A Global Depression or Platonicity?

``A novel, a story, a myth, a tale, all have the same function: they spare us from the complexity of the world and shield us from its randomness. Myths impart order to the disorder of human perception and the perceived “chaos of human experience.””- Nassim Nicolas Taleb- Black Swan, The Impact of the Highly Improbable

This leads us to the next topic: global depression.

Major deflationist advocates argue that since the US economy is the sole consumption engine of the world, the transmission of potential debt defaults or credit destruction through the finance and trade channels would lead to a global depression. The Japan’s LOST DECADE scenario is the most frequently cited example.

And global depression means significantly higher US sovereign bond prices or lower yields and a rising US dollar. All other asset classes are likely to struggle including gold (although some deflationist argues counter-intuitively that gold will prosper under such scenario).

Let me first say that in the financial markets anything can happen. Therefore, extremities as a FED prompted “magic” or global depression could also occur and we don’t discount these. But to my opinion, the weightings I would assign for such probabilities would be in proportion to the logic in support of such arguments.

First of all, while it is true that the US FEDERAL Reserves and the other global central banks may not be able to “stop” deflationary forces our question is the US the world or the world the US?

In his book, Black Swan (incidentally my textbook) Mr. Nassim Nicolas Taleb describes “Platonicity” as (highlight mine) ``our tendency to mistake the map for territory, to focus on pure and well-defined “forms”, whether objects, like triangles, or social notions, like utopias (societies built according to some blueprint of what “make sense”), even nationalities. When these ideas and crisp constructs inhabit our minds, we privilege them over less elegant objects, those with messier and less tractable structures…Platonicity is what makes us think that we understand more than we actually do.”

Let us take for example some ingredients of the present crisis, such as Collateralized Debt Obligations or CDO or a type of asset backed security and structured credit product which pools several collateral including mortgage securities.

Figure 2: SIFMA: Global CDO Issuance Market Data

One of the attributions to the present seizure in the global financial system has been due to the opaque valuations of the said highly levered and illiquid instruments.

Figure 2 from SIFMA tell us that up to 76% of CDO issuances in 2006 and 75% of 1^st half of 2007 have been US dollar denominated.

Since the US mortgage market is about $6.5 trillion (about $1.3 trillion are subprime), many of these securitized mortgages make up the tranches pooled within these CDOs, and as we previously mentioned…sold and distributed worldwide.

The predominance of US CDO issuance is a testament to the degree of leverage faced by the US financial system relative to the world.

Figure 3: IMF: GFSR Global Hedge Funds by Geographic Source of Funds

Hedge funds are said to be one of the major investors of CDOs, according to the Bloomberg, ``About 25 percent of the trading in U.S. asset-backed securities was done by hedge funds. They were responsible for 20 percent of the volume in mortgage-backed securities trading.” (highlight mine)

In figure 3 courtesy of IMF, while the growth of the hedge funds industry have been worldwide leading to a reduction of the share of US based institutions, what we want to point out is that if there will be any destruction of credit, the bulk or meat of the damage would likely still be in the US, where 62% of hedge funds are located.

Of course, hedge funds and CDOs don’t make up the entire investing sphere, but what we would like to point out is that deflationist school of thought overestimates the universality of the global credit structure. Such view is ultimately too US centric.

The problem of “foreign currency reserve rich” Asian countries has been as BUYERS of these tainted instruments which could result to some balance sheet losses but should not affect its economic functions in the entirety.

FinanceAsia interviewed ANZ's Melbourne-based chief economist, Mr. Saul Eslake, from which we quote,

``Asian investors and financial institutions will have some of this toxic debt on their books. And will have to confess to how much they have lost. But I doubt there are many institutions in Asia – that matter – whose fundamental stability will be put at risk by those losses. In a sense, Asia has spent the last 10 years taking out insurance against the events that laid Asia low 10 years ago – and that will insulate Asia from some of those things. But people who write insurance, take a hit when claims are made, and that is effectively what is happening at the moment.

``But as far as the Asian economies are concerned they should be resilient. If there is a recession in the US – it is not more forecast, but it is a risk – then there will be adverse consequences for economic growth. But what we are talking about is maybe a percentage point off Asia’s growth rate, not a recession.

