Nassim Taleb: We Are Probably Worst Off Than Before

Interesting discussion between Nassim Taleb and Nouriel Roubini on Ben Bernanke at the CNBC.

Mr. Taleb avoids directly confronting Mr. Roubini, but runs an argument against policies undertaken by Bernanke from which Mr. Roubini supports. Nevertheless, Mr. Taleb in pun notes that Mr. Roubini's weakness is that "he likes Bernanke too much".

Here is Henry Blodget's summary of the interview:

-We're all in denial
-We're replacing private debt with public debt.
-We're not dealing with the cancer in our banking system.
-We're not making the structural changes we need to make.
-We're not being aggressive enough about restructuring debt (debt for equity swaps).
-Bernanke is a wimpy Greenspan sycophant
-Obama's rewarding the fools who got us here (Summers, Bernanke, Geithner)
The banksters are taking over again

In A Bernanke Market, Comparisons With The 80s Are Like Apples And Oranges

This is another example why I wouldn't be listening to Wall Street.

The Bloomberg chart of the day tries to simplistically associate today's market rally with 1980s.

According to Bloomberg, ``The CHART OF THE DAY compares the Standard & Poor’s 500 Index’s advance since March 9, when the benchmark fell to its lowest level in 12 years, with its recovery from a two-year low set on Aug. 12, 1982. The S&P 500 rose 15 percent for all of 1982 and moved higher every year for the rest of the decade.

``“Investor sentiment today is quite similar” to what prevailed 27 years ago, James W. Paulsen, chief investment strategist at Wells Capital Management, said yesterday in an interview.

``“There’s nothing but doubt” about the economy’s ability to recover from its slump even as consumer and business confidence, retail sales, exports and other indicators point to a rebound, not depression, Paulsen said. The S&P 500 reached its August 1982 low during the second U.S. recession in three years."

But the financial and economic environment 1980s is entirely different than today.

In the past debt levels had not been as disproportionate as today relative to GDP.

Another, globalization and "Reaganomics" has taken off in the 80s. Today, the "Obamanomics" or the growing role of government/s in the economy via a slew of new regulations and welfare programs funded by higher taxes will curb globalization trends and politicize vital sectors of the national economic system which will reduce productivity and returns.

More, the 80s had analog cellphones in contrast to today where internet and digital phones rule.

So it would seem like an apples-to-oranges comparison or simply clustering illusions- a cognitive bias of looking for patterns where non exist.

Importantly, much of today's rally has evidently been liquidity driven as shown by chart above from the WSJ article.

As former hedge fund manager Andy Kessler rightly observes,

``At the end of the day, only one thing has worked -- flooding the market with dollars. By buying U.S. Treasuries and mortgages to increase the monetary base by $1 trillion, Fed Chairman Ben Bernanke didn't put money directly into the stock market but he didn't have to. With nowhere else to go, except maybe commodities, inflows into the stock market have been on a tear. Stock and bond funds saw net inflows of close to $150 billion since January. The dollars he cranked out didn't go into the hard economy, but instead into tradable assets. In other words, Ben Bernanke has been the market."

US Financial Crisis: It Ain’t Over Until The Fat Lady Sings!

``For speculative and especially for Ponzi finance units a rise in interest rates can transform a positive net worth into a negative net worth. If solvency matters for the continued normal functioning of an economy, then large increases and wild swings in interest rates will affect the behavior of an economy with large proportions of speculative and Ponzi finance.” Hyman Minsky, Inflation Recession and Economic Policy

Price signals have a powerful psychological impact. The recent upsurge in global stock markets has been heralded by many as an end to the crisis.

We beg to differ.

In contrast, we think that this is a lull before the storm for the US.

Further, we think that this appears to be seminal phase to an even more severe crisis in the future; one that will deal with a possibility of combined bubbles of private and public sector debt in the face of outsized inflation!

Figure 4: IMF: Global Financial Stability Report (2007)

As you can see in Figure 4, for most of 2009 the reset schedule for subprime mortgages have indeed been at a diminishing pace. Hence, the seeming moratorium in the market turmoil as these subprime resets ease.

However, renewed pressures on foreclosures will likely be felt or experienced later this year as Option adjustable rate and Alt-A mortgage resets mount and is expected to accelerate and culminate by 2011!

