Long-Term Economic Outlook

Hope for the best, plan for the worst

Originally published in the March 2008 issue

Oscar Wilde’s phrase “the triumph of hope over experience” could be applied to investors who assume that equities will always be sound in the long-term. Anyone with an eye for financial history knows that stock markets can stagnate and drift for decades at a time, especially when inflation is in the ascendant. Such episodes can also be tough for hedge funds as massive outflows were witnessed under similar conditions in the late 1960’s.

So why should one plan for bad times and black swans? Great investors of the past have prepared themselves by wallowing in the worst case scenario as a dress-rehearsal of what could go wrong. Those who make no plans will be buffeted by unexpected events and will inevitably join the ranks of the consensus hoard. Until recently we assumed that quant risk modelling would cover the bases but Value at Risk may be a suspect measure of our vulnerability. When planning for possible economic problems one should contemplate their cause, effect and potential consequences.

Cause: post-911 stimulation and tax cuts, too much money created from too much debt
Effect: inflation and debasement followed by deflation
Consequence: property and equity slump, power shift from West to East

Causal credit

The author John Gardner once wrote, “History never looks like history when you are living through it.” The TMT crash of 2000 should have been the pre-cursor to a major recession which over time would have brought the economy back into balance. Sadly, the terrorist attacks of 2001 made a recession politically unacceptable and America was goaded into a state of artificial economic stimulation. We are now paying the price for what may prove to be the biggest bet in financial history in the form of a credit crisis. This term is really a misnomer as what we face is a debt crisis, which undisciplined developing countries endure; only that sort of thing is not meant to happen to smart westerners like us.

We should take a hard look at our own numbers. The US current account deficit could be confused with that of a banana republic. This can be funded as long as developing countries’ currencies remain dollar-pegged and commodities are dollar-denominated. These assumptions may well have a shelf-life. Reserve currency status is a privilege of military might and a dominant trade status. As America’s influence diminishes, its steady depreciation coupled with asset freezing orders is undermining the dollar’s desirability – for the very people who subsidise their tax and interest rate cuts. We can now appreciate the foresight of the Founding Fathers who wrote America’s Constitution in the same year as the French Revolution. Their currency was backed by precious metals to avoid economic turmoil. The trebling of silver in the last 5 years versus a 40% decline in the dollar is a graphic reminder of their wisdom.

Inflation then deflation

As with many previous episodes where a currency is mass-produced to pay for wars or wastrel policies, the more that is created, the less it buys. Just as the road to hell is paved with good intentions so the inflationary path is the most popular to pursue. While we have enjoyed the rising tide of liquidity through a pumped-up money supply we cannot go on subsidising our lifestyle with debt, leaving a lifetime of liabilities for our offspring.

“The US current account deficit could be confused with that of a banana republic”

The same people who used to talk of market forces when they stood to benefit, now beg for rate reductions and bank bail-outs. If the problem is too much credit, how does making it cheaper help us? This is the question that Japan has wrestled with for two decades. In the late 1980’s, Japanese interest rates were set too low for too long which inflated an equity and property bubble, just when the population was ageing. As American baby-boomers begin toretire en masse in 2008 perhaps a similar fate awaits them. While deficits as a proportion of GDP understandably peaked at the height of the Great Depression, this time round we have breached even these extremes; only we’ve done so during the good times. When posterity turns to penury, we may remember the acumen of our agricultural ancestors who stored in the good times to prepare for the bad.

Consequence and cure

The hangover from the consumer party is taking the form of soaring consumer prices. As debt-fuelled earnings evaporate then equity prices may be pole-axed, in spite of lower interest rates. Precious metals could once again provide one of the few bolt-holes for investors, just as they did in the 1930’s and 1970’s. They should be held unemotionally as an insurance policy to preserve purchasing power in the face of dollar devaluation. While gold will offset declines elsewhere we ultimately need to fix a bad system. The longer-term threat we face is that of a power shift from West to East. We have accrued debt and outsourced our manufacturing while developing countries have accumulated cash and created an industrial base. They have also negotiated future supplies of raw material. In future, real wealth may well be access to real assets.

Like a dock leaf near a nettle, the cause and cure are often in the same place. In recent years we have seen a surge in Islamic Finance, particularly in London. Westerners are missing the point of this system, seeing it as just another method of making money from oil-rich countries. They are also applying their own twists to Islamic products, much to the disdain of some scholars: a case of following the letter but not the spirit of Sharia’a Law.

Contrary to first impressions, this financial system reflects the core principles of Islam which shares risk and reward (or loss). Instead of debt, it uses equity. Instead of interest, investors receive rental income. It has been described as the best bits of capitalism and communism combined. Ironically, while we fight with Islamic countries to secure access to their oil, their financing methods can offer a path to sustainability.

Such a balanced system does not provide high rates of growth compared with western fractional banking which allows loans to be created in many multiples of deposits. Perhaps excess growth is the source of the problem and we should be humble enough to learn from nature, where cycles consist of dormancy as well as development.

Many mistakenly use the term Armageddon to describe a calamitous end of days but the actual biblical meaning is that of new beginning. We should therefore not fear a financial crisis because western economies need to undergo a period of cleansing or detoxification, after which they will (hopefully) rehabilitate. To come full circle, perhaps the title of this article should not be ‘Hope for the best, plan for the worst’ but ‘planning for the worst is our best hope’.


Toby Birch is manager of the Blackfish Capital Exodus Fund. He is a Fellow of the Securities and Investment Institute and holder of the Islamic Finance Qualification. He wrote a book warning of a debt-driven downturn (The Final Crash: Addictive Debt and the Deformation of the World Economy: Pendula Press 2007, pen-name Hugo Bouleau).