``As far as Asian equity markets are concerned: if the central banks succeed in restarting the credit mechanimsm, part of the means by which they will do that is by cutting interest rates. Lower interest rates, combined with what is fairly good growth, should be good for Asian equity markets, particularly since – China aside – they are not really overvalued.”

Figure4 BIS: Median debt equity ratios

We think ANZ’s Paul Eslake makes a good point to rebut against a global depression. Figure 4 from Bank of International Settlements tells us how deleveraged Asian economies are following the Asian Crisis.

Quoting the BIS on their latest quarterly outlook (highlight mine), ``The situation improved significantly after the crisis. Beginning in 1998, leverage began to fall significantly for Korea and Thailand, with book (market) leverage dropping to 77% (76%) in Korea and 99% (52%) in Thailand by 2005, well below pre-crisis levels. At the same time, interest coverage ratios improved markedly to above pre-crisis levels in all of the crisis countries except the Philippines (Graphs 1 and 2). By 2005, much smaller percentages of firms in East Asian countries had an interest coverage ratio below 1. Only in the Philippines was the percentage of firms unable to cover their debt service still relatively high, at 13.5%.”

Second, is that depression advocates argues in the context oblivious of the existence of today’s Fiat currency Standard.

What we mean is that the US Dollar being the world’s de facto currency standard would require the US Government to fight tooth and nail for the sustenance of present system, which underpins its quintessential pride and dignity.

It could, under present circumstances coordinate with global central banks to institute measures to mitigate the present junctures circumstances as what we have lately. What used to be national is today global, such is the marked nuance.

Yes while there is no guarantee that these efforts would work, synchronized moves could allow central banks more arsenal at their disposal. In other words, the inflationary system could last longer more than what the depression advocates may think of.

Further global central bankers appear to operate under the concept of the game theory called the NASH equilibrium, from which we quote the old article of one of my favorite analyst John Maudlin (highlight ours),

``The Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.”

Put differently, in the eyes of central bankers, there is less of an incentive to upset today’s conditions, regardless of the imbalances built under the present setup. Hence, they would probably attempt to work for the status quo, while gradually attempt (or at least pay lip service) to deal with the imbalances —the NASH equilibrium!

Third, the financial markets are not limited to reflect on the economic domain but transmissions of monetary policies…

Figure 5: zse.co.zw: Soaring Zimbabwe stocks!

Zimbabwe is a functional example. The economy is undergoing recession if not depression, suffers from 7,000% of hyperinflation, have a chaotic political order…BUT a SOARING STOCK MARKET! See Figure 5 from the Zimbabwe Stock Exchange.

We discussed this in our April 9^th to 13^th edition [see Zimbabwe: An Example of Global Inflationary Bias?], our point is, regardless of the economic situation, inflationary activities by central banks could lead to leakages elsewhere (in any asset classes) in this globalized world.

Maybe under a PROTECTIONIST or “closed” world order, the depression scenario could possibly have more clout.

Lastly, the Japan LOST DECADE scenario has been the frequently cited case of the deflation disorder, where Keynesian infers this phenomenon as the “liquidity trap”-- ``that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes (Paul Krugman)”—allegedly responsible for over a decade of economic slump.

The peculiar thing is that Bank of Japan has followed to the hilt the prescriptions of its Keynesian and Monetarist mentors to no avail--from exhaustively heaving up of public spending (which today led to the largest public debt among developed nations 176% to GDP -CIA, 2006 est) to adopting monetary policies as Quantitive Easing.

Of course, there are some extreme and elaborate distinctions; culturally, Japanese is the world’s biggest saver against the US which is the world’s most spendthrift nation. So a comparison is definitely an apples-to-oranges one but since our discussion covers the globe, depressionists suggest of covering of the entire basket of fruits.

Second, the polemics boils down to the valid analysis of the present conditions.

