How Political Tea Leaves Will Shape The Investment Landscape

``One key attribute that gives money value is scarcity. If something that is used as money becomes too plentiful, it loses value. That is how inflation and hyperinflation happens. Giving a central bank the power to create fiat money out of thin air creates the tremendous risk of eventual hyperinflation. Most of the founding fathers did not want a central bank. Having just experienced the hyperinflation of the Continental dollar, they understood the power and the temptations inherent in that type of system. It gives one entity far too much power to control and destabilize the economy.” Dr. Ron Paul, The Neo-Alchemy of the Federal Reserve

Never has ascertaining the probabilities of the rapidly evolving highly fluid macro environment been as critical today in shaping one’s portfolio or even in anticipation of the how to allocate resources in the coming business environment.

Why? Because future revenue streams, productivity levels, earnings and all other micro metrics, aside from market or business cycles, will all depend on the outcome from the present set of policy choices.

While the investment field shudders at the thought mentioning such ominous phrase; ``it’s different this time”, well, it hard to say it but it does seem different this time.

As we noted in last week’s Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?,

``Even as global governments have been rapidly anteing up on claims to taxpayers’ future income stream by a concoction of “inflationary” actions such as lender of last resort, market maker of last resort, guarantor of last resort, investor of last resort, spender of last resort and ultimately buyer of last resort, a credit driven US economic recovery isn’t likely to happen; not when governments are tightening supervision or regulatory framework, not when banks are hoarding money to recapitalize, not when borrowers are tightening belts and suffering from capital losses on declining assets and certainly not when income is shrinking as unemployment and business bankruptcies rise on falling profits, and most importantly not when the collective psychology has been transitioning from one of overconfidence to one of morbid risk aversion.

``Thus the best case scenario for the credit driven “economic growth” will be a back to basics template-the traditional mechanisms of collateralized backed lending based on borrower’s capacity to pay. But these won’t be enough to reignite the Moneyness of credit. Not even under the US government’s directive.”

We found our assertions pleasantly echoed by the world’s Bond King in his latest outlook; from PIMCO’s Mr. William Gross (who confirms our cognitive biases-emphasis ours)

``My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.”

So as global governments take up the shoes from the private sector, the outcomes as reflected by market conditions and on the economic landscape will obviously be different, see Figure 1.

Figure 1 Gavekal: Portfolio Distribution In Different Environments

From Gavekal’s Brave New World is a simplified template where we see basically four economic environments; from which a long term theme, at the moment, has been struggling to emerge, albeit under a current, possibly temporary, dominant theme which are being battled out by government forces.

But nonetheless, we can identify whence our recent past, posit on the present environment and identify possible outcomes.

From the privilege of hindsight the most obvious is the inflationary boom, which was characterized by a credit inspired boom in almost every asset classes across the world, but in contrast to the template, this includes a boom in government bonds!

Today we are seeing the opposite- a market driven deflationary bust, where the unwinding debt burden has prompted for a reversal of the former order or an across the board selling except for US treasuries and the US dollar. Thus the characteristics as described in the template are presently still being perfected.

Yet, given the observable actions of governments, one may infer that the current deflationary bust phase is being engaged in with a tremendous surge of inflationary forces (bailouts, guarantees, lending, capital provision, etc.) in the hope to restore the former order.

And this has been the source of the fierce debates encapsulating the investment industry; will today’s deflationary bust outrun inflationary forces and transit into a modern day global depression? Will the unintended consequences of the concerted inflationary injections by global central banks result to a US dollar crisis or inflationary bust or hyperinflationary depression? Or will Goldilocks be resurrected with government stilts?

Deflation and Endowment Effects

The basic problem is the house of cards built upon by an unsustainable credit structure from which the world’s economy has been anchored upon, see figure 2.

Figure 2: courtesy of contraryinvestor.com: Unsustainable Credit Market

As we previously noted there are basically two ways to preside over such predicament. One is to allow market forces to reduce debt to levels where the afflicted economy could pay these off. Two, is to reduce the real value of debt via inflation. Of course, there is always the third way: the default option.

But since we believe that the US government and the other debt laden economies are likely to avoid the third option, as their taxpayers have been aggressively absorbing the losses, these relegate us to the first two options.

Deflation proponents (mostly Keynesians) argue that the central bank measures are proving to be impotent when dealing with the tsunami of debt because losses have simply been staggering to drain “capital” than can be replaced and which has similarly devastated the credit system beyond immediate repair. Hence, the global central bank actions are unlikely to rekindle a credit driven (inflationary boom) economic recovery.

In addition, they argue that because of the credit prompted seizure in the banking system its spillover effects to the real economy will lead to a much further decline in aggregate demand which accentuates the overcapacity in the global trade network which will further transmit deflationary forces worldwide.

Moreover, they’ve boisterously indulged in a public blame game in the context of trade balances. They accuse the current account surplus economies, who still seem reluctant to abide by their behest of absorbing declining world aggregate demand via their prescribed policies of increasing domestic consumption, of being ‘beggar thy neighbor’. Some of them have even implied that the continued thrust towards mercantilism in today’s recessionary as “Protectionism In Disguise” (PID).

This of course, according to our self-righteous omnipotent camp will lead to further deflation as excess capacity will forcibly be dumped into the markets and may result to countervailing protectionist actions.

Grim indeed.

The bizarre thing is that Keynesians have been fighting among themselves: the insiders or policymakers believe that eventually their actions will triumph, while the outsiders believe that their sanctimonious wisdoms represent as the much needed elixir to the present predicament.

Yet all of these exhibits nothing more than the cognitive bias of the “endowment effect” or placing a higher value on opinions they own than opinions that they do not.

The rest is speculation.

End Justifies The Means: The Gathering Inflation Storm?

There are two ways one can categorize all these competing analysis.

One, means to an end- (free dictionary) something that you are not interested in but that you do because it will help you to achieve something else; or applied to the recent events, the analysis that “my way has to be followed” regardless of the outcome.

