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Craigmore Sustainables market commentary. Brief commentary from Forbes Elworthy of the Craigmore Forestry Fund and the Craigmore Farming Fund.

“THE END OF THE TWENTIETH CENTURY”


Investing in Agriculture


In this Commentary I advance two reasons for investing in farmland. The first is that “selective inflation” means that on-going money-printing will see liquidity flow to this “tight supply” sector more than to  over-supplied victims of  over-expansion such as housing and finance. To achieve a modest reflation of housing and debt markets the “blunt instrument” which is Quantitative Easing is going to cause far higher levels of inflation in tight sectors such as global food commodities. The second is that, although the main means of combating current macro imbalances is likely to be inflation, there is a chance that smooth policy coordination is not achieved, and a much more damaging downward spiral of nominal as well as real prices occurs, in which case a “tight supply” and low beta industry such as agriculture will protect investor’s capital.

I have noted before many times in these Commentaries that NZ’s exports fell 1% in 2008, while those of Germany and China each fell 9%. Agriculture, especially NZ land which is currently priced at attractive yield ratios given a local de-leveraging, is attractive in the likely inflationary future, and even more attractive in the much more scary future that is unlikely to unfold, but if it did would be well worth having prepared for.


The 20th Century Orthodoxies


Three large 20th century macroeconomic policy ideas have now reached their limit. The twin financial and sovereign crises mean that 1) deficit spending, 2) sector subsidisation and 3) credit expansion are now failing. As they fail they are shrinking measured economic activity.  The 20th century is finally over - about 10 years late!

In New Zealand and Japan, for various reasons, these macroeconomic policy ideas reached their natural limits in the late 1980’s (though as we will see the Japanese are still denying this). This Commentary explores the experiences of NZ and Japan to see if they tell us something about the future of those countries where the policies failed more recently.

(I gather that Sweden, also, discovered the three policies were not working in the 1990’s – I do not know enough about that country to be able to include it in these discussions).

I conclude with some comments on implications of these matters for investment strategies.


Three progressive policies


Three macroeconomic policies characterised the 20th Century:
  1. Using government deficit spending to stimulate (and occasionally slow) the economy (“Keynesianism”)
  2. Using targeted government subsidies and tax policies to stimulate (and occasionally slow) specific industries (“agricultural, R&D and home ownership support”),
  3. Using a government supported banking system and low interest rates and other monetary policies to stimulate (and occasionally slow) the economy (“credit-led GDP expansion”)
 
Each of the policies had its cheerleaders in academic, government and political circles. Keynesians sought to reduce unemployment. Industry subsidisers argued for special care. Bankers and central bankers argued that low interest rates and credit expansion contributed to economic growth.

All three policies may be described as “activism”. Behind each lay an assumption that progressive government macro-economic action can improve the economic lives of citizens. 


The disastrous consequences of progressive macroeconomics:


All three have had (and will have further) massive unintended disastrous consequences.
  1. Keynesianism led to the sclerosis of the welfare state, and, when deficits were not properly financed, to inflation.
  2. Housing subsidy (and related low interest rate policies) led to the housing crash. Agricultural subsidies beggared the third world. 
  3. Government support of banking and credit created false GDP and absorbed the energies of many elites into a (largely) zero-sum activity.
I now review the history of my own country, New Zealand.


Getting over the 20th Century early – the New Zealand experience


We New Zealanders are a population of restless souls eager to build a better country on some islands in the New World. Naturally this progressive population took all three of the big 20th century economic ideas to heart. If Oxbridge and Ivy League economists told us to run fiscal deficits in order to support the economy we did it with abandon (the 1970’s – disastrous expansion of welfare state, and inflation). Catching onto another vogue we subsidised our largest industry (farming) in the late 1970’s and early 80’s – until this nearly sent us broke. Also like most western countries we had, until the 1990’s an elaborate banking supervision system. Like many we believed, then, that “more banking” would somehow be good for our economy.

