After last Friday's market action, I am dumbfounded by the complete lack of understanding of bad economics, not only by investors but by many governments.
Last week, I was asked at a client meeting what caused this next leg of the global financial crisis; again, as with the mess Wall Street got into, it's about bad short-term decisions over good long-term ones, and these decisions are burying the world.
People have to understand that 80 per cent or higher debt-to-GDP ratios are a new dynamic and a game changer in Europe and the United States. As a result, all of us have to stop thinking that all recoveries are the same and all selloffs are buying opportunities because of what happened in the past. If my reading is accurate, debt restructuring will be the next wave and will be extremely painful.
At this point, the market is losing confidence in our leaders' ability to steer the world in the right direction. There is an argument to be made that the "nanny state" is going parabolic and this is completely unsustainable. Tim Geithner telling Europe what to do is scary at best - to re-stimulate economies via fiscal largesse at a time of explosive debt ratios is dangerous. The rapid declines in risk asset prices to close out last week is a telltale sign that there is now a growing distrust of government spending, manipulation of information, and demagoguery.
The only way to regain confidence is to come clean and to then do something about it. We now have a global debt problem and in order to deal with it we must understand the magnitude. The issues with the government balance sheets are not dissimilar to those of the banks. Real stress tests were needed for the financials and, for transparency sake, are needed for sovereign governments because of the lack of trust. Derivatives, especially credit derivative swaps, must be on the balance sheet so that we can have the right amount of capital. I have repeatedly made the case that Fannie and Freddie's debt must be on the government's balance sheet. It is never counted.
How about AIG, the entire banking system under Federal Deposit Insurance Corp. contingent liability and the Federal Housing Administration? The same with pension liabilities of the government, social security, etc. The IMF demanded this of emerging market countries; why not of developed ones?
It is crucial that we understand that maintaining the same policies of bailouts will push the world over the brink. In my mind, there is no doubt that there will be some significant sovereign debt restructurings. But paired with the right growth policies, confidence will come and with it a sustainable recovery.
Let's learn from past experience. The lesson from the emerging markets debacle of the 1980s and '90s is that once you've been at the edge of the cliff, you probably won't come back to it again. It is therefore not a coincidence that countries like Brazil, Peru, Chile and Colombia, the toxic waste of the past, aren't in any fiscal trouble this time around. If Thomas Jefferson were alive today he would be depressed beyond belief to see what his Republicans and the Democrats have done to the U.S.
I continue to get asked: when will I pull the trigger and turn bullish. Well, we are in an extraordinary period of economic and financial history and I doubt very much we have truly seen the lows in the stock market for the cycle. As I have said before, 80 per cent rallies in a 12-month span last happened in the early 1930s and were followed by gut-wrenching spasms to the downside. For any investment team out there, return of capital is yet again re-emerging as a very important theme.
David Rosenberg is chief economist and strategist for Gluskin Sheff + Associates Inc. and a guest columnist for Report on Business
David Rosenberg