Yes, the US and many European governments have practically followed nearly all Keynesian prescriptions short of outright nationalizations of the affected industries, yet NO definitive progress.

In short, we see many analysis based on the strict adherence to ideological methodologies than the actual pursuit of economic goals.

Of course, this will have to be wrapped with technical gobbledygook, such as liquidity trap, debt trap, and assorted claptraps (possibly even crab traps), to entertain and wow their audience, especially catered to those seeking easy answers or explanations to the performance of today’s market as the trajectory for the future.

Two, end justifies the means- (free dictionary) in order to achieve an important aim, it as acceptable to do something bad or the end result determines the course of action.

As we have earlier said the major alternative recourse to deal with an unsustainable debt structure is to ultimately inflate the real value of debt, which essentially shifts the burden from the debtor to the creditor.

And there have been rising incidences of voices expressing such direction:

This from Atlanta Federal Reserve President Dennis Lockhart (Wall Street Journal) ``A direct path to recovery is unlikely, as we have seen, events arise that knock us off the path to a stable credit environment…the Fed retains a number of options to help the economy.” (highlight ours)

This from former IMF Chief Economist Kenneth Rogoff whom we earlier quoted in Kenneth Rogoff: Inflate Our Debts Away!

``Modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts. Securitisation, structured finance and other innovations have so interwoven the financial system's various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed….

``Fortunately, creating inflation is not rocket science. All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20% or 30% instead of 5-6%. Indeed, fear of overshooting paralysed the Bank of Japan for a decade. But this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary.

This from a commentary entitled “Central banks need a helicopter” by Eric Lonergan a macro hedge fund manager at the Financial Times (highlight mine),

``What is lacking is a legal and institutional framework to do this. The helicopter model is right, but we don’t have any helicopters…Central banks, and not the fiscal authorities, are best placed to make these cash transfers. The government should determine a rule for the transfer. It is the government’s remit to decide if transfers should be equal, or skewed to lower income groups….The reasons for granting this authority to the central bank are clear: it requires use of the monetary base. Granting government such powers would be vulnerable to political manipulation and misuse. These are the same reasons for giving central banks independent authority over interest rates.”

Let’s go back to basics, the reason governments are inflating the system away (albeit in rapid phases) is because of the perceived risks of destabilizing debt deflation. Yet you can’t have market driven deflation process without preceding government stimulated inflation. Thereby deflation is a consequence of prior inflation. It is a function of action-reaction, cause and effect and a feedback loop- where government tries to manipulate the market and market eventually unwinds the unsustainable structure.

Our point is simple; if authorities today see the continuing defenselessness of the present economic and market conditions against deflationary forces, ultimately the only way to reduce the monstrous debt levels would be to activate the nuclear option or the Zimbabwe model.

And as repeatedly argued, the Zimbabwe model doesn’t need a functioning credit system because it can bypass the commercial system and print away its liabilities by expanding government bureaucracy explicitly designed to attain such political goal.

As Steve Hanke in the Forbes magazine wrote, ``The cause of the hyperinflation is a government that forces the Reserve Bank of Zimbabwe to print money. The government finances its spending by issuing debt that the RBZ must purchase with new Zimbabwe dollars. The bank also produces jobs, at the expense of every Zimbabwean who uses money. Between 2001 and 2007 its staff grew by 120%, from 618 to 1,360 employees, the largest increase in any central bank in the world. Still, the bank doesn't produce accurate, timely data.”

In other words, the Rogoff solution simply qualifies the ‘end justifying the means’ approach, where the ultimate goal is political -to reduce debt in order for the economy to recover eventually or over the long term for political survival, than an outright economic end. Yet because of the vagueness of such measures, there will likely be huge risks of unintended painful consequences. But nonetheless, if present measures continue to be proven futile, then path of the policy directives could likely to lead to such endgame measures-our Mises moment.

Yet, the Rogoff solution simply cuts through the long chase of the farcical rigmarole advanced by deflation proponents who use their repertoire of technical vernaculars of assorted “traps” to convey a deflation scenario. When worst comes to worst all these technical gibberish will simply evaporate.

Moreover, deflation proponents seem to forget that the Japan’s lost decade or the Great Depression from which Keynesians have modeled their paradigms had one common denominator: “isolationism”.

Japan’s debacle looks significantly political and culturally (pathological savers) induced, while the Smoot Hawley Act in the 1930s erected a firewall among nations which essentially choked off trade and capital flows and deepened the crisis into a Depression.

This clearly hasn’t been the case today, YET, see Figure 3.

Figure 3: US global: Global Central Banks Concertedly Cutting Rates

There had been nearly coordinated massive interest rate cuts this week by several key central banks; the Swedish Riksbank slashed its rates by nearly half, cutting 175 bp to 2%, followed by the Bank of England, which slashed rates by 100bp (last month it cut by 150 bp), while the ECB was the most conservative and cut of 75bp. Indonesia followed with 25 bp while New Zealand cut a record 150bp to 5% (guardian.co.uk).

And as we quoted Arthur Middleton Hughes in our Global Market Crash: Accelerating The Mises Moment!, ``the market rate of interest means different things to different segments of the structure of production.”

If the all important tie that binds the world has been forcible selling out of the debt deflation process, then as these phenomenon subsides we can expect these interest rate policies to eventually gain traction.

And it is not merely interest rates, but a panoply of distinct national fiscal and monetary policies targeted at cushioning such transmission.

Remember, even in today’s globalization framework, the integration of economies hasn’t been perfect and that is why we can see select bourses as Tunisia, Ghana, Iraq or Ecuador defying global trends, perhaps due to such leakages.

The point is there is no 100% correlation among markets and economies. And when the forcible selling (capital flow) fades, the transmission linkages will focus on other aspects as trade or remittances which have varying degrees of external connections relative to their national GDP.

Thus, considering the compounded effects of individual economies and their respective national policy actions, market or economic performances should vary significantly.

The idea that global deflation will engulf every nation seems likely a fallacy of composition if not a chimera.

Reviving Smoot-Hawley Version 2008?

