In January 2012 the key question is whether all the looming economic problems facing the United States, Japan, Europe and China have created the conditions for a re-pricing lower of Canadian assets.

I think the answer to that question is ‘yes’.

This will be the year of living dangerously.

The outlook for the global economy in 2012 is clear as it is ugly: recession in Europe, Japan’s AIDS dilemma, below potential growth in the United States, a sharp slowdown in China and in most emerging-market economies.

The global economy is at dangerous inflection point because the fact is that monetary and fiscal policies used to reverse every other post World War II recession have been severely compromised by the magnitude and the scope of the problems we face.

More troubling however is that we are suffering from a lack of imagination because of the grip that economists have on public policy.

In my professional life the nostrums which economists peddle as insightful description and prescription for our economies, and societies, have never failed to amaze me.

First, the thesis that markets are rational.

A little like flat earth geology.

Then there is the arguments about peak oil, commodity prices staying permanently high, central banks controlling prices, economies tending to equilibrium, lower taxes and deregulation guaranteeing economic success, liberalisation of financial markets reducing the risk of a banking crisis, financial firms as great self-regulators, and command and control economies being sustainable.

This reminds me of the old joke of the economist walking proudly alone in the middle of a long military parade full of tanks, missiles, and infantry because the misguided policy of a single economist can create a swath of destruction rivaling any military strike.

How does the economics profession get away with this stuff?

It has much to do with media financial illiteracy, particularly the willingness to swallow whole, the ‘market fundamentalism’, which swept aside arguments for a positive role for the state and importance of civil society.

Economists convinced our political leaders that the state had no place, no capacity, and risked economic catastrophe if the state tamed the flow of transnational capital and the pressures generated by the new hyper-competitive global economy that emerged in the last quarter of the 20th century.

Worshipped were fallacious theories like ‘the invisible hand of the market’ a phrase incidentally Adam Smith never coined, and whose unfettered free market intent a simple review of his writings would show he never even considered, but a phrase that became imbedded in our collective imagination.

Political leaders were less willing to tackle the great inequalities that globalisation inevitably creates and in some cases even amplified them.

This shift in our thinking about the relationship between our democracy and the economy, the former serving the latter rather than the other way round, has occurred at the very moment when the speed and the reach and the impact of globalisation accelerated to the economic equivalent of something approaching the speed of light.

Since 1980 the sweeping power of new manufacturing, financial, communication, information, and transportation technologies revolutionized the global economy.

It is in this historical context that any annual forecast for the next decade needs to be put.

Think about manufacturing for a moment.

In 1988 I completed my Ph.D. thesis on the Japanese auto industry at the University of Tokyo.

At that time the Japanese were under enormous pressure to invest in manufacturing facilities outside of Japan.

Most observers, particularly the Japanese and the Americans, thought that Japanese automakers would not be able to replicate the efficiencies of their manufacturing system because they would lack the key ingredient for efficiency, Japanese employees.

Toyota fought tooth and nail against investing in the United States, and the President of GM at a Senate hearing in the mid-1980s said, and I quote, “the Japanese car makers will not be able to build good cars in the United States because they will have to use American workers.”

They were both wrong.

In fact, Japan’s just in time production, and just in time design and development systems were not only exportable to developed countries like the United States and Canada, they were exportable anywhere there was a literate work force and a transportation system to accommodate it.

The export of Japan’s manufacturing technique revolutionalised the global economy crushing middle class manufacturing wages in every developed country except Germany that has institutionalised a role for labour.

Alongside this development was the evolution of a global financial system that demanded few regulations but whose biggest players were for the most part protected by the state.

The pace of globalisation from 1985-2010 has only been matched once before from 1850-1870.

At that time, the export of wheat from North and South America devastated the agricultural communities of Central Europe, iron production and train transportation technologies dramatically reshaped economies and the societies they hosted.

The consequence was a collapse in prices and the beginning of almost a quarter century period of deflation from 1873-1896 known at the time as the ‘Great Depression’.

