Monday, November 5, 2007

The Unintended Consequences of Globalization

JEDDAH, 23 August 2004 — I’m often asked why I’m so much recommending gold as an ideal investment, instead of stocks and bonds. The answer is that man behaves even more poorly as a political animal than he does as a rational economic one. And the world’s financial markets are more and more driven by politics... on a global scale. It’s a trend, unfortunately, that’s gathering momentum, from bombings in Madrid to assassination attempts in Taiwan to successful assassinations in Gaza. None of this is good for markets.
But political change doesn’t happen haphazardly. It’s driven by economic change. And some regions are going to do better than others in the future. The questions are: Which regions, why, and how do you profit?
To answer those questions, you’ve got to understand who’s winning and losing out in globalization.
The globalization process of the ‘90s used to look like nothing but good news for the affluent West. Western economies outsourced the production of manufactured goods to Asia and got lower prices in return. And for a while, this had no immediate effect on Western job markets, or the direction of global capital flows.
In fact, capital flows favored the West, too. High-saving Asian countries loaned the West capital on the cheap or bought American financial assets including the widely known US Treasury bonds. And every so often, Western capital poured into an emerging market, created an asset bubble, took profits, and moved on for the next high return.
But the unintended consequences of globalization are only now making themselves apparent. And if I’m right, they are not good for the unprepared investors. Falling financial asset prices, rising prices for commodities and raw materials, lower average incomes, and a much, much more competitive world appear to be on the horizon.
Globalization has already begun to redistribute relative economic advantages from West to East. Asia, especially Japan and China, enjoys a competitive advantage in manufacturing because of abundant labor and high-tech know-how... in fact, it has become the world’s factory for durable and mass-produced goods. Meanwhile, India, with the world’s largest educated English-speaking population, is capable of providing professional services to the world at comparatively low prices.
By contrast — and whether it’s true or not — the rest of the world perceives America as a hotbed of technology-driven research and development. As such, America will continue to attract capital and interested risk-takers, as well as new technology businesses. But given Asia’s manufacturing advantage and India’s ability to provide low-cost professional services, the US’s role in these two areas is coming under pressure.
These are generalizations, of course. But if market forces hold sway, I think these trends will more or less hold true for the next 50 years.
Shifts like these cannot help but lead to, and in fact have already begun to create, significant social and political disruption. I believe this will be an increasingly determinant factor in understanding global markets. But more important in the United States today is financial disruption — that’s going to come first. In fact, I think the wave of selling that came after the Madrid bombings and Israel’s assassination of a Hamas political figure indicated just how tenuous the investing public’s confidence is.
The economic position of America appears to be untenable. The culprit, of course, is debt. Enormous, overwhelming, totally out-of-control debt. Government debt. Mortgage debt. Credit card debt. Debt, debt, debt.
And in some ways, expectations are also to blame; the US is still locked into a culture of “getting something for nothing.” Americans still expect wealth as their political birthright.
We live in odd monetary times. In America, there is a growing divergence between the value of tangible real assets and the value of financial assets and derivatives.
Because of that divergence, and because of the tremendous industrial-productive capacity in the world today — as well as the intense competition for jobs, fomented by globalization — I think you’ll see both deflation and inflation in short order.
How can you have both? Well, the inflation in tangible assets (commodities) is fairly easy to identify. Commodity prices are determined largely by supply and demand. Demand for tangible assets and raw materials is obviously growing, driven by Asia, and notwithstanding the languid economic growth in Europe, the United States, and Japan. Supply, however, is not keeping up. Add to that years of underinvestment in productive capacity, and you have all the elements for rising raw material prices — even if the dollar weren’t falling off a cliff. We are at the start of a major, multiyear bull market in commodities.
But the dollar is falling hard. And because of that, it’s possible that even as commodity prices rise on the cheaper dollar, you’ll also see deflation in assets whose value depends on the dollar itself as a source of value.
For the last five years, American financial assets have enjoyed enormous capital flows. Global money went to buy American stocks and bonds, not to build factories. That money, which was borrowed at low interest rates, has created a huge bubble in financial assets. It’s also made those assets extremely risky.
Anything bought with money borrowed at low interest rates is susceptible to a sudden decline in value if that money becomes worth less. That money is the dollar. As the dollar declines, it makes financial assets bought with borrowed dollars virtual locks to deflate in value.
It’s an odd world where you can have debt deflation (falling prices for assets bought on credit) and inflation in natural resources and raw materials (as central banks print more money to devalue the nominal value of the debt) — at the same time.
We may soon see falling prices for houses, stocks, cars, and bonds... even as prices for precious metals, oil, and raw materials continue to rise. The dollar will lose purchasing power against tangible assets (assets not purchased with debt) while debt-financed assets will fall in value.
The implications for investors are clear. Beware the US “financial economy.” Decrease your exposure to the US dollar market. For real saving... the gold market might not be a bad long-term place to be.

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