All three policy approaches foundered in New Zealand in the 1980’s. Our finance minister Roger Douglas wrote a liberalising book called “There Has to be a Better Way” during a ministerial flight back from Europe to NZ. During this period New Zealand’s leadership progressively fell out of love with the prescriptions of the 20th Century economic orthodoxy. We then proceeded to dismantle their deleterious effects on our economy. The story of this restructuring follows.

 New Zealand’s government debt had risen to over 70% of GDP by 1990. Given higher rates of interest at that time this level of debt was almost beyond the solvency of even a naturally prosperous “low beta” economy such as that of New Zealand. We were severely downgraded by the rating agencies and were potentially on a path to restructuring of our debts or money printing to devalue our currency.

We did neither. Instead New Zealand then spent about 15 years experiencing sub-par economic growth (eliminating the false GDP of the excessive government and credit expansion). A series of privatisations and restructuring followed. Government services were repeatedly redesigned in order to make the formerly bloated government sector more efficient and more affordable. 

During this period New Zealand undid each of the three 20th century orthodoxies as follows:
  1. We regularly ran budget surpluses, and paid down debt to around 30% of GDP.  Taxes have been progressively lowered, to now a top rate of 28% of income, and tax collection has been boosted by successful introduction of a sales tax (GST) and closing of tax loopholes.
  2. NZ’s economy became the most liberal in the OECD, with very low levels of sector-specific subsidy (sector subsidies are now frowned upon in NZ).
  3. In the banking sector New Zealand dismantled government regulation and hence implicit support of the banking industry. My father was chair of the Independent Directors of the Reserve Bank at the time. He and Governor Don Brash concluded we did not need hundreds of banking supervisors to look after the 7 or 8 domestic banks. Instead they concluded “caveat emptor” regarding depositor credit risk, and also kept real interest rates high enough to squeeze (at least banking sector if not property) speculation out of the economy.  The result is that New Zealand does not really have a banking industry. We outsourced both deposit taking and lending to offshore banks who wanted to open locally capitalised subsidiaries within New Zealand.
New Zealand rejected and moved on from a series of approaches that almost bankrupted us. Thankfully.

An Oxford economist told me the other day that he felt NZ economic growth could have been higher if we had not been so obsessed with austerity over the past 20+ years. God help those countries who listen to these types of people. Their policy amateurism (inspired in the 1930’s by a genius subversive called Keynes), to my mind, lie behind many of the policy mistakes of the 20th Century.


Japan – on a Monty Python-esque kamikaze policy trip


Japan has, if possible, been filled with people even more naively hopeful about the possible success of policy optimism than was NZ in the 1970’s.

Japan’s economy by 1989 had “grown” a lot of economic activities that were not worthwhile. Mind-numbingly large property and lending bubbles had come about as a result of credit expansion, itself fostered by negative real interest rates. The general attitude of the Japanese population, politicians and bankers to Japan’s success (and of many foreign commentators including my professors at Harvard Business School – mightily impressed by superficial measures of growth) might be described as “industrial megalomania”. The country believed it could do no wrong.

After the stock market crashed and, at least to financial investors the “game was up”, instead of restructuring the false GDP, and realising their mistakes, Japan’s leaders decided** to keep that GDP “alive” via a programme of massive government deficit spending. This policy has kept Japan larger, for a time, than it would otherwise be. However the country has now placed at risk the integrity of its contractual arrangements between government and citizens. Many savers who have bought JGB’s are going to have their savings confiscated in a likely inflationary denouement to the experiment.

**this advice from academics and economists such as Richard Koo, the author of a brilliantly intelligent but dangerous book called “The Holy Grail of Macroeconomics”. The title alone tells you the author – head of the Nomura Research Institute and key advisor to successive Japanese Prime Ministers – is eccentric.


Why has NZ “got it right” and why has Japan chosen to head for disaster?


