Money supply must be controlled - or we will all pay the price

Gwyn Morgan is the retired founding CEO of EnCana Corp.

Last week, I spoke to the annual conference of the Canadian Investor Relations Institute, the people whose job it is to keep investors informed of their company's strategy and prospects. My topic was the post-recession investment outlook. Needless to say, the past year has not been an easy one for investor relations professionals. I wish I could have painted a more promising picture.

There are two sets of forces that will fundamentally transform post-recession financial markets. The first is the impact of the crisis, and the second is the reaction of governments.

Traumatized by lost savings, unreliable advice and cult-like, guru-led investment fund megafrauds, the retail investing public has lost faith in stock markets. This means a shift to lower-risk securities such as sovereign debt and highly rated corporate bonds. It also means placing savings with mutual fund managers backed by well-known major financial institutions.

Institutional investors have seen their core axiom: "You must hold equities to deliver competitive returns over the full cycle" brought into serious question. Battered pension fund managers may never again be as heavily weighted in equities, accepting lower returns in favour of reduced volatility and risk. Lower pension fund return targets mean that higher capital levels are required to meet actuarial pension obligations, placing even more funding pressure on both private and public pensions.

Private equity transactions have stagnated (or died, as in the case of BCE), but don't count them out of the post-recessionary world. High-leverage buyouts dependent upon easy credit and low interest rates are history, but private equity's resurgence will be driven by increased regulatory red tape and CEOs looking to escape the dysfunctional quarter-to-quarter focus of public securities markets, along with institutional investors wanting to diversify away from stock market volatility.

What about the role of investment analysts employed by traditional brokerage houses?

Needless to say, the utter failure of the vast majority of analysts to question the structured credit derivative mania or any other part of that house of cards has profoundly damaged their credibility. Expect to see a shift of investment research away from brokerage houses in favour of independent analysts and institutional investor in-house research.

The overall impact of the market collapse includes a highly skeptical risk-averse investing public, a move away from traditionally high common-equity weightings, a huge need for increased pension funding, the resurgence of private equity on a sounder base, and restructuring of securities research. We can also count on complex credit derivatives bearing such acronyms as SIV, ABP and CDO to be relegated to the hall of investor infamy.

The second set of forces that will profoundly affect the future investment landscape is the reaction of governments to the crisis. For our neighbours to the south, and to a lesser degree, some members of the European Union, the proverbial "light at the end of the tunnel" may well be an out-of-control train carrying a cargo of runaway inflation, fuelled by more money being printed than at any other time in recorded history.

Inflation is an insidious disease. It brings with it a huge moral hazard in that the value of savings and pensions collapse, while those who have built up debts are rewarded. Nevertheless, in the end, everyone loses. The Trudeau Liberals' huge deficits in the 1970s resulted in runaway inflation that subsequently drove interest rates to 20 per cent, with more than one-third of federal revenues being taken by interest payments on our national debt. High bond yields drove investors away from equities, killing business capital formation and jobs.

The arithmetic behind inflation is brutally simple. Prices are largely a result of total money supply divided by a given amount of hard assets, consumer goods and services. During a recession, there is "slack" in the economy's productive capacity, restraining or reducing prices - deflation. But during economic recovery, that slack dissipates and new money that was printed by governments results in rising prices. If the amount printed is large, and if governments increase money supply even more through early-recovery deficit spending, the purchasing value of their currency falls and inflation spirals out of control. Given the Obama administration's multitrillion-dollar combination of bailouts, stimulus spending and expanded social programs, this scenario is virtually guaranteed in the United States. This makes the greenback highly vulnerable to serious decline.

More prudent spending and a return of higher resource export prices will likely keep our inflation rate lower and our dollar stronger. But this is a double-edged sword for a country so dependent on trade with the United States, hammering Canadian exporters and service providers.

Given the harsh effects of inflation, it's not surprising that, until less than a year ago, the singular mission of central bankers around the world was to control inflation. German Chancellor Angela Merkel is imploring her G8 colleagues to "stop the madness" of excessive deficit spending. Lately, U.S. Federal Reserve Board chairman Ben Bernanke is getting that nervous deer-in-the-headlights look because he knows that the trillions being poured into the money supply have already planted the seeds of a devastating inflationary spiral that no one knows how to stop.

In a desperate effort to avoid the dreaded devil of deflation, money-printing governments have struck a Faustian bargain that dooms people to a darker and longer-lasting kind of purgatory.