Burning Platform’s James Quinn gives us the details (bold highlights mine), ``There are over 4 million homes for sale in the U.S. today. This is about one year’s worth of inventory at current sales levels. You can be sure that another one million people would love to sell their homes, but haven’t put their homes on the market. The shills touting their investments on CNBC every day fail to mention the approaching tsunami of Alt-A mortgage resets that will get under way in 2010 and not peak until 2013. These Alt-A mortgages are already defaulting at a 20% rate today. There are $2.4 trillion Alt-A loans outstanding. Alt-A mortgages are characterized by borrowers with less than full documentation, lower credit scores, higher loan-to-values, and more investment properties.

``There are more than 2 million Alt-A loans in the U.S. 28 percent of these loans are held by investors who don’t live in the properties they own. That includes interest-only home loans and pay-option adjustable rate mortgages. Option ARMs allow borrowers to pay less than they owe, with the rest added to the principal of the loan. When the debt exceeds a pre-set amount, or after a pre- determined time period has passed, the loan requires a bigger monthly payment.”

And yes, the US economic system will be envisaged with more bouts of deflation….

McKinsey Quarterly estimates that some $2 trillion worth of losses has yet to be recognized.

About half of these losses will be accounted for the US financial system, see Figure 5.

Figure 5: McKinsey Quarterly: $3.12 trillion of losses from 2007-2010

Let me quote the McKinsey Quarterly in What’s Next For US Banks (bold emphasis mine),

``While 2008 was the year for taking losses on broker–dealers, this year and next will be the years for taking losses on assets subject to hold-to-maturity accounting. These are the losses that show up in stress tests, in which regulators make assumptions about how the economy will perform and calculate the resulting loan losses under various economic outcomes. For example, credit card losses are highly correlated with unemployment. By projecting unemployment rising to a certain level, stress testing can then project the attendant credit losses.

``McKinsey research estimates that total credit losses on US-originated debt from mid-2007 through the end of 2010 will probably be in the range of $2.5 trillion to $3 trillion, given the severity of the current recession (Exhibit 2). Some $1 trillion of these losses has already been realized. Since US banks hold about half of US-originated debt, the US banking and securities industry will incur about $750 billion to $1 trillion of the remaining $1.5 trillion to $2 trillion of projected losses on this debt, which includes residential mortgages, commercial mortgages, credit card losses, and high-yield/leveraged debt. These numbers are in the same range as those of the US government, which calculated a $600 billion high-end estimate of credit losses for the 19 largest institutions.”

So despite the declaration by Mr. Ben Bernanke in the US Congress last week that, ``The Federal Reserve will not monetise the debt” and even warned of the burgeoining deficits (Financial Times), we believe that Mr. Bernanke isn’t being forthright.

He wasn’t even trying to be funny.

The fact that the US Federal Reserve earmarked $1.25 trillion to acquire $750 billion of agency mortgage backed securities and $300 billion in longer term treasury securities belies Mr. Bernanke’s statement.

Moreover, the Wall Street Journal reports that the ``Fed has purchased $156.5 billion of government bonds” and ``has bought $555.9 billion of mortgage securities.” (see figure 6)

In short, the Mr. Bernanke hasn’t only been talking, he has been nearly exhausting its allocation for Quantitative Easing (QE) or effectively monetizing debt!

Figure 6: WSJ: Fed to Keep Lid on Bond Buys

So we can’t easily buy into cacophonous signals shown by the Fed that they are having second thoughts on buying more of the above government securities. As the WSJ reports, ``Fed officials have become more confident recently that they have stabilized the economy and set the stage for recovery. But divisions are brewing within the Fed over whether it should do more to speed the healing, pause, or start pulling back to avoid an outbreak of inflation.”

Just wait until the pressures from Alt-A and Option adjustable resets, combined with strains from the commercial mortgages, credit cards and auto and leveraged loans escalates, then all these appearances of jawboning against inflation will be moot.

This means that more episodes of systemic deflation should translate to even more inflation from the US government via Ben Bernanke’s Federal Reserve and Tim Geithner’s US Treasury!

Global Inflation Transmission From Quantitative Easing

I might like to also add that perhaps the US dollar reserves recently harvested by the BRICs, as earlier noted, could have been proceeds from US Federal Reserves purchases of Long term Treasuries and Agency backed mortgages than from export revenues or portfolio inflows, both of which while exhibiting some signs of improvements are less likely to have contributed to such material reserve accumulation.

