Poker Bluff: The Exit Strategy Theme For 2010

Many have used the strong showing of 2009 to advert that 2010 would be the year of “exits”. I don't buy it.

As in the game of poker, I’d call this equivalent to a policymaker’s Poker bluff.

Clear Divergence: Periphery Versus Core

This ‘exit strategy’ may be probably ring true for many emerging markets whose economies have been more responsive to the hodgepodge of policies designed to cushion the economies from downside volatility.

Again, the wide variance of performances of emerging markets relative to advanced economies validates our theory since the peak of the crisis where each nations would respond differently to the near uniform set of policies adopted, leading to divergent market and economic results.

And such patent discrepancies have led to earlier tightening policies of some nations. According to the Businessweek, ``Since Nov. 30, the central banks of Australia, Vietnam, Norway and Israel have raised interest rates, and signs the global recession is ending have spurred speculation the U.S. Federal Reserve will follow this year.”

On Thursday, China joined the roster of countries engaged in a rollback of easy money policies, the Businessweek quotes the Bloomberg, ``China's move to raise the cost of three-month bills will probably lead to the nation's first interest-rate increase in almost three years by September, a survey of economists showed.”

Figure 2: Economist: Decoupling in Government Debt and Growth

The Economist says that a major source of this growth discrepancy will likely emanate from the PONZI scheme employed by major economies to substitute lost ‘aggregate’ demand with leverage incurred by government to spur this ‘demand’.

From the Economist, ``Advanced economies, which aggressively stimulated demand and are forecast to experience weak GDP growth next year, contrast starkly with the G20’s developing countries. After some gentle fiscal stimulus, these countries are on track for strong growth next year. The IMF forecasts that gross government debt among advanced economies will continue to rise until 2014, reaching 114% of GDP, compared to just 35% for developing nations. With governments struggling to rein in their finances, rating agencies are becoming increasingly twitchy; rich countries such as America and Britain are fearful of losing their hallowed triple-A status.” (all bold highlights mine)

Of course there are many other reasons to suggest why emerging markets seem to be on a secular trend to play catch up with advanced economies, particularly positive demographic trend, urbanization, high savings rate, low debt or systemic leverage, unimpaired banking system, rising middle class and most importantly a trend towards embracing economic freedom via more freer trade, investments, financial and migration flows [e.g. see Asian Regional Integration Deepens With The Advent Of China ASEAN Free Trade Zone]

However the more important factor revealed by the Economist in the terse article above is that the debt onus for advanced economies implies low productivity, cost of crowding out private investments, larger tax burden, greater risks of escalating consumer prices, higher than average unemployment rate, greater cost of financing debt, heightened sovereign risk premia and fiscal austerity measures that may entail a higher degree of political volatility.

Harvard’s Carmen Reinhart and Kenneth Rogoff seconds this view in a recent study,

``Our main finding is that across both advanced countries and 23 emerging markets, high debt/GDP levels (90 percent and above) are associated with notably lower growth outcomes. In addition, for emerging markets, there appears to be a more stringent threshold for total external debt/GDP (60 percent), that is also associated with adverse outcomes for growth. Seldom do countries simply “grow” their way out of deep debt burdens.”

Alternatively, this also raises the risks of an implosion in the fast emerging government debt bubble, which we will call as the Keynesian Debt Crisis-(since most of these debts were acquired in the context of the Keynesian ideology), one of the risks that could spoil our fun in 2010.

Nearly 90% of the world’s bond markets have been denominated in these four major currencies (Ivy Global Bond): the US dollar, the Japanese yen, British pound, dollar, and the euro.

This means that even if many emerging markets will tighten, it is the policies from the advanced economies that will likely have a greater impact on global capital flows.

And it is why we hypothesize that even if global policymakers pay lip service to the so-called “exit strategies”, what truly matters will be the policy actions by authorities in the face of the evolving activities in the marketplace, the real and the political economy.

Hence, it would be an immense mistake to parse on a single variable, e.g. unemployment, when there would be sundry factors in determining political action.

In other words, this means deducing political and economic persuasions or ideology of the incumbent officials, interpreting their underlying cognitive biases based on their speeches, interviews or official pronouncements, analyzing their interpretation of events and lastly appraising on the political influences of certain interest groups that may determine the prospective actions of policymakers.

The Underlying Incentives Of The Poker Bluff

So what factors could likely determine the direction of policy actions?

Interest Rate Derivatives. One must realize of the extent of sensitivity of global asset values are to interest rates.

Figure 3: BIS: Composition Of Global Derivatives

Interest rate derivatives account about 72% or $437 trillion of the notional $605 trillion as of June of 2009 according to the Bank of International Settlements.

Any unexpected volatility from so-called monetary rollback could amplify the risks of unnerving the markets. Thereby, policymakers would likely remain supportive of unorthodox actions like Quantitative Easing.

