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Friday September 10, 2010 - 17:26:42 GMT
Black Swan Capital - www.blackswantrading.com

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A Friday Ramble of Doom

A couple of years ago, as the credit crunch was starting to crunch, we showed two charts that suggested bad news ahead.  One was the US Current Account graphic showing an improvement that started over a year before the credit crunch hit, suggesting at the time credit was already draining out of the global economy.  The second was the Fischer Debt-Deflation Theory.  
 
[Chart not available in text format]

At the time, we said the US could be following down the same policy path as Japan.  Japan ran right on the Fisher plan.  And with a couple of years of hindsight, the US is doing a pretty good imitation of its friend from the east. 

Keep in mind how incredibly overleveraged the globe was when the credit crunch reared its ugly head.  The total value of derivatives outstanding was about 10 times greater than total world GDP combined.  It is an astounding number, considering about 20-years before the level of derivatives was somewhere around 1/5th of total global GDP. 

Granted, not all derivatives are created equal.  In fact, many are quite useful and important to operating a modern financial system that is globalized.  Problem is so many of the derivatives created were so darn awful.  Heck, some were so bad and so dubiously fabricated one might have thought they were designed precisely so investment banks and some well connected hedge funds could profit from them exploding.  But I digress ...

If we fast forward to now, and watch all that public debt being thrown into the market place as the private stuff we just talked about continues to fade, i.e. often referred to as private deleveraging, it is no surprise this massive level of de-leveraging has suppressed the stimulative impact of new credit as governments pump up their debt-to-GDP ratios (with our money of course).  We know this story ... but let’s quickly look at some validation.

If our policymakers had read what Fischer said in point #2 and #8 above about falling velocity, they would have known their efforts would be thwarted to a large degree and any infusion to financial institutions would mostly stay with financial institutions for a while.  This is precisely why the Fisher Model makes sense. 

Many analysts rely on the Milton Friedman quip: “Inflation is always and everywhere a monetary phenomenon,” to justify their view that all the credit being created by the Fed and Federal Government will be massively inflationary.  But Fisher understood that money that is not spent on real goods, whether it remains stuck in the financial system (which isn’t money but only the potential to be so) or is hoarded, as in point #8 again above, is not inflationary.  In fact, if it persists then the lack of confidence leads to more hoarding, and hoarding (or not spending) becomes self-reinforcing, i.e. “things are so bad I better build up more cash” mentality multiplied across our fair land. 

Add to the consumer mentality side, plus credit default which not only impoverishes the lender and borrower, it destroys collateral values by virtue of the fact the pool of wealth supporting the lending is gone -- as collateral values fall, future lending falls in conjunction.  So no surprise bank loans in this environment are relatively anemic given all the potential credit they have thanks to our illustrious Fed and our tax dollars.

So, we keep seeing this: US Consumer Credit declining for the first time in forever!  There was another reported decline in the numbers yesterday -- not exactly recovery type of raw material now is it? 

US Consumer Credit Outstanding Going Back to 1943:
 [Chart not available in text format]

The next shows US Consumer Credit as a % of US Gross Domestic Product.  It has naturally ebbed and flowed during recessionary periods.  But it’s now ebbing from a very high level.  If this ebb becomes a reversion to the mean type of move, it would represent a huge amount of consumer purchasing power taken out of the global economy.  No wonder policymakers are in panic mode.  Heck, if this trend continues maybe this administration may even layoff the class-warfare jargon soon and give all those “rich” small business owners (otherwise known as labor exploiters to the current regime’s base) a real tax cut (instead of some useless targeted complicated credit) to actually infuse some confidence back into the real economy.  Sorry, a man can dream!
 
[Chart not available in text format]
 
And of course yesterday, we had a bit of surprise improvement in the US trade numbers, i.e. the US Current Account Deficit improved again. Is that good news or bad news?  We would argue it is bad news near-term, but good news long-term.  Why do we say that? 

Near term it is bad because it supports what the decline in consumer credit numbers are telling us: Mr. US Consumer is shaking off his old drunken sailor ways and finding religion.  

Anyway, as you all know this continued downward momentum of US consumer demand (granted the jury is still out), if it is that, continues apace at a very treacherous time -- a time when most all the big players credited with keeping the wheels of commerce greased (Germany, China, and Japan) -- need to export for grease to flow.   

What happens when everyone wants to export and few wish to, or lose the capacity to, import (a la the core states within Europe now being crushed by austerity; with Germany being the exception but soon to lose that demand is our guess)?  You guessed it: it’s “beggar thy neighbor” time. 