We are experiencing a similar period the only difference being that the consequences are not being exacerbated by gold backed currencies.

One of the features of that Great Depression was that economic outcomes were not uniform, countries like Sweden and Japan actually prospered partly because they were at an early stage of economic development driven by large infrastructure spending.

In thinking about specific national outcomes for 2012 this is an important lesson because despite what most economists will tell you there is not one model for national economic success because ultimately geographical, political and cultural features are more defining.
For example, coming to grips with understanding what can not be understood with conventional economic tools is the long decline of Japan.

For me this comes from the torture-like experience of forecasting the Japanese economy from mid-1991 to late-1992 when I was very bullish and completely wrong despite an accurate call on monetary ease and fiscal expansion, and in 1993 when I was very bearish and was so right that my Japanese wife and I left Japan with our 6-year old son in December 1994, a decision we have never regretted.

It is critical to understand that economics is a social science informed by politics and culture that can have a definitive impact on investing because markets are neither efficient nor culturally neutral despite what economists tell us.

By the summer of 19-92 the Japanese stock market, the Nikkei, had fallen by about 50% from its December 19-89 peak.

A cyclical analysis that focused on the evolution in components of GDP and prices by forecasting changes in monetary and fiscal policy that so dominated the approach of investment bank economists and strategists had become a recipe for failure, and potential bankruptcy.

A more insightful economic analysis was structural.

This structural analysis was based on two simple facts about the Japanese economy.

The first was that the credit process was broken because it had never worked according to market principles, was poorly regulated, and had been ruined by reckless late-1980s boom time lending.

The second was that capital investment as a percentage of GDP was at least 30% too high leading to a consistently low return on capital, and an economy that under-consumed.

Over investment in Japan was a consequence of the asset driven investment boom from 1985 to 1990, and the political support for an economy that was biased to savings-investment-and exports and not borrowing-consumption and imports in order to produce a permanent current account surplus.

Most economists took the working of the financial system and the structure of the Japanese economy as normal instead of fundamentally flawed.

It was becoming obvious to a few maverick economists that the only real solution was to allow large parts of the Japanese financial and industrial system to be destroyed.

I concluded that this was much more than an economic issue because the analysis had to go beyond economics both cyclical and structural, analysis that was first political, and later I came to understand, cultural.

Incidentally, this was not a great conclusion for someone being paid to be a Japanese economist in an investment bank in Japan.

Culturally, the most important insight into determining the fate of Japan then, and now, remains the cultural predisposition for Japan to be ‘Japanese’ with an enormous emphasis on societal control and stability.

In 19-93 any talk of change was framed by the unwanted risk of becoming ‘American’ with sharply higher income inequality.

This was so terrible an outcome that most Japanese were prepared to accept a falling standard of living as the price for keeping their culture and their ‘Japaneseness’ intact.

This they have done.

What Japan has not done is to rescue the economy from permanent economic decline particularly now that the country has fallen into a terrible demographic dead end whose only solution, immigration, poses an even greater cultural threat than income inequality ever could.

As far as the future of Japan is concerned, if becoming American was the cost to be avoided to break out of the 1990s structural economic down turn, it does not take much imagination to conclude how willing Japan will be to dramatically increase the number of immigrants – mostly from Asia – to break out of its demographic dead end today.

I want to draw a few lessons from this tale.

First, analysts are biased to the sectors they cover, it is in their interest for the sector to be investable; it’s how they get paid.

Second, although we speak about a ‘global’ equity market, the truth is not all markets are created equal; each national market operates in cultural and political contexts that have a defining impact, and although structural and cyclical economic forces vie with each other for dominance, they often are irrelevant to big market outcomes.

Learning to invest on that basis is a key to above market returns.

There is no one size fits all economic and political strategy that guarantees a country’s success.

But everywhere that there is social peace the state plays a critical role in advancing the rule of law, protecting property ownership, and delivering best in class education, health, community, and by consequence, economic outcomes, the foundation upon which sustainable civil societies emerge and thrive.

