Peter T Treadway, PhD
Historical Analytics LLC
July 1, 2011
THE DISMAL OPTIMIST
As I write this, the stock market is going up again. It wouldn’t matter if the world were indeed coming to an end. (Actually it might be.) Zero percent short term interest rates and reasonably healthy corporate profits are enough. The Fed is manipulating the stock market up, interest rates down. Good news for Obama’s billionaires and millionaires and private jet owners who own lots of stocks. Bad news for the masses of ordinary “poor slob” retirees who depend on interest income. I cannot understand why the AARP (aka American Association of Retired Persons) is not picketing in front of the Federal Reserve.
Meanwhile, both places I call home – the US and Hong Kong – are celebrating their national days. July 4 is the day when Americans declared their independence from the evil British and embraced the liberating concept of taxation with representation. July 1 is the day when the citizens of Hong Kong escaped the clutches of the evil British and dedicated themselves to arranging the provision of condominiums and Louis Vuitton and Chanel and all kinds of luxury products for their Mainland comrades.
The Debt Ceiling Is the Wrong Place to Draw a Line in the Sand
As I have been writing in these essays, the problem of out-of-control American government expenditures will only be resolved by a major market access crisis. As they have said to Greece, the markets must say to the mighty US government that it can borrow no more. That day has not come yet. I do not believe the political will exists for the US government to voluntarily do what is necessary. I’m a big Ron Paul fan on monetary matters but I think he will remain an interesting intellectual curiosity serving in the House of Representatives. The American public believes it has a divine right to its entitlements. The Republicans only control the House and not all of them are genuine fiscal conservatives anyway. The President and his party seem to be dedicated to more, not less spending.
At the end of the day, the debt ceiling has to be raised. A legal default at this point is simply unthinkable for the world’s major borrower and issuer of the world’s principal reserve currency. The strategy of shutting down the government and just servicing the government debt is not politically viable. The American people won’t stand for it. The Republicans are in fact threatening to commit political suicide and take the United States and the entire world with them. One can only hope they don’t really believe their own press releases. If indeed the US is forced to default the result would be a global catastrophe. Today’s limp recovery would quickly seem like the good old days.
Nobody knows when the markets will, in the immortal words of boxer Roberto Duran, say no mas (no more) to further US government borrowings. You can find all kinds of forecasts for when this will happen—this year, next year, ten years from now. Everyone knows that in the coming years a huge demographic burden is to be heaped on an already out of control fiscal deficit situation. High debt levels mean slower economic growth. Market responses are unpredictable. My fear as I wrote in the last piece is that the crisis could come right after the 2012 elections unless those elections produced a clean sweep by those totally dedicated to politically unpopular entitlement cuts. I doubt such a sweep will happen.
A big question is what will the US do if the markets do say no mas? I think the only response is a combination of higher taxes (wrong choice since this will then bring even slower growth), spending cuts and most importantly, money printing as the Fed buys the bulk of Treasury debt. The US borrows in its own currency. It can just print more of it.
Barring some Republican insanity in 2011, the US will not legally default. But default in an economic sense can take other forms. And a default by another name would still smell as bad. Substantial unanticipated inflation via money printing and deliberate currency destruction is one. Financial repression, like robbing 401K pension plans, or forcing banks and other intermediaries to buy Treasuries, is another. Curtailing the purchase of alternative stores of value like gold is a third.
The US is no virgin here. The US has legally defaulted twice, the first time when the gold clause was eliminated from debt obligations in 1934 and in 1971 when President Nixon refused to honor the Bretton Woods rule that the US sell its gold to foreign nations at $35 per ounce. And a dollar in 2010 was worth 4.6 cents as compared with $1.00 in 1914 (see mykindred.com/cloud/TX/Documents/dollar/). In 1914 the traditional near- zero-inflation gold standard was jettisoned and the Federal Reserve was established.
Fiat paper money was first introduced in Sung Dynasty China in the eleventh century. The Sung paper money eventually became worthless would so many other fiat currencies. The US dollar is not exempt from the laws of political economics. The urge to print money and engender inflation to escape fiscal problems is an irresistible one.
To some extent what is looming in front of the US is a massive generational and, although it is politically incorrect to talk about it, racial/ethnic conflict. The big winners under the current arrangements are predominantly white baby boomer senior citizens whose representatives generously provided them with a smorgasbord of social security and health benefits. Their children and grandchildren—of whom they forgot to have enough – are going to have to pay for all this. Although nobody really understands the full implications of Obamacare, it looks like the program will add another major recipient group. That group would be predominantly low income minority entitlement beneficiaries as Medicaid and beneficiary roles expand. The President said in his campaign that he wanted to “spread the wealth around.” Obamacare will do that. Strange bedfollows – old whites and younger minority groups. Will they come to see themselves as competitors or allies?