And when was the last time we saw the nasty impact of “beggar thy neighbor” in a big way?  I think it was during the so-called Great Depression.  Countries did all they could to avoid taking the impact of dwindling global demand domestically, thus currency devaluations and trade barriers resulted. 

And who do we coin the biggest of the “beggar they neighbor” players (though all play the game)?  Another easy question indeed—China.

You may have noticed the news story on the wires this morning. If you didn’t, the gist of it is this: Japan is complaining because China is buying Japanese bonds.  Say what?  Yes, you heard that correctly.  The problem of course is that buying Japanese government bonds by China is supporting and pushing up the relative value of the yen, according to Japan. 

There is so much here to discuss it is frightening ... and goes to how completely messed up our global monetary system really is. 

The US effectively begs the biggest “beggar thy neighbor” to buy its bonds at each auction.  Yet Japan, still thinking the internal funding of debt game is easy (back when Japanese savings were 20%, maybe, but now that savers are near zero that game is about over), is worried about the impact on the yen.  It is too fresh. We used to hear that the value of the currency didn’t matter when the US or Europe complained about undervalued Asian-block currencies, but now, of course, it matters greatly.  Secondly, it shows that China, with all its reserves thanks to keeping its currency about 50% undervalued relative to the US dollar (if you believe The Economist Big Mac Index), has no place to hide.  If they stop buying US Treasuries to keep their currency relatively suppressed, they take trade friction heat elsewhere. 

It also begs the question: why in the heck does anyone want Japanese bonds now?  Granted the US debt picture looks ugly, but we’d bet big that Japanese government bonds break first, on a relative basis.  Why do we say that?  Well, the US doesn’t yet have debt to GDP anywhere close to 200%; and remember the dirty little secret we started out with: US savers are saving and Japanese savers are not.  Thus, Japan’s need for capital may soon hike up tremendously relative to the US.  They will need to hike rates for international investors to take on that risk, telling the world that Japan can internally fund no more.  Fy slamma jamma! 

You may also remember when China supposedly poured a little more into European bonds, as a much needed shot of confidence; it also dovetailed with the rise in the euro, which, you guessed it again, makes German exports less competitive against China clearing the way for transfer of China’s much needed domestic adjustment off onto its trade partners.  We would say two-for-two on Chinese allocation of fresh funds to European and Japanese bond markets.

This our last “guess what” -- China better start circling the wagons because the natives are getting very restless; which suggests why our favorite economic czar, Larry “I am somebody” Summers is in China this week.  He likes the food, but danger abounds and it’s why he abandoned his post at the White House.  Here’s to hoping he stays awhile.  Sorry, a man can dream!

But hope springs eternal as China “reported” its imports rose sharply for the month of August.  As to content, we don’t know.  But we do know this: this is not your usual cyclical recession thanks to the massive leverage still in place and massive malinvestment held afloat because of artificially low interest rates (which goes to point #9 in Fischer’s brilliant summary, i.e. low rates have zero stimulative impact when real rates, thanks to deflation, are rising). 

We are not usually this doomy and gloomy -- sorry.  But because, as you well know, Keynes is not our favorite economist, our gloom grows.  If fiscal policy is powerful and lags, then all that potential money thrown into the financial institutions will eventually make its way into the real economy, pulling us out of this gloom and proving our economic czar right. 

Commodity currencies -- Aussie and New Zealand dollars-- are challenging their old highs (pre-credit crunch) against the US dollar again.  Suggesting by price action alone growth will continue. 

But if beggar they neighbor continues, exposing the fault lines so everyone can see just how precarious this so-called system is wired, the credit crunch might look like child’s play and the next phase will likely look like Chuckie (of horror movie fame).  That’s bad news, because those who are supposed to protect us from Chuckie have no bullets left in the gun.   

Here is the scary part, according to Fischer [our emphasis]:

“It is always economically possible to stop or prevent such a depression [1929-33] simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.”

What if Fisher is wrong about “always” being able to reflate the price level?  What if because we no longer operate effectively in a closed-loop economic system primarily dominated by domestic factors somewhat controllable and instead policies shaped for that just don’t work in a globalized world where major capital flows and related market adjustments can be manipulated more easily? 

So far, the world’s defacto central bank, and world’s most powerful fiscal policy have been unable to inflate the price level.  If they can’t, the path is a real market solution that will be that much uglier thanks to policymaking failure.
 

 

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  • POTENTIAL PRICE RISK: HIGH Tue-- 08:30 GMT GB- CPI top tier confirmation of Inflation.

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John M. Bland, MBA
co-founding Partner, Global-View.com

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