Next, there is this camp agitating for a revised form of protectionism.

They accuse nations with huge current account surplus, particularly China, for nurturing trade frictions amidst a recessionary environment-by obstinately opting to sustain the present trade configuration which is heavily modeled after an export led capital intensive investment growth.

The recent surge of the US dollar against the Chinese Yuan and China’s recent policies of providing for higher rebate and removal of bank credit caps have been interpreted to as being implicitly protectionist.

The alleged risks is that given the slackening of aggregate demand, China’s export oriented growth model could pose as furthering the deflationary environment by dumping excess capacity to the world.

Echoing former accusations of currency manipulation, but in a variant form, the adamant refusal by China to reduce its export subsidies (via Currency controls etc.) at the expense of domestic consumption, is seen by critics as tantamount to fostering protectionism and thus, should require equivalent punitive sanctions.

Recessions are, as seen from the mainstream, defined as a broad based decline in economic activity, which covers falling industrial production, payroll employment, real disposable income excluding transfer payments and real business sales.

But recessions or bubble bust cycles are mainly ``a process whereby business errors brought about by past easy monetary policies are revealed and liquidated once the central bank tightens its monetary stance,” as noted by Frank Shostak.

In other words, when China gets implicitly or explicitly blamed for “currency manipulation” or for failing to adopt policies that “OUGHT TO” balance the world trade, it assumes that the US, doesn’t carry the same burden.

But what seems thoroughly missed by such critics is that the extreme ends of the current account or trade imbalances reflect the ramifications of the Paper-US dollar standard system. You can’t have sustained and or even extreme junctures of imbalances under a pure gold standard!

Besides, since the supply or issuance of currencies is solely under the jurisdiction of the monopolistic central banks, which equally manages short term interest rate policies or the amount of bank reserves required, then the entire currency market operating under the Paper money platform accounts for as pseudo-market or a manipulated market.

To quote Mises.org’s Stefan Karlsson, ``Any currency created by a central bank is bound to be manipulated. In fact, manipulating the currency is the task for which central banks were created for. If they didn't manipulate the currency, there would be no reason to have a central bank.” (underscore mine)

In addition, the fact that the US functions as the world’s reserve currency makes it the premier manipulator- for having the unmatched privilege to extend paper IOUs as payment or settlement or in exchange for goods and services.

We don’t absolve the Chinese for their policies, but perhaps, by learning from the harsh experience of its neighbors during the Asian crisis, the Chinese have opted to adopt similar mercantilist nature to protect its interest but on a declining intensity as it globalizes.

The point that Chinese authorities are considering full convertibility of the yuan, as per Finance Asia (emphasis mine), ``The Chinese authorities should raise the profile of the renminbi during the global financial turmoil and get ready for the currency’s full convertibility, according to Wu Xiaoling, deputy director with the finance and economic committee of the National People’s Congress”, or this ``Wu, who was a deputy governor of the People’s Bank of China (PBOC) until earlier this year, told a seminar in Beijing in November that the renminbi should become an international reserve currency in tandem with its full convertibility, reflecting a renewed interest in loosening control of the currency as the country becomes more deeply integrated in the world financial system. She said it was difficult to find an alternative reserve currency but added that the renminbi was ready to become an international currency to replace the dollar,” equally demonstrates the political thrust to gain superiority by becoming more integrated with the world via reducing mercantilist policies and adopting international currency standards.

But, unlike the expectations of our magic wand wielding experts, you don’t expect them to do this overnight.

Figure 4 Gavekal: China Reserves Outgrow China’s Trade Surplus & FDI

Also during the past years, China’s currency reserves didn’t account for only trade surpluses or FDI flows, but as figure 4 courtesy of Gavekal Capital shows, a significant part of these reserves could have emanated from portfolio or speculative flows even in a heavily regulated environment.

Thus, the recent surge of US dollar relative to the Yuan may not entirely be a policy choice but also representative of these outflows given the current conditions. The fact that China’s real estate has been decelerating and may have absorbed most of these speculative flows could reflect such dynamics.

Nonetheless Keynesians always focus on the aggregate demand when recessions or a busting cycle also means a contraction of aggregate supply.

Malinvestments as seen in jobs, industries or companies or likewise seen in supply or demand created by the illusory capital or “money from thin air” which would need to be cleared. Or when the excesses in demand and in supply are sufficiently reduced or eliminated, and losses are taken over by new investors funded by fresh capital, then the economy will start to recover.

Again Frank Shostak (highlight mine), ``Contrary to the Keynesian framework, recessions are not about insufficient demand. In fact Austrians maintain that people's demand is unlimited. The key in Austrian thinking is how to fund the demand. We argue that every unit of money must be earned. This in turn means that before a demand could be exercised, something must be produced. Every increase in the demand must be preceded by an increase in the production of real wealth, i.e. goods and services that are on the highest priority list of consumers (we don't believe in indifference curves).”

The point is whatever decline in aggregate demand also translates to a decline in capacity as losses squeezes these excesses out. Today’s falling prices may already reflect such oversupply-declining demand adjustments.

Said differently the calls to maintain or support “demand” by means of more government intervention aimed at propping up of institutions, which are not viable and can’t survive the market process on its own, isn’t a convincing answer. The pain from the adjustments in debt laden Western economies is also felt but to a lesser degree in Asian economies.

Likewise, imposing undue protectionist sanctions to suit the whims of such pious and all knowing experts, will likely have more unintended consequences, foster even more imbalances and or risks further deterioration of the present conditions.

Forcing China to radically reform, without dealing with the structural asymmetries from today’s fractional reserve banking US dollar standard, won’t resolve the recurring boom-bust cycles. This simply deals with the symptoms and not the cause.

Changing The Rules Of The Game By Inflation

``The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price.”-James Grant, Little logic to bond world amid current risk phobias

Inflationary or deflationary outcome will ultimately be decided politically.

If the US government decides to safeguard its currency and allow for these market adjustments to occur, then there could be a deflationary unwind. However, this isn’t going to be politically palatable.