The great rivalry of competing economic interests and the bias to cheat requires a transparent political process if economic growth is to be sustainable.

It is political structures that sort out imperfect competition, the market’s tendency to monopoly, intellectual property theft, trade deficits and other market issues.

The state’s role in providing social and political stability is a key economic asset.

When investing in a country’s bonds, find out in which ones the rule of law prevails and not rule by law, find out in which ones female literacy is rising, find out in which ones income inequality has not risen markedly in the last decade, and find out which regimes successfully integrate the first born children of immigrants.

This analysis goes beyond most economists and strategists because they believe in the efficiency and cultural neutrality of markets, neither of which is true.

The most healthy and sustainable societies manage to achieve the vital but delicate balance between the twin virtues of equality of opportunity and inequality of outcome.

The outlook for Japan, Europe, the United States, and China is lousy but for different reasons.

First, Japan.

Japan has AIDS -- Advanced Investment Depressed Syndrome – because of its cultural barriers to institutional change and to immigration.

Japan is in 100 year decline and will be as important to the global economy by the end of this century as Portugal is today.

Europe is in the grips of a balance of payments crisis from which it cannot adjust.

While the depth and length of a certain European recession cannot be predicted, a continued credit crunch, sovereign-debt problems, lack of competitiveness, and fiscal austerity imply a serious downturn.

Europe is trapped in a Titanic-like currency union that is missing an ingredient much more important than fiscal balance, and that is labour mobility.

In a monetary union like Canada, if someone loses their employment they have two choices, live a life of poverty on social assistance or move to somewhere there are jobs.

In the Eurozone, an inefficient labour market, linguistic and cultural barriers makes it highly unlikely that the plumber in Athens is going to move to Stuttgart to look for work nor is the unemployed bank teller going to move from Madrid to Helsinki.

Moreover, countries like Greece and Italy are structurally uncompetitive and trapped into a currency they cannot afford, so they cannot benefit from a depreciating currency like Canada did in the mid-1990s to sort out its fiscal problems, and are only going to be crushed by ongoing rounds of austerity.

The breaking point maybe reached when a Greek national sets off a bomb in a German nightclub, it is the social dislocation that ultimately will bring an end to the Euro in its current form.

The US not only faces downside risks from the eurozone crisis, it must also contend with significant fiscal drag, ongoing deleveraging in the household sector (amid weak job creation, stagnant incomes, and persistent downward pressure on real estate and financial wealth), rising inequality, and political gridlock.

The US is also paying the price for a protracted period of under-investing in best in class education and health outcomes, and tolerating Great Gatsby-like widening income inequality.

What is becoming clear, as the fabric of our societies are being frayed by constant economic crises, is that it is the state and civil society that stand between individual citizens and the unpredictable forces of global economic change.

And nowhere in the developed world is this more obvious than in the United States.

When my wife Taeko and I lived in Boston we were struck by how fearful Americans were; well in the United States middle income families seem to live over a trap door that can be suddenly sprung open by unemployment, divorce, an accident or even ill health.

And lower income families well they live directly underneath.

The American combination of economic insecurity, social inequity, and minimal government welfare support is proving to be a model incompatible with competing in the present day global economy.

The persistent underinvestment that the United States has made in primary and high school education has left the country with an estimated shortage of 2 million skilled workers that could take a big bite out of its high unemployment rate if they were available, but there’re not.

Anyone travelling in the United States today can see the impact of a lack of investment in roads and bridges, airports and railways.

The United States has begun the process of losing part of a generation of economic growth.

I would also remind you that the system of checks and balances that make up America’s political system have proven remarkably incapable of dealing with matters of national importance until it was almost too late, the dates 1861, 1933, and 1941 are a reminder of this truth.

2012 will not see some dramatic breakthrough in the political process in the United States, instead Washington will become more acrimonious and more dysfunctional with the nasty economic consequences to boot.

