2009: The Year of Surprises?

``A profound restructuring of global capital has become unavoidable. Such a process is quite different from a recession in the traditional sense. In contrast to a sharp and typically short-lived recession, when, after the rupture, business as usual can go on, the restructuring of a distorted capital structure will require time to play out. Rebalancing the distorted capital structure of an economy requires enduring nitty-gritty entrepreneurial piecemeal work. This can only be done under the guidance of the discovery process of competition, as it is inherent in the workings of the price system of the unhampered market.”-Antony Mueller, founder of Continental Economics Institute, What's Behind the Financial Market Crisis?

2009 will surely be an exciting year.

How can it not be?

After markets got beaten black and blue in 2008, the world in terms of government policy actions have been responding in an unprecendented breadth and scale, using up all possible and known tools, to prevent the financial meltdown or debt deflation from filtering or spreading to the real economy on a global dimension.

Given the alarmist response of policymakers, fear appears to have given way to outright panic. This suggests that at worst, we could be at risk of walking the tightrope between a depression and a collapse of the world’s monetary standard. At best, this could signal a monumental shift to a new financial and economic world order.

Undue Panic? First, global central bankers of major economies have collectively been lowering rates at a frenzied pace. A few economies like such as the US Federal Reserve Bank, Bank of Japan and Swiss National Bank have now embarked on a Zero Interest Rate Policy (ZIRP) regime. Others are expected to play catch up.

Next, the same authorities have been taking up the manifold role of last resorts as lender, guarantor, liquidity provider, market maker, financiers and investor, all within the doctrinal confines of the monetarist approach led by the illustrious late Milton Friedman.

Third, global policymakers have been doing a John Maynard Keynes in adopting massive fiscal stimulus programs. This seems to be the largest D-Day like operations to ever take hold where national economies would be coughing up trillions of dollars to replace “lost” aggregate demand with government spending.

Meanwhile, some central bankers have now been resorting to the crudest of all central banking tools; the printing press. Under the technical label of “Quantitative Easing” some central banks would be intervening directly in the marketplace mostly bypassing the commercial banking system-by providing loans directly to end users or by buying assets directly (mostly bonds to possibly even stocks) with the goal to reduce interest rate gap arbitrage, buoy asset prices and forcibly pry open the banking system to “normalize” lending or by intervening in the currency market with the tacit goal of “depreciating” the currency-without sterilizing or mopping these up.

Essentially today’s primary practitioner of the printing press, a signature approach of Zimbabwe’s central bank governor Dr. Gideon Gono will in essence be given a boost, as central bankers of major economies will likewise be utilizing these as the NUCLEAR option.

Politics and Inflation As Drivers, Overcapacity Balderdash

As anyone should notice, to gloss over the political dimension as drivers of markets and of economies in 2009, when governments have arbitrarily bestowed upon themselves the divine privilege of administering life or death to which industries or companies it would deem as qualified or otherwise, would be a monumental mistake!

For instance, in the US, given the approval of General Motors’ financing affiliate, the GMAC, to upgrade its status into a bank holding company, which essentially grants license for it to access government loans, has used this extraordinary privilege to aggressively launch a market pricing offensive (how about predatory pricing?) by offering 0% financing to the public at the expense of other automakers as Ford, Toyota or others that have not availed of government loans and rescues programs. In short, the competitive edge seems shifting in favor of those closest to Washington.

And it is no wonder why political lobbying has now transformed as the de facto booming Industry in the US and elsewhere as governments rediscover their clout in the economic horizon.

And it would be no different when applied to any country, such as the Philippines which has slated to undertake its own P 300 billion stimulus program for 2009 (abs-cbn). Political pandering will mean beneficiaries of such inflationary policies would get a boost over and at the expense of the rest. It would be a heyday for politicos, cronies, the bureaucracy and those affiliated with them.

Altogether, a few trillions of US dollars will be earmarked to “stimulate” national economies around the world.

And this “political variable as determinant of economic and market output” will not be confined to the premises of domestic politics but one of geopolitics too.

