Warren Buffett’s Greenback Effect Weighs On Global Financial Markets

``If it seems too good to be true, it probably is. Always look at how much the other guy is making when he is trying to sell you something. Stay away from leverage.” Warren Buffett, Three Rules for Average Investors

Hardly has the ink dried from the issues we dealt with last week when events unfolded almost exactly as anticipated, albeit in a fusion [see Will China’s Stock Market Correction Spread Globally?]

US Dollar Leads The Markets

Here is a summary of what we wrote:

1) We expected that China’s overextended markets to have some ripple or leash effect on global stock markets and the commodities markets.

2) The correction in the China’s markets would possibly trigger a correlation trade-where the US dollar would rise in conjunction with falling markets.

3) We also noted of a contingent provision-our suspicion that the US dollar’s rise wouldn’t find firm legs to stand on, ``if the US dollar fails to rally while global stocks weaken, then any correction, thus, will likely be mild and short.”

True enough during the early part of the week, global markets crumbled resonating China’s rapid fall. This initially prompted for a short rise in the US dollar index.

However, the US dollar index failed to maintain its bullish composure (can’t get to cross the 50-day moving averages) and eventually faltered steeply going into the close of the week.

Figure 1: Stockcharts.com: USD Dollar Index Leads The Markets

The result-global markets, especially in the US and Europe, came back with a vengeance. (see figure 1)

On the other hand, China’s market (SSEC down 2.83% week on week) appears to have hit our defined bottom range and has fiercely bounced back, while the commodities market caught fire- Oil (WTIC) sped back and drifts at its resistance levels!

And again we see some technical pictures failing to keep up with evolving market events.

All of these hyper volatile actions in just a span of one week! Amazing.

And when the US dollar leads the financial asset markets, it is no less than a symptom of inflation driving markets today.

Warren Buffett Warns On The Greenback Effect

Even the sage of Omaha Mr. Warren Buffett acknowledges the growing risk of inflation as the “greenback effect or greenback emissions”. Last week in the New York Times he wrote

(all bold highlights mine)

``Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent. Admittedly, other countries, like Japan and Italy, have far higher ratios and no one can know the precise level of net debt to G.D.P. at which the United States will lose its reputation for financial integrity. But a few more years like this one and we will find out.

``An increase in federal debt can be financed in three ways: borrowing from foreigners, borrowing from our own citizens or, through a roundabout process, printing money. Let’s look at the prospects for each individually — and in combination.

``The current account deficit — dollars that we force-feed to the rest of the world and that must then be invested — will be $400 billion or so this year. Assume, in a relatively benign scenario, that all of this is directed by the recipients — China leads the list — to purchases of United States debt. Never mind that this all-Treasuries allocation is no sure thing: some countries may decide that purchasing American stocks, real estate or entire companies makes more sense than soaking up dollar-denominated bonds. Rumblings to that effect have recently increased.

``Then take the second element of the scenario — borrowing from our own citizens. Assume that Americans save $500 billion, far above what they’ve saved recently but perhaps consistent with the changing national mood. Finally, assume that these citizens opt to put all their savings into United States Treasuries (partly through intermediaries like banks).

``Even with these heroic assumptions, the Treasury will be obliged to find another $900 billion to finance the remainder of the $1.8 trillion of debt it is issuing. Washington’s printing presses will need to work overtime.

``Slowing them down will require extraordinary political will. With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required. A revived economy can’t come close to bridging that sort of gap.”

Here Mr Buffett makes an elementary calculation. I have to admit my admiration for Mr. Buffett’s ability to explain or relate circumstances in very simple “layman connecting” terms.

Essentially, US savers “borrowing from our own citizens” ($500 billion) + Foreign surpluses “borrowing from foreigners” ($400 billion)= $900 billion. US debt initially estimated at $1.8 trillion, which has been scaled down to $1.58 trillion equals a deficit of still at least $680 billion-that would have to be financed out of “a roundabout process, printing money” or central bank money from thin air!

The US treasury is slated to sell $197 billion next week (CNBC). This means that the US sovereign bond markets will likely be tested anew and the US dollar index will likely remain under siege or under pressure.