Hence, we see the recent measures by the Bank of Japan to impose their version of Quantitative Easing last December has catapulted the Nikkei to outperform [see The US Federal Reserve Experiments On Unwinding Stimulus As Bank Of Japan Engages in QE]. In addition, the Bank Of England remains with on track with its ₤ 190 billion of asset purchases and which is likely to increase to ₤ 200 billion (Edmund Conway, Telegraph) and possibly more.

Expanding GSE Operations. In the US, a day before Christmas eve, as everyone had been partying, the US government via the US Treasury stealthily lifted its financing cap on the Government Sponsored Enterprise of Fannie Mae (FNM) and Freddie Mac (FRE) [Wall Street Journal].

Essentially, this places the GSE debt on the US balance sheets, which technically has been operating on “implied” guarantees. Some analysts see that the ambiguity of the US position has led to foreigners to become risk-averse and avoid purchases of these securities.

Hence, the US treasury hopes that by making “implicit” guarantees as “explicit”, it would reduce the pressure on US Fed to bolster the US housing market via Quantitative Easing, and make GSE assets more attractive.

Remember about 9 out of 10 mortgages transacted today have been consummated by these GSE entities, thereby by opening the checkbook to absorb more tainted assets and in the absence of the resumption of foreign interests, the alternative view is that the Fed could increase its scope of quantitative easing programs.

Of course by incorporating the aforementioned GSE debt on the US balance sheets, recorded US liabilities will rise and exert pressures on its sovereign credit ratings.

The point is, US housing market, even faced with some semblance of recovery, remains heavily sensitive to interest rates movement which will likely compel authorities to tweak with financial markets and remain policy easy.

Policymaker’s Economic Ideology. Ben Bernanke is known as an expert of the Great Depression from which his views on monetary policy has been oriented towards the Milton Friedman model, i.e. to provide generous liquidity during an economic recession. The illustrious Mr. Milton Friedman in an interview with Radio Australia said, ``So in our opinion, the Great Depression was not a sign of the failure of monetary policy or a result of the failure of the market system as was widely interpreted. It was instead a consequence of a very serious government failure, in particular a failure in the monetary authorities to do what they'd initially been set up to do.”

And it is likely that from this monetary paradigm he sees the risks of an economic relapse from premature tightening as that in 1937-38. Hence Mr. Bernanke is likely to pursue what he sees as a triumphant path dependency policy of money printing.

Analyst Mike Larson says it best, ``Look at Chairman Bernanke’s background. Massive money printing is at the heart of his entire philosophy. He literally wrote the book on this subject — the book that’s now essentially the Fed’s operating manual on precisely how to print enough money to overwhelm almost any economic collapse.

``Bernanke believes in his heart of hearts that the Fed prematurely hiked rates in 1937, prolonging the Great Depression into 1938 and beyond. He’s convinced that that single, momentous blunder of history is what doomed the world to a nasty “double dip.” (emphasis added)

It’s also the reason why Fed Chair Ben Bernanke recently put the blame squarely on the shoulders of belated regulatory response as having caused the crisis and exculpated the low interest regime (Bloomberg).

By keeping the political heat off low interest rates, he hopes and intends to divert the public’s attention away from his primary tool to manipulate markets.

Ironically and bizarrely too, Mr. Bernanke used the Taylor Rule model to justify the exoneration of role of low interest to the recent crisis.

However John Taylor, a Professor at Stanford University and a former Treasury undersecretary, the creator of the popular model challenged and issued a rejoinder on Bernanke’s interpretation saying ``The evidence is overwhelming that those low interest rates were not only unusually low but they logically were a factor in the housing boom and therefore ultimately the bust.” (Bloomberg).

This goes to show that the fudging, twisting and the manipulation of the means (model or data) in order to come up with the desired end signify as a symptom of economic dogmatism, which operates regardless of the veracity of the implied causality.

Record Debt Issuance, Rollover and Interest Payments. We have pointed out that the US economy, while indeed has been manifesting signs of recovery, hasn’t been entirely out of woods.

The next wave of mortgage resets, which we identified as Alt-A, Prime mortgages, and commercial real estate, which follows the original strain-the subprime mortgages, are still putting pressure on the US real estate industry [as discussed in Governments Will Opt For The Inflation Route].

Moreover, many US States have been staggering from bloated deficits stemming from falling tax revenues in the face of bubble day spending budgets, probably this year will mark a series of bailouts from the Federal government [see Federal Bailout For US States In 2010?]

So together with huge fiscal spending slated for 2010 plus the rollover of maturing debts and the attendant interest payments, as previously discussed in Market Myths and Fallacies On The Dubai Debt Crisis, all these would translate to some $3.6 Trillion of financing required for the US for this year.

We said then,

``$1.9 trillion of debt required for refinancing + $1.5 trillion in additional deficits + $ .2 trillion in interest payments=$3.6 trillion of financing required for 2010! Since US and global savers (particularly Asia) are unlikely to finance this humungous amount, [other parts of the world will require debt financing too (!!)], the available alternative options appear to be narrowing-the Federal Reserve would have to act as the financer of last resort through the Bernanke’s printing press or declare a default. Of course, Bernanke could always pray for a “Dues ex machina” miracle.”

