‘We are in for another deflation shock … So actually it’s time to own cash’

How do you see things in Europe right now?
The way I try to look at these economies is really to look at the financial conditions, the banking systems, credit availability etc. Those numbers are about bad for Europe. If you look at bank lending, it is contracting to the private sector. The money they are lending is going to the governments. The key issue really is lack of credit to the private sector. There is more and more evidence that it is actually due to lack of demand, and that just makes it just a more difficult problem to solve.

Why is that?
When your banking system is incapable of providing credit there are lots of things you can do to help it. But when people fundamentally don’t want to borrow and corporates don’t want to borrow then it’s a different situation. What would normally happen is quantitative easing and trying to keep money growing at a time when bank credit is contracting. But for political reasons that is difficult in Europe. So Europe is facing a very difficult and nasty economic downturn, and things are going to get significantly worse. There is a chance that somebody is going to have to leave the euro as early as next year. All seventeen members have to ratify the fiscal compact which is a major constitutional change. Still quite a few of them haven’t ratified it and as early as the first quarter next year some country may be unable to ratify. At that stage we would have a crisis because the country that fails to ratify wouldn’t be able to stay in the euro. So we are all rolling into a European crisis next year.

So what can keep the euro going?
If they become a Federal States of Europe.

Can they?
No, that’s highly unlikely. All seventeen members have to make the same constitutional changes and the same surrenders of sovereignty. And this is not an economic call. This is a political and social call. It is highly unlikely they will end up surrendering their sovereignty to a Federal government of Europe.

How do you see the things in the United States?
There is a much more mixed picture coming out of the United States of America. Bank credit is expanding and private sector is borrowing. What is interesting is that small and medium enterprises have been borrowing and we have been seeing a growth there for over a year now.  That is normally a very good sign of things because those are normally the people who create jobs.

What about other borrowing?
Banks balance sheets have premium components to them in terms of credit. And one is credit to small and medium enterprises. The other is mortgage credit. There is no sign of growth of mortgage credit. The other is consumer credit. There is no sign of growth in consumer credit either. At this stage one can be more optimistic about the US simply because small and medium enterprises are borrowing.

What about the long-term view?
I have a longer term problem with the US which isn’t going to show up quarter to quarter in the growth numbers but it is structurally the most important thing that is going on there. The rate at which foreign central bankers, particularly the Chinese, are accumulating treasuries has dropped very dramatically. The Chinese are not buying and actually seem to be selling treasuries. Along with the Federal Reserve, they are the biggest owners of treasuries. They are neck and neck. When the biggest owner of treasuries is effectively a forced seller, it has to make you cautious on America despite the shorter term positive data coming out.

What will be the impact of this?
If the Chinese are not going to be funding the American government, it’s more of an onus on the American savers to fund the American government. With savings being a reasonably finite number there is less to lend to the private sector. I see us already in a larger picture trend of America where the savings of America will be increasingly be funding the American government and not the private sector. At the minute that is not having any negative impact or particularly negative impact on private sector credit availability. But ultimately it will.

That being the case, are Americans saving enough to bankroll the American treasury?
No. They are not saving enough to bankroll the American treasury and the private sector. You have to put them together. But if it comes to a push on whether the government is funded or the private sector is — even in America, which is ideologically more to the right, more free market than elsewhere —  you will find savings are forced towards the government and away from the private sector.

So how do you expect the US to finance its unfunded liabilities such as social security and medicare over the years? One estimate even puts the unfunded liabilities at $222 trillion.
In the short term, as long as they can keep borrowing at this level, they will probably keep borrowing at this level. There is a basic rule.  A government that can borrow at 2% will borrow at 2%. That’s an entirely and completely unsustainable path for the American government. But it is just so easy to borrow at 2% that they will continue to do that.

So that reality for America will not dawn for unfunded liabilities until it has to borrow at a more realistic interest rate, which is inevitable. The numbers you point out are absolutely huge but it’s becoming incredibly difficult to say when that will happen, when they will have to live with proper real interest rates. It could be several years. It could be several days. But eventually, of course, they will have to do that. And there is a whole host of solutions for the US government.

Like what?
There is a thing called financial repression which is effectively forcing people to lend money to the US government or forcing financial institutions to lend money to the US government. That  is the path to travel for all the developed world countries. But there will have to be a renegotiation of benefits to the baby boomer generation. Every society has to choose where the burden has to fall. Does it fall on taxpayers? Does it fall on savers? Or does it fall on people who are recipients of this dole of money from the government. It will be a mix of all of these. So at some stage we will have to see a major renegotiation of the obligations that were signed for the baby boom generation in the 1960s. But it could be many years away.  I have to stress that this will be political dynamite. No society wants to withdraw benefits from its retired or elderly population. But the entire western world faces the reality that is exactly what it will have to do.