Analyzing Inflation From A Political Dimension

While many have been saying that because of the deflationary pressures in bubble stricken economies inflation won’t take hold soon, for sundry mainstream reasons of money velocity, oversupply, output gap, excess capacity, liquidity trap, capital short banking systems, Federal Reserve paying interest rates on commercial bank reserves or a combination thereof, we aren’t sure of the interim impact.

We can’t be “timing” inflation because its impact has always been relative.

However we understand inflation to be an epochal problem of human society, which specifically constitutes a series of processes that makes up a cycle.

We can’t simply read through recent events and interpret them as the future.

Since inflation is a political process, it requires the understanding of the underlying motivations of the current crop of political leaders and their prospective actions. After all, politics revolve around economics.

And this has been a phenomenon that has haunted civilizations, kingdoms, governments or empires alike, which has always been expressed through the purchasing power of the underlying currencies.

Mises Institute President Douglas French in recommending cigarettes as an inflation hedge enumerates on such cycle, ``one of Ludwig von Mises's outline of the typical inflation process: prices aren't rising nearly as much as the money supply… phase two of Mises's inflation outline: instead of a rising demand for money moderating price increases, a falling demand for money will instead intensify price inflation. Finally, we come to phase three, where prices go up faster than money supply, the demand for money drops to zero, and government fiat currencies collapse.” (bold highlights mine)

Currently we seem to be drifting in between the phases of “prices aren't rising nearly as much as the money supply” and “falling demand for money”.

Eventually, we should see a transition deeper into “intensifying price inflation” and most probably segueing into “prices go up faster than money supply” depending on the incentives driving policymaking.

And if consumer prices don’t immediately reflect on the impact of the intermediate inflation process, then most of the present political actions will likely be felt or manifested in the financial asset markets.

And so a boom in asset markets is in the first order, as what we’ve been seeing today, and may likely continue as the US dollar index falls.

In short, asset markets are likely to continue functioning as the immediate absorbers of the inflation process.

As Morgan Stanley’s Manoj Pradhan observed of the difference between today’s cyclical patterns with the previous,

``During this cycle, however, interest rates that matter for borrowers have fallen only very slowly while the flow of credit to the private sector is likely to be weaker than usual due to financial sector deleveraging. Only risky asset prices have been roaring forward since the rally began in March. This imbalance between the various channels creates complications for the prospects of returning monetary policy to neutral. If central banks decide to tolerate higher asset prices in order to compensate for the weaker impact of both the interest rate and the credit channel, they risk inflating another asset bubble. If they respond to rapidly rising asset prices while the other transmission mechanisms have only played a weak role, they risk tightening policy into a weak economic recovery.” (bold highlights mine)

Politically, further inflation is required to sustain the elevation of asset prices, however economically, the risks is that these surges will result to a bubble. So maneuvers for an exit from policymakers seem to be getting trickier by the moment.

Will they take the booze away from the party and allow “normalization” or will they further supply more booze to enliven the atmosphere?

Here, we will bet on another major policy miscalculation.

Yet this boom in financial asset prices won’t translate to sustainable “green shoots” of economic recovery. Instead today’s inflation process will heighten misallocation of resources that would eventually culminate into another enormous bubble cycle.

As Murray N. Rothbard in Money Inflation and Price Inflation wrote, (bold highlights mine)

``Even if prices do not increase, this does not alleviate the coercive shift in income and wealth that takes place. As a matter of fact, some economists have interpreted price inflation as a desperate method by which the public, suffering from monetary inflation, tries to recoup its command of economic resources by raising prices at least as fast, if not faster, than the government prints new money…there is a relative underinvestment in consumer goods industries. And since stock prices and real estate prices are titles to capital goods, there tends as well to be an excessive boom. It is not necessary for consumer prices to go up, and therefore to register as price inflation. And this is precisely what happened in the 1920s, fooling economists and financiers unfamiliar with Austrian analysis, and lulling them into the belief that no great crash or recession would be possible. The rest is history. So, the fact that prices have remained stable recently does not mean that we will not reap the whirlwind of recession and crash.”

So while consumer price inflation may still be currently subdued, this doesn’t exempt us from a prospective bust from the fast evolving malinvestments.

More Inflation Equals Greater Risks

Despite the recent crisis, the fractional banking sponsored debt driven economy conjoint with government policies to rev up the credit cycle has reflected on Mr. Buffett’s admonition of debts reaching record unsustainable levels.