Foreigners own a substantial segment of US treasuries as much as it owns mortgage debt backed by the Agencies. As of 2007, according to Yale Global’s Ashok Bardhan and Dwight Jaffee, ``Foreign ownership of US Agency securities, bonds and mortgage-backed securities (MBS) issued or backed by agencies such as Ginnie Mae, Fannie Mae and Freddie Mac totaled just under $1.5 trillion. While the absolute amounts may be large, it’s the share held by foreign investors of total US securities outstanding that conveys the significance of these global financial flows.”

So even while foreigners have been selling agency debt prior to the Fed QE program, the recent activities could have opened the window for more accelerated liquidations on the part of Emerging Market central banks on their portfolio holdings of US mortgage securities backed by Federal Agencies.

And part of these proceeds could have been recycled into short term US T-bills.

AND as the Federal Reserve prints money to buy US securities held by foreigners, this could, effectively, serve as transmission channels for many of the global monetary inflation taking place, aside from, of course, the collective national fiscal spending being undertaken worldwide.

So it matters less that the current account balances have been improving due to reduced consumption and rising savings, since the inflationary mechanism appears to be retransmitted via the financial claims channel into the world.

And perhaps part of the outperformance by emerging markets could have been driven by such inflationary leakages.

And more of this could be in play see figure 7.

Figure 7: Casey Room: Rapidly Expanding Government Debt

And perhaps too, Mssrs. Bernanke and Geithner could be tacitly rooting for Emerging markets and Asia to miraculously pull the US out of the doldrums which implies even more QE!

Conclusion

The main issue is if US government liability issuances to fund the US deficit spending programs would eclipse the ability by the world or by US savers to finance these. Then the US will either be faced with massively inflating or defaulting.

Don’t forget that aside from rescue packages and the prospective entitlement (Social Security, and Medicare) strains, President Obama has ambitious health, environment, infrastructure, education and energy programs that could equally pose as additional pressures to US taxpayers.

Hence the recent overtures by BRICs to fund the IMF (WSJ) instead of recycling spare reserves into the US could be another proverbial “writing on the wall”.

Lastly, it isn’t total borrowing that should be THE concern, as some observers opine as necessary.

The last boom saw household and financial sector borrowing explode, which brought the world economy to the brink of a collapse through its unraveling.

This was in spite of US Federal debt not being in play.

The crux of the issue is if the present debt load incurred by either the private sector or by government or both can be paid for by the economy operating under a new environment characterized by higher tax rates, vastly increased regulations, lesser degree of a free markets and a hefty politicization of the economy.

As Hyman Minsky wrote in Finance and Profits: The Changing Nature of American Business Cycles, 1980 ``Three financial postures for firms, households, and government units can be differentiated by the relation between the contractual payment commitments due to their liabilities and their primary cash flows. These financial postures are hedge, speculative, and ‘Ponzi.’ The stability of an economy’s financial structure depends upon the mix of financial postures. For any given regime of financial institutions and government interventions the greater the weight of hedge financing in the economy the greater the stability of the economy whereas an increasing weight of speculative and Ponzi financing indicates an increasing susceptibility of the economy to financial instability.” (bold highlight mine)

Hence if the deficit spending programs equates to another form of “Ponzi financing” then financial instability is to be expected in the fullness of time.

So it ain’t over until the fat lady sings!

Cartoon of the Day: Sons of Frankenstein

A recent headline from the Wall Street Journal says "China Takes Aim at Dollar".

Maybe this is the reason why....

Good humorous stuff from about.com

Expect A Different Inflationary Environment

``For inflation does not come without cause. It is the result of policy. It is the result of something that is always within the control of government—the supply of money and bank credit. An inflation is initiated or continued in the belief that it will benefit debtors at the expense of creditors, or exporters at the expense of importers, or workers at the expense of employers, or farmers at the expense of city dwellers, or the old at the expense of the young, or this generation at the expense of the next. But what is certain is that everybody cannot get rich at the expense of everybody else. There is no magic in paper money.” -Henry Hazlitt, What You Should Know About Inflation p.135

Ever since the US Federal Reserve announced that it would embark on buying $300 billion of long term US treasury bonds and ante up on its acquisitions of mortgage-based securities by $750 billion, this has generated an electrifying response in the global financial markets.

First, it hastened the decline in the US dollar index, see figure 1.

