Gary North on Irving Fisher: The Most Influential Economic Crank in American history

Austrian economist Gary North on a smackdown of the late Irving Fisher. (hat tip Bob Wenzel) 

Fisher was the most influential economic crank in American history. Fisher offered a simple formula that supposedly enables economists to understand the complexities of monetary policy and its effects on the price level: MV=PT. It relies on an intellectual construct, namely, the price level. This must be created by statisticians and economists. The formula does not explain cause-and-effect in terms of the transmission and spread of newly created money throughout the economy. It is totally an aggregate concept. It ignores individuals who make decisions: in government, central banks, commercial banks, and specific markets.

Ludwig von Mises' theory of money begins with real central banks, real borrowers, and the spread of fiat money over time: none of which is considered by Fisher or Friedman.

Fisher proved in 1929 that he was the most highly educated economic fool in the world. He went public with two predictions.

"There may be a recession in stock prices, but not anything in the nature of a crash." (i>New York Times, Sept. 5, 1929)

"Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months." (Oct. 17, 1929)

http://www.gold-eagle.com/editorials_01/seymour062001.html

Then, over the next four years, he lost his own personal fortune. He was so poor in 1933 that Yale University had to subsidize housing for him. Yet this consummate fool, whose economic theories not only led to a catastrophic personal error, but which to a great extent were responsible for the original monetary policies of the Federal Reserve, which it pursued in the late 1920s, is now heralded as some kind of economic genius. Friedman regarded him as "the greatest economist the United States has ever produced." (Money Mischief, p. 37).

Fisher was a crank, and Mises exposed him as a crank within a year of the publication of Fisher's 1911 book. If you want to get an idea of how different their theories are, read Mark Thornton's article. Fisher believed that we can safely trust the government or its central bank to formulate monetary policy. He opposed the gold coin standard, because he thought it is inefficient. That was also true of Friedman. Neither of them ever understood that the free market is capable of providing a sufficient quantity of money, by means of gold mining, for a market economy. Supply and demand for goods and services are regulated by means of a private currency system that itself is created by market processes. Neither Fisher nor Friedman ever believed this. They both believed that the government must intervene in order to create a reliable monetary system, so that there can be economic growth, market clearing processes, and individual liberty. They both believed in the wisdom and power of the state with respect to the central commodity in an economy, namely, the money supply.

Ironically Irving Fisher has been regarded as the “greatest economist of the last century” by some.

Nonetheless, I find Mr. Fisher’s sequential description of debt deflation as useful

Mr. North also points out that Mr. Fisher was also a eugenics crank

Read the rest here.

Philippine Economy’s Achilles Heels: Shopping Mall Bubble (Redux)

Early December, my daughter went with her cousins to watch a movie at one of the long established popular mall. I went to fetch my daughter after. And as we exited the mall, my wife’s relative made a striking remark, “This is strange. It’s December. But the crowd seems distinctly sparse compared to last year.”

Such observation doesn’t seem to meld with the overall atmosphere which is supposed to showcase an economic boom. Thus my initial intuitive response was to ignore this, thinking that perhaps this had been merely been a mall and time specific quirk.

And given the holiday ambiance, I didn’t have the motivation to pursue further research on this fresh micro perspective. Yet somehow, her piquant observation stuck into my mind: has there been a shopping mall bubble in the Philippines?

The perspective of the shopping mall bubble got rekindled and reinforced when I came across an article which narrated of the demolishment and of the impending deconstruction of some shopping malls in the US.

It dawned on me that the Philippines could be faced with a real risk of a shopping mall bubble bust. So I delved further.

Shopping Malls have not just been a way of life for the Philippines.

Instead, the Philippines have become the shopping mall mecca of the world, hosting 9 of the world’s largest 38 malls, according to Wikipedia.org[1]. The Philippines essentially beat the US and China or any developed economy for that matter.