This is a zero sum game. Growth prospects are reduced because of the heaving debt load and higher taxes. Massive destruction of the dominant baby boom generation’s entitlements and wealth could be the only way the US could avoid economic stagnation. But just wait until the aging boomers—who worked hard and paid taxes all their lives– can’t find a doctor who will accept price-controlled Medicare payments that have become absurdly under-market because of inflation. That’s how the politicians may renege on an entitlement. The process is already underway. For the boomers, their golden years may not have a happy ending.
The Euro Will Survive
I have written in numerous prior essays that I thought the euro would survive. I still think so. The gains from the single European currency outweigh the negatives by a substantial margin. History and the desire to avoid more totally destructive European wars, advances in telecommunications and transportation, the overwhelming simplicity and economic efficiency of the single European currency vs a multiplicity of currencies, outweigh the negatives. Moreover, were Greece to leave the euro, some type of Argentine solution would have to be imposed, i.e., Greek bank accounts denominated in euros would have to be forcibly converted to a new Greek drachma at a depreciated exchange rate. Think about how the Greeks would react to that, not to mention the Italians, the Spanish, the Portuguese and the Irish, all of whom would rush to withdraw their own euros in their own banks to avoid a similar fate. This would be the mother of all bank runs.
It won’t be allowed to happen. Ignore all the trendy treatises about the Treaty of Westphalia and how country-based European nationalism will reassert itself. The Europeans can’t afford too much nationalism. Nationalism means spending more money on military items. Retiring US Defense Secretary Gates has even implied the Europeans can’t even bomb Libya properly.
The Europeans have committed their share of blunders. For one thing, it would have been better to let Greece default on day one as the US states defaulted in the 1840s. True, the banks across Europe would have required a bailout. They were stuffed with Greek government credits. But now the European Central Bank (ECB) and some of the national central banks are stuffed with Greek paper. Bailing out the Greek government is just an inefficient way of bailing out the banks.
I am almost embarrassed to argue this but in many ways the banks are not at fault here. They were incentivized by bank capital regulations to buy Greek government debt which was automatically classified as a risk free asset with no capital requirements. No matter that Greece according to Rogoff and Reinhart in This Time It’s Different had been in default one out of every two years since gaining its independence in the nineteenth century.
Banks ultimately are hostages of their regulatory and economic environments. The banks rather than the Greek government should have been bailed out directly. Shut out of the markets, the Greek government could have been allowed to default. Greece couldn’t devalue like Argentina in 2001 but a default would have been a better state of affairs than having the IMF and the other Europeans dictating austerity.
One aside regarding risk free rates. As someone who has taught the standard capital asset pricing model, the current environment makes this model a joke. What is the risk free rate? The near zero Fed funds rate? Rates that governments borrow at? The rate on Greek government short term bonds? All those MBA students, who spent so much time and money mastering this model, must now be suffering buyers’ remorse.
Perhaps one day as so many have prognosticated China will rule the world. But keep this in mind. In 1800 the US was an unimportant newby located in then far off North America. One hundred years later it was the world’s leading industrial nation. A great growth story in which to invest, right? Not always. The US economic ascent was a very bumpy affair. British investors in particular lost their shirts repeatedly investing in the new world. The 1840s, 1860-65, 1873, the 1890s, were bad times for investors. Overbuilding of railroads and canals, a fragmented banking system, a civil war and a less than one hundred percent commitment to the gold standard were some major problems.
Why should the path be any smoother for China? I have drawn upon a construct that Eamon Fingleton calls the East Asian model to describe China’s economy. Heavily protectionist, an undervalued exchange rate, a state owned and directed banking system that misdirects capital into state owned companies and murky local government entities, overinvestment in capital projects, low transparency and lack of honesty of some Chinese companies, are just some of the less than perfect attributes of the Chinese economy. Yes the Chinese people are relatively well educated, resourceful and hardworking. And certainly the system is better than that which prevailed over 1949-1980. But the last few years has seen a huge jump in Chinese money supply and bank loans. And now the government is cutting back.
The possibility of a hard landing for China (say GDP growth of five percent) coupled with a banking crisis requiring a bailout is high for China. China’s problems go far beyond cooked books of reverse merger listings in New York.
Peter T Treadway, PhD
Historical Analytics LLC
305 761 4718
July 1, 2011