Figure 1: stockcharts.com: Transmission Impact of the US Fed’s QE via the US dollar

Next, it goosed up both the commodity markets (as represented by the CRB-Reuters benchmark lowest pane) and key global equity markets, as seen in the Dow Jones World index (topmost pane) and the Dow Jones Asia ex-Japan (pane below main window). The seemingly congruous movements seem to be in response to US dollar’s activities.

At the end of the week as the US dollar rallied vigorously, where the same assets reacted in the opposite direction. So it is our supposition that correlation here implies causation: a falling US dollar simply means more surplus dollars in the global financial system relative to its major trading partners.

In other words, since the efficiency of the global financial markets have greatly been impeded by collaborative intensive worldwide government interventions, the main vent of the officially instituted policy measures have been through the currency markets.

And since the US dollar is the world’s de facto currency reserve, the actions of the US dollar are thereby being transmitted into global financial assets. As former US Treasury secretary John B. Connolly memorably remarked in 1971, ``The US dollar is our currency, but your problem!”

Bernanke’s Inflation Guidebook

And as we have long predicted, the US Federal Reserve will be using up its policy arsenal tools to the hilt. And if there is anything likeable from Mr. Bernanke is that his prospective policy directives have been explicitly defined in his November 21 2002 speech Deflation: Making Sure It Doesn’t Happen Here which has served as a potent guidebook for any Central Bank watcher.

For instance, the latest move to prop up the long end of the Treasury market was revealed in 2001 where Bernanke noted that ``a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities”, and the shoring up of the mortgage market as ``might next consider attempting to influence directly the yields on privately issued securities”.

Nevertheless even as Mr. Bernanke once said that ``I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar”, he believes in the ultimate antidote against the threat of deflation could be through the transmission effects of the US dollar’s devaluation, ``it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation” where he has showcased the great depression as an example; he said,`` 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.”

Of course, this isn’t merely going to be a central bank operation but one combined with coordinated efforts with the executive department or through the US Treasury, again Mr. Bernanke, ``effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities”.

Although Mr. Bernanke’s main prescription has been a tax cut, he combines this with government spending via purchases of assets, he recommended `` the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”

And the recent fiscal stimulus, guarantees and other bailout programs which have amassed to some nearly $9.9 trillion [see $9.9 Trillion and Counting, Accelerating the Mises Moment] of US taxpayers exposure plus the recent $1 trillion Private Investment Program or PPIP have all accrued in accordance to Mr. Bernanke’s design.

In all, Mr. Bernanke hasn’t been doing differently from Zimbabwe’s Dr. Gideon Gono except that the US Federal Reserve can deliver the same results via different vehicles.

Inflation is what policymakers have been aspiring for and outsized inflation is what we’re gonna get.

Stages of Inflation

There are many skeptics that remain steadfast to the global deflationary outlook based on either the continued worsening outlook of debt deleveraging in the major financial institutions and or from the premise of excessive supplies or surplus capacities in the economic system.

We agree with the debt deflation premise (but not the global deflationary environment) and pointed to the dim prospects of Geither’s PPIP program [see Why Geither's Toxic Asset Program Won't Float] precisely from the angle of deleveraging and economic recessionary pressures. However, this is exactly why central bankers will continue to massively inflate-to reduce the real value of these outstanding obligations. And this episode has been a colossal tug-of-war between government generated inflation and market based deflation.

It is further a curiosity how the academe world or mainstream analysis has been obsessing over the premise of the normalization of “borrowing and lending” in order to spur inflation. It just depicts how detached “classroom” or “ivory tower” based thinking is relative to the “real” functioning world.

We don’t really need to restore the private sector driven credit process to achieve inflation. As manifested in the recent hyperinflation case of Zimbabwe; all that is needed is for a government to simply endlessly print money and to spend it.

The sheer magnitude of money printing combined with market distortive administrative policies sent Zimbabwe’s inflation figures skyrocketing to vertiginous heights (89.7 SEXTILLION percent or a number backed with 21 zeroes!!!) as massive dislocations and shortages in the economy emerged out of such policy failures.

By the way, as we correctly predicted in Dr. Gideon Gono Yields! Zimbabwe Dump Domestic Currency, since the “Dollarization” or “rand-ization or pula-ization” of Zimbabwe’s economy, prices have begun to deflate (down 3% last January and February)! The BBC reported ``The Zimbabwean dollar has disappeared from the streets since it was dumped as official currency.” The evisceration of the Zimbabwean Dollar translates to equally a declension of power by the Mugabe regime which has resorted to a face saving “unity” government between the opposition represented by current Prime Minister Morgan Tsvangirai of the MDC and President Mugabe's Zanu-PF.