Moreover, the Philippine international marquee malls are mostly located in the Metro Manila area. To consider, these 7 Metro Manila establishments are collectively larger than the combined 8 biggest malls in the US, considering that on a per capita basis[2], the US has $48,112 (World Bank 2011) or $48,328 (IMF 2011) which dwarfs the Philippines at $4,1119 (World Bank 2011) or $4,080 (IMF 2011).

And we are just talking of the largest malls, which are manifestations of the broader picture/pathology: a shopping mall bubble. There are countless of smaller scale malls which compete for the same peso from the Filipino consumer.

Aside from the publicly listed SM and Ayala, other competitors[3] are publicly listed Robinsons, Gaisano, Megaworld Lifestyle, Walter Mart Malls, Ortigas Malls, Starmalls, Greenfield Development, the NCCC Mall and many more

In short, while the public has been mesmerized by financial and economic growth prospects from a supposed ‘consumption economy’, nobody seems to even question the basic economic premises: How can a consumption based economy be sustained?

Everybody has been made hardwired or brainwashed to believe that consumption has been an incontrovertible ‘given’ or a fact. Nobody dares question the limits of the Philippine consumer.

This reminds me of the logical fallacy of the proof of assertion[4] embodied by Vladmir Lenin’s famous quote “A Lie told often enough becomes the truth”

And the behavioral reason why people readily embrace myths is the intuition to seek certainty via ‘cognitive ease’ or ‘coherence’

As Nobel Prize winner Daniel Kahneman explains[5],

An unbiased appreciation of uncertainty is a cornerstone of rationality-but it is not what people and organizations want. Extreme uncertainty is paralyzing under dangerous circumstances, and the admission that one is merely guessing is especially unacceptable when the stakes are high. Acting on pretended knowledge is often the preferred solution.

Thus political agents and their academic and institutional accomplices has mastered on how to indoctrinate society via plausibly coherent but false theories which essentially feeds on the bubble mentality.

But basic economics suggests that the rate of Shopping Mall boom relative to consumer spending or demand seems unsustainable.

ON the demand side, based on the consumer spending trend chart from Tradingeconomics.com[6] (sourced from National Statistics Coordination Board) from 1998 to early 2012, the average growth rate has been about plus or minus 6%.

ON the supply side, which is guesswork on my part—based from past growth rates, estimates on future growth rates and capex announcements of some the largest malls, perhaps we can deduce that the Philippine shopping mall industry operate on a baseline rate of 10%.

In 2012, SM Malls in the Philippines expanded by 10% according to SM Investment’s 3^rd Quarter media and analysts briefing presentation[7] (based on Gross Floor Area).

Yes, SM [PSE: SM] has exposure to China which we exclude from this analysis.

In 2010, in a speech[8] by Teresita Sy-Coson, eldest child of magnate and SM founder Henry Sy Sr., Ms. Coson noted that SM malls have grown from 23 in 2005 to 37 in 2010 or an average growth rate of 12%.

In addition, SM Investment’s reported capex which will fund shopping mall and other property projects has been slated to increase[9] by 16% to Php 65 billion in 2013 from Php 56 billion in 2012.

So the SM group will likely expand their shopping mall business at the baseline rate of at least 10%.

On the other hand, Ayala Land [PSE:ALI] will like raise capex to SM levels.

Ayala has reportedly been targeting a capex of P70 billion in 2013 from the original target of P37 billion due to “unbudgeted property acquisitions”, according to the Manila Standard[10]. Of the Php 34.9 billion capex for 2012, 11% has been allotted for shopping malls.

Ayala’s “unbudgeted property acquisitions” reveals of the current accelerated pace of snapping or bidding up of land areas to increase inventory for prospective development. Property developers seem to be in a frenzied pace of momentum land acquisition.

