The Biggest Scam of All: Governments Saving us from the Credit Bust

By: MoneyWeek

The world's becoming a riskier place.

For a while there, it seemed that risk had been abolished. All through the boom, we still had terrorism, and we still had wars – but they didn't seem that important. They were sideshows, niggling little inconveniences in an otherwise near-perfect world.

Central bankers and governments had found the secret of ever-lasting growth with low inflation and low interest rates. China , India and the rest of the developing world were embracing capitalism and creating a new world order. One day they'd be the superpowers, but we'd all get rich and drink together in the meantime.

Nothing was too dangerous to invest in. No returns were too outlandish. No corner of the property market was off-limits.

And then reality reared its ugly head...

There is a long line of 'too good to be true' investment stories

We never seem to learn. Every boom's the same. "It's different this time," they say. And because it's different this time, everyone throws caution to the winds. Some people get rich. Other people see them getting rich, and they want to get rich too. Everyone's looking for the next big thing, be it new-builds in Nottingham , or Iraqi government debt.

And because everyone's looking for the next big thing, you can sell them anything. In a world where people are getting rich just by buying houses from one another, then promises of ongoing double-digit returns don't seem that extraordinary.

Thus we have Bernie Madoff, the pillar of Wall Street, who has apparently ripped off investors to the tune of $50bn (by his estimates) and certainly at least $20bn that we know off, if the banks, hedge funds, and all his other clients are doing their sums right.

It seems that his idea was one of the oldest in the book. He attracted investors with the promise of solid, regular returns. What they didn't know was that what drove those returns was not any great investment skill. It seems he was simply paying them out of the new money that clamoured to invest with him.

We'll have more on Mr Madoff in the next issue of MoneyWeek, out on Friday. But he's just the latest in a long line of investment stories that turned out to be too good to be true. The idea that property prices could only ever go up – that was a good one. Yet at one point, it seemed that everyone actually believed it.

Then there were the 'Brics' and other emerging markets. The idea was that they'd be able to decouple from the developed world. The fact that their respective economic miracles were driven almost entirely by demand from the developed world never seemed to figure in this equation.

Emerging markets can't save the global economy

Yet now we're seeing the reality. As US consumers buy fewer goods, China has less work to do. " China 's once ravenous hunger for energy is weakening at a record rate," reports Robin Pagnamenta in The Times this morning. With official GDP figures as trustworthy as government statistics across the rest of the world (ie not very), electricity usage isn't a bad guide to what's really happening in the economy. So the news that the country's electricity output in November fell 9.6% year-on-year doesn't bode well.

Lower demand from China means lower demand for fuel and commodities – one reason for the slump in oil prices . The Opec cartel is meeting up today and tomorrow to try to control the plunge in oil prices – down 70% or so from their peak in July. Russia plans to join in with any plans for a cut. But with demand continuing to plunge, it seems unlikely they can stall the fall for long.

And emerging market consumers don't seem to be planning to pick up the slack from America any time soon. Inchcape, the world's biggest car dealer, scrapped its final dividend yesterday. It warned that profits for 2009 would be below expectations. A plan to cut 1,600 jobs was expanded to 1,900 jobs. Chief executive Andrew Lacroix said: "We believe that in 2009 we will be faced with a downturn that is unprecedented, frankly."

Investors had hoped that the group's global exposure would help offset downturns in the West. But Inchcape warned that the Russian market – previously one of its fastest-growing – is faltering as the rouble weakens.

Government intervention risks making things worse

And as the sheen vanishes from the economic picture, so political risk suddenly becomes more important. The head of the International Monetary Fund (IMF), Dominique Strauss-Kahn, is warning of "social unrest" across the globe and violent protests unless governments do more to get their economies moving. But this constant call for government intervention risks making things worse.

Here in the UK , for example, we need to go through a long period where we save more than we spend; and where the money we do spend is spent more efficiently – in both the public and private sectors. Unpalatable as it is, that basically means letting a lot of businesses go to the wall, and a lot of people losing their jobs, so that other businesses that we actually need can spring up in their place, creating new jobs.

But the preferred option of governments is to go for short-term bail-outs that will secure votes. Thus you end up with zombie industries, and public sector non-jobs, which drain money from the productive economy. That leaves you with Japan . Taken further, you get protectionism, and trade wars – that leaves you with the Great Depression.

It also makes life very complicated for investors. If the return on your money is dictated more by the day-to-day whims of Gordon Brown than an industry's economic prospects, then it becomes almost impossible to plan ahead. And that makes demand for 'safe' investments shoot up – hence the ongoing rush to government debt.

Yet continued calls for 'fiscal stimulus' and government spending suggest that investors still believe in the biggest scam of all – the idea that governments can control the economy and save them from the bust.

They'll learn soon enough.

By John Stepek for Money Morning , the free daily investment email from MoneyWeek magazine

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