* Published in print edition on 12 November 2010