Robinson’s Land Corporation [PSE: RLC] has also reported an increase shopping malls by 11%, that’s according to their analyst briefing last August 15 2012[11]. The planned mall expansion will translate to over a million of sqm of Gross Leasable Area (GLA) [see right window]. This has been backed by a reported Php 20 billion in capex[12] over two years, which does not cover the $1 billion gaming complex recently concluded partnership with Japanese gaming tycoon Kazuo Okada. 

The bottom line is that from the supply side perspective, major malls, as benchmark for the industry’s growth, seem to have set the 10% level as the baseline growth for the retail shopping mall industry.

If the rate of supply grows faster than the rate of demand then eventually we will have an oversupply, Economics 101. Applied to the above, theoretically, if consumer spending demand grows at a sustained rate of 6% per year, while supply swells at a constant 10% over the same period, then, whether you like it or not, there is bound to be an oversupply and the consequential undesirable effects that go along with it.

And at the rate of 6% growth, Filipino consumers would need to nearly double consumption in the hope to fill in such a chasm. This means we should expect a miracle in productivity growth in the domestic real economy and in the global economy (to increase the rate of remittances from our OFWs). This may well be a delusion considering that this government, like all the rest, seeks every opportunity to tax away productive opportunities.

The other means is to resort to the depletion or of the running down of savings rate, and or by massively resorting to the use of credit, which represents the frontloading of consumption at the expense of the future.

Of course, foreigners may be lured to compliment spending, but this will still remain small given current political environment.

As I recently posted on my blog[13], (italics original)

The current shopping mall boom will not only depend on a sustained low interest rate environment but will likewise depend on the greater rate of growth of income—via economic output from both formal and informal economy and from remittance transfers—relative to rate of growth of supply of malls. Debt will temporary augment spending, but has its limits.

Once supply of malls grows faster than the consumer’s capacity to spend (income and debt), then trouble lies ahead.

I don’t know yet how much of the banking industry’s loan portfolio are exposed to these malls. But given that the Philippine retail industry from which the shopping malls are categorized, accounts for approximately 15% of the domestic economy and 33% of the service sector and employs some 5.25 million people, representing 18% of the Philippines' workforce (according to Wikipedia.org), there is a possibility of significant exposure.

This also implies that shopping malls will be faced with stiff competition among themselves. While this should be a good thing since competition should mean lower rental prices and provide more quality services, unfortunately the policy induced boom has clouded the effects of competition—giving the incentive for both consumer and investors to jump on the debt bandwagon which magnifies on such errors.

It’s one thing to have bankruptcies as a result of failing to satisfy the consumers via competition, and it’s another thing when the public has been enticed to a cluster of business errors (malinvestments) which accrue from price signaling distortion brought upon by manipulated policy rates and from other forms of policy interventions.

Once the tipping point has been reached where an oversupply becomes apparent, and where markets begin to awaken to such economic reality, then we are likely to see an increase in bankruptcies at the margin. Smaller malls are likely to suffer first.

If such insolvencies are funded merely be cash flows from retained earnings or from equity, or from bond markets then this won’t be much of a problem because the impact would likely remain isolated. Those who will suffer the losses would be the shareholders of the malls or bondholder-non bank creditors.

However, it’s a vastly different story when these projects are bankrolled by debt from the banking system as repercussion to artificially low interest rate regime, and or, if bonds used to finance shopping mall expansions have used as collateral to acquire related or non-related loans, and or, if such liabilities have been acquired or held by banks in their balance sheets.

The likely consequences will be a contagion via an increase in the number of foreclosures, a tightening of lending standards, calling in of loans, negative feedback loop via sharp downside adjustments in prices of equities and collateral values and higher interests rates or a chain link of effects from a bursting bubble as accurately identified by the late economist Irving Fisher as debt deflation[14] (italics original)

(1) Debt liquidation leads to distress setting and to

(2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes

(3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be

(4) A still greater fall in the net worths of business, precipitating bankruptcies and

(5) A like fall in profits, which in a " capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make

(6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to

(7) Pessimism and loss of confidence, which in turn lead to

(8) Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

And such ensuing bubble bust will likely hit the banks, malls and the property hardest, but the negative effects will spillover to consumer spending too, aside from the business channels, the transmission mechanism will be felt through labor via rising unemployment, falling wages and restrained access to credit.