Yet, given the extent of the recent aggressive policy maneuvers, the penchant to use up all the available arsenal by the US Federal Reserve or by the President elect Obama (e.g. to engage in the “single largest investment program”) and or their respective ideological underpinning, all these tilts the risks towards greater than expected inflation, if not hyperinflation.

For us, deflationists have been underestimating the government’s capability to destroy their currency. It doesn’t take complex mathematical equations to do so. It only takes basic universal economic laws-exponential growth of supply of money relative to goods or services.

So far, Fed Chair Ben Bernanke’s outline to deal with this ‘deflation’ problem has gradually been implemented according to his playbook. In a worst case scenario, Mr. Bernanke in his 2002 speech elaborated the nuclear option (underscore mine),

``But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation…

``Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”

Applied today, the problem is to devalue against what?

During the great depression, the US dollar devalued against gold, but today’s monetary system which has no gold for its anchor, has nothing to devalue against.

``Unlike fiscal policy, which encourages other countries to "free ride" on any US expansion, the attraction of US monetary expansion is that it will force a global response. When the United States expands its money supply, thus putting pressure on the dollar to weaken, Asia and the United Kingdom will quickly follow suit to prevent their currencies from strengthening,” wrote Peter Boone and Simon Johnson for Peterson Institute for International Economics (emphasis mine).

In other words, once the political path has been chosen, then either a global currency war ensues, where all countries will be massively printing money in a race to the bottom or the global central banks undertake a coordinated approach – a new monetary standard that would allow for such devaluation to take place by using an anchor, possibly arising from IMF’s Special Drawing Rights SDR (as suggested per George Soros), a multilateral based currency, or partial reactivation of gold’s convertibility.

However, gold is unlikely to be a priority considering that it would seriously hamper the global political leadership’s power, as it would limit or hamper government expenditures.

Moreover, perhaps we can’t have the typically known “US dollar crisis” simply because if the central banks who are major currency reserve holders decide to head for the exit doors or liquidate all at the same time or simultaneously, there won’t be any buyers, not the private sector or not the US government itself, which makes these an unlikely event.

So the most likely path will be a change in the rules of how the games are played, and this would most likely involve a rather big dose of inflation.

CDS Market/Default Risk Ranking: Philippines Maintains 12th Place, Europe Dominates Monthly Laggards

Bespoke Investment gives us a colorful snapshot of the pecking order of the cost of insuring debts of various nations, as measured by changes in Credit Default Swaps.

Based on month to month changes, according to Bespoke, ``Ireland, Austria, Greece, and the UK have seen default risk rise the most over the last month. All have risen close to or more than 100%. US default risk has risen the 8th most at 68%.”

Among the 10 worst monthly performers, notice that except for the US which ranks 8^th, European countries have dominated the field.

While we may not have the sufficient explanation on why the markets have priced in serious jitters to many European sovereign debts, we suspect that this has been related to

1) credit risks concerns via banking exposures to the Balkan States, which had overheated and whose internal bubbles has imploded, and possibly combined with

2) the recent deleveraging which has heightened liquidity strains in economies with accentuated budget deficits as below courtesy of Danske …

We also understand that Europe’s economy has been more dependent on the banking sector than the capital markets relative to the US. And when the cardiac arrest engulfed the global banking industry last October, the region’s banks, which carried substantial toxic instruments, saw its lending flows to the real economy critically impaired.

Thus, credit driven economic slowdown plus accentuated budget deficits compounded with credit risk exposure to the Balkans may have raised the market’s concern over many of the European nation’s default risk.

National CDS Ranking according to prices.

More from Bespoke, ``Since then, default risk has risen for all but two of these countries (Lebanon and Argentina). Below we provide the current credit default swap prices for these countries, along with where they were trading one month ago and at the start of the year. As shown, Argentina, Venezuela, and Iceland have the highest default risk, with Russia not far behind. Germany, Japan, and France all have lower default risk than the US at the moment. It now costs $60 per year to insure against US default for the next five years. While this may not seem high, it was at $8 earlier in the year, and $36 one month ago.”

Nonetheless, the CDS market shows how exposures to toxic papers, credit bubbles or failed government policies have largely impacted national credit ratings.

Hence, to engage in the narrative generalization that emerging markets reflect a similar state to toxic waste papers that prompted this crisis is to engage in a fallacy of division.

What we should watch is how the markets will price US CDS, as the world's reserve currency, to reflect on the market's approval or disapproval of present policy actions. A continued march upward could signify strains in its privileged status.

Meanwhile, the Philippines maintained its 12^th ranking with minor changes relative to the rest, on a month to month basis. That should be a relief.

Kenneth Rogoff: Inflate Our Debts Away!

As what we’ve been repeatedly saying, this episode is unlikely to be dealt with economically but politically.

Now, Kenneth Rogoff, professor at Harvard University and formerly chief economist at the IMF seems to be the first among the high profile experts to candidly acknowledge the urgency (and helplessness) of the situation and has subsequently called for the use of our nuclear option-the Mises Moment.

Stating the obvious, the political "nuclear option" solution is to inflate all debts away!

From Mr. Rogoff (read entire article here: guardian.co.uk),

(all highlights mine) ``Yes, inflation is an unfair way of effectively writing down all non-indexed debts in the economy. Price inflation forces creditors to accept repayment in debased currency. Yes, in principle, there should be a way to fix the ills of the financial system without resorting to inflation. Unfortunately, the closer one examines the alternatives, including capital injections for banks and direct help for home mortgage holders, the clearer it becomes that inflation would be a help, not a hindrance.

``Modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts. Securitisation, structured finance and other innovations have so interwoven the financial system's various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed….

``Fortunately, creating inflation is not rocket science. All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20% or 30% instead of 5-6%. Indeed, fear of overshooting paralysed the Bank of Japan for a decade. But this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary.

Dr. Gono of Zimbabwe should even be more delighted with this apparent exoneration of his model, as policy directives appear increasingly headed for a Zimbabwean denouement!