Why did NZ position itself beyond the siren calls of activist government management of the economy? The difference between the two countries is in their savings culture. The NZ’ers don’t “save” by investing in bank deposits and securities, etc. They (perfectly rationally in my opinion) don’t trust either the government or finance industry to look after their savings. Instead us Kiwis like to borrow money (even though interest rates in NZ are around 7%), and to build up our savings in real property. We have read Keynes’ General Theory and we know that saving is an evil bourgeois activity that creates a leakage to GDP. Governments don’t like it and they will take steps to discourage it and in time to destroy it. NZ’ers, like most Anglo’s, have very sensibly taken heed!

The Japanese, on the other hand, have retained faith in the abilities of 20th century macroeconomics far longer than the Kiwi’s. They loyally save for the fatherland (and for their retirement) and the government uses their savings to prop up the economy. In fact, however, Japan has saved as a whole  less than it appears The government has dis-saved (consumed) what the population believed it was saving. There will not be anything there for the population to be given when, in future, they wish to redeem their JGB’s and live off them in retirement. The government has no ability to redeem its debts. It will either default hard, or it will default via a massive inflation (the second more likely). The savings of the Japanese population have already been destroyed; they just don’t know it yet. A growing ratio of retirees to workers will only accelerate this.

Japan must eventually experience significant shrinkage as a country, in real terms, once the above realities are revealed.

Hopefully, after their government has defaulted, they will finally “get over” the policy optimism of the 20th century.


What about the USA?


America may be coming to many of the conclusions that NZ came to in the 1980’s. In particular, and I am surprised to find myself saying this, the Tea Party seem to be on the right track, economically speaking.

I am an environmentalist and a liberal so not a typical Tea Party’er. I do share their scepticism, nevertheless, about the claims for big government activist policies.

US government debt is approaching 100% of GDP. NZ’s got to 70% (albeit with much higher levels of interest rates) before we hit the buffers. America badly needs to rescue itself from the 20th century activist policy package.

Rescue is not a given however, given the low interest rates the Chinese and Japanese have been spoiling the Americans with. And how addicted America seems to be to debt and to deficit spending. 

It is ironic that the West poisoned China 150 years ago with cheap opium, and China has now poisoned much of the West with cheap credit. And both times the transactions were routed via the investment banks (in those days called trading houses). Who says there is no justice in history?

It may take time, and a few more credit downgrades and crises for America to come to its senses (which will be about the time that China realises its investments in US Treasury bonds are tanking in value).

 My guess is it will take at least 5 and probably 10 years (and during that time a very nasty burst of inflation) for America to turn the corner to a more reasonable and post-20th century way of running its economy.

During that period, ironically, the healthiest part of the US economy, the corporates, may continue to do well, and indeed some may benefit from inflation. I could see the US stock-market, despite high unemployment and an effective default on US debt via money-printing, doing quite well during the next 15 years.

The US agricultural sector, also, given likely tight agricultural markets, should also do very well during this period. Although at some point the current level of ethanol subsidies – currently absorbing 43% of the US maize crop, may be reduced as is a massive budgetary cost. In the long run this will not change the positive outlook for agricultural investments but would entail some softening of agricultural commodities during the period the policy is being unwound (exactly for that reason it would, if adjusted, likely be adjusted over 10 years, greatly softening the effect).


Prospects for Europe


Prospects are even worse in Europe. The Europeans show little sign of “getting it”. The German approach appears sensible but they have made the mistake of excessive reliance on credit growth to drive economic growth. They have supported their own economy (and more recently that of their neighbours), with extraordinarily low interest rates for far too long. Credit in the German household sector has been acceptable. But German corporates have taken on far too much debt (120% of GDP).

Meanwhile the German banking and insurance sectors have spent years seeking yield in a low interest environment i.e. speculating. They are now challenged by a series of systematically negative NPV investments. Not least a whole bunch of “risk free” southern European bonds, some of which are already being restructured. 

Since Germany may well be coerced into allowing ECB money printing and lending to insolvent countries (a debt that can never be re-paid and will fall upon the Germans), Germany does not look like a country with a positive medium term future. Almost a bad as that of its neighbouring client states – into which it is, effectively, being asked to merge.