However, instead of a swelling of the US dollar, as noted by Prof Fisher, we will likely encounter capital flight and a meltdown of the local currency, the Peso, ala the 1997 crisis.

Again, all these will depend on the degree of leverage by the industry, and or, of their exposure to the banking system.

Finally, shopping malls exist to serve the consumer, and thus, are subject to the market discipline of profits and losses.

This also implies that programs undertaken by malls to draw in crowd, signifies as means to an end—serving the consumer through sales of goods and services—where the social benefits of ‘assembly’ or ‘gathering’ are ancillary.

No shopping malls exist to provide free lunches unless these are subsidized from other more profitable lines of other businesses by the same company, or as redistribution from social policies via the taxpayer funding.

Let me be clear: This is NOT to say that the current inflation of the shopping mall bubble will extrapolate to a BUST tomorrow, perhaps not in 2013 yet.

Rather this is to say that IF the current trend (or growth rate) of the industry persists without substantial improvements in the demand side via real economic growth—and not statistical growth from government spending or zero bound rates or credit expansion, then economic imbalances will continue to mount or worsen which essentially increases the risk of a bubble bust sometime ahead.

Prudent investing means that we should scrutinize at potential risks instead of swallowing mainstream disinformation hook, line and sinker.

I end this article with a poignant warning from French social psychologist, sociologist and author[15] Gustave Le Bon on paying heed to the wisdom of the Crowd[16] 

The masses have never thirsted after truth. They turn aside from evidence that is not to their taste, preferring to deify error, if error seduce them. Whoever can supply them with illusions is easily their master; whoever attempts to destroy their illusions is always their victim.

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[1] Wikipedia.org List of largest shopping malls in the world

[2] Wikipedia.org List of countries by GDP (PPP) per capita

[3] Wikipedia.org List of shopping malls in the Philippines

[4] Wikepedia.org Proof by assertion

[5] Daniel Kahneman Thinking, Fast and Slow Farrar Straus and Giroux p 263

[6] Tradingeconomics.com PHILIPPINES - NATIONAL STATISTICS

[7] SM Investment Corporation 3^rd Quarter Media and Analyst Briefing Presentation

[8] Teresita Sy-Coson Keynote Address Philippine Stock Exchange 06 May 2010

[9] Manila Standard Today SM Group allots P65b in 2013, November 9, 2012

[10] Manila Standard Today Ayala Land increases capex target to P70b November 12, 2012

[11] Robinson’s Land Corporation QUARTERLY INVESTORS’ BRIEFING August 15, 2012

[12] Philstar.com Robinsons Land sets P20-billion capex for 2 years, January 7, 2013

[13] See A Philippine Shopping Mall Bubble? January 7, 2013

[14] Irving Fisher THE DEBT-DEFLATION THEORY OF GREAT DEPRESSIONS St. Louis Federal Reserve

[15] Wikipedia.org Gustave Le Bon

[16] Gustave Le Bon The Crowd: A Study of the Popular Mind, Google Books Page 53

Does High Debt And Falling Credit Lead To Deflation?

``The chief source of the existing inflationary bias is the general belief that deflation, the opposite of inflation, is so much more to be feared that, in order to keep on the safe side, a persistent error in the direction of inflation is preferable. But, as we do not know how to keep prices completely stable and can achieve stability only by correcting any small movement in either direction, the determination to avoid deflation at any cost must result in cumulative inflation." Friedrich A. Hayek

Many say that huge debt loads carried by the world today would lead to deflation.

While there is some truth to this, the answer isn’t straightforward.

This mainstream view is best represented by economist Irving Fisher’s description of the events of the Great Depression, which we covered in 2008[1], ``Debt liquidation leads to distress selling and to Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes A fall in the level of prices, in other words, a swelling of the dollar.”