Thankfully in Canada we have a parliamentary democracy that gives the Canadian Prime Minister a very strong hand even if our present day Prime Minister is well … ok let’s leave that for another day.

Meanwhile, the deep flaws in China’s growth model are becoming obvious.

Falling property prices are starting a chain reaction that will have a negative effect on developers, investment, and government revenue.

China’s outsized unequal economic results and withered civil society underlines that these types of outcomes are not just confined to countries where politics are market driven but also where the markets are politically driven, perhaps more so.

On the surface no country seems to have benefitted more than China from the last quarter century of globalisation.

Yet, I think there are very few countries that are going to pay a bigger price for the distortions to the economy, the state, and civil society than have been created in the wake of the state-directed push to modernize.

In China, the economy is a tool of the state to achieve narrow political ends that are not in the interests of the society as a whole specifically an elite drawn from the Communist Party, the bureaucracy, the People’s Liberation Army, and the National People’s Congress each competing amongst themselves to hold on and to profit from their political power.

While it is fashionable to forecast that China will easily become the world’s largest economy the much more important issue is what kind of shape China will be in when it gets there.

China has three very big problems among many.

First, the Chinese economy has the same woeful characteristics as Japan.

China’s tremendous bias to savings, investment, and exports, coupled with the financial, manufacturing, communication, information and transportation improvements in the global economy, at the very moment that China developed, has led to investment as a percentage of GDP to reach a level not seen anywhere before, a level well over 40%.

Driving this colossal rise in investment is a state directed banking system that floods money into capital rich projects divorced from any market discipline and supervised only by local party officials many of whom profit at same time.

Typical of this type of economy is a real estate centred boom, and China is no different.

Many measures of China’s real estate market are consistent with the real estate booms and busts experienced in Spain, the United States, Ireland and Japan.

Second, the crushing of the democracy movement in 1989 resulted in the re-assertion of the Communist Party over the levers of economic power symbolised by the rise of state owned enterprises in China.

China’s roughly 120,000 state-owned enterprises, and countless subsidiaries, receive about 75% of all bank loans, and during the massive stimulus to the Chinese economy in 2008, received about 90%.

The stories of corruption, price fixing, and illegal activities that constantly crop up are usually rooted in the small and privileged group of people who run these state owned firms and the long line of people behind them who benefit mostly family and friends.

It is remarkable how the closed, authoritarian, economically manipulated economies capture our imagination, countries that for a time seem invincible but ultimately, cannot find the keys to sustainability, which are openness and flexibility: Italy in 1920, Germany in 1930, Russia in 1970, Japan in 1980, and I think, China today.

Finally, China will become the world’s fastest ageing country by 2020 no matter what it does to inflect its fertility rate up in the next decade and will cause the labour force to start shrinking in about 5 years.

At the same time, China’s preference for boy babies over girl babies has resulted in the greatest imbalance between males and females in recorded human history.

China is short about 35 million women, and 15% of Chinese men will not be able to marry a female unless of course there is a second or even third husband.

Of note, the key difference between the demographic dynamics at work in China and Japan, is that Japan got rich then aged; China will become aged before it gets rich putting enormous pressure on Chinese society.

None of this is good for Canada because Japanese AIDS, the continued trust crisis in Europe, America’s economic and political gridlock, and unwinding the imbalances in China will continue to put great deflationary pressure on the global economy.

Consequently, the adjustment of the Canadian dollar which began in the summer of 2011 will continue, and I expect that the loonie will fall to 85 cents US by the end of the year.

The TSX’s performance being much more sensitive to the global business cycle since approximately 50% of its market cap is weighted towards resource prices will result in a drop of the TSX by about 10%.

Perversely because government finances are so dependent on resources and real estate the bond market will come under pressure and 10 year bond yields will rise by about 1%.

The real wild card for Canada is the property market particularly in Vancouver but being very long real estate in British Columbia I will do what any good analyst would do when confronted with a large downside risk to a sector they hold dear, start praying, in the year of living dangerously.

Thank you