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J. Anthony Boeckh and The Great Reflation

By Kevin Press,

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J. Anthony Boeckh’s important new book The Great Reflation: How Investors Can Profit From the New World of Money might just as well be called The Great Experiment. He believes that the massive government stimulus programs implemented around the world in response to the credit crisis were necessary, but that it’s too early to tell if they will work. We are in uncharted territory, and investors can expect continued volatility in the near term. Boeckh and I spoke yesterday.

What is the Great Reflation?
The reflation refers to the attempt by the authorities – Canadian, U.S. and all around the world – to basically pump air back into the balloon with monetary and fiscal policy, lots of free money and huge budget deficits. We have a 25-year build-up of private debt and we had a series of asset bubbles: commodity prices, stock prices, derivatives, housing prices and so on. It all came to an end in 2008-2009. The authorities have really tried to prevent the crash in the markets and the recession from turning into another 1930s Great Depression.

You describe money being pumped in on “a grand scale,” and that there has to be major consequences. What should we be looking for?
We’ve been seeing one of the consequences in the last few weeks with the sovereign debt crisis in Europe. Governments have pushed their budget deficits to extraordinarily high levels; way past the point of sustainability. Finally the markets have caught onto it and are putting pressure on governments everywhere to cut expenditures, raise taxes and reduce their deficits. That’s one consequence that we’ve seen from this reflation effort. On the question of money being created and it having to go somewhere, we’ve seen a huge rise in stock prices up until recently, a huge housing bubble in China, in Canada we’re seeing a huge rebound in house prices across the country to levels above where they were before the crisis hit, so money is percolating through the system and it’s going into different asset categories. One thing that’s really clear is that it’s not going into consumer prices. The world is a very deflationary place.

Did governments make the right decisions in 2008?
There wasn’t any other choice. They were really looking at an open-ended catastrophe, and I think there were a couple of months when it was totally out of control. The authorities really didn’t know what to do next. They were just having to stuff money into the system and bail out everything in sight. I think that the collapse would have spiraled into something worse than the 1930s if they had not taken the action that they did. They really had no choice at all. Pumping money into the system, stimulus, running huge budget deficits, basically that was all about converting excessive private debt into public or government debt.

You believe we’re headed into a period of enhanced risk.
One of the points I make in the book is that this whole thing is an experiment. I wanted to use the word “experiment” in the title, but the publisher didn’t like that word. This is truly an experiment, and nobody knows where it’s going to go. One thing we do know is that we’re on a roller coaster. It’s going to be a more volatile roller coaster than we’ve seen before, and there will be shocks to the system that will come out of left field like the Greek debt crisis. So there will be a lot of risk in the system, a lot of volatility. It’s very important for investors to understand risk, to understand where we’ve come from and how this is going to play out in the future. I think the next five years are critical. We’re going through an unwinding of private debt, which got pushed to ridiculous extremes. The next stage is going to be the unwinding of excessive public debt. I think that will probably take five years, give or take a bit – it’s very hard to be precise about it. During this period of deleveraging, it’s going to be a pretty risky shock-prone kind of world.

In addition to understanding this, what can investors do?
It’s pretty tough. People need tools to navigate this. It’s not really a buy-and-hold sort of world. You have to go with the liquidity flows. So when liquidity in the system is expanding, like it has been for 15 months, the riskier assets will tend to go up and you want to be with those flows. And then when the liquidity flows start to turn negative; you really should be taking some money off the table. That’s one aspect of managing through this. Another one is obviously diversification. One of the lessons of the crash of 2008-2009 is that virtually all risk assets had a correlation of one. In other words, they all moved sharply together. People thought they were diversified, and they turned out not to be. I think something else that’s really important is for people to hold appropriate amounts of liquidity. Almost everybody I talked to in 2008-2009 when the crash was gaining momentum, they all realized they didn’t have enough liquidity. So they were really kind of terror-struck.

Will we ever break out of this repeating bust-boom cycle?
I don’t know the answer to that. I wish I did. All I can say right now is that we’re still very much in this boom-bust cycle. We had the bust; we had a bit of a boom as governments threw all this money into the system – in Canada, the U.S. and all around the world. Now they’re going to have to take some of that money off the table because the public bond markets have got really concerned about sovereign debt defaults. Governments are being forced to cut back, and that’s going to slow down the economy. I don’t think it’s going to create another recession, but at this point I don’t think anybody can say that for sure.

You’re not betting on a second dip.
I don’t think we’re going to see a secondary recession, but I don’t have a 100% certainty of that. As I said, I think this is an experiment. Government cutbacks on expenditures and raising taxes is going to be another experiment, and we don’t know if the social fabric is going to take it – whether we’re going to see riots in the streets in other European capitals as those governments cut back. I think the whole thing is kind of tenuous. We just have to watch and see when governments really cut to get their debts under control, whether the social fabric can take the additional deflation and the pain that comes with that. That’s what everybody should be watching closely.

You also write that the underlying causes of money and credit excesses remain. “The system continues to be flawed.” What should be done?
What I meant by a flawed system is that we’re in a floating U.S. dollar standard. This affects all countries. China’s got a hugely undervalued currency, so money is flowing into China. The Chinese have to convert the dollars to renminbis, so that inflates their monetary system. The dollars get reinvested back in the U.S., so that tends to continue to inflate the U.S. system. Until we can fix the international monetary system – create some stability in it – we’re going to see a lot of gyrations with currencies going up and down sharply. Some currencies undervalued, some overvalued. There’s nothing really to stop this engine of instability from carrying on. One of the things that I really think needs to be done is to fix the international monetary system. And there are no really good alternatives that have been put out there on the table that have any credibility.

Will the role of the U.S. dollar change?
I don’t think so. Countries have been diversifying away from the dollar for a long time. But the world can’t really live without the U.S. dollar. It doesn’t make any sense for countries to try and get rid of dollars because if a central bank wants to sell its dollars, all it’s going to do is push its own currency way up. The Chinese for example are the biggest holders of dollars. The last thing they want to do is see their currency go up because they want to keep their big export machine cranking at full capacity.

So global interests are aligned around a relatively strong U.S. dollar.
For the time being, yes. The Chinese and the Americans are the two biggest parts of the relationship. I think they both have a self-interest in maintaining the status quo, maintaining some stability. And then you’ve got Europe and Japan. The euro and the yen are pretty fundamentally weak currencies. So even though I don’t like the U.S. dollar in the long run, it really looks like the best-looking horse in the glue factory so to speak. Apart from the Canadian dollar, which is probably one of the best currencies.

Will the Canadian dollar rise above parity with the U.S. dollar?
I think for the Canadian dollar to go much above parity, you’re really betting on a big commodity price increase. I wouldn’t want to rule that out, but I don’t see that happening in the near term. The world is much too deflationary and I think economic growth is going to slow quite dramatically in the next year or two.

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