April 15, 2009
It is too late to avoid a depression in the US now. If the steps taken today were taken 12 months ago, right after the collapse of Bear Sterns, there would have been some possibility of an eventual turnaround. But the authorities ignored all the signs of impending economic calamity, dismissed the gigantic and interconnected risk structures of the past era as a market mechanism, and when that mechanism attempted to correct itself, they did not allow it to liquidate the bankrupt sectors. And now, by sustaining the tumour, they ensure that the cancer will do long term damage.
The government and the Federal Reserve are trying to make the American people spend like they were doing in the past, but unlike the past, there’s no credit, no secure jobs, no appreciating asset markets to back their exhortations. In response, Americans are saving like they have not done for quite a while. The dream is that ghe government can make people spend by simply giving them money; a foolish proposition disproven by the decades-long slump of the Japanese economy, and the various stagflationary periods of different nations.
There are two types of economic boom. One is created by expanding money supply and government action. The other is caused by fundamental factors such as technological innovation, or the global spread of productivity-enhancing techniques and tools. The former only creates illusory periods of speculative inflation, and its consequences are destructive, not creative. The latter can also fuel speculative activity, but it’s impact is usually long-term, and positive for the society at large. Our pessimism for the next 5-10 years is due to the fact that there will be a lot more monetary expansion than productivity-driven growth during the period. And the consequences of that will be turmoil, conflict, poverty, and despair.
As the sole remedy, we would be much more optimistic if China could be made to unleash its potential in a healthy manner. But given the attitude of the government, and also the traditions of the China people, we have grave doubts about the credibility of the “China-saves-the-world” scenario.
Yes, the stock market is rallying right now. Commodity markets are also rallying, and even shipping rates have been rising for a while. But we ask the reader to keep our word in mind, and to come back here a while later to check if we have been right or not: these episodes in all these markets are but bouts of volatility, created by the disappearance of the many liquidity-generators. The up-up-up markets of the past were an aberrance, and now we’re back to a normal situation where volatility complicates trading decisions, and economic analyis.That the economy will be in a slump for many years to come is a certainty. How much money the governments will print in their futile endeavour to resurrect a dead banking system in a deflationary environment is uncertain. Consequently, it is not possible to know if the price of a barrel of oil will be 1 USD, 10 USD, 100 USD, or 1000 USD, but until real liquidation and consolidation reshape the global financial system, volatility will remain high, real GDP growth will be low, and ROI in general miserable. We’d willing to bet one million dollars on this conjecture.
September 23, 2008
In general, there’re two opinions on where money supply and the dollar are headed:
1. The world and the US are headed for a “nasty” recession, quite possibly a depression. A universal contraction in demand will cause the services sector to shrink very strongly in the US, leading in turn to a halt to manufacturing expansion in Asian nations, and, eventually, to a large number of bankruptcies, as a large part of industrial capacity becomes idle. This will lead to higher unemployment across the globe, and cause deflation in commodities, goods and services, leading to higher dollar.
2. The world economy is headed for a one-two year long recession, as the US government continually bails out increasing segments of the economy, starting with banks. That the Treasury has moved so fast from rescuing the GSE’s to rescuing the entire banking industry of the US, and then some more in the rest of the world, shows that the Americans have no interest in paying the price of the excesses of the past decades, and will instead do whatever they can do save the day, regardless of what happens in the longer term. They will print more and more Treasury bonds to sustain the US consumer and to prevent the necessary adjustment in the consumer’s spending habits, which will prevent the rest of the world from suffering a severe slowdown, but will create inflation and crush the dollar in the process.
What does Washington want? I believe that the answer is very clear. At all costs, they want to prevent a demand contraction, and they have the means to achieve this, albeit only in the short term. “Live today, forget the rest” is more or less the modus vivendi of the American, and it now seems that this will also be how they manage this problem.
To be fair however, the administration is only willing to consider reflating the economy because it believes that the results would be more controllable and orderly than a depression and a collapse in demand. It’s not illogical to think that an artificially induced inflationary environment is easier to live with than a sudden, severe and unpredictable contraction of the economy. Those who oppose this argument suggest that it’s far from clear that the inflationary remedy can resolve the problem, that is, it’s not clear that by resorting to inflation we will not end up with both inflation and a depression. It must be mentioned that there’s no real example of an economy that has averted depression through easy monetary policy.
But I believe that the government at least has the power to devalue its currency: they can create such a great supply of dollars that even the most fearful investor sees little value in holding an asset which is likely to shrink at great speed as soon as the fear factor that is upholding it lessens.
That is why I support number two of the above options. I believe that the dollar is sentenced and damned. The US, as a nation, has chosen to sacrifice its tomorrow for saving the day, and the first to pay the price will be the dollar.
September 16, 2008
Wilbur Ross has told CNBC yesterday that one thousand regional banks could fail. He’s basing his opinion on historical record in light of recent developments.
What does this mean for the Federal Budget? Morgan Stanley believes it is manageable. (See bottom of the page)
The government is expected to create stimulus packages, take over bank failures, finance the restructuring of the GSE’s, bailout failed financial firms, pursue two wars in Iraq and Afghanistan, provide or maintain tax cuts, and keep spending in order to sustain economic activity in general; and each of those items is at least a hundred billion dollar item.
At the same time the government’s revenues are likely to shrink as more bankruptcies and higher unemployment will be a feature of the next few years.