As Ludwing von Mises wrote in Human Action, ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved”

Zimbabwe’s Gono Lauds US and UK For "Seeing the Light" and "Making Positive Difference"

We frequently cite Zimbabwe because it has been a living example and the epitome of how government policies can, out of political motivations, deliberately cause the destruction of a nation’s currency and its aftereffects to its markets and economy.

Bizarrely, just last April, Dr. G. Gono, Governor of the Reserve Bank of Zimbabwe, or Zimbabwe’s central bank lauded the US and UK in his Zimbabwe’s Monetary Policy Statement (HT: FT Alphaville) for following his footstep.

Quoting Dr. G. Gono (all bold highlights his)

``As Monetary Authorities, we have been humbled and have taken heart in the realization that some leading Central Banks, including those in the USA and the UK, are now not just talking of, but also actually implementing flexible and pragmatic central bank support programmes where these are deemed necessary in their National interests.

``That is precisely the path that we began over 4 years ago in pursuit of our own national interest and we have not wavered on that critical path despite the untold misunderstanding, vilification and demonization we have endured from across the political divide.

``Yet there are telling examples of the path we have taken from key economies around the world. For instance, when the USA economy was recently confronted by the devastating effects of Hurricanes Katrina and Rita, as well as the Iraq war, their Central Bank stepped in and injected life-boat schemes in the form of billions of dollars that were printed and pumped into the American economy.

``A few months ago, the USA economy confronted a severe mortgage crisis, which threatened to spark an economy-wide recession. The USA Central Bank again responded by injecting over US$160 billion between December, 2007 and March, 2008, to provide impetus to the American economy and prevent a worse crisis from happening.

``A look at the recent developments in the UK equally reveals how increasingly, leading central banks in the global economy are bailing out troubled economic sectors to achieve macroeconomic and financial stability.

``Faced with a yawning threat of systemic bank failures on the back of the aftermaths of that country’s mortgage crisis, the Bank of England was directed by its Government to intervene by providing a £50 billion lifeline to the UK’s banking sector.

``Here in Zimbabwe we had our near-bank failures a few years ago and we responded by providing the affected Banks with the Troubled Bank Fund (TBF) for which we were heavily criticized even by some multi-lateral institutions who today are silent when the Central Banks of UK and USA are going the same way and doing the same thing under very similar circumstances thereby continuing the unfortunate hypocrisy [italics-mine] that what’s good for goose is not good for the gander.

``Those who yesterday did not see the interconnection between sanctions and the politics of this country as they sought conventional and dogmatic textbook methods of moving this economy now have good cause to reflect on these examples of quasi-fiscal interventions by the central banks in the USA and the UK and review their dogmas in the interest of adopting more flexible and dynamic approaches [italics mine] informed by the exigencies of the economic situation on the ground.

``Our economy is and has been in trouble for over ten years and our extraordinary interventions by whatever name have helped to keep the wheels of this economy moving.

``Even though our efforts have been criticized and derided clearly for undisguised political reasons, we are proud that we had the courage to do something that made a positive difference when it would have been far too easy for us to appear reasonable by doing nothing and thereby make the situation worse.

``As Monetary Authorities, we commend those of our peers, the world over, who have now seen the light on the need for the adoption of flexible and practical interventions and support to key sectors of the economy when faced with unusual circumstances.

``Of course, in the short-term such interventions are without doubt inflationary but in the medium to long-term they trigger and propel economic growth and development that everyone craves for.”

Our comment:

Well, Dr. Gono should be exceptionally pleased to know that his peers have since been gradually and methodically assimilating his paradigm, albeit in a developed economy version and as showcase of the manifold tools available to the modern banking system.

Where Dr. Gono gloats, ``we are proud that we had the courage to do something that made a positive difference when it would have been far too easy for us to appear reasonable by doing nothing and thereby make the situation worse.”

Making a positive difference?

We refer to this top-10 “worst list” article where Zimbabwe is ranked the worst currency of the world.

Why?

Because $1 USD = 642,371,437,695,221,000 Zimbabwean Dollars!

According to top10-list.com, ``It's hard to keep track of just how fast the Zimbabwean dollar has fallen since the government reinstated electronic parallel market transfers on Nov. 13, but even before that the currency of Zimbabwe was the most worthless in the world.

``While the official rate on Monday was 19,393.94 Zimbabwean dollars to the $1 USD, the old mutual implied rate, generated from comparing the Zimbabwe and London stock exchanges, valued the currency at more than 642 quadrillion to one.

``When the currency was revalued this summer, an egg cost about $35 billion Zimbabwean dollars.”

Zimbabwe’s currency is losing value almost every minute, and that’s the positive and speediest difference!

Well for the list of the other worst currencies…

2^nd worst currency $1 USD = 35,000 Shillings

3^rd worst: Turkmenistan $1 USD = 24,000 Manat

4^th worst, Vietnam $1 UDS = 16,975.00 Dong

5^th Sao Tome and Principe $1 USD = 14,350 Dobra

6^th Indonesia $1 USD = 11,198.40 Rupiah

7^th Iranian Rial $1 USD = 10,179 Rial

8^th Laos $1 USD = 8,640.75 Kip

9^th Guinea Franc $1 USD = 5,115.00

10^th Paraguay $1 USD = 4,615.00 Guarani

Read the details here

US Recession Declared; Market’s Violent Reaction Due To Prospects Of More Pain or Typical Cyclical Behavior?

It took ONE year or 12 months for the National Bureau of Economic Research (NBER) to officially recognize that the United States is in a recession.

Yet if we look at the durations of past recessions we note that such economic cycle has ranged from 6-16 months as shown by the New York Times chart.

Of course, this time might be different. In considering the extent of spillover damage as a consequence to the extraordinary episode of intensive debt deflation- the seizure in the banking system compounded by forcible liquidations- the US recession could extend longer.

By how long?

That’s something we can’t say.

Nonetheless the global financial market’s response has seemingly been excessively violent. The selloff had been across the board and across wide array of asset classes, and had been one of the largest in terms of scale-if we measure the decline of the US S&P 500 this year.