And going back to inflation basics, we might add that a dysfunctional deflation plagued private banking system wouldn’t serve as an effective deterrent to government/s staunchly fixated with conflagrating the inflation flames.

For instance, in the bedrock of the ongoing unwinding debt deleveraging distressed environment, the UK has “surprisingly” reported a resurgence of inflation last February brought about by a “rise” in food prices due to the “decline” in UK’s currency the British pound-which has dropped by some 26% against the US dollar during the past year (Bloomberg). While many astonished analysts deem this to be a “hiccup”, we believe that there will be more dumbfounding of the consensus as inflation figures come by. And we see the same “startling” rise in inflation figures reported in Canada and in South Africa.

What we are going to see isn’t “stag-deflation” but at the onset STAGFLATION, an environment which dominated against the conventional expectations during the 70s.

Why? Because this isn’t simply about demand and supply of goods and services as peddled by the orthodoxy, but about the demand and supply of money relative to the demand and supply of goods and services. Better defined by Professor John Hussman, ``Inflation basically measures the percentage change in the ratio of two “marginal utilities”: the marginal utility of real goods and services divided by the marginal utility (mostly for portfolio and transactions purposes) of government liabilities.”

For instance mainstream analysts tell us that stock prices reflect on economic growth expectations and that during economic recessions, which normally impairs earnings growth, this automatically translates to falling stock prices.

We’ll argue that it depends--on the rate of inflation.

Figure 2: Nowandfutures.com: Weimar Germany: Surging Stock Prices on Massive Recession

This is basically the same argument we’ve made based on Zimbabwe’s experience, in the Weimar hyperinflation of 1921-1923, its massively devaluing currency, which accounted for as the currency’s loss of store of value sent people searching for an alternative safehaven regardless of the economic conditions.

People piled into stocks (right), whose index gained by 9,999,900%, even as unemployment rate soared to nearly 30%! It’s because the German government printed so much money that Germans lost fate in their currency “marks” and sought refuge in stocks. Although, stock market gains were mostly nominal and while the US dollar based was muted (green line).

In other words, money isn’t neutral or that the impact of monetary inflation ranges in many ways to a society, to quote Mr. Ludwig von Mises, ``there is no constant relation between changes in the quantity of money and in prices. Changes in the supply of money affect individual prices and wages in different ways.”

For example, it doesn’t mean just because gold prices hasn’t continually been going up that the inflationary process are being subverted by deflation.

As Henry Hazlitt poignantly lay out the divergent effects of inflation in What You Should Know About Inflation (bold highlight mine) ``Inflation never affects everybody simultaneously and equally. It begins at a specific point, with a specific group. When the government puts more money into circulation, it may do so by paying defense contractors, or by increasing subsidies to farmers or social security benefits to special groups. The incomes of those who receive this money go up first. Those who begin spending the money first buy at the old level of prices. But their additional buying begins to force up prices. Those whose money incomes have not been raised are forced to pay higher prices than before; the purchasing power of their incomes has been reduced. Eventually, through the play of economic forces, their own money-incomes may be increased. But if these incomes are increased either less or later than the average prices of what they buy, they will never fully make up the loss they suffered from the inflation.”

In short, inflation comes in stages.

Let us use the example from the recent boom-bust cycle…

Figure 3: yardeni.com: US Debt as % of GDP

When the US dot.com bust in 2000 prompted the US Federal Reserve to cut interest rates from 6% to 1%, the inflationary pressures had initially been soaked up by its household sector which amassed household debts filliped by a gigantic punt in real estate.

As the speculative momentum fueled by easy money policies accelerated, monetary inflation were ventilated through three ways:

1. An explosion of the moneyness of Wall Street’s credit instruments which directly financed the housing bubble.

Credit Bubble Bulletin’s Doug Noland has the specifics, ``As is so often the case, we can look directly to the Fed’s Z.1 “flow of funds” report for Credit Bubble clarification. Total (non-financial and financial) system Credit expanded $1.735 TN in 2000. As one would expect from aggressive monetary easing, total Credit growth accelerated to $2.016 TN in 2001, then to $2.385 TN in 2002, $2.786 TN in 2003, $3.126 TN in 2004, $3.553 TN in 2005, $4.025 TN in 2006 and finally to $4.395 TN during 2007. Recall that the Greenspan Fed had cut rates to an unprecedented 1.0% by mid-2003 (in the face of double-digit mortgage Credit growth and the rapid expansion of securitizations, hedge funds, and derivatives), where they remained until mid-2004. Fed funds didn’t rise above 2% until December of 2004. Mr. Greenspan refers to Fed “tightening” in 2004, but Credit and financial conditions remained incredibly loose until the 2007 eruption of the Credit crisis.” (bold highlight mine)