Policies implemented by one country could have economic and political repercussions which could force a policy response elsewhere. For example, fearing the loss of its domestic automakers industry as consequence to the recent bailout extended by the US to its domestic auto industry, Canada had been compelled to match with its own bailout program.

The obvious risk from the rampaging streak of overregulation and excessive market intervention is to raise the level of protectionist sentiment at a time when global economies appear fragile and reeling from the deleterious contagion impact of the financial meltdown.

Moreover, the general deterioration of the economic landscape could also translate to a snowballing of public security risks. Growing societal discontent could translate to rising incidences of public disturbances or social upheavals. For example, this financial crisis has claimed its first victim in the Belgian government which had its third leader for 2008.

Then there have been emerging incidences of global financial crisis instigated rioting in Greece, Russia and in China.

In other words, increasing signs of political instability at home is likely to induce policies that are “nationally” oriented than from a “global” perspective.

Thus, experts advocating for the “great rebalancing” of the global balance of payments asymmetries are like operating in the field of dreams- inapplicable under the realities of the US dollar standard system, (see The Myth of the Great Rebalancing), aside from the ongoing dynamics in the geopolitical sphere.

Aside, such “noble intentions that don’t square with reality arguments” seem to justify Black Swan Guru Nassim Taleb’s denunciation of the economic industry’s ‘intelligent nonsense’, this time for playing up the pious hype of using “exporting overcapacity” as rationale for compelling policymakers to be seek globally oriented interventions to correct current account imbalances.

A lucid example to debunk such theories comes from empirical evidence accounted for by a report in the New York Times, ``Through August, steel production was actually up slightly for the year. The decline came slowly at first, and then with a rush in November and December. By late December, output was down to 1.02 million tons a week from 2.1 million tons on Aug. 30, the American Iron and Steel Institute reported. The price of a ton of steel is also down by half since late summer.

``“We are making our steel at four mills instead of six,” said John Armstrong, a spokesman for the United States Steel Corporation, adding that two mills were recently idled and the four still operating are running at less than full capacity…

``Foreign producers no longer have an advantage over the refurbished American companies. Indeed, imports, which represent about 30 percent of all steel sales in the United States, also are hurting as customers disappear.” (underscore mine)

The point is unless the economic agents driving the supposed "overcapacity" is the government itself, the reality is that if private businesses can't get enough orders or not enough demand, then they simply will have to reduce output or suffer accrued losses, or at worst, fold up as in the account of the US Steel industry’s woes. Even when supported with indirect incentives as “exports subsidies, subsidized financing, import tariffs or currency devaluation”, if demand falls enough to render businesses unviable then the supply side will need to adjust.

It isn’t overcapacity as the problem but excess supply. Yet falling prices around the world seems to account for the market clearing adjustment process of such surpluses.

Moreover, excess capacity in a world of scarcity is a misnomer. We simply don’t have enough of anything. And that’s why a pricing system exists for goods or services. And that’s why poverty still exists. Excess capacity thrives only in a relative sense, and is mainly due to government interventions designed to prop up certain industries.

Finally, geopolitical tensions have likewise been apparently increasing, possibly aggravated by the present global financial and economic conditions. Some recent examples include:

-The mounting tensions between India and Pakistan. Following the terrorist attack in Mumbai India, which India has pinned the responsibility to Pakistan, the latter’s reaction had been a remobilization of troops along the Indian border. This raises the risk of another outbreak of military conflict from which the belligerent South Asian neighbors had suffered 3 wars over the past 70 years (1947-48, 1965 and 1971).

-Russia’s arbitrary shut down of gas supplies to Ukraine came amidst an acute financial crisis in the region. Russia supplies 25% of Europe’s energy requirement with about 80% of natural gas imports coursed through Ukraine. Given the recent military victory of Russia over Georgia, Russia’s exploits could be deemed as another attempt to reassert geopolitical control over the crisis stricken Eastern Europe (Ukraine recently secured $16.4 billion in loans from the IMF). On the other hand, given Russia’s domestic crisis, the Ukraine gas supply episode may be construed as an attempt to deflect the public’s attention towards regional concerns. Nonetheless, an acrimonious environment could again raise the specter of another war conflagration.