This simplistic narrative makes an impression that all debts are similar. Yet, this does not take into consideration the many other factors that hold sway to such an outcome, such as the monetary standard that the Great Depression operated on, regulations that limited interstate branch banking (McFadden Act[2]) which prevented banks from diversifying portfolios, the legal tender laws from central banking which prohibited the US banks from issuing their own notes[3], ‘bank holidays’ which denied depositors access to funding which equally increased uncertainty[4], and importantly the boom bust cycle or the clusters of malinvestment created by earlier monetary policies to uphold certain political interests.

According to Murray N. Rothbard[5], (bold emphasis mine)

``But a more indirect and ultimately more important motivation for Benjamin Strong's inflationary credit policies in the 1920s was his view that it was vitally important to "help England," even at American expense. Thus, in the spring of 1928, his assistant noted Strong's displeasure at the American public's outcry against the "speculative excesses" of the stock market. The public didn't realize, Strong thought, that "we were now paying the penalty for the decision which was reached early in 1924 to help the rest of the world back to a sound financial and monetary basis." An unexceptionable statement, provided that we clear up some euphemisms. For the "decision" was taken by Strong in camera, without the knowledge or participation of the American people; the decision was to inflate money and credit, and it was done not to help the "rest of the world" but to help sustain Britain's unsound and inflationary policies.”

So such storyline, which looks intellectually formalistic, sells well to the mainstream. What seems plausible is accepted without question or examining its basis.

But of course not all debts the same.

There are debts that are funded from savings and there are debts financed from ‘money from thin air’. The distinction is important because this defines the conditions that affirm or debunk the dynamics of Fisher’s debt deflation.

Dr. Frank Shostak[6] explains, ``when Joe lends his $100 to Bob via the bank, this means that Joe (via the intermediary) lends his money to Bob. On the maturity date, Bob transfers the money back to the bank and the bank in turn (after charging a fee) transfers the $100 plus interest to Joe. Observe that here money never disappears or is created; the original $100 is paid back to Joe.

"A fall in normal credit (i.e., credit that has an original lender) doesn't alter the money supply and hence has nothing to do with deflation."

``Things are, however, quite different when Joe keeps the $100 in the bank warehouse or demand deposit. Remember that by keeping the money in a demand deposit, Joe is ready to employ it at any time he likes.

``Now, if the bank lends Bob $50 by taking it from Joe's demand deposit, the bank will have created $50 of unbacked credit, out of "thin air." By lending $50 to Bob, the bank creates $50 of extra demand deposits. Thus, there is now $150 in demand deposits that are backed by only $100.

``So in this sense, the lending here is without a lender. The intermediary, i.e., the bank, has created a mirage transaction without any proper lender. On the maturity date, when Bob repays the money to the bank, that money disappears. The money supply falls back to $100, dropping by 33%.”

Robert Blumen[7] argues from the gold standard perspective,

``Suppose that on an isolated island the total money supply consisted for 1000 oz of gold and there are no fractional reserve banks. Now suppose that people lend either other various sums of money. Total debt could expand if the same money were lent and re-lent by the borrower more than once (which happens with a lot of securitized financial instruments). Suppose that total nominal debt reached 2000oz of gold, twice the money supply. Now if all of this debt defaulted (not realistic but for the sake of discussion), would there be any general deflation? No, because the money supply remained the same.”

In short, bank credit deflation as described by Mr. Fisher is conditional to debts funded by fractional banking system which causes contraction in the money supply.

According to Joseph Salerno[8],

``During financial crises, bank runs caused many banks to fail completely and their notes and deposits to be revealed for what they essentially were: worthless titles to nonexistent property. In the case of other banks, the threat that their depositors would demand cash payment en bloc was sufficient reason to induce them to reduce their lending operations and build up their ratio of reserves to note and deposit liabilities in order to stave off failure. These two factors together resulted in a large contraction of the money supply and, given a constant demand for money, a concomitant increase in the value of money.”