2. These deepened the current account deficits, which signified the US debt driven consumption boom.

Again the particulars from Mr. Noland, ``It is worth noting that our Current Account Deficit averaged about $120bn annually during the nineties. By 2003, it had surged more than four-fold to an unprecedented $523bn. Following the path of underlying Credit growth (and attendant home price inflation and consumption!), the Current Account Deficit inflated to $625bn in 2004, $729bn in 2005, $788bn in 2006, and $731bn in 2007.” (bold highlight mine)

3. The subsequent sharp fall in the US dollar reflected on both the transmission of the US inflationary process into the world and the globalization of the credit bubble.

Again Mr. Noland for the details, ``And examining the “Rest of World” (ROW) page from the Z.1 report, we see that ROW expanded U.S. financial asset holdings by $1.400 TN in 2004, $1.076 TN in 2005, $1.831 TN in 2006 and $1.686 TN in 2007. It is worth noting that ROW “net acquisition of financial assets” averaged $370bn during the nineties, or less than a quarter the level from the fateful years 2006 and 2007.”

In short, the inflationary process diffused over a specific order of sequence, namely, US real estate, US financial debt markets, US stock markets, global stock markets and real estate, commodities and lastly consumer prices.

Past Reflation Scenarios Won’t Be Revived, A Possible Rush To Commodities

Going into today’s crisis, we can’t expect an exact reprise of the most recent past as the US real estate and the US financial debt markets are likely to be still encumbered by the deleveraging process see figure 4.

Figure 4: SIFMA: Non Agency Mortgage Securities and Asset Backed Securities

Some of the financial instruments such as the Non-Agency Mortgage Backed Securities (left) and Asset Backed Securities (right), which buttressed the real estate bubble have materially shriveled and is unlikely to be resuscitated even by the transfer of liabilities to the government.

Besides, the general economic debt levels remain significantly high relative to the economy’s potential for a payback, especially under the weight of today’s recessionary environment.

Which is to say that today’s inflationary setting will probably evolve to a more short circuited fashion relative to the past.

This leads us to surmise that most of global stock markets (especially EM economies which we expect to rise faster in relative terms) could rise to absorb the collective inflationary actions led by the US Federal Reserve but on a much divergent scale. Currency destruction measures will also possibly support OECD prices but could underperform, as the onus from the tug-of-war will probably remain as a hefty drag in their financial markets.

And this also suggests that commodity prices will also likely rise faster (although not equally in relative terms) than the previous experience which would eventually filter into consumer prices.

In other words, the evolution of the opening up of about 3 billion people into the global markets, a more integrated global economy and the increased sophistication of the financial markets have successfully imbued the inflationary actions by central banks over the past few years. But this isn’t going to be the case this time around-unless economies which have low leverage level (mostly in the EM economies) will manage to sop up much of the slack.

Take for example China. China’s economy has generally a low of leverage which allows it the privilege of taking on more debts.

Figure 5: US Global Investors: China Loans and Fixed Asset Investment Surge

And that’s what it has been doing today in the face of this crisis-China’s national stimulus and monetary easing programs is expected to incur deficits of about 3-7% of its GDP coupled by the QE measures instituted by the US has impelled a recent surge in China’s domestic bank loans and real fixed investments.

Qing Wang of Morgan Stanley thinks that the US monetary policy measures has lowered “the opportunity cost of domestic fixed-asset investment”, which means increasing the attractiveness of Chinese assets.

According to Mr. Wang, ``In practice, lower yields on US government bonds means lower returns on the PBoC’s assets. This should enable the PBoC to lower the cost of its liabilities by: a) lowering the coupon interest rates it pays on the PBoC bills, which is a major liability item on its balance sheet; b) lowering the ratio of required reserves (RRR) on which the PBoC needs to pay interest; or c) lowering the interest rates that the PBoC needs to pay on the deposits of banks’ required reserves and excess reserves, currently at 1.62% and 0.72%, respectively. These potential changes should then lower the opportunity cost of bank lending from the perspective of individual banks.” (bold highlights mine)

In other words, low interest rates in the US can serve as fulcrum to propel a boom in China’s bank lending programs.