-The recent spate of bombing by Israel of the Hamas controlled Gaza strip and its possible escalation have also added to geopolitical jitters.

Political Motives Allude To INFLATION As Resolution To Ongoing Debt Deflation

Over $30 trillion of market capitalization have vanished last year as a result of the 2008 meltdown while write downs from financial firms have been estimated to have topped $1 trillion (IHT). With $8.6 trillion of US taxpayer money pledged to guarantee and support the financial system, possibly plus another $1 trillion for the inaugural stimulus package for incoming US President Barack Obama many have been optimistic about a quick turnaround in the US economy.

For us, it is highly unlikely that a “normalized” credit recovery would happen the same way as it did in the recent past.

In a credit cycle the relationship of lending and collateral values becomes a self-reinforcing feedback loop. In a boom phase, increases in lending prompts for higher collateral values which fosters even more lending or gains beget even more gains, until such trends tips over to the inflection point. And when debt deflation ensues, the decrease in lending prompts for a similar reduction in collateral values which further impels for a decline in lending activities, thus, losses fuel even more losses.

This means that “normalization” should extrapolate to a “resurrection” of the previous 20-1, 30-1 or 50-1 leveraging seen in the securitization –derivatives market and the over $10 trillion shadow banking system! Unfortunately, with roughly 20% of US banking now owned by the US government, we won’t see the same degree of leverage, unless the US government and other governments will assume such a role.

Yet the US government has so far absorbed or cushioned much of the losses in collateral values but has been unable to push prices higher in order to spur the release of the huge stash of bank reserves in the system (see figure 1)

Figure 1: St. Louis Fed: Spike in Adjusted Monetary Base

Ironically too, while the US government has been trying to reignite the borrowing lending or credit cycle in the banking system with a gigantic infusion of funds into the system, calls for tighter regulation in the financial system is apparently offsetting all these efforts. In short, what the right hand is doing, the left hand is taking away.

For us, what seems most likely to occur is a back to basics lending template than a sudden reinvigoration of the credit system which is hardly going to successfully reverse the debt deflation process.

In addition, today’s housing and securitization bubble bust has been transforming the American psyche to a cash building deflation psychology (a.k.a. Keynesian term: slowing monetary velocity). In other words, US savings which has been nearly zero over the recent years will be improving as households and the financial sector repair their respective balance sheets. There would have to be an immense force strong enough to reverse such psychological trend.

This brings us to the basics: the fundamental problem of the US economy is simply having too much debt. Or debt levels more than the economy can afford, with most of these unsustainable liabilities tacked into the balance sheets of the financial industry and the US households. Today’s losses have reduced some of the imbalances but have not been enough to normalize credit flows with or without government interference. And the obvious solution is to bring debt levels down to where the economy can be able to sustain them.

Unfortunately given the severity of the situation the alternative solutions to the problem we could see are: Default, Debt forgiveness and or market based deflation or inflation.

As we have noted before default isn’t likely to be a favored option because it would entail a severe geopolitical backlash:

-The most probable response to the US government debt repudiation would be an outright collapse of the US dollar standard and the US banking system as every creditor nation would possibly disown or seize the US dollar and US dollar based assets when available.

-Protectionist walls will rise everywhere which would lead to the modern day great depression and possibly a world at war.

-given the US sensitivity to import dependence, the severance of trade will create extreme shortages in the economy.

On the other hand, market based debt deflation is representative of today’s meltdown.

Market based debt deflation seems an anathema to the existence of global central bankers, or seen alternatively, for debt deflation to succeed means the loss of justification for the existence of modern central banking. Thus, central bankers will likely exhaust all possible means to prevent deflation from succeeding with every available or known tool as we have been witnessing today.

