Peter T Treadway, PhD
Historical Analytics LLC
THE DISMAL OPTIMIST
July 8, 2010
“Show me where he sits and I’ll tell you where he stands.”
-Old Washington proverb
“As the buyers become less eager and the sellers become more eager an uneasy period of ‘financial distress’ follows… For the economy as a whole, the equivalent is the awareness on the part of a considerable segment of both firms and individual investors that it is time to become more liquid…Some highly leveraged investors may go bankrupt because the decline in asset prices is so sharp that the value of their assets declines below the amounts borrowed to buy the same assets.”
From Kindleberger and Aliber, Manias, Panics and Crashes, p 32.
Are We All Deer In the Deflationary Headlights?
Bloomberg ran an article saying that market volatility in May had turned hedge fund managers into “deer in the headlights.“ This is scary and possibly an economic indicator. Hedgies after all are supposed to be smarter than everyone else. They make money, or so we are told, whether the market goes up or down. Nobody else can do that. But in this case the hedgies are as confused as everyone else. I think the basic question is will the world in the next three years have inflation or deflation. And right now on this most important issue all the vital signs are giving opposing signals and the cross currents are buffeting the markets.
The money managers and investors who make the right inflation/deflation call will be the winners. Longer term—say over the next ten years – barring some major changes the global monetary system and some major fiscal reforms, inflation will be inevitable. But for most mere mortals in the investment business, who cares about the next ten years? It is the next three years that count.
Given the explosion in monetary bases in major countries around the world under quantitative easing, the easy answer is that inflation is around the corner. And the record since the collapse of Bretton Woods in 1971 supports the inflation argument. Under today’s fiat money system, peacetime inflation has become the norm since 1970. For example, $1.00 in 1970 would be worth $5.73 in 2010. (See http://www.dollartimes.com/calculators/inflation.htm). Even worse, the huge surge in global money supplies and global reserves since 1970 and the lack of discipline imposed on the United States has produced one global bubble after the other in asset prices. No wonder the price of gold has been rising steadily. But as the prospectuses say, past performance is no guarantee of future results.
Consider: The lynchpin of the current global fiat money system, the United States, is verging on deflation. The Eurozone likewise. Japan of course has been stuck in deflation for more or less three decades. The Japanese invented quantitative easing and hold the world’s record for building roads to nowhere. Japan’s monetary and fiscal spigots have been going full throttle. US and Japanese long term interest rates are supposed to be going up but they keep going down. On a gross basis, Japan’s government debt/GDP ratio is over 200%. How high does it have to go before Japanese Government yields finally rise? China’s got an inflation problem right now but, as the renminbi appreciates and the property and their investment boom cools, deflation or at least some slowing in the economy and price declines in property could be looming. Of the major countries, only India with its miserable infrastructure seems to have entrenched inflation.
All this is “bad” demand side post-bubble debt deflation. For the last thirty years as economist Gary Shilling has argued, the world has benefitted from “good” deflation. Computer and communications technology, the fall of the Berlin Wall, the addition of the Chinese, Indian and other “third world” labor supplies to the global economy have been powerful forces for economic growth and lower prices. The world’s central banks got away with printing all kinds of money and the inflation numbers remained at acceptable levels because good deflation would be holding down prices for tradable goods and services. The excess money went into stock market and property bubbles which generally weren’t targeted by central banks.
Unfortunately, a good part of the world may now be in a debt/deflation post-bubble mode. What happens, as with the case of Japan, if the expansive US and European government spending combined with higher taxes depresses productivity and economic growth and leads to more deflation? Is it possible that most of the world has it wrong and that wasteful Keynesian spending coupled with tax increases are deflationary? Does shifting debt from the private to public sectors accomplish anything? Is Ricardian Equivalence, which asserts that government deficits are anticipated by individuals who increase their saving because they realize that government borrowing today has to be repaid later, a real phenomenon?
American Fiscal Policy –What Me Worry?