Yet if large debts presumptively results to a reduction in demand or a slack in credit takeup which leads to ‘deflation’, as linearly thought by the mainstream, inflation would be an imaginary event or that we would be seeing a fall in prices everywhere (see figure 8).

Figure 8 St. Louis Fed and TradingEconomics.com: Fall in credit and inflation

The upper window in figure 8 is a favourite chart by perma bears who love to spook themselves with the deflation phantom. It shows of the falling demand for credit, which according to them should be ‘deflationary’.

Yet since 2008, commercial and industrial loans have serially declined, yet inflation has been rising, after a short “foray” in the deflation territory in middle of 2009 until the end of the year.

So the deflation theory does not match real events. The reason for this is that there are many other factors, as government spending, QE, zero interest rates, steep yield curve, globalization and etc... that influences these financial, economic and political conditions.

But I see more problems for the perma bears. Commercial and industrial loans at all banks seem to cease declining and could be bottoming out. And if I am right, where the response to the yield curve will prompt for a material improvement in the health of the credit conditions by the end of the year, this chart will be excluded in the presentation for deflation.

Last word, today’s markets have been tidal driven, and there is little substance to argue for a micro based ‘decoupling’. Although inflationism has relative effects, global markets generally move in synch with the actions of the US markets. But this can be differentiated by the degree of gains or losses.

As such, the only way for the Philippine or Asian markets to outperform is for the US markets to trade sideways or head higher. Asian markets can’t and won’t defy a US crash. Nevertheless, we remain bullish with Asian markets for the simple reason that we don’t see a crash in the US markets or a redux of 2008.

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[1] See Demystifying the US Dollar’s Vitality

[2] Wikipedia.org, McFadden Act

[3] Wikipedia.org, Federal Reserve Note

[4] Wikipedia.org, Emergency Banking Act

[5] Rothbard Murray N., Reliving the Crash of '29, Mises.org

[6] Shostak, Frank, Does a Fall in Credit Lead to Deflation? Mises.org

[7] Blumen, Robert Massive Debt Deflation in Store? Mises Blog

[8] Salerno Joseph T. An Austrian Taxonomy of Deflation

Demystifying the US Dollar’s Vitality

``The Achilles Heel of the United States is the dollar. The reserve status of the US dollar is absolutely critical to the health of the US. If the dollar begins to lose it's reserve status, the US economy will be in shambles.”-Richard Russell

Some have found the recent rise of the US dollar as mystifying while the others have found the surging US dollar as a reason to gloat.

While there are many ways to skin a cat, in the same way there are many ways to interpret the US dollar’s vigorous advance, see figure 3.

Figure 3: stockcharts.com: US Dollar’s Rise Coincided with Market Breakdowns

From our end, we read the action of the US dollar index (geometric weighted average of 6 foreign currencies of major trading partners of the US) by looking at its relationship across different asset markets.

And as we can see, the dramatic surge of the US dollar index coincides with an astounding symmetry-the collapse of the oil market (lowest pane) and the equivalent breakdown of critical support levels (vertical arrows) of stock markets of the US (signified by the S&P 500- pane below center) and Emerging Markets (pane below S&P).

And market actions have fantastically been too powerfully synchronized for us to ignore its interconnectedness or the apparent simultaneous cross market activities.

While we can discuss other possible influence factors such as the shrinking trade deficits which may have contributed to a narrowing current account deficit or an improvement in US terms of trade or the ratio of export prices over import prices, the fact that the US dollar behaved in a spectacular fashion can’t be interpreted as a sudden market epiphany over some unlikely radical improvement in trade fundamentals.