Again this leaves us with two likely alternative paths:

In an inflation dependent economy (see Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?), structural economic growth requires the sustained acceleration of money and credit expansion similar to a pyramiding structure. This means that with the private sectors hands tied, only government can take its place by massively inflating the system from which they can implement through the banking system or outside the banking system (see Welcome To The Mises Moment)

In addition, the only possible way to reverse a deepening transition to a cash building deflation mindset is to debase the currency enough to incite people to seek an alternative “store of value” (as example see The Origin of Money and Today's Mackarel and Animal Farm Currencies).

Next, while the promulgated political incentives will be targeted to (hopefully) resuscitate the economy, the tacit incentives for authorities like US Federal Chair Ben Bernanke (and other central bankers who seem stooges for the Bernanke Doctrine) could be to erode the real value of existing liabilities echoing the calls of Harvard Professor and former IMF economist Ken Rogoff (see Kenneth Rogoff: Inflate Our Debts Away!) or simply to defeat inflation by all costs to validate Bernanke’s thesis as the “qualified” expert of the great depression (plain vanilla hubris).

Finally, central bankers have this notion that once they unleash the inflation genie out of the proverbial lamp, having to use it according to their desires, they can easily control, recapture and return it.

Yet the Federal Reserve could be overestimating their powers, according to Robert Higgs at the independent.org, ``So much potential new money is now impounded in the commercial banks’ holdings of excess reserves that it is difficult to see how the Fed will be able to stem the flood once the banks begin to transform those excess reserves into normal loans and investments. If the Fed attempts to sell enough government securities to soak up the growing money stock, it will drive down the prices of Treasury bonds and hence drive up their yield, increasing the government’s cost of borrowing to finance the huge budget deficits the government will be running because of its various bailout commitments and so-called stimulus programs. This scenario holds the potential for a complete monetary crackup.”

This implies that perhaps the risks that the markets or global economies could be faced with in 2009 will be tilted towards GREATER inflation if not HYPERINFLATION.

And for those who expect such a risk transition to be in a gradual phase, we just might get flummoxed. Let us take a clue from Murray Rothbard on 1923 Weimar Germany’s experience in his Mystery of Banking,

``When expectations tip decisively over from deflationary, or steady, to inflationary, the economy enters a danger zone. The crucial question is how the government and its monetary authorities are going to react to the new situation. When prices are going up faster than the money supply, the people begin to experience a severe shortage of money, for they now face a shortage of cash balances relative to the much higher price levels. Total cash balances are no longer sufficient to carry transactions at the higher price. The people will then clamor for the government to issue more money to catch up to the higher price. If the government tightens its own belt and stops printing (or otherwise creating) new money, then inflationary expectations will eventually be reversed, and prices will fall once more—thus relieving the money shortage by lowering prices. But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races. Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,” doing something like tripling every hour. Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and Phase III’s runaway psychology is as follows: “The value of money is disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it matters not what, so long as it isn’t money.” A frantic rush ensues to get rid of money at all costs and to buy anything else. In Germany, this was called a “flight into real values.” The demand for money falls precipitously almost to zero, and prices skyrocket upward virtually to infinity. The money collapses in a wild “crack-up boom.” (bold highlight mine, italics-Rothbard)

When governments decide that the risks to the real economy would require a dramatic reduction of debt levels then they may resort to massive devaluation which independently may lead to a currency war, hyperinflation, severance of the dollar links or dollar pegs, and a disorderly unraveling of the US dollar standard.

However, if global central bankers decide to resolve this problem collectively they may opt for “debt forgiveness” which may entail a reconfiguration of the world’s monetary architecture similar to one floated in yesterday’s Wall Street Journal Editorial over the seeming success of the Euro as a model, ``the lessons point to the eventual need for a single global currency. That may be a political leap too far. But the world could still harness the benefits of exchange-rate stability if its political and economic leaders began to discuss how better to coordinate monetary policy.” Not that we support such theme but our intention is to depict of the growing recognition of the cracks in the present monetary system by the mainstream.

Nonetheless, any new monetary architecture will effectively translate to a diminished role of the US dollar as the world’s currency reserve or the world’s economic and financial hegemon. So 2009 could be the advent for a new world order.