Once again the one-eyed man has rolled the blind opposition. The dollar, for all its faults, in the last month was still king. A major change has occurred in the world of international finance. The euro, which in the last few years was shaping up as a major competitor for the dollar as a store of value and a major reserve asset for central banks, has fallen badly. Unless major reforms are undertaken related to the structure of the euozone, central banks and investors in general will not want to hold large euro positions as reserves.
Whether this is good for the US in the long run remains to be seen. Take the just concluded G20 Toronto meeting. The European leaders have all shed any recidivist Keynesian predisposal to more stimulus and spending. Thanks to Greece, they have all looked into the bond markets’ angry eyes and collectively have realized that the orgy of endless expansion of government debt is over for them. The Europeans have resigned themselves to a long winter of austerity and climbing out from ongoing banking crises and debt deflation.
Not so the US which seems to have been granted more rope by which to hang itself. Confident that for the moment the bond markets have nowhere else to go except to US Treasuries, the US President urged more stimulus. “What me worry,” seems to be the guiding principle of US fiscal policy. For now, the vision of endless US budget deficits and an ever growing government debt/GDP ratio is being ignored by the bond vigilantes. The dollar centric international financial system once again is giving the US a pass.
Obama was the lone Keynesian in Toronto. Oddly enough the only barrier to more US stimulus is an increasingly unhappy US electorate. Even a Democratic controlled Congress is reluctant to get on board the stimulus train this time. Perhaps the electorate has started to connect the dots. Ever expanding government borrowing cannot go on forever. And any new “stimulus” in reality will become a massive bailout for the many US states that are having their own fiscal crisis. A crisis largely due to financial burdens placed on them by the Federal government’s new health care plan and the states’ own over-indulgence of their public sector employees particularly through lavish defined-benefit retirement programs. Awareness of this is starting to permeate the US electorate, the bulk of whom who are eligible for relatively modest market driven defined-contribution retirement plans or who have no retirement plans at all because they are unemployed and have no job to retire from. A consensus is building that the current system is grossly biased in favor of the government sector. And that borrowing money for a wasteful and unjust “stimulus” will do nothing for economic activity. Except retard it.
All the while of course US government bonds have been rallying and overall the economic numbers have been lousy. Again, does stimulus equal inflation or deflation? Does the public, which seems to have discovered frugality and savings, know something the politicians and economists do not? Most of the US public today would be outraged by Ben Bernanke’s remark about throwing money out of helicopters. Let him get before a Senate committee and repeat it. This time people other than economists will be listening.
And by the way this bad deflation doesn’t mean that some prices can’t go up. The BP oil spill for example is likely to push up the price of oil. Off-shore drilling will be banned or become more expensive, and countries (if they can scrounge up the money) will spend billions on unproductive green energy projects. Higher energy costs mean slower economic growth and possibly more overall deflation.
The Euro – the Crisis Isn’t Over
As for the euro, it has rebounded some from its recent lows. But the euro has at least one huge problem in front of it and it is called SPAIN. The Spanish problem is well known: 20 percent unemployment, a rigid set of labor laws, and a massive real estate bubble that has now burst and fits perfectly into the debt/deflation Minsky/Kindleberger model. That doesn’t end happily. The banks finance a real estate bubble; the bubble bursts; the borrowers default; the banks go broke. That’s the model. That’s where Spain is right now. Non-performing loans are said to be massively underreported at Spanish banks and the banks themselves are reportedly unable to fund themselves in the wholesale markets and must rely on the European Central Bank (ECB). Like the Asian crisis of 1997, the Japan crisis of 1990-? and the American crisis of 2008, the euro crisis is a banking crisis. European banks are stuffed to the gills with government debt of Greece, Spain, Italy and Portugal and real estate loans in Spain. Doing stress tests on these banks is tricky. How do you treat government bonds from the so-called Club Med countries and what do you do with Spanish real estate? Do you assume a) no bailout, b) partial bailout or c) total bailout? A euro package of 110 billion for Greece and 750 billion for the eurozone as a whole has been announced. Will it be enough and is it real? We will find out.
This Spanish banking problem, with possible contagion effects spreading to Portugal and Italy as well, suggests that further near term downward pressure against the euro lies ahead. And that Europe risks deflation.
Dr. Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong
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