Do you see what they call the American Dream changing?
It has massively changed over the last two decades already. American people sustained by going from one person working to two persons working and then adding significant leverage to it.  So the dream has been extended through those two mechanisms and clearly it is not going to go much further from here. It’s a much harder slog from here given excessive levels of debt on the starting position. It’s not only an American phenomenon but it’s a developed world phenomenon. It’s easy to be negative but the only possible positive way out of this is some technological innovation which gives us some very high levels of no inflationary growth and very high levels of productivity.

Could you elaborate on that?
If you read financial history sometimes these things just come along. They surprise everybody.  One thing that is that could do it is cheap energy.  Shale oil and shale gas are the main places we would be looking at for cheap energy. But it is worth stressing that we are going to need a very high level of real economic growth. So in America it will have to be in excess of 4% or maybe as high a 4.5%. 

That’s the sort of real economic growth that would help countries grow their way out of the debt problem and meet most of the potential liabilities going forward. One shouldn’t rule out that we have that wonderful outcome but it still does seem like very unlikely.

Talking about technological innovation, can you give me some examples from the past?
Yeah, absolutely. They have really been energy-related. In the United Kingdom, the canals were such a revolution that the transportation cost collapsed. The price of coal in some major cities came down by 60-70% due to the introduction of canals.  Obviously, when energy prices fall by that much you get a productivity revolution. The railways had several impacts. Electricity, which we didn’t really get going into the industrial process until the start of the last century, had a major impact. The automobile had a major impact.

These are the types of major technological innovations which can change the world. When you can give the world cheap energy then that’s when you can begin to talk about much higher levels of growth. It is almost impossible to tell where these things come from but one that is sort on the horizon is shale oil and shale gas and potentially what that can do. But I want to stress it is going to have to produce levels of real economic activity in America, which haven’t been seen for a very, very long period of time, perhaps ever.

Do you see the American government defaulting on all the debt it has accumulated?
They will not default in the technical term of the word, which means refusing to pay back in dollars the debt in principle. But we are already in a situation where the Federal Reserve has intervened in the treasury market to hold the treasury yield below inflation. Now that is not a default. But if you own treasuries and the yield is below the rate of inflation then the real value of your investment is declining in dollar terms. In terms of you and I investing in that treasury market it means that we are losing capital and therefore I would call this a democratic default.

The second democratic default which I will come to America and the whole developed world will eventually be restrictions of free movement of capital. We are heading towards a world of controls and capital restrictions, which was a norm from 1945 to 1980-81.
Do you see them printing money to repay all the accumulated debt?
The answer is that partially they are already doing it. Quantitative easing is a form of printing money. Therefore you can say that is a process that is underway. So I have no doubts whatsoever that the Americans will be printing money to satisfy their foreign creditors.

Does that mean a hyperinflation kind of scenario?
No. It is always assumed that if there is a dramatic sale of the treasuries by the Chinese, the Federal Reserve will simply buy all those treasuries and simply create lots of money in the process. If that mechanism happened you would end up with hyperinflation. But it’s worth remembering that there is a technical definition of hyperinflation and that is a rate of inflation of 50% per month or more. So it’s a very high number. Sometimes people think that 20% per annum is hyperinflation but its 50% per month technically. The Federal Reserve is not stupid enough to do that. It would not simply print all the money it could to do to repay its creditors.

So what will happen?
What will happen is that there will be some money printing and, as I stressed, inflation will be higher than the yield on treasuries. But Plan B is financial repression which is to effectively force the financial institutions and the people of America to buy the treasuries. Now this does not involve printing of money. I am sure that if the Federal Reserve sees inflation climbing to anywhere near 10%, it would go to the government and say that we can’t continue to print money to buy these treasuries and we need to force financial institutions and people to buy these treasuries. In India, banks have to compulsorily buy government debt.

We can force banks and government companies to have a minimum amount of their assets in government debt. The road to hyperinflation is well known to central bankers. It has never ended well even though it can wipe out your debt very, very rapidly indeed. Nevertheless, the political and social implications of that are truly dire. It tends to throw up despots and destroy democracies.  Financial repression, if you are a saver, is terrible, but is much less painful than hyperinflation.

But what about the Western world practising austerity to repay its debt?
True austerity is when you simply closed down on government spending and accepted the economic consequences of that and still kept taking in tax revenues. But that’s a politically painful way of doing it. True austerity is highly unlikely. What Europe has is nothing like sufficient austerity to take them to a situation where they can repay government debt. So the only way out is repression, which is simply funding the government by forcing the people and financial institutions to buy government securities. That’s a very painful thing if you are a saver, but so much better than austerity, default and hyperinflation.

It is ultimately the most acceptable form of getting out of this problem. Even with repression we are talking about a couple of decades before we could gain levels of gearing in the developed world drawn towards normal levels.