What we understand was that by mid July, cracks over the financial markets began to surface with the US Treasury publicly contemplating to inject funds to support both Fannie Mae and Freddie Mac. From then, the deterioration in the financial markets accelerated which inversely prompted the skyward ascent of the US dollar. Fannie and Freddie were ultimately taken over by the US government in September.

DEBT DEFLATION Dynamics In Progress

So what could be the forces behind such phenomenon?

``Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Hoarding and slowing down still more the velocity of circulation.

``The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”

This according to Irving Fisher is what is known as the DEBT DEFLATION theory dynamics. As you would notice the chain of events leading to the current market meltdown and the precipitate rise in the US dollar have closely shadowed Mr. Fisher’s definition.

How?

Figure 4: Bank of International Settlements: CDS and Foreign Exchange Derivatives Market

One, a significant market of the structured finance-shadow banking system (estimated at $10 trillion) and derivatives ($596 trillion, Credit Default Swap $33.6 trillion down from nearly $60 trillion-left pane- see figure 4) have mostly been denominated in US dollars (foreign currency derivatives also mostly US dollar denominated-right pane), thus deleveraging or debt deflation means the closing and settlement of positions and payment in US dollars.

This also implies whether the counterparty is from Europe or from Asians settlement of such contract means payment in US dollars. Thus, the sudden surge in demand for US dollars can be attributed to the ongoing debt deflation-deleveraging process.

Figure 5: Investment Company Institute: World Mutual Fund

Two, cross currency arbitrage or 'carry trades' have also significant US dollar denominated based exposures.

For instance US mutual funds in 2007 totaled US $12 trillion (see Figure 5 courtesy of ICI) with 14% of the total allocated to International Stock funds or $1.68 trillion.

We may not know exactly how much of these funds flows were borrowed in order to buy into international stock funds, but the idea is, once the margin call came, highly levered funds were compelled to liquidate their positions in order to repay back their loans in US dollars.

Isn't it ironic that the epicenter of the present crisis emanated from the US and yet the debt deflation dynamics prompted a gravitational pull to the US dollar? Had these been something resembling like an Asian crisis then such dynamics would have been understandable.

The US Dollar’s Hegemon and Threats To Its Dominion

Figure 6: Bill Gross: Going Nuclear

Lastly, we have always described the architectural platform of the US dollar standard as pillared upon the cartelized system of US banking network which extends to a syndicate of peripheral banks abroad or global central banks.

PIMCO’s chief Bill Gross in his latest outlook wrote a good analogy of this as a function of nuclear energy see figure 6.

From Mr. Bill Gross (all emphasis mine), ``Uranium-238 has something like 92 electrons circling its nucleus…And, importantly, uranium-238 is metaphorically quite similar to the global financial system of the past half century. At its nucleus was the overnight Fed Funds rate which, when priced low enough, led to an ever-increasing circle of productive financial electrons. The overnight policy rate led to cheap commercial paper borrowing and then leapfrogged outward and across the oceans to become LIBOR. In turn, government notes and bonds as well as markets for corporate obligations were created, leading to their use as collateral (repos), which fostered additional credit and additional growth. The electrons morphed into productive financial futures and derivatives of all kinds benefitting all of the asset classes at the outer edge of the #238 atom – stocks, high yield bonds, private equity, even homes and commodities despite their being tangible as opposed to financial assets.”

``This was how the scientists, the financial wizards with Mensa IQs, visualized the financial system a few years ago: leverageable assets held together by a central bank policy rate at its nucleus with institutional participants playing by the rules of conservative self interest and moderate government regulation. Out of it came exceptionally high returns on assets with minimal risk – the highest returns occurring with the most levered electrons farthest from the nucleus.”

Since financial flows appear to have revolved around the foundations of the US banking system with its core at the US Federal reserve, the recent logjam in US banking sector caused a ripple effect to the peripherals via shortages of the US dollar, a liquidity crunch and a subsequent scramble for US dollars which triggered several crisis among EM countries whose balance sheets have been vulnerable (excessive exposure to foreign denominated debt or currency risks, outsized current account deficits relative to GDP, excessive short term loans or highly levered domestic balance sheets).

