Thrift is the Future: Interventions will only Prolong the Credit Crisis

London, UK - 11th December 2008, 15:58 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

We are grateful to David Roche, President and Global Strategist at Independent Strategy, London, for his contribution to the ATCA Socratic dialogue on The Great Unwind. He writes:

Dear DK and Colleagues

Let us state it bluntly. If recessions are to be judged by their length and depth, the current policies of the American, British and French governments will not make the global economic recession any less painful. They may make it less deep, but they are equally likely to prolong it. Fiscal stimulus and lax monetary policy will help avoid debt deflation and depression. But many of the measures taken to "save" the financial system will prolong credit contraction and the recession and leave the financial system permanently impaired.

That is because the underlying cause of the great global credit crunch is the ingrained societal behaviour of the US and many other economies over the past two decades: instant gratification of "needs" without reference to the ability to earn the satisfaction of doing so. This did away with the economic virtue of thrift and encouraged excessive consumption. Excessive consumption resulted in global imbalances such as the US current account deficit.

The trigger for the collapse was the bursting of the credit bubble that funded the leverage, the asset price inflation and the global consumption boom. But the immediate cause of the crisis cannot be addressed without dealing with the underlying cause too. Any attempt to prolong the credit party will simply prolong the disease.

The correct method to deal with credit crises is not rocket science. It is as well tried and original as the recipe for instant soup. It was first etched in stone by the Scandinavians in the early 1990s. But it is being applied nowhere.

The UK model comes closest. But it too lacks the essential ingredient: forcing the banks to write down their assets to market and take the hit to shareholder capital before recapitalisation begins. Without this, there is no way of knowing how much capital is needed and no telling which institutions are solvent or distinguishing between good and bad banks.

In the US, about 90 per cent of all the measures to deal with the credit crisis aim to prevent asset prices falling to market levels, at which they would clear. The balance sheets of borrowers and creditors will remain encumbered by dud assets and liabilities, slowing the resumption of credit expansion and risking stagnation of the process of intermediation between saving and investment.

A substantial proportion of the fiscal measures enacted and planned, as well as the initiatives to restructure mortgages either through private sector banks or government-sponsored entities, are intended to bail out borrowers and prevent the repossession of houses. This will stop the ultimate cause of the crisis, lack of household thrift, being addressed rapidly. Such measures train the Pavlovian dog not to learn new ways when that is precisely what it needs to do.

What the world economy needs is reduced leverage. To avoid similar credit crises in the future, thrift must replace leverage and scarcer capital has to be invested more productively. Policies that deviate from this aim are bad. Thus replacing excessive private sector leverage with inefficient and market-distorting state leverage is not a path to a more stable world.

It is a matter of simple arithmetic to work out that the new layers of state debt to deal with the credit crisis are not a substitute for private debt, but an addition to it. This is because the state debt does not extinguish the private debt, but merely finances it, so increasing the layering of leverage that lies at the heart of the credit crisis.

Worse, bigger budget deficits and borrowing requirements will increase the US and the UK need for foreign capital. The foreign funding may not be forthcoming, which could cause the dollar to crash. The increased role of the state will crowd out more productive uses of capital and create a bigger bureaucratic role in the economy.

Historical precedent is often the forecasting tool of the mediocre mind. The deflation periods of 1929 in the US and Japan's post-bubble period are not accurate forecasts of where we are destined. We have created our own very serious, but quite unique, mess. Fiscal stimuli and the creation of central bank liquidity, unless rapidly reined in when the economy starts to recover, will generate inflation and low productivity growth down the road.

David Roche

[ENDS]

David Roche is President and Global Strategist at Independent Strategy which he founded in 1994. Well known for his original and provocative ideas, he was the first to move away from investment strategy as parochial country allocation and to focus on investment themes, based on fundamental long-term analysis, backed up by strongly held convictions. He has forecast some of the major 'turning points' in global investments of the past 20 years such as the demise of the Soviet Bloc and the subsequent fall of the Berlin Wall, or the sharp monetary tightening which heralded the financial reversal in world bond markets in 1994. Early in 1997 his was the lonely voice, which predicted the development of the Asian crisis. In February 2000 he advocated switching out of the over-stretched technology sector into more traditional companies who would benefit from "new economy" productivity improvements. Since mid 2006 he has developed and expanded the theory of New-Monetarism which forms the basis of the credit crunch which we are currently experiencing.

Until 1994, David Roche was Head of Research and Global Strategist at Morgan Stanley. He holds an MA from Trinity College Dublin and an MBA with the highest distinction from INSEAD. He is also a Chartered Financial Analyst and has a diploma in accounting and finance from the UK's Association of Certified Accountants. David Roche contributes regularly to the Financial Times, the Wall Street Journal and other top financial publications. He is also a regular commentator on the BBC, CNN and CNBC television networks. David's pioneering work on Liquidity and the Credit Crunch is explained and discussed at length in his recently published book: New Monetarism.

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