Do you see the paper money system surviving?
Yes I do see the paper money system surviving. To say that it doesn’t survive means we replace it with something that is based or anchored on metal. But the history of the paper currency system or the fiat currency system is really the history of democracy. Within the metal currency there was very limited ability for the elected governments to manipulate that currency. And I know this is why people with savings and people with money like the gold standard. They like it because it reduces the ability of politicians to play around with the quantity of money.

But we have to remember that most people don’t have savings. They don’t have capital. And that’s why we got the paper currency in the first place. It was to allow the democracies. Democracy will always turn towards paper currency and unless you see the destruction of democracy in the developed world and I do not see that we will stay with paper currencies and not return to metallic currencies or metallic based currencies.

What about gold?
Gold is never easy to predict and it is particularly difficult at the moment. In the long-run view, which I have just stated — that repression is ultimately the best choice for democracies —  gold is the best asset class. It is the standout asset class. In a world of negative real interest rates, prolonged for some decades, gold does really well.

And in a world where tax rates are going up, where the government needs to get more private wealth under its own control, gold, being small, portable and hideable, becomes an asset of choice. So my long-term prognosis for gold remains very good. In the short run, I am concerned that if we get another economic setback from here and we see growth coming down from here, the price of gold may come down. But I would say any decline in the price of gold is a wonderful opportunity to buy some more and for the long term holder gold remains essential.

What are the other asset classes you would be bullish on?
I tend to believe that we are in for another deflation shock. The Asian crisis of 1998 was a deflation shock and we had one in 2002 when the American economy slowed and Ben Bernanke had to make his helicopter speech. We had another one post Lehman Brothers. So what you would want to look at is what asset classes did well during those periods? And really very little does well when we have deflation shocks. Whether deflation turns up or not, the shock is very bad for pro-growth assets. So actually it’s time to own cash.  Cash has historically been a good preserver of health during periods of deflation. It is worth buying debt of some of the governments that don’t have very much debt.

There are some countries out there with small amount of government debts and they are small such as Singapore and Norway. So I would recommend cash and very small holding in government debt in markets where the governments don’t have very much debt. Also when markets have come down a bit we are looking to buy equities and we are looking to buy gold.

By when do you see this deflationary shock coming?
Well its coming. It is very rare for these things to erupt in the morning. Lehman Brothers was the exception -- a bank with $600 billion of liabilities going bust suddenly threatens the stability of the entire financial system. Sometimes it happens like that but rarely. It happened like that in the 1930s with the bankruptcy of Creditanstalt (an Austrian bank that went belly-up in 1931 and started a chain of bankruptcies).

Occasionally, it can be a major event. But it can be just like it was in 2003 — just slower and slower growth.  The one red flag which could suddenly jump and signal deflation is if someone leaves the euro because clearly if it’s a major currency leaving the euro, they will be re-denominating their debts in their domestic currency which is tantamount to a large default on the global banking system. That is a small chance of that early next year.

What if the country is Greece?
Frankly Greece defaulting on its debts isn’t going to make much difference to a banking system but makes a big difference to the IMF and the government. But more likely it’s just going to be slower and slower growth coming forward, particularly in China.  The world has bet a lot on Chinese growth. The more the growth slows in China and capital flows out of China, the more the world begins to realise that it’s China which has been the source of global growth and global inflation, and if that’s not there we are more likely to get deflation. So that’s the more likely scenario rather than a Lehman Brothers-style event.

So, you are basically saying that the high Chinese growth rates will now be a thing of the past?
Yes, unless they do some major reforms. And in my opinion that they need to do is reforms which will encourage private Chinese capital to remain in China and invest in China. There is very limited reason for Chinese private capital to remain in China now, because the returns are so poor. So anything they could do to open up the financial system for private sector investment and competition would be good.

And more importantly, allow the private sector to take over some state-owned enterprises and restructure them. If they are prepared to make that giant leap in terms of reforms. then there is every prospect that keep they will keep capital in China. The good thing is we are getting a new administration. The bad thing is it is very difficult to predict what a new Chinese administration stands for. But soon enough we will know and if they come up with some policies like this, then there are many reasons to be more optimistic about the outlook for global growth.

By what levels do you see the stock markets falling in the coming deflationary shock?
I will just go back to my book Anatomy of the Bear, which was published in 2005 and in the book I forecasted that the equity market, the S&P 500 (an American stock market index constructed from the stock prices of the top 500 publicly traded companies) will fall to 400 points (On Friday the S&P 500 closed at 1,428.5 points). As you know, in March 2009 it got to 666 points. It got somewhere there but it did not get to 400. So I am happy to stick with the number of 400 and then just tell everybody else who sort of reads this interview to work out what that means for the rest of the world.

Interviewer Kaul is a writer. Email: vivek.kaul@gmail.com