Jim Mellon and Al Chalabi predicted the current financial crisis in Wake Up! Survive and Prosper in the Coming Economic Turmoil
18th March 2008: Wake Up! Survive & Prosper in the Coming Economic Turmoil (Wiley, 2005) is a book we released a little over two years ago when the global economy looked very rosy. We argued that this apparent economic boom was ephemeral and would prove to be unsustainable because the underlying reasons behind it were unsound: cheap credit.
We discussed how the Federal Reserve's irresponsible behaviour was trading short-term gain for long-term pain – and a deep recession lay ahead. Many critics dismissed our forecasts initially, yet now that events are unfolding before us, the matter is indisputable. However, just when we thought that the Fed was going to start acting sensibly to curb inflation by putting up interest rates, it decided to LOWER them in a desperate effort to provide the market with cheap credit once again. It is not working and it will not work, simply because of a very simple formula: MONEY x CONFIDENCE = GROWTH. Unfortunately, confidence has fallen to zero which means that no amount of money can provide the economic stimulus the Fed is hoping for.
We drew parallels with Japan, which again, many critics argued was not a comparable situation, and yet with each passing day, the similarities become more apparent. Japan's boom-bust cycle resulted in over a decade of deflation and they have had near zero interest rates there for years with no effect on stimulating growth. Deflation is not something many of us have experienced in our lifetime. Simply put, deflation is when the price of a product or service in the future is cheaper than it is today. The effect that this has is people do not spend unless they absolutely have to, as all they have to do is wait and things get cheaper. Given that many economies are driven by consumer spending (for the US, it is 70%) a reduction in consumer spending will be catastrophic.
Unlike Japan, US consumers do not have any savings, so not only are they not inclined to spend, they do not have any money to spend in the first place. Their previous sources of cash - credit cards, loans, re-financing mortgages and tax rebates - have dried up. Even banks and businesses cannot get access to credit as the market sentiment has turned from lending to "anyone with a heart-beat" to not lending to anyone, even those with perfect credit histories. The problem is systemic and not one that can be fixed quickly as some pundits initially thought. Let us not forget that it has been over a year (February 2007) since we experienced the first market jitters over the credit crisis. We had another wobble in August 2007 but again, there was so much positive momentum that the severity of the situation was shrugged off. Now everyone is paying attention and fear and uncertainty has replaced that confidence.
So where do we go from here? Well, unfortunately there is very little that can be done to save the US dollar under the current Fed policy. Cutting rates when they should have been increasing them indicates that the problems with the US economy are more severe than controlling inflation - that is worrying in itself. Unless the Fed starts to increase rates, the US dollar will continue to lose ground against most other major currencies for three reasons:
1) Confidence - no one wants to hold a currency that can no longer hold its value against other major currencies;
2) Low interest – why would an investor deposit funds in US dollars when interest rates are so low compared to the alternatives, namely the euro, but also the British pound and the Australian dollar; and
3) Inflation remains higher than the cost of borrowing, so we are in the same situation that started this mess in the first place except this time there is no confidence in the market.
There will eventually be a light at the end of the tunnel: the credit crunch will work its natural course - banks will fold, consolidate or be bailed out; economic growth will slow down, possibly shrink; more funds will close their doors; unemployment will rise. But eventually stability will resume to the financial system. However, the unpredictable factor is what the Federal Reserve Bank will do. We always believed that the Fed would try to control inflation above all else - clearly there has been a change of priorities. If rates remain low for some time to come, inflation could creep up to double digits in the US and that would spell more trouble for the US dollar and the US economy itself. If the Fed raises rates and manages to control inflation, the domestic economy will feel the pinch. Nevertheless, this is good medicine - it is the long overdue detox a debt junky needs to break his addiction. At least the dollar would stabilise and in time, confidence in it will resume and by the end of the decade, the US will be poised for a new cycle of healthy growth. High-end manufacturing will be able to export competitively to the rest of the world, especially in the Euro-zone and Japan and perhaps this will help the US balance its trade deficit and start running a trade surplus - back to the sensible way to run an economy and one that leads to economic strength and stability. Tourism would thrive due to the cheap dollar (provided that Immigration Officers were made to attend courses on how to be friendly and welcoming to visitors).
Understandably, there are many factors influencing the global economy - the credit crisis has been the biggest headline grabber of late and has sent shockwaves throughout global markets. But there are additional factors that are demographic, geopolitical and environmental – whose influence will extend long after the US economy has repaired itself. If you are interested to find out more about how we ended up with this credit crunch and what else we should all be looking out for over the medium to long-term, please consider reading our book entitled "Wake Up! Survive & Prosper in the Coming Economic Turmoil." In some sections, it is already starting to read like a history book - banks have failed, oil and gold are already at record highs, the credit party is over, etc., but in others it is looking into the future to advise readers on trends and events that will shape and influence tomorrow’s global economy.
By Al Chalabi, Hong Kong
Al Chalabi is the co-author, with Jim Mellon, of The Top Ten Investments for the Next Ten Years which published in February 2008. For further information about this book, please click here.
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