Why another big crash is inevitable

By MoneyWeek Editor John Stepek Jan 13, 2010

John Stepek

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We mentioned yesterday how any hint of disappointment from China could have a nasty impact on the markets this year.

As if to prove the point, markets took a slide as China decided to tighten up its monetary policy. Meanwhile, the dollar rose and gold fell as an executive at one of China's sovereign wealth funds suggested that the dollar had bottomed and that gold looks a bit dear.

China is walking a tightrope. On the one hand, it doesn't want to end up with a horrendous bubble like its Western counterparts. On the other, it doesn't want to crush economic growth.

But will it be any more successful at scrapping boom and bust than Gordon Brown or anyone else? We doubt it...

China can't scrap boom and bust

Asset markets of all sorts were rattled by various moves from China yesterday. Peng Junming, an investment strategist at China's $300bn sovereign wealth fund, China Investment Corp, said he reckoned the dollar had bottomed out. He also said that "China should have the right attitude about investing in gold. There is no urgent need for China to increase gold buying for now, because prices are high."

The dollar bounced and gold slid, although they settled later after the analyst clarified that his remarks were personal, rather than policy. Still it shows just how much attention markets are paying to any information that comes out of China.

Far more important though, was Beijing tightening up monetary policy again. Stocks across the world slid as investors fear that China won't keep pumping up its economy with cheap money.

China's concerns are understandable. The Chinese are well aware that they are in danger of suffering a real estate bubble. They've seen just how badly that's panned out for the rest of the world and they don't want it to happen to them too.

But what to do about it, that's the rub. For now Beijing has told banks to set aside more money in their reserves. In other words, they need to hang on to more money, so they can't lend as freely. It also hiked interest rates in the inter-bank market, so borrowing is more expensive for them.

But they don't want to squeeze on the brakes too hard and scupper the boom altogether. The Chinese authorities are scared to death of allowing economic growth to slow. This is for fear of civil unrest, as we're always told by China experts. And it's a fair point. Tiananmen Square after all was as much the result of anger at high inflation as it was of a genuine desire for more democracy.

Every government is scared of growth slowing

But the Chinese aren't unique in this at all. Every government, authoritarian or democratic, is terrified of growth slowing. Why? Because they'll lose their jobs. Whether that's at the end of a rope or more benignly at the ballot box doesn't make any practical difference in economic terms. The fact is that the people in power will always do their damndest to keep a boom going for as long as possible. And that's what ultimately does the economic damage.

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Gideon Rachman wrote an interesting piece in the Financial Times earlier this week. He suggested that bankruptcy (or near-bankruptcy at least) might end up being good for the US. He pointed out various other episodes where countries had looked over the edge (and in some cases gone right over it) then returned, stronger than ever before.

Rachman doesn't say it explicitly in his piece. But for me, his column basically makes the point that sometimes you need a slap in the face to show you that your current trajectory is unsustainable. That's what recessions are for. The process that Joseph Schumpeter called 'creative destruction' gets rid of all the bad investments and unproductive clutter that gathers during a boom.

Projects that represent sustainable, efficient, productive use of resources such as raw materials and labour survive. Wasteful and uncompetitive businesses fail, and the resources that were being squandered on them are reallocated to better uses.

Why we need recessions

Lots of people say that we don't need recessions, and to suggest we do smacks of puritanism. But that's drivel. If you follow those arguments to their logical conclusion, then no business should ever be allowed to go under. And all threats of change should be crushed to defend the status quo.

What's perhaps closer to the truth is that you probably don't need to have big recessions, or depressions. If you allow little recessions to happen sometimes, then you don't need a much bigger correction. Allowing the economy to correct occasionally might mean a bit of suffering for some sectors and businesses. But if the correction isn't too extreme, then other parts of the economy (or the world for that matter) can always pick up the slack.

The problem is, little recessions are quite easy for central banks and governments to avoid, as long as you don't mind saving up a bigger one for later. And given the choice, most of us will vote in favour of putting the pain off – that's just human nature. So perhaps it's idealistic to imagine that we'll ever see an end to catastrophic boom and bust.