We quoted self-development author Robert Ringer in his article “Beware of False Perceptions” in the past (highlight mine), ``Action is the starting point of all progress, but an accurate perception of reality is the foundation upon which a successful person bases his actions. A false perception of reality leads to false premises, which in turn leads to false assumptions, which in turn leads to false conclusions, which, ultimately, leads to negative results…Which is why it’s incumbent upon you to become adept at distinguishing between reality and illusion. A false perception of reality — regardless of the cause — automatically leads to failure. An accurate perception of reality doesn’t guarantee success, but it’s an excellent first step in the right direction.”

From which we question, “could the liquidity trap theory be erroneous if not fallacious?”

The Austrian School through Chris Mayer disputes such widely believed theory, we quote at length (emphasis mine)

``Many are those who believe Japan is or was in a "liquidity trap." The basic idea is that people's "liquidity preference," or their demand for cash, is so high that the interest rates cannot fall low enough to stimulate investment. The basic Austrian criticism of the liquidity trap concept is that it has the causation backwards. Interest rates do not drive investment.

``As Murray Rothbard points out in his book, America's Great Depression, "saving, investment and the rate of interest are each and all simultaneously determined by individual time preferences on the market. Liquidity preference has nothing to do with it." In other words, the consumers' choices drive the rate of interest—not vice versa.

``Other analysts obsess over the "deflation problem." The idea that deflation is the villain of the piece misses an obvious fact: money supply continues to grow. However you slice it, be it M-1, M-2 or "broadly-defined liquidity"—they have all been growing every year since 1984, the earliest date provided by the BOJ data bank on its website. M-1 grew 8.5% in 2001, 27.6% in 2002 and 8.2% in 2003. M-2, a broader index, grew 2.8%, 3.3% and 1.7% in each of these years.”

The St. Louis Fed has charts on Japan’s growth of monetary aggregates click on the link to prove Mr. Mayer’s point.

``Deflation proper—a decline in the supply of money—clearly has not happened. Prices, as measured by the current fashionable indices, have fallen, but that is not a deflation—no more so than our current mild CPI readings measure low inflation. But even so, the Japanese consumer price index decline has been quite mild. According to the Japanese Statistic Bureau, the Japanese CPI stood at 98.1 at the end of 2003, a decline of 0.3% from the prior year (the base year, 2000 = 100).”

Again click on this link from the St. Louis Fed on Japan’s Inflation (Consumer and Producer Prices).

``It seems to defy common sense to suggest that the problem with Japan is the small annual decreases in its CPI. Surely, if a mild 1–3% increase in prices is acceptable to mainstream economists, then a decrease of less than 2% ought to pose no dire problems. Mainstream economists insist on treating price deflation as if it were some unholy beast and inflation as some manna of prosperity.

``The central problem of Japan is not a liquidity trap and it is not deflation—the fundamental problem is a pattern of production ill-suited and ill-fitted to meet the realities of the marketplace.

``In general terms, the Japanese wanted to protect their exporters, despite the fact that the marketplace had changed and moved against them. They wanted to persist in the belief that the blue chip debtors of yesteryear were still creditworthy. The Japanese economy was like a shopkeeper in denial of what his customers were telling him. Pretending not to hear it, he goes about his daily business as before only driving himself further into losses.”

Yes, mainstream analysts today espouse the view that Japan is under deflation. This prevalent thinking represents an oversimplified “platonified” explanation of developments even when they even don’t MEET THE TECHNICAL DEFINITION.

As Robert Ringer suggests above, misdiagnosis leads to the wrong cures or even worst, possibly a cure worst than the disease. The anatomy: False perception leads to false assumptions, which then leads to false conclusions thereby rendering negative results on the actions applied.

Obviously Japan’s policymakers in refusal to lose power and privileges to free markets adopted the backward process of thinking or the “rear view mirror” syndrome to apply ineffectual policies that have prolonged the slump.

It goes the same with investment analysis…

A FED induced economic and financial markets turnaround and…

A global depression operates on a common thread…

They are based on Nassim Taleb’s “Platonicity”- makes us think that we understand more than we actually do- or…

OVERESTIMATING what we know and UNDERESTIMATING on what we don’t. We don’t give room enough for randomness but rather play up on our biases.

Which is why we give weight to the second probability, a potential recessionary risks coupled with open ended global outlook…