Courtesy of Bespoke Investment

This could probably mean that either the deleveraging process has still ways to go or that markets have absorbed the official announcement as harbinger of more and longer pain.

But as Dr John Hussman says, the gist of the losses has usually been factored in, ``that substantial losses typically occur between the market's peak and the point that a recession is universally recognized, and major gains reliably begin only about three months prior to the end of a recession, and continue into the recovery.”

``Aside from that, between the point that a recession is well-recognized, and a short period before the recession ends, the market's direction is extremely variable and largely depends on how the economic news evolves, as well as the extent to which stock prices become oversold or overbought in the interim. There can be strong and prolonged advances during this period, as well as wicked declines from points where the market becomes overbought.” (emphasis mine)

That is if we reckon from the standpoint of typical market or economic cycles.

But what if the markets could be reading from the perspective of the economic consequences from the present and prospective interventionist policies from the incoming administration?

Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?

``The premise that a president can affect the economy in a positive way is ludicrous on its face, yet the vast majority of voters accept it as a premise. The reason for this can be found in French philosopher Michel Montaigne's observation that "Men are most apt to believe what they least understand." The vast majority of the population knows nothing about macroeconomics (and some would argue that the same is true of most professional economists), so they are ripe to believe almost anything — especially if it sounds like it's going to put dollars in their pockets.”- Robert Ringer, Ted Koppel and the False Premise, Part II

Normally, the concept of stock market investing can be construed as claim to very long-term stream of future cash flows. But these days don’t seem like normal times.

Especially not when government actions risk severely impacting the economic environment or the financial marketplace enough to possibly distort future revenue streams.

To consider the US taxpayers tab has now reached some estimated $7.36 trillion or about half of the US economy. To quote CNBC, it’s a ``complicated cocktail of budgeted dollars, actual spending, guarantees, loans, swaps and other market mechanisms by the Federal Reserve, the Treasury and other offices of government taken over roughly the last year, based on government data and news releases. Strictly speaking, not every cent is a direct result of what's called the financial crisis, but they're all arguably related to it.”

While one may contend that government actions seem directed towards “normalizing” the business cycle and or appear targeted to cushion the angst from the adjustments in the present financial and economic conditions, we are seeing this from a different light-this looks more about politics.

The Credit Driven Growth Mentality; Moneyness Of Credit

First of all we must understand the mainstream viewpoint.

Figure 1: American Institute For Economic Research: Falling US Dollar

Figure 1 from American Institute for Economic Research, is a chart from the last issue, but this time they are marked by reference periods depicting the architectural framework of the US monetary system.

The period covered by the red ellipse manifests of mostly a gold standard regime that spanned across two failed central banks (First and Second Bank of the United States (1791-1836), a free banking era (1837-1862) and the rise of national banks through the National Banking Act in 1863 (wikipedia.org).

Whereas the blue region, exhibits the value of the US dollar under the US Federal Reserve system introduced in 1913 via the Federal Reserve Act (wikipedia.org).

Some observable developments:

1. Periods where the US dollar had been redeemable to Gold saw its purchasing power rise relative to goods (as measured by the Wholesale Price Index). In other words, the economic nirvana brought about by the Industrial Revolution had been mostly from “growth deflation” as the supply of goods grew more than the supply of money.

2. Intermittent periods that saw an impairment of the gold standard automatically led to a depreciation of the US dollar.

3. While even under the gold standard, financial panics occurred-but for different reasons: the ramifications of over issuance of paper money (1837) or bank notes (1819), attempts to corner gold supply (1869), restrictive monetary policies (1873), war reparations, protectionism and shortage of gold (Long Depression 1873-1896) and bank run related panics of 1884,1893 and 1907-they had mostly been in relation to the repeated attempts by authorities to inflate the system.

4. The introduction of the Federal Reserve and the central banking system shifted the structural drivers of economic growth from one of productivity driven “growth deflation” to one of expansionary credit driven inflation.

The point is, the public has been indoctrinated to believe that economic growth can only be generated by (to borrow Prudent Bear’s Doug Noland’s terminology) the “Moneyness of Credit”; credit not just driven by the central bank’s printing presses, but likewise from Wall Street’s “unbounded capacity to inflate Credit instruments that are perceived as safe and liquid. (Doug Noland)”

That is why you always hear experts associate rising prices of goods and services (consumer inflation) with economic growth, when the truth is a sustained rise of consumer goods can only be propelled by persistent money and credit expansion.

And most importantly, this is why the overall thrusts of collective government actions seem directed at the restitution of the severely impaired credit mechanisms, simply because this has been the dogma that has underpinned the modern day global political economy.

Yet, the fundamental problem missed by most (governments and experts) is that the world has generated and absorbed far too much debt than it can pay for. We have reached a level where debt or the leveraging process had been totally dependent on the appreciation of the value of assets as means of refinancing; Economist Hyman Minsky in his Financial Instability Hypothesis calls this the Ponzi finance.

The ensuing episode of market revulsion and intensive credit distress has reflected a phenomenon of the crumbling debt structure or “debt deflation”-as a consequence to previous massive inflationary actions.

Again we quote Mr. Noland (emphasis mine), ``The severity of today’s crisis is not the result of policies – good, bad or otherwise – implemented over the past few months. The greatest Bubble in the history of mankind – nurtured by decades of flawed economics, flawed finance, flawed policymaking and irresponsible behavior throughout – is bursting and there is little our authorities can do about it. Everyone was content during the boom to buy into the notion of all-powerful Fed reflation and Washington stimulus, and we must now come to grips with the reality that the entire framework advocating post-Bubble “mopping up” strategies was specious.”

But the basic problem seemingly unseen by authorities and experts today is that we cannot simply restore a dysfunctional credit system in the US by myopically expecting the resuscitation of the previous bubble structure (e.g. structured finance-ABS, MBS, CMBS, CMO, CDO, CBO, and CLO instruments that collateralized the $10 trillion shadow banking system, derivatives).