How will the government get out of this without monetising some of these problems? Can the US avoid higher inflation in the long term?
Liquidity and the money supply are seen to be the solution by the Federal Reserve, but neither the government nor the private sector have a solid financial position to provide that liquidity. This is a solvency problem, and the cash is in the pockets of exporters, the debt is in the US Treasury. And as the debtor was the creator, and originator of a vast part of global economic activity in the past years, if the world wants to avoid a general economic cataclysm, it will have to bailout the American economy, arguably by continuing to buy increasing amounts of treasuries and other government paper.
This is not unprecedented in history. When, after the first world war, Germany faced financial catastrophe, it was the US that organised the bailout of the German state, as it was realised that a complete collapse of that nation was threatening the health of the American and international economies. In today’s case the Chinese and others are sitting on trillions of dollars, which are likely to depreciate significantly, if, as expected, the US does decide to solve its problems through monetisation. More importantly, neither the Chinese economy, nor in fact any other economy in the world is sophisticated enough to create or absorb those enormous sums without creating financial instability: it was a mistake on the part of the Chinese to accumulate that much in reserves, now they must at least make use of them. If they don’t, the US will depreciate its currency in the middle of a global recession, creating more insecurity, more contraction, and no one knows where this would lead us.
In the long run, as I said, in the absence of an international solution, I believe that political reasons will lead the Congress and the administration to choose the path of monetisation, that is, inflation as the cure-all for the private sector’s problems. This is even likelier under Obama, and just today Barney Frank has been urging the government to begin to buy debt and other assets in the market. Indeed there does not appear to be any other solution to this issue. So far I have not heard a single voice providing a solution to the issues facing the economy: usually the suggestion is to let the markets solve their own problems, but politically the costs of this are going to be enormous: certainly double digit unemployment, and thousands of bankruptcies will be the outcome. But more importantly, if panic is allowed to take hold, the feedback loop can create problems that are not imagined today.
The United States escaped from the depression of the thirties only through war: the needs of a war economy, coupled with the psychological stimulus of a warlike mentality, allowed the system to grow out of its pessimistic stupor and create economic dynamism. Why did the recovery take so long? Because the collapse in confidence and goodwill after a long and severe bottoming, instead of creating new momentum and optimism, perpetuates the negative attitudes of the previous contraction. People are likely to enter the market to pick bottoms many times over many months, even years, and eventually it will be confidence that suffers the greatest damage. No amount of financial loss can account for the damage that confidence will suffer in a long term financial collapse. And that phenomenon is one of the reasons of Japan’s decades long slump too.
August 26, 2008
Monetary policy in the modern age dictates that a central bank should provide liquidity and expand credit during a slowdown or financial crisis. But this time there’s every sign that isolated strong action by a single central bank is not only ineffective, but also counterproductive.
Of the major central banks of the world, only the Federal Reserve responded to the financial crisis with aggressive rate reductions. The ECB has chosen to interprete its legal mandate strictly, and has actually increased rates in response to inflation that has recently reached 4 percent. Rising inflation and rapidly deteriorating economic outlook has prevented Bank of England from acting decisively, while Bank of Japan has chosen to remain neutral but fearful, with rates already near zero. Brazil, Turkey, Thailand, China, Russia, India all face significant inflationary pressures, and some have been forced to raise rates in order to combat the risk of runaway inflation, which so far seems to have materialised only in Vietnam.
In the US and to a lesser extent in the EU, credit growth decelerated sharply, with banks and financial institutions tightening some forms of credit to unprecendented levels; in contrast, in most emerging markets money supply has continued to expand strongly, invigorated by flows of short term money from the industrialised world seeking better yield. Exacerbated by the parabolic rise in commodity prices, mostly a result of the falling dollar, the already heated economies of these developing nations have been grappling with increasing inflationary issues ever since the Federal Reserve began its rate cut cycle in September of last year.
The argument that rate reductions by the FED have prevented the situation from worsening in the US is devalued by the fact that in the Eurosystem the experience of financial institutions has not been any better or worse than those in the US. European banks have had massive exposure to problematic US paper, and some of the worst write-downs have been taken by a Swiss institution.
What is more, because of the lagged effect of constricted credit channels, the stimulative effect of reduced rates on the real sectors of the economy have been hardly felt so far. A shutdown of credit sources to non-financial institutions is far from being the case, both in Europe and the US, and central bank interventions have not prevented banks from shrinking balance sheets and squeezing credit where they believed it to be be necessary.
What then, has been the achievement of monetary policy thus far?
In the US, the result has been the falling dollar, and high inflation. Neither the fear premium on LIBOR, nor mortgage rates have been ameliorated by lower rates. And the near failure of Bear Sterns occurred at a time when the Federal Reserve had already reduced rates by about 200 basis points from their August 2007 levels. Reduced rates, and even the new and innovative liquidity facilities announced by central banks, have not been successful in preventing financial participants from nervously speculating on who is to fall next.
In the rest of the world, where stimulus wasn’t needed, the Fed’s inflation gift, via the lower dollar, has forced central banks to increase rates, making sure that the only parts of the world where growth was relatively unhurt by the financial crisis would now be on the inevitable path to recession because of high interest rates necessitated by inflationary pressures.
The impact of the Fed cuts on the global economy has been mostly negative. The global recession that’s yet to be experienced in its full force is likely to be long lasting and painful.