“Everyone wants to live at the expense of the state. They forget that the state lives at the expense of everyone” - Frederic Bastiat.

1. Petrocapita Update
May 2011

2. Petrocapita Update
“Everyone wants to live at the expense of the state. They
forget that the state lives at the expense of everyone”
- Frederic Bastiat
By virtue of more than a decade of low and often
negative real interest rates, rapid monetary growth
and emerging market currency pegs, the economies
of the developed world have been skewed towards
consumption rather than production. Unfortunately,
consumption is the destruction of capital - by definition
it represents the diversion of resources from productive
purposes. Both the private and public sectors have been
indulging in this protracted debt fuelled consumption
spree. Savings rates have plunged and fiscal deficits
have expanded.
To the increasing bafflement of the Keynesians, it has
been requiring a larger and larger amount of debt to
create each additional unit of GDP - on the order of $4
of incremental debt to less than $1 of incremental GDP.
Why? Because on average, we are incurring debts that
do not create offsetting cash generating assets. At some
point this type of trend must result in default - whether
outright or via the printing press.
Surprisingly or perhaps not surprisingly, the governments
and central banks of the developed world (let’s continue
to call them non-profit maximizers or NPMs) seem intent
on continuing this trend as they desperately force feed
the markets consumption-oriented programs in place
of stagnating private sector demand. An interesting fact
is that for the last decade in the US, private sector job
growth effectively has been absent and virtually all net
job growth has been in government or state dependent
sectors. We are facing political as well as monetary
inflation.
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3. Petrocapita Update (continued)
There are many (invariably of the Keynesian stripe) stage for much greater problems in the future. By
who observe that money must be lent into existence preventing private sector savings from replenishing
and due to deleveraging in the private sector we face the pool of capital our governments are going further
a deflationary environment. Of course that ignores into debt to finance policies that at best can only
that money can be simply spent into existence by serve to pull future consumption into the present -
the state - a powerful inflationary mechanism when once again more consumption is not what the west
the state represents well over 30% of the western requires at this moment.
economies and central banks have thrown off the
last few vestiges of restraint and are willing to directly So what of the seemingly relentless rally in the equity
monetize fiscal deficits. markets? Rather than indicating sound fundamentals
a nascent recovery in the western economies, I
In our current world I would argue it’s a relatively believe we are simply witnessing the re-ignition of
trivial matter to bypass private sector borrowers bank intermediated speculative finance funded by
altogether and have government spending inject a wealth redistribution from savers to the financial
newly printed money into the economy. The presence sector. Of course the financial sector is a vocal
of heavily leveraged and highly impaired asset classes proponent of this process for in the words of George
- commercial and residential real estate and many Bernard Shaw “A government which robs Peter to
banks to name a few - don’t act as an offsetting pay Paul can always depend on the support of Paul”
deflationary force as Keynesians would have us
believe. Inflation is not an aggregate phenomenon. To reiterate, what western economies need is more
After being released into the economy by the state, capital. There is no way to create capital other than
the newly created funds are simply avoiding past through savings and hard work - a message to which
“bubble” sectors and flowing into new and less western governments are reluctant to listen. Printing
levered areas as is their wont. Banks may not be money seems alluringly easy at first, but it does not
lending to homeowners but the state is spending create capital, and worse, the inflation it creates
and this money is most certainly turning up in the ultimately causes long lasting harm to the production
economy - commodities are just the most recent structure of the economy. To ask a rhetorical
manifestation of that process and will not be the last. question, what possible outcome does the Federal
Reserve expect by increasing the base money supply
The problem arises that all state spending requires (M0) of the world’s reserve currency 200% in 24
that capital is first taken out of the hands of the months - a stronger currency, low food and energy
private sector via taxes, borrowing or inflation, then prices, a robust economy?
deployed in typically loss-making (capital destroying)
activities. The net result is that while government I believe that until the developed nations stop
spending may appear to increase nominal GDP, this engaging in capital destroying activities and our
spending and the attendant deficits are setting the capital base recovers, it will be difficult for sustained
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4. Petrocapita Update (continued)
real growth to take place. A depleted and declining wheat and $175/barrel oil. How does your portfolio
capital pool, combined with enormous expansion of and standard of living fare in such a world?
the monetary base and negative real interest rates are – Are you holding a long duration portfolio of fixed
creating the ideal conditions for an extended period rate debt investments, particularly sovereign
of stagflation in the west. With this backdrop in mind, credits?
perhaps this is an appropriate time to engage in – Are you dependent on consumption growth in the
some “what if” analysis. west for investment returns?
– Are commodities an input cost rather than a profit
NPMs have allowed vast amounts mispriced risk to centre for you?
accumulate in the financial system and are eager
to foster more in the form of higher nominal prices If the answer to these questions is yes imagine if
in real estate and equities. Even if we assume a real growth were to decelerate in the west while
small probability of the negative outcomes, given the commodity prices/inflation accelerated - stagflation.
magnitude of the consequences, investors should Sooner rather than later you should take a mental
take the time to properly consider these risks. walk through your portfolio - be objective and ask
yourself what investments benefit and what suffer in
For instance, imagine a world with more than 10% the world I outlined above and to what degree?
inflation, minimal real growth in the west, $12/bushel
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