17/04/2009: Aesop reloaded

In one form or another, Aesop’s tale of the ant and the cricket, with its hard lessons about the rewards of thrift and improvidence, is well known. The carefree cricket sings the whole summer long, putting nothing aside for the winter, while the hardworking ant labors tirelessly to build up an ample store of food. When winter takes hold, the starving cricket begs its neighbor for food and the ant replies, “You sang through the summer; now you can dance through the winter!” (Disney’s version was kinder.) The moral of this story is clear: the frugal are rewarded, the profligate punished.

In what passes for economic commentary in some quarters today, especially from those pundits who question the economic model of the past twenty-five years or so, the spirit of Aesop’s fable is often invoked. Like the singing cricket, the argument goes, the economies of US and the UK and some others only generated “virtual” products in wispy endeavors like financial services or entertainment. And they did not save for the inevitable hard times. Thus it is no surprise they are in big trouble, because winter has arrived in form of a chilling financial crisis. This view is often expressed with varying degrees of that lovely German word, “Schadenfreude,” the enjoyment of someone else’s pain.

Ant nations would be those frugal and industrious countries that manufactured “real” stuff, like cars and flat screens. Germany, Japan or China come to mind. Having saved for hard times, they should now be able to seriously outperform the crickets.

However, here is where modern economic reality departs from ancient fable. Many manufacturing nations have suffered more than the US or the UK in the global recession. As the recession has deepened, unemployment among the ants has risen at an even faster pace. And we should remember: the ants could only prosper because the crickets consumed their manufactured goods. Now that the crickets have rediscovered the “virtue” of saving, the ants are faced with crumbling demand for their goods.

The governments and central banks of many cricket nations are borrowing, printing and spending huge sums to prevent the global economy from sliding into depression. And some ant nations have also put aside their frugal ways, understanding that having saved for bad times, now is the time to release their stored wealth. But they are still some governments, especially in continental Europe, who remain “antsy” about taking this step. Their mindset remains close to Aesop’s: the crickets caused the crisis so they can sing for their supper. This attitude ignores the fact that the model only works if crickets have the money to buy the ants’ output.

The economic moral of Aesop’s fable should be re-written. Not only do we prefer understanding, compassion and cooperation to self-righteous posturing; the latter is simply self-destructive. The ant cannot afford to let the cricket dance (and die) in winter. We got into this mess together and that is the only way we will get out of it.

03/04/2009: The aftermath’s new math

Until last year, the word “trillion” rarely crossed our lips. Even economists had little occasion to use it. But now we hear it everywhere we turn. From the trillions of dollars in financial-sector write-downs to the trillion-plus budget deficit and the trillions added to central banks’ balance sheets, “Trillion is the new billion,” as the saying goes. At least linguistically, inflation is on the rise.

While it is still too soon to say that the financial crisis has been vanquished, the efforts of governments to combat it are truly astonishing. Two weeks ago, the Fed announced that it intends to swell its balance sheet by more than a trillion dollars to buy mortgage-backed securities, agency bonds, and, for the first time since the 1960s, Treasury bonds. In sum, these measures will more than triple the US monetary base from its September 2008 level, which boggles this writer’s mind. We are in new territory here, undertaking a reflationary experiment on a scale never before applied in developed countries.

With the news flow relating to the financial crisis and the economic downturn still intense, it is difficult – but vital – to take a step back and analyze the long-term implications of the crisis and the various government interventions it has spawned. This is what we have done in our new UBS research focus: “The financial crisis and its aftermath.”

The conclusions of this in-depth study are rather sobering. In the aftermath of the crisis, a new economic era is taking shape. In short, the patterns and drivers of growth and inflation over the last twenty-five years look certain to change over the next twenty-five years.

Falling trade barriers, increased international capital flows, and the spread of private-sector activities produced enormous benefits for the world economy in the last quarter century. At the same time, however, these burgeoning international trade and capital flows became increasingly unstable. Restoring sustainable economic growth will not be easy.

Even before the crisis hit, demographic forces were already pointing to both slower long-term economic growth and greater pressure on government finances. In the aftermath of the crisis, the unwinding of household and corporate balance sheet leverage, as well as heightened regulation we expect, are likely to slow economic activity even further. The state is already playing a much bigger role in economic affairs than it did before the crisis and it is unlikely yield center-stage after the situation stabilizes.

We therefore expect public-sector imbalances to grow steadily as countries grapple with tough choices over potential spending cuts or higher taxes. In this context, inflation could become an expedient tool for policymakers to redistribute the burden of high levels of private and public debt. Finally, protectionism looms as a regrettable knee-jerk reaction during times of economic upheaval.

For investors, two important truths are clear: the past two years, since the financial crisis began, should not be taken as a benchmark for the future. Nor should the past twenty-five years.