Thus, the paucity of US dollars has compelled some nations to bypass the banking system and utilize barter (see Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?) such as Thailand and Iran over rice and oil. Whereas Russia and China have announced plans to use national currencies for trade similar to the recently established Brazil-Argentina (Local Currency System).

The recent crisis encountered by South Korea (heavily exposed to short term foreign denominated debt) and Russia (corporate sector heavily exposed to foreign debt) seem to be prominent examples of the US dollar squeeze.

Figure 7: finance.yahoo.com: South Korea Won-US dollar

Understanding the present predicament, the US Federal Reserve quickly extended its currency Swap lines to some emerging nations as South Korea, which has so far resulted to some easing of strains in the Korean Won, see figure 7. However, we are yet uncertain about its longer term effects although it is likely that access to the US dollar should demonstrably reduce the liquidity pressures.

The important point to recognize is that some nations have began to acknowledge the risks of total dependence on the US dollar as the world’s reserve currency and/or its banking system. A furtherance of the crisis with the US as epicenter can jeopardize global trading and finance. Hence, some countries have devised means of exchange around the present system or have been mulling over some alternative platform.

Such developments are hardly positive contributory factors that would buttress the value of the US dollar over the long term especially as the US government has been throwing much weight of its taxpayer capacity to resuscitate and bolster the present system.

Mr. Ronald Solberg, vice chairman and lead portfolio manager of Armored Wolf, in an article at Asia Times online articulates more on this (emphasis mine),

``According to Goldman Sachs estimates, the US Treasury faces an unprecedented financing need in fiscal year 2009.2 Excluding funding requirements under the Supplemental Financing Program (SFP), they estimate 2009 FY issuance at $2 trillion compared to last year’s $1.12 trillion, which itself was already outsized. This prospective amount is driven by an estimated budget deficit reaching $850 billion, funding TARP purchases of up to $500 billion and the rollover of maturing debt equal to $561 billion.

``On top of these needs, it would not be unreasonable to expect additional SFP funding requirements of $500 billion, the amount already issued to date in FY 2008 used to recapitalize the Fed’s balance sheet. The magnitude of such funding requirements will test the operational efficacy of the Treasury, requiring increased auction size, frequency and expanding maturity buckets on debt issuance, and will likely extend through FY 2009 and into FY 2010, prior to these pressures abating. Perhaps even more ominously, issue size will severely test market demand for such an avalanche of debt.”

Conclusion

All these demonstrate the two basic factors on why US dollar has recently surged.

One, this reflects the US dollar’s principal function as international currency reserve and importantly,

Second, most of the leveraged assets markets had been denominated in US dollars. And in the debt deflation dynamics as defined by Economist Irving Fisher, ``Debt liquidation leads to distress selling and to Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes A fall in the level of prices, in other words, a swelling of the dollar.”

Finally, with US government printing up a colossal amount of money within its system (yes that includes all swap lines extended to other countries as de facto central bank of the world), financing issues will be tested based on the (supply) issuance of its debt instruments and the (demand) market’s willingness to fund the present slew of government programs from internal sources (US taxpayers and corresponding rise in savings) and or from external sources (global central banks amidst normalizing current account imbalances).

We don’t buy the idea that US debt deflation will spur hyperinflation abroad which could further bolster the US dollar. Monetary inflation doesn’t necessarily require a private banking system to extend credit and inflate, because the government in itself as a public institution can inflate the system through its web of bureaucracy.

Zimbabwe is an example. Its banking system seems dysfunctional: savers don’t trust banks, the government has been using such institutions to pay for government employee salaries yet have suffered from government takeovers, while some of the banks have engaged in forex accumulation than operate normally.

Basically, Zimbabwe’s inflationary mechanism is done via the expansion of its bureaucracy to a leviathan and the attendant acceleration of the printing press operations.