Even as global governments have been rapidly anteing up on claims to taxpayers’ future income stream by a concoction of “inflationary” actions such as lender of last resort, market maker of last resort, guarantor of last resort, investor of last resort, spender of last resort and ultimately buyer of last resort, a credit driven US economic recovery isn’t likely to happen; not when governments are tightening supervision or regulatory framework, not when banks are hoarding money to recapitalize, not when borrowers are tightening belts and suffering from capital losses on declining assets and certainly not when income is shrinking as unemployment and business bankruptcies rise on falling profits, and most importantly not when the collective psychology has been transitioning from one of overconfidence to one of morbid risk aversion.

Thus the best case scenario for the credit driven “economic growth” will be a back to basics template-the traditional mechanisms of collateralized backed lending based on borrower’s capacity to pay. But these won’t be enough to reignite the Moneyness of credit. Not even under the US government’s directive.

So the problems can be viewed from a fundamental angle and most importantly the psychological dimension.

Why the US Government Is Determined To Use The Inflation Path

We see the resolution to the problem of having too much debt in only two ways:

One, by allowing debt deflation to run its course; by bringing these to levels where its economy can sustain or pay for them.

But this isn’t likely a politically palatable idea because of the pain associated with the losses especially by the politically connected-Wall Street and Banking industry. And most importantly, the risk of an implosion of the US banking industry could undermine the operating pillars of the present monetary architecture known as the US dollar standard. Thus, the US can’t afford such an option because it poses a serious risk to its geopolitical hegemony.

Two by reducing the real value of its debt levels through the inflation mechanism-where creditors will get paid by a greatly diminished purchasing power of the US dollar. Again one must be reminded that the unstated function of central bank is to generate growth by inflating the economy.

Of course, the US government is looking at the optimistic side or hoping that they might buy enough time for parts of the globe to assume the credit intermediation role.

For instance, the banking system and economies of Asia though having been equally hurt but to a lesser degree by the recent deleveraging phenomenon, hasn’t been as equally leveraged or has seen its credit system damaged by the forcible liquidation, see Figure 2.

Figure 2 Money Week: Asia’s Low Corporate and Consumer leverage

Since the debt exposure of the Asian economies are low in terms of corporate and consumers, the transmission channels from the combined policies of global central banks to "reflate" the system could possibly emerge or impact Asia’s economy by fostering an earlier recovery via inducing more borrowing (relative to the US). This may materially help ease the debt burden of the US by restoring trade and the continued financing of the US rescue policy programmes by the purchasing of US financial claims.

But this is the optimistic view.

If the US government is indeed on its way to inflate with the stated “hope” for a recovery and or implicitly reduce it’s the real value of financial claims, it would 1) continue to bailout companies, 2) nationalize companies or industries, 3) influence (or compel) banks to “lend” via its ownership stakes 4) extend fiscal stimulus and subsidies directly to homeowners, debtors (mortgage payers) who signify most of the voting public 5) expand bureaucracy 6) use the nuclear option of the Federal Reserve through a bypass of the banking system and buying public IOUs or assets and lastly 7) devalue the US dollar via the printing press to deflate the real value of its debts.

The fact that the Bernanke’s US Federal Reserve has embarked on a full scale “quantitative easing”-further expanding balance sheet, printing money by buying debts or officially monetizing government debt- as the US Central Bank announced measures to acquire $500 billion in Mortgage-Backed securities (MBS) backed by Fannie Mae, Freddie Mac and Ginnie Mae and $100 billion in direct debt obligations from the Government Sponsored Enterprises Fannie Mae, Freddie Mac and the Federal Home Loan Bank with the goal of reducing relative borrowing cost as reflected by the high spread in the yields of government agency debt over Treasury debt-means that the Fed has began to activate its nuclear option ( also previously discussed in Will Debt Deflation Lead To A Deflationary Environment?)

Moreover, the losses from the current debt deflation-asset deflation process have led to cash building deflation. This has prompted consumer price index to fall in the developed economies which had been mainly attributed by media and experts to “falling demand”.

And this signifies as a change in public psychology, from an overconfidence boom to risk aversion bust psyche, which many have attributed to as the fatalistic deflation bogeyman. Hence, the only way to oversee a radical swing in such a mindset is to reduce the incentives of holding cash balances. And the only way to do it is by invariably diminishing the purchasing power of a currency.

Government Policy Cycles

The other important matter is that of the understanding of the mutually reinforcing dynamics of inflation and deflation. Deflation and inflation is like assessing the virtues of right and wrong- an ex-post measure of a previous action taken. An action and an attendant reaction. Yet, you can’t have deflation when there have been no preceding inflation. At present times, the reason government has been massively inflating is because they have been attempting to combat perceived threats of equally intense debt deflation.

One action requires the presence of the other action. In terms of Sir Isaac Newton’s Third law of motion, “To every action there is an equal and opposite reaction.”

So you have a feedback loop mechanism where more perceived risks of deflation in the marketplace would prompt for more inflationary policies to counter the perceived menace, which is again what we have been seeing today.

Ergo, the circular loop of money and credit inflation boom and debt deflation bust isn’t just a representation of a market or economic cycle but also signifies as government policy cycles, under a fiat standard central banking system.

Markets As Unreliable Indicators

Yet since global governments have been exhausting their arsenal to absorb much of the world’s losses, it hopes that domestic taxpayers, global taxpayers and the ability to source financing from other entities by borrowing will remain unrestricted. We hope so.

Otherwise, failing to do so suggest that while systemic deflation might be the perceived risk today for the US and several OECD economies (not the world), the coming risks could be one of greater than expected inflation and if not the risk of hyperinflation via a US dollar crisis.

Also while it is also true that yields of US treasuries maybe at record levels, one of the nuclear options is for the Fed to buy these long term debt instruments to keep the interest rate environment low, in the hope of stoking a revival of credit use.

So near record low yields shouldn’t be entirely construed as “safehaven” buying from fears of deflation, since government actions have been heavily distorting these markets. The fact that US Credit default swaps are at record high levels also indicates of the increasing probability of default risk or perhaps higher inflation. So both signals appear to be offsetting each other.