This means that to activate an “exit” mode by raising interest rates risks heightening the amount required for financing. That’s obviously is a NO CAN DO for the authorities.

Moreover, the US won’t likely take the risks of a “failed auction” during its record Treasury sales this year, since this would likely send the interest and bond markets into a tailspin or a mayhem.

This means that as contingent plans we expect that the US Federal Reserve will remain as THE buyer of the last resort for the US treasury markets.

Devaluation as an unofficial policy. We have stated in numerous occasions [e.g. see Changing The Rules Of The Game By Inflation] how Ben Bernanke champions the mainstream view of oversimplifying economic problems by reducing (yes reduction ad absurdum) them into few variables. Hence by focusing on a few variables such as global imbalances, he sets forth devaluation as the key instrument for economic salvation- via his Helicopter “nuclear” option.

Again Mr. Bernanke in his Helicopter speech, ``it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation.”

Yes it’s a supreme irony for government to promote debt, yet fear its consequence-deflation.

It’s also worth repeating that the only way to achieve devaluation is through inflationism which is what Bernanke’s Zero Interest Rate policy, quantitative easing and host of other interventionism-in the form alphabet soup of programs to the tune of Trillions of spending and guarantees, have all been about.

As Ludwig von Mises wrote in Stabilization of the Monetary Unit? From the Viewpoint of Theory ``The valuation of a monetary unit depends not on the wealth of a country, but rather on the relationship between the quantity of, and demand for, money.”

The same ideology afflicts other policymakers as seen in Japan, England and most of the central bankers of the world.

Remember, inflationism is a form of protectionism, since it supports or protects the interests of some politically favorite sectors at the expense of the rest of the society.

In the case of the US, such collective ‘devaluation’ policies appear aimed at alleviating the untenable debt levels held by the banking industry.

Although the public seem to have been grossly misled by political demagoguery and politically colored experts who try to make believe the tomfoolery that devaluation is about exports (only 11% of the economy see Dueling Keynesians Translates To Protectionism?) or about jobs.

Of course, another mechanism of devaluation is the transferring of the resources from the real economy to the banking and finance industry.

Unfortunately for the gullible adherents, who seem to have lost any semblance of critical thinking and common sense enough to swallow hook line and sinker the hogwash that such political propaganda as the “truth”, “candidness” of the messenger and meant as “best” for the social order.

Hardly in the understanding that such political actions represent as ruse for a political end. Again from Professor von Mises, ``By deceiving public opinion, it permits a system of government to continue which would have no hope of receiving the approval of the people if conditions were frankly explained to them.”

Hence, the so-called “exit” program would be antipodal to the policy thrust to devalue the currency.

Political Influences On Policy Making. One unstated reason why companies like General Motors or Chrysler have been nationalized or significantly buttressed by the government is due to the payback of favors to a political constituent, particularly in this case the labor union.

Considering that labor had been a big contributor to Obama’s election, where according to Heritage Foundation, ``Big Labor spent an estimated $450 million on the 2008 election, and the SEIU alone put $85 million into the political campaign — almost $30 million just for Obama’s election”, many of Obama’s major policies appears to have been designed as remuneration for political ties.

This can be seen with the recent tariffs slapped against China, the infrastructure stimulus spending which forces contractors to hire labor union members, the latest $154 billion round of stimulus passed in Congress last December targeted at reducing unemployment, proposed taxes on stock trades to fund labor projects, mass unionization of the US government which now constitutes more than half or 51.2% compared to 17.3% in 1973 and many more.

Of course the other vested interest group as stated above would be the banking sector.

The point is- a higher cost of financing from a series of interest rate increases and monetary policy rollback will vastly reduce the Obama administration’s capacity to fund the pet projects of his most favored allies.

And going into the election year for the US Senate in 2010, greatly reduces this incentive especially that the popularity of Democrats has been on a free fall, as shown by recent Gallup polls, WSJ-NBC News, and Ramussen Reports

Finally, the Question Of Having To Conduct Successful Policy Withdrawals. This would be technical in nature as it would involve the methodology of how excess reserves, the alphabet soup of market patches, guarantees and commitments will be successfully scaled down.

For us, thinking that garbage would be bought back at the original “subsidized” price is no more than wishful thinking. Most of the so-called “plans: would be like having off balance sheet holdings.

Figure 4: BIS: Central Bank Balance Sheet and Spreads for the Crisis

Analyst Jim Bianco was spot on when quoted by Tyler Durden of Zero Hedge, ``We believe the proposal of this new tool signals the Federal Reserve is still flailing around trying to look busy so everyone is assured they have a plan.” (Bold highlight mine)

Bottom line: Interest Rate Derivatives, Expanding GSE Operations, Economic Ideology Record Debt Issuance, Rollover and Interest Payments, Devaluation as an unofficial policy, Political Influences On Policy Making and the Question Of Having To Conduct Successful Policy Withdrawals all poses as huge factors or incentives that would drive any material changes in the Federal Reserve and or the US government policies.

In knowing the above, I wouldn’t dare call on their bluffs.