(Monaco) This little strip of real estate on the southern tip of France is only about two kilometers long and no more than 400 metres wide, perched in all its splendor on the azure blue Mediterranean.

The Principality of Monaco, home of the world’s ultra-rich, is a great place to get a close view of the effects of the financial crisis that has ripped around the globe in the past year, and maybe even see some clues of the dangers that lurk ahead of efforts to get us out of this mess.

Things are deadly quiet here. Monaco is morose. The lounge in the very chic and largely  vacant Hotel de Paris across from the empty Casino de Monaco has just three patrons on a Thursday afternoon during cocktail hour. Black limos are lined up in front of the hotel, fancy taxis waiting for guests that aren’t showing up. There is no noon rush hour at any of the restaurants in the Principality. The heli-jet service taking passengers from here to the Nice airport has scaled back its flights, most of which operate with only one or two passengers.

Where did everyone go? Well, for starters, Middle Easterners, who have always made up a large portion of Monaco’s visitors, are obviously rocked with oil prices dropping by more than $100 to $36 per barrel today. The Dubai economy has cratered, pulling many of the nouveau riche and movers and shakers from there back home.

The Russians Are Going
But it’s really the absence of the Russians, probably the single largest and most visible group of ultra wealthy in Monaco for the past five years, that is really felt the most here. They are now long gone, victims of over-leverage, a devalued ruble, and their stock market down 70 per cent. They leave behind them idle yachts, empty mansions and shuttered night clubs. Most of the Swiss banks in Monaco have shut down their desks catering to high net-worth  Russians, simply because there aren’t many high-net worth Russians around anywhere these days.

When you speak to money managers here, you hear fascinating stories of how quickly things have turned sour in Russia. Why? Because foreign investors have largely lost trust in Russia, which is still largely an authoritarian state, with bribes and political interference rampant in the business circles, and true reforms that would free up capital and manpower still lagging far behind what’s needed for a vibrant economy.

An op-ed piece that appeared in the Wall Street Journal Europe recently captured the essence of the problem in Russia, and at the same time pointed out some lessons learned about government intervention that we can all keep in mind as we look for ways out of the economic crisis that we’re in.

Mart Laar, former prime minister of Estonia and an economic advisor to the government of Georgia, lamented that government intervention is coming back into vogue today, with the “invisible hand” of the market blamed for all the failures we saw in the United States. His thoughts are interesting, coming just as President Obama has signed the massive US budget stimulus bill into law.

“It is not markets that have failed” wrote Laar, “but governments, which did not fulfill their role of the visible hand – creating and guaranteeing market rules. Weak regulation of the banking sector and extensive lending, encouraged by governments, are examples of this failure.”

Amen. In the US, the Fed kept interest rates artificially low while the government encouraged the sale of mortgages to low income Americans who really had no means of making mortgage payments. These new, but still poor, homeowners were then allowed to borrow heavily against the value of their homes as banking regulators turned a blind eye to this practice. To top it off, Wall Street investment bankers, with again no oversight from regulators, took these theoretically high-return loans and packaged them up for sale, dumping them off onto unsuspecting investors around the world. These toxic packaged products spread through the arteries of the world’s financial networks, clogging up access to credit and infecting investment portfolios. Mix in falling commodity prices, and economic slowdown and a lack of liquidity all over the world, and that’s the mess we find ourselves in.

So, what’s the best way out?  

The Invisible Hand vs. Big Brother
Laar strongly insists that it is the “invisible hand” of the markets – not heavy government intervention – that should lead the way out . He traced the path of economic reforms from the early 1990’s until today of several of the former Soviet Baltic republics and saw how they fared during the tough economic times that they all went through. He points out that those countries that had strong “visible hands” in effective government oversight of the financial system, along with equally strong “invisible hands” of lower taxes, lower government spending and more open markets, did much better than those that did not, especially in times of economic slowdown. 

“Moving the world away from free choice and restoring the power of Big Brother is not the right answer to our current economic problems,” he concludes.

Well, it looks like Big Brother is coming back in a big way in the west, lead by President Obama’s  recently passed $787 billion stimulus package. As this massive pig was being pushed along the legislative python in the US, the ages-old debate raged on as to which strategy is best to lift the economy out of the ditch: the Keynesian approach of massive government stimulus vs. the Milton Friedman approach of lower taxes, less regulation, and cuts in government spending.

The answer is arguably closer to the Friedman approach, but in Canada we’ve come down somewhere probably closer to Keynes, based on the recent Conservative budget, at least – strange as that may sound. But we’re nowhere close to the US, where critics say the ambitious Obama plan is back-loaded to 2010 and beyond and is stuffed with pork-barrel projects that are more politically favourable for local Democrats rather than in the best interest of the economy. There’s no denying that huge amounts of funds like that can’t help but provide some sort short term lift, although nobody seems to be able to quantify the benefits or come up with a reasonable illustration of how the Keynesian multiplier effect is supposed to work this time around. And it’s also a pretty safe bet to say that most of the funds won’t likely be allocated until the economy slowly comes around on its own – which can also be said of Canada’s recently announced federal infrastructure spending.

Let’s just keep in mind one very important fact: in the longer term, government intervention comes with a steep price. Today’s deficit means tomorrow’s government borrowing, pushing interest rates higher and crowding out others who need capital, increasing taxes and eventually leading to cut backs in services as lower spending is needed down the road.

And, as residents of Monaco and neighboring France can tell you, history shows us that massive government intervention can really, really go wrong.

Economic Lessons from  Maximilien Robespierre
As a recent article in the Globe and Mail reminds us, the French revolution of 1789 provides an eerily similar scenario to one we know well today in the US: a group of community organizers led by an amazing orator, Maximilien Robespierre, swept to power. They find a government deeply in debt and a tanking economy. They can’t raise taxes – since nobody has any money – so they try to pay the debt back by cranking up the government printing presses and issuing new supplies of money, similar to what’s happening in Washington today. Any dissenters who warned about this massive intervention are shouted down, with warnings that a “catastrophe” would befall the country if the stimulus measures aren’t adopted. Hmmm – sounds familiar, doesn’t it?

Soon the new French regime found they needed more money, so they simply printed more. That hasn’t happened in the US experience, yet, but you can bet Congress will be back asking for more if the stimulus funds are used up and things don’t turn around quickly. Hopefully not, because in post-revolutionary France, the economy up-ticked briefly and then was consumed by the fires of inflation. Napoleon rounded up the herds of unemployed and enlisted them as cannon fodder for his continental wars.

We’re not likely headed that way soon in the US, but inflation is clearly the biggest danger posed by the massive US stimulus bill. And the pain of higher interest rates that will be needed to kill inflation – remember Paul Volcker in 1982? - will deliver a body blow to the economy until things slowly begin turning around.

For those of us in British Columbia, these are timely lessons to keep in mind. A provincial election campaign is about to get into full swing.

The B.C. Liberal government has recently introduced a budget that will dip the province into a modest deficit for two years, but proposes to return to a balanced budget – if all goes well. On the whole, this government deserves enormous credit for cutting taxes, making the province more competitive and focusing on key infrastructure projects in conjunction with private partners. They will likely be offering more of the same, once the storm passes.

The opposition NDP, on the other hand, can be expected to turn up the volume on calls for massive spending and intervention in key sectors of the economy in order to “protect families” and stop privatization “giveaways”.

It’s a pretty easy choice – and one that you can see clearly even from Monaco.

Cordially,

Rick Peterson