Russell Napier of CLSA in a recent audio interview at McAlvany says that reading the treasury market is unreliable because it is 50% owned by bureaucrats whose incentives are non-economic. We would like to add that the same markets are susceptible for government manipulation as part of the deflation fighting tactical approach.

Figure 3: Economagic: 10-year Treasury

Yet looking at the longer term, 10 year US treasury constant maturity has been on a downtrend for about 26 years. Combine today’s predicament with the coming Baby Boomer entitlement crisis, as discussed in US Presidential Elections: The Realisms of Proposed “Changes”, you have a recipe for high rates in the future. And as inflation picks up we should expect a reversal of this trend.

Nonetheless, it is equally hazardous, if not ludicrous, to suggest that risk taking should be avoided simply because what follows hyperinflation will be deflation. As example, if we have Php 1,000,000 today, whose purchasing power affords us to buy a second hand car, a hyperinflation similar to Zimbabwe in scale suggest that in less than a month that Php 1,000,000 would only buy a stick of cigarette, so keeping the money in cash and waiting for deflation is like Waiting For Godot!

Ultimately, hyperinflation results to a death or disintegration of a currency as in the case of Brazil, which had many changes to its currency [e.g. Cruzeiro, Cruzeiro Novo, Cruzado, Cruzado Novo, Cruzeiro, Cruzeiro and the Real]. So if you’d be holding a Cruzeiro issued in 1964 today, in the hope of a deflation, you’d end up with a piece of paper with absolutely no value except for as wallpaper or memento.

Reading Political Tea Leaves

Charles Krauthammer is dead right when he says that you don’t read balance sheets today to invest in the stock market, you need to learn how to read political tea leaves.

Why? Because of the extensive government intrusions, there will be some sectors that would benefit or lose from major political decisions, in the same manner where there will be vast economic effects.

Quoting Townhall.com’s Charles Krauthammer,

``We need to face the two most important implications of our newly politicized economy: the vastly increased importance of lobbying and the massive market inefficiencies that political directives will introduce.

``Lobbying used to be about advantages at the margin -- a regulatory break here, a subsidy there. Now lobbying is about life and death. Your lending institution or industry gets a bailout -- or it dies.

``You used to go to New York for capital. Now Wall Street, broke, is coming to Washington. With unimaginably large sums of money being given out by Washington, the Obama administration, through no fault of its own, will be subject to the most intense, most frenzied lobbying in American history.

``That will introduce one kind of economic distortion. The other kind will come from the political directives issued by newly empowered politicians…

``Bank presidents are gravely warned by one senator after another about "hoarding" their bailout money. But hoarding is another word for recapitalizing to shore up your balance sheet to ensure solvency. Is that not the fiduciary responsibility of bank directors? And isn't pushing money out the window with too little capital precisely the lending laxity that produced this crisis in the first place? Never mind. The banks will knuckle under to the commissars of Capitol Hill. They control the purse. Prudence will yield to politics.”

As we have repeatedly said, a government determined to inflate will inexorably inflate, regardless of the agenda of economic recovery, because political survival is at stake.

For instance, we noted how the victory of President elect Barack Obama in the recent elections had greatly been influenced by the development in the financial markets, where the Lehman Bros. debacle decidedly shifted voters preference to his camp (as discussed in Has The Barack Obama Presidency Been Driven By Market Dynamics?). Yet the history of US elections shows that the fate of the market and the economy has had some significant influence over elections outcomes (see US Political Economy: History Repeats Itself)

The point is that the Obama leadership, whose election came about from the need for a rescue, but packaged as “The Change We Need”, needs to be seen by the public to do something. Hence, the public will expect more government intervention and correspondingly nourish the illusion of a messianic based recovery. And President Obama will simply oblige.

And like Mr. Krauthammer’s exposition, lobbying will likely become THE BUSINESS. And that puts the United States on the path of the Philippines of imbuing third world policies and outcomes of having rent seeking oligopolies, political client-patron relations, and crony capitalism which essentially breeds dependency culture and corruption.

Conclusion

The US government will continue to choose the path of inflation, as it has been clearly doing today, because it feels the need to do so. It is primarily a political choice. The economic and financial agenda, while much publicized as justification for the inflationary actions, are subordinate. Any ensuing economic growth recovery might just be incidental.

It is a political choice because this will deal with the public’s addiction to a credit driven economic growth environment, long inculcated by the government and academicians through the central banking system, hence the prerequisite to fight forces of debt deflation with even more inflation. This is also going to be about the furtherance of the government policy cycle of inflation-deflation and a populist leadership expected to deliver economic and financial salvation by adopting more intensified inflationist policies.

It is a political choice because government actions will work for the alleviation of the pain and distress of the politically connected, thus lobbying efforts will be become the fundamental order of business. The political leadership will play the role of Gods who will determine which entity survives or perishes.

And yet the sheer magnitude of government intervention will likely foster the emergence of more rent seeking oligopolies, deepen crony capitalism, and advance political patron-client relations which will only intensify the dependency culture and corruption, aside from furthering economic distortions, which may put at risk productivity, capital investments, innovation, cost of money, the US dollar’s purchasing power and economic growth.

And most importantly it is a political choice because it deals with the sine qua non objective of protecting the US geopolitical hegemony through the preservation of its privilege as the monetary architecture of the world, even at the risk of continued depreciation of the US dollar.

Seen from the investment aspect, no market indicators look consistently reliable because of the intensive actions of global governments, which are heavily distorting market signals. But given the collaborative power exerted to inflate the economic and financial system, we should expect asset markets to recover not because of “recovery” but due to the sheer might of inflation. But you can expect any sustained asset inflation to be rationalized as “recovery”.

Besides, you don’t need economic growth drive up stock prices, as evidence look at Zimbabwe. A substantial dose of inflation will be enough do it.

Thus, reading political tea leaves seem likely a better gauge in determining how to invest in the stock markets.