Pain and prudence are the only cure for excess

Can you sum up your big picture economic view?

We have an inherently unsustainable economic model in the US, predicated on the world continuously extending us credit so we can consume more than we produce, borrow more than we save. We have benefited in the short run, living beyond our means, while other parts of the world lived beneath their means to subsidise us.

However, when US subsidies are withdrawn, we will experience a big decline in our standard of living, and will have to fend for ourselves. The sooner we deal with that reality, the better off we will be in the long run.

Where do you see the origin of that problem?

When President Nixon closed the gold window in 1971, it removed all real value from the currency, despite the fact the world continued to keep the dollar as its reserve currency. The reserve status allowed us to abuse the privilege, continue to print money and borrow without adverse consequences.

Politicians got used to it and Americans didn’t have to save. As long as Chinese or Saudis lend us money we’ll keep spending it. Why should we stop? We’ll only make the hard choices if our ‘enablers’ go away. Meanwhile, much of our economy has transformed itself. We’re no longer an industrial powerhouse, and our manufacturing base is gone. Our economy depends on services, like retailing, none of which would even be possible without foreign products.

So where are you investing in this environment?

US fixed income is the worst thing to buy. I’m not a big fan of fixed income - we have less than 10% in bonds - but if you must do it, buy other countries’. Dividend income from equities is preferable. In inflationary times you should own sectors with pricing power, such as raw materials, agriculture, chemicals, commercial and industrial property that can raise rents.

We have investments in Hong Kong, Singapore, and natural resource countries like Australia, Norway and Canada. We have a little in emerging markets like Brazil and India. Emerging markets have financed the lion’s share of the US current account deficit, and have the most to gain when they stop doing that and the dollar collapses. The conventional wisdom is that they will suffer because they lose export markets.

But they will replace exports with domestic markets. People in China now are richer than we think, although the Chinese government hasn’t so far let that wealth be realised. Until now, they have been suppressing it and transferring it to us.

Any particular message for UK asset managers?

Yes. Don’t send your money here!

Do you think this year’s equity market rally will be sustained?

It depends what the Fed [Federal Reserve] does. If the Fed raises interest rates back to about 6%, where we were a couple of years ago, the market will make a new low. The housing market will implode and more banks will fail. If the Fed doesn’t raise rates, the market won’t make a new low in dollars but probably will do in euros, or certainly in terms of gold.

There will be some phony improvement in GDP, as a result of borrowed money being spent, and politicians will claim the stimulus is working.

The dollar will continue to lose value and prices will head higher. Liquidation of excess inventory is still keeping pressure on prices, but businesses won’t replenish because they have no customers. Inventories will continue to slide, and companies will try to raise prices.

Your widely publicised pre-crisis predictions panned out with the 2008 meltdown. Where do you foresee the next crisis?

A dollar crisis is the only way this can end. The US government won’t permit major companies, or citizens who made deposits or financial institutions that bet on real estate, to go bankrupt. They keep everyone propped up by printing money, so money loses value instead.

They can’t make losses go away but can change the form the losses take. If you have one million dollars in banks, you won’t lose half of your money but your money will lose half its value. Prices will double and we will inflate our way into a bigger crisis.

When do you expect the dollar to collapse? And how about sterling?

There’s no way to know exactly when the dollar bubble will burst, since it is artificially supported by speculators and foreign banks. The key is simply not to hold money in dollars.

Britain shares many of our problems. Sterling is not a reserve currency, but the UK economy is also imbalanced and must be corrected. But sterling has a lifeline: the euro. If the UK were to go into the euro, it would be beneficial for both the pound and euro, and negative for the dollar.

What is your worst fear?

Hyperinflation represents a worst-case scenario on our current trajectory. I hope we can change policy before it happens.

The longer we wait, the more painful it will be.

To avoid inflation, we must tolerate some pain and suffer some losses. Even now, asset prices and real estate prices are much too high relative to rents or ability to pay; insolvent institutions and unsustainable businesses need to fail. As a simple example, we have far too many shopping malls and retailers. Politicians, who have overpromised, must level with voters, which involves cutting entitlements and raising interest rates to real levels.

The government is very good at postponing pain, but cannot eliminate the consequences. Entrenched politicians are always ready to trade more pain in future for less today, doing what is easier and expedient. Yet the trade off actually exacerbates the trouble.

Is there any cure?

Recession is only cure for what ails. Make no mistake, of course I don’t like recession, but I know it is necessary.

Former Fed chairman Alan Greenspan created the concept of the ‘Greenspan put’, and continuously spiked the punch bowl.

People believed if anything went wrong, the government would come to the rescue. When Bush said Wall Street had got drunk, he forgot that the Fed had liquored them up. Now the Obama administration is following all the same plays, stimulating the economy with cheap money and subsidies to buy new cars, houses and appliances.

In 2001, President Bush’s first speech after 9/11 was an appeal to go out and spend more money.

Right now, consumption is 71% of GDP, compared to a post War average around 65%.

So we need to spend less than average - maybe, around 50% - to make up for years of excess spending, and build excess savings to get back to where we were.