Sunday, 28 December 2008


28th December 2008
The Malta Independent on Sunday

This time last year I had made three predictions for 2008. It is time to review how well I performed before making fresh ones for 2009.

My first prediction was related to the property market. I had predicted that “The supply/demand equation is changing so rapidly because of an over-supply in the pipeline that it is quite predictable, with limited risk of error, that the Maltese property market will cool down substantially in 2008 with certain sectors of the market where the supply/demand is way out of balance starting to show outright price reductions in the 10-15 per cent range.”

Spot on you might say. The process is still unfolding and while we may have not yet hit the extent of price reductions indicated the trend is clear.

My second prediction was related to the general election:

“After 21 years of nearly uninterrupted tenure by a PN government I predict that by a hair or by a mile this time it will be Labour. This could be unfair on Dr Gonzi who seems to score consistently higher than Dr Sant in any opinion survey involving a direct choice between the two leaders, but this is not enough to overcome the swell of fatigue with his government.”

I missed this one by a hairline. A week is a long time in politics and, with hindsight, it is clear that Gonzi and clan snatched victory from the jaws of defeat through capillary persistence in bringing out the vote in comparison to Labour’s misplaced confidence that its success was all but wrapped up.

The third prediction was dependent on realisation of the second one and accordingly there was no opportunity to test it in practice.

As for 2009, it is almost obligatory to be gloomy. We are living in dangerous times as 2008 draws to an end and goes on record as the year when the international financial system nearly collapsed, when the banking system changed from a titan of strength to a sickly behemoth needing extraordinary government support to stand on its feet, and which changed its dictum from being too big and too strong to fail, to genuine concern that it could be too big to save.

Reality is we are flying blind. The world financial system can currently be compared to an aeroplane that was flying in full control when a storm suddenly knocked out all its equipment, forcing its cockpit crew to fly blind and attempt a soft landing without the assistance of the technology instruments they normally rely on.

The world economy for 2009 is largely in the hands of officials appointed rather than elected and who have tremendous autonomy, power and responsibility in managing the main central banks of the world. Our cockpit crew for this highly risky journey towards a soft landing are Ben Bernanke of the US Federal reserve, Jean Claude Trichet of the European Central Bank, Masaaki Shirakawa of the Bank of Japan, Mervyn King of the Bank of England and their counterparts in China, India, Brazil, Mexico and elsewhere.

Never before have central banks had to switch focus so suddenly from watching inflation to guarding against the risk of deflation. Never before have central banks been forced by a crisis of confidence to cut interest rates so savagely in a co-ordinated manner where the destination is clearly zero rates on a global basis for a considerable time. The USA, Japan and Switzerland are already there or nearly so. The Euro area and UK are well on the journey to that destination and are being joined by others such as China and Australia.

Our instruments cannot tell us whether this will work to kick start the economy and restore consumer confidence because we have never been here before. Keynes had mused that cutting interest rates so aggressively could be likened to the sterility of pushing on a string, leaving the economy anchored in doom. Would anybody fearing loss of their job be interested in buying a new house because the mortgage rate got cheaper?

So what if zero interest rates won’t work? As a precaution, governments are loosening their fiscal purse to fill the gap created by falling private demand by creating public demand.

Tax credits or tax reductions are generally considered ineffective for stimulating demand, as it is likely that in the face of uncertainty consumers would save the tax rebates rather than use them to stimulate the economy.

There is however a limit to how far fiscal largesse can get us. Spending on infrastructure, if well planned and judiciously chosen to support growth when the cycle turns, is sensible but the lead time needed between decision making and execution probably means it cannot be relied upon to support global demand in 2009. The irony is that governments who were fiscally prudent when the going was good, like Germany and China, and consequently have greater capacity for fiscal stimulus seem the least interested to stimulate their consumers to spend, whereas those who were fiscally reckless, like the US, now feel compelled to raise their fiscal deficit to frightening levels.

So what can we expect for 2009? There are three scenarios that may evolve. On the gloomy side, what if all the fiscal and monetary loosening will not restore confidence and the world economy remains in deep recession bordering on the depression, with property and commodity prices continuing to fall, unemployment exploding and governments continuing in fire-fighting mode to keep their banking system on its feet by effectively re-nationalising it?

On the optimistic side there is a scenario where the monetary and fiscal medicine will prove effective, aided by lower energy and commodity prices (which effectively are equivalent to a consumer tax cut as proven by the 20 per cent reduction announced last week in prices of fuel at the pump) leading to a short recession and a quick re-bounce. The risk is that this could ignite an inflationary spiral as the tremendous increase in liquidity injected by the central banks to ward off a deep recession starts creating excessive demand in the context of low interest rates.

Maybe excessively leveraged countries like the US and the UK, suffering from a deep property crisis, will tacitly accept an overdose of inflation as the most practical way to reduce leverage and increase value of real assets as money values erode through inflation. In reality this is already happening vis-à-vis the rest of the world as the external value of the USD and the GBP plummets. In circumstances of high inflation and low interest rates, commodities, especially precious metals, will be an attractive investment.

The third and least likely scenario is that central banks succeed in using blunt monetary policy with clinical precision in raising interest rates quickly when the economy is stabilised in order to avoid the risk of a quick shift back from deflation to inflation. This would be a feat as heroic and miraculous as the safe return of Apollo 13. But nothing forbids us from hoping for it. However, I would still put gold in a diversified investment portfolio for 2009. Happy New Year.


No comments:

Post a Comment