Figure 2: AIER: US DEBT AT RECORD LEVELS

According to Mr. Kerry A. Lynch senior fellow of the American Institute of Economic Research, `` The total debt owed by Americans increased to $51 trillion in the first quarter of 2009. One way to put such a mind-boggling number in perspective is to compare it to the value of what Americans produce. Gross domestic product is roughly $14 trillion per year. Thus, Americans now owe $3.62 for every dollar of GDP. As can be seen in the chart below, this is a record.

``By comparison, in 1980 Americans owed just $1.55 per dollar of GDP. The ratio began to rise sharply in the 1980s, leveled off in the early 1990s, and surged again in the late ‘90s, continuing to do so through the past decade.”

While the recent crisis should have pruned down debt levels to the capacity where the economy may be able to handle it, however, the inherent fear by US and global governments of “deflation”, aside from the implied goal to sustain previous boom days, and the addiction towards inflation has prompted such continued accumulation of systemic imbalances.

As we said in the The Fallacies of Inflating Away Debt, the misleading notion of inflating away such debt levels would make the stagflation era of the 70s a virtual “walk in the park”.

Yet, Mr. Buffett seems quite optimistic on the resolve of the present administration to work this out, which we think could be attributable to the special political influenced privileges acquired from the administration, during the latest crisis, for his personal benefit [see Warren Buffett: From Value Investor To Political Entrepreneur?].

However, Mr. Buffett seems to seriously underestimate the political nature of the inflation process.

The expanded cash for clunkers, the administration’s foisting of its socialized version of health reform (which means another $1.3 trillion through 2019), cap and trade policies and the potential bailouts from the next wave of mortgage resets, the prospective support on FDIC’s eroding funding base as more banks suffer from closure, and the Obama administration’s consideration of future stimulus programs are simply symptoms of MORE (NOT LESS) government addiction towards consolidating power by debt and inflation based solutions.

As Ludwig von Mises on The Truth About Inflation presciently wrote, ``But the administration does not want to stop inflation. It does not want to endanger its popularity with the voters by collecting, through taxation, all it wants to spend. It prefers to mislead the people by resorting to the seemingly non-onerous method of increasing the supply of money and credit. Yet, whatever system of financing may be adopted, whether taxation, borrowing, or inflation, the full incidence of the government's expenditures must fall upon the public.” (emphasis added)

Hence, the current political leadership adheres to the typical path of leaders opting for the profligate inflation route. Inflation is what they want, then inflation is what we get.

So in contrast to the mainstream who thinks inflation isn’t in the near horizon, we join the outliers who have been warning of the risks of a potential disorderly unwind.

The Newsmax quotes Nobel Prize economist Joseph Stiglitz, ``The "dollar now is yielding almost zero return," Stiglitz said in a speech at the United Nations regional headquarters in Bangkok. "The current global reserve system is fraying. It's falling apart. The issue isn't whether we go to a new system. The question is do we do so in an orderly or disorderly way.” (emphasis added)

Meanwhile, PIMCO’s CEO Mohamed El-Erian says the policy divergence or “disjointed approach” between the US and other global central bankers could risk leading “to volatile financial markets, a damaging drop of the dollar and slower global growth.”

The Bloomberg quotes Mr. El-Erian ``The question is not whether the dollar will weaken over time, but how it will weaken,” said El-Erian, a former deputy director of the International Monetary Fund whose firm runs the world’s largest bond fund. “The real risk is that you will get a disorderly decline.” (emphasis added)

Thus, we won’t underestimate or discount the odds of the growing risks of an inflationary pass through by a lower (or a possible meltdown of the) US dollar on asset, commodity or consumer prices.

Remember inflation isn’t only generated through the credit system but also through fiscal expenditures.

In Zimbabwe, where consumer credit is virtually inexistent, an output gap of -99% (Marc Faber) and unemployment of 94% didn’t stop hyperinflation (89,700,000,000,000,000,000,000% year on year basis in 2008 or a doubling of prices daily)!!!

So the obsession with all sorts of perverse math models by mainstream economics vividly manifest that they don’t have a clue on reality.

That’s the reason why they haven’t rightly predicted last year’s crisis and why they are unlikely to be dependable forecasters.