What it does tell us, is that 2008 wasn't the final phase of this credit crunch, depression, whatever you want to call it. And it seems pretty clear that the next phase will involve some country-sized bankruptcy events. We can't be sure what the trigger will be – fear of tighter monetary policy in China is one, but there are plenty of others. But as we keep saying, it's a good reason to keep your portfolio positioned defensively: Why you should stick with defensives for 2010.

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Comments (9)

Published in Economics | More articles by John Stepek

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  • 1. Bob Roberts

    (13 January 2010, 12:28PM)  Complain about this comment

    I don't know why China needs to be worried about a property bubble - seems to have worked out fine for Gordon Brown and all those with liar loans. The prudent are the ones who suffer when it comes to property.

  • 2. Allen Newport

    (13 January 2010, 02:20PM)  Complain about this comment

    if there is to be another major correction, then will not defensives suffer falls also?

  • 3. Wickesy

    (13 January 2010, 03:47PM)  Complain about this comment

    Allen is surely right. It is hard to believe that even defensives will thrive during a major correction. And on top of that, will not the country's gigantic debts have to be dealt with -- either by default or by a big devaluation of the currency ?

    No wonder people are buying commodities, including gold.

  • 4. niall shalloe

    (13 January 2010, 04:28PM)  Complain about this comment

    if there is another correction, how will that affect house prices in areas of high employment? Will that happen before or after the election, because at present they keep going up.

  • 5. Peter Kellow

    (13 January 2010, 08:46PM)  Complain about this comment

    “Lots of people say that we don't need recessions ... that's drivel. If you follow those arguments to their logical conclusion, then no business should ever be allowed to go under. “

    Economic neo-liberalism is lurking in that statement - along with its inherent contradiction.

    Let the free market jungle reign – followed deftly by “but not for the International Corporate Banks”.

    As John goes on to cite “all threats of change should be crushed to defend the status quo. “ – the banking status quo that is. The rest can go to hell.

  • 6. IJ

    (14 January 2010, 11:24AM)  Complain about this comment

    I also agree with Allen on defensives. They would indeed fall, and dividends would likely shrink or disappear. In fact, I tend to believe defensives are for those who have to own stocks, namely equity fund managers. Individual investors should just buy high beta if they think stocks are going up and not own any stocks / go short if they think they're going down. Now clearly that's easier said than done and there are lots of caveats / exceptions, depending on things like risk profiles, conviction levels. Indeed, you might own defensives when you're not sure about things. But John - you seem pretty convinced to me in your very bearish stance. If you're that negative - believing not just that a minor correction might be on the way but a "big crash" - and furthermore that convinced about it (seeing it as "inevitable"), then surely you should be advocating holding no stocks at all / recommending short ideas?

  • 7. PRO

    (14 January 2010, 03:36PM)  Complain about this comment

    Some of these posts are very insightful. The mantra of "Money Weak" is buy defensives. If you do belives there is about to be a crash or correction how will they protect you agains the correction unless they do not fall whilst other stocks do.

    If that happens its not a crash, but a normal market. If however you beleive (say) M&S will fall by more than national Grid then your argument still only makes sens if the fall for defensives is less than the annual dividend. So as it is possible to get 3% interest from my LLoyds account and (say) 10% dividend from defensives then you are saying that defensives will fall by no more than 6% ish. If you truly believe that in a forseablle framework then they will fall more, then your argument should be put your money on deposit. I think you need to develop a new mantra or spell out exactly what you are advising rather than vaguries like "Stick with Defensives"

  • 8. RobinBanks

    (17 January 2010, 05:11PM)  Complain about this comment

    I agree with Pro's Freudian slip that "Money Weak" advice is to buy defensives!

  • 9. Peter Cooper

    (20 January 2010, 11:18AM)  Complain about this comment

    Short ETFs are a winner in a big plunge - you just don't want to hold them as markets shift in the opposite direction. Otherwise treasuries are the classic defensive position but they do not necessarily gain very much in a market fall.

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