Please, click here to read this article in pdf format: january-18-2009
Given last week’s events, it may be important to step back and look at the current environment with a bit of perspective.

Historians date Polibius’ life between 201-118 B.C. Polibius, who made insightful observations on the transition that took place from Greek to Roman culture, also  wrote “The Histories”. In its Book VI, he suggested that there is a cycle in the forms of government. Based on his own experience, civilizations started under a monarchy, which provided the necessary cohesive force. But as power corrupts, the monarchy morphed into tyranny. Under tyranny, people suffered and reacted by choosing the best among them (i.e. the “aristos”) to bring down the tyrant. Tyranny therefore gave way to an aristocracy. Polibius then noted that the aristocracy would later rule only for their own benefit, becoming an oligarchy. The people had to revolt once more and forced the oligarchy into a democracy. But democracy would later lead to demagogy.  The only way to get rid of the demagogue was to find a leader to bring it down. This leader would be the monarch, and the cycle would start all over again.

We can also find a cycle in economic thought. In particular and relevant to our situation (the Keynesian paradigm we live in since the 1930s) , we could suggest the following: Central banks issue money that, through the credit expansion process, generate asset bubbles. Banks lend to the participants in the inflated markets at higher leverage ratios to remain profitable until these markets go bust. When they go bust, the financial system goes bankrupt and governments bail them out. The bailouts are financed with public debt which will have to be repaid. Consistent with Keynesianism, these governments refuse to restructure their budgets and to address their growing fiscal deficits, they increase taxes and promote social hate against “proprietors of stock” (i.e. bankers, investors, etc.), who are to blame for their greed and the generation of asset bubbles. The situation becomes increasingly untenable and soon governments find themselves debasing their currencies, generating inflation. As the asset bubbles (inevitably in raw materials) end up also lifting consumer prices, the lower income (with fixed wages) strata of economies begin now questioning the wisdom of their politicians. If these economies are educated, as is expected in the developed world, they replace their leftist politicians with radical conservatives. The conservatives begin by privatizing government-owned assets, reducing taxes and reopening their economies to free trade. But they don’t reduce government expenses, because they also believe in Keynesianism and because they need the vote of the public. Therefore, deficits may still linger at the beginning, but the tax rate reductions, privatizations and free trade lift productivity. As governments tax activity, when activity picks up, revenue increases and deficits wane. But the higher activity at higher prices requires a new and higher level of money supply, to support the rate of interest. For that, there are central banks issuing money, which takes us back to the start of the cycle…

If we understand the cycle, we can always make money in each stage. Banks in particular will also always make money: Financing the asset bubbles, with the refinancing of public and private debt, with advisory and capital markets fees during the privatization of government assets (you will see this soon in Greece), with FX fees when free trade reopens and with derivatives as activity picks up. Such is the cynical nature of Keynesianism…In my view, we are currently at the beginning of the cycle, with governments increasing taxes (i.e. reserve requirements in China, bank taxes in the US, higher regulation worldwide) and promoting social hate against proprietors of stock. However, in this global world, there is some heterogeneity. As I wrote on January 7th  (www.sibileau.com/martin/2010/01/07 ), we will see a dichotomy in capital flows:

“…Since my last letter of 2009, the US Treasury announced it would lift the cap on the Preferred Stock Purchase Program (…) This explicit show of support for agency debt (which I assumed it was going to smoothly disappear in 2010) tells me that the USD strength will be only a relative notion in 2010. I say relative because the strength should show vs. those countries that explicitly decide to import USD inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro zone), while the weakness should show vs. those countries that will profit from the credit-inflated recovery (Emerging markets or commodity currencies, like the CAD)…”

If we give serious consideration to this dichotomy and play a beta strategy in any space (credit, stocks, fixed income), we’ll be ahead of the curve in 2010.

Martin Sibileau