In the longer term things look brighter for Germany.  It is finally achieving what the Habsburgs and the Prussians and two German world wars failed to do – the unification of Europe under its leadership. Neither German financial nor corporate investments will be very promising during the period Germany is restructuring Europe – and potentially lumbering itself with the obligations and welfare of its neighbours. Once the restructuring is complete, however (if does not disintegrate into series of financial collapses and/or war in the meantime), Europe, as an entity now led by Germany, could once again emerge as a powerful economy. It is just that a lot of restructuring has to happen first. 


Prospects for the UK


The UK has a chronically large government deficit, large government debts, massive banking sector problems and twin nasty negative shocks to its economy with the demise of both North Sea oil and the global investment banking boom. Very sensibly this country has already started a massive money printing programme while, at the same time, restructuring the bloated government sector and allowing the banking industry to shrink. Over time inflation will take away much of the present value of the Pound. Britain does not have a choice. These are the right policy settings for a difficult period. Great Britain faces a number of years of economic decline and restructuring. I do not see many terrific investment opportunities in the UK, although some of the more international UK companies must, one would assume, do well in a time of inflation.


Prediction of widespread defaults:


Clearly a number of countries are going to default. Many of them will not officially cease paying their debts (a sovereign can always print its own currency) but they will default through money printing and inflation.


My main economic prediction: selective inflation:


In an early draft of this Commentary I wrote a long list of predictions: it will take a long time for restructuring to be achieved; interest rates (on low risks) are likely to remain low. However these sorts of observations are not specific enough to help investors to direct their capital.

Therefore my main “value added” prediction for my readers is that we will see “selective inflation” in future.

When a government, in an attempt to off-set the decline of the  20th century policy created GDP’s, lowers interest rates or prints money to try to stimulate, this “new money” does not always flow as the government intended. The intention of such policies, normally, is to goose up the housing sector, and perhaps to stimulate spending and investing in the SME space. Financial intermediaries, however, do not always act in line with good policy implementation objectives. If lent or given cheap money they will, of course, invest in the project that offers the highest perceived risk adjusted return. The markets they will “chase” will not likely be the depressed markets still working off their excesses (housing, banking, the over-supplied elements of the service and manufacturing sectors). Instead they will focus on industries that have good price improvement prospects and Industries which have tight supply. In the 1970’s this was agricultural land, and, once again in the 2010’s, I suspect agricultural land, above all other asset classes (with the possible exception of precious metals), will benefit from that selective inflation. Possibly more so as global population has doubled since then (from 3.7 bn in 1970 to 7 bn people now) and, as we explained in our September Commentary, agricultural productivity is now not growing fast enough to keep up with their increasing food demands.


The Risks to the above forecasts


The main risk to the above forecasts is that they are too optimistic, and that a much worse “great depression” style rolling series of defaults and economic and personal disasters awaits the world.

This risk arises from the fact when we extrapolate from NZ (and Japan) we extrapolate from economies that were just parts of the world economy – and the world economy was relatively strong during their restructurings.

Since Europe and America (with the still restructuring Japan) constitute a very major proportion of the world economy, and since much of the rest depends on these regions for demand, there is a possibility of a much worse downward spiral of economic activity, as falling demand from most regions shrinks the others. This risk (of a great depression) would be so disastrous for many individuals that, even though it is remote (a more likely and optimistic probably is that America recovers, even while Europe shrinks), it is worth seriously analysing and taking steps to position oneself and one’s family for it.

This is the second major reason to invest in agriculture. An investment in land in a stable country will protect capital in the hopefully unlikely event of a melt-down of other markets.

Best regards,
 
Forbes Elworthy
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FORBES ELWORTHY
CEO & CIO
Email: forbes.elworthy@craigmore.com
Office: +44 (0) 2033 000 152 Mobile: +44 (0) 7525 424 191
Skype: forbes.elworthy
 

DENISE SABER
Head of Sales and Marketing
Email: denise.saber@craigmore.com
Office: +44 (0) 2033 000 150 Mobile: +44 (0) 7552 161 226
Skype: denise-saber
 

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