This brings us to the next perspective, which assets will likely benefit from such inflationary activities.

Henry Hazlitt gives us again a possible answer ``In answer to those who point out that inflation is primarily caused by an increase in money and credit, it is contended that the increase in commodity prices often occurs before the increase in the money supply. This is true. This is what happened immediately after the outbreak of war in Korea. Strategic raw materials began to go up in price on the fear that they were going to be scarce. Speculators and manufacturers began to buy them to hold for profit or protective inventories. But to do this they had to borrow more money from the banks. The rise in prices was accompanied by an equally marked rise in bank loans and deposits.” (bold highlight mine)

This suggests that expectations for more inflation are likely to trigger rising prices and growing shortages, which will likely be fed by more money printing, and eventually an increase in credit uptake in support these actions.

Some Proof?

China is on a bargain hunting binge for strategic resources, according to the Washington Post March 19^th, ``Chinese companies have been on a shopping spree in the past month, snapping up tens of billions of dollars' worth of key assets in Iran, Brazil, Russia, Venezuela, Australia and France in a global fire sale set off by the financial crisis.

``The deals have allowed China to lock up supplies of oil, minerals, metals and other strategic natural resources it needs to continue to fuel its growth. The sheer scope of the agreements marks a shift in global finance, roiling energy markets and feeding worries about the future availability and prices of those commodities in other countries that compete for them, including the United States.”

China has also engaged in a record buying of copper, according to commodityonline.com March 14^th, ``China has started to buy copper in a big way again. As part of the country’s strategy to make use of the recessionary trends in the global markets, China has hiked its copper buying during the past few months…

``According to recently released data, China’s copper import hit a record high of 329,300 tonnes in February, up 41.5 per cent from the 232,700 tonnes of January.”

Summary and Conclusion

Overall, these are some important points to ruminate on:

-It is clear that the thrust by the US government seems to be to reduce the real value of its outstanding liabilities by devaluing its currency. Since the US dollar is the world’s de facto currency reserve the path of the US government policy actions will be transmitted via its exchange rate value to the global financial markets and the world’s real economy. And this translates to greater volatility of the US dollar. Moreover, except for the ECB (yet), the QE efforts by most of the major central banks could translate to a race to the bottom in terms of devaluing paper money values.

-Collaborative global policy measures to inflate the world appear to be gaining traction in support of asset prices but at the expense of currency values.

-Global central bankers have been trying to revive inflationary expectations that are effectively “reflexive” in nature. By painting the perception of a ‘recovery’ through a rising tide of the asset markets, officials hope that this might induce a torrent of asset buying from a normalization of the credit process.

-The monumental efforts by global central banks to collectively turbocharge the global asset markets could eventually spillover to consumer prices and “surprise” mainstream analysts over their insistence to “tunnel” over the deflation angle. We expect higher consumer prices to come sooner than later especially if EM economies would be unable to fill the role of raising levels of systemic leveraging.

-Money isn’t neutral which means that the impact of inflation won’t be the same for financial assets and the real economy. Some assets or industries will benefit more than the others.

-We can’t expect the same “reflation” impact of the past episode to happen again as the ongoing tug-of-war between market-based debt deflation and government’s fixation to inflate the system has displaced the gains derived from the previous trends of globalization and the sophistication of financial markets. The US real estate markets will have surpluses to work off and the financial markets that financed the US real estate markets will remain broken for sometime and will take substantial number of years to recover.

-The impact of inflation will come in stages and perhaps accelerate in phases.

-The risk is that inflation could rear its ugly head in terms of greater than expected consumer prices earlier than what the consensus or policymakers expect. And if this is the case then it could pose as management dilemma for policymakers as the real economy remains weak and apparently fragile from the excessive dependence on the government and from the intense distortion brought about by government intervention in the marketplace. To quote Morgan Stanley’s Manoj Pradhan, ``Can QE be rolled back quickly? In theory, yes! Both passive and active QE could be reversed very quickly. The desire to hike rates above their currently low levels complicates matters slightly. Why? The effectiveness of passive QE depends on the willingness of banks to seek returns in the economy rather than simply parking excess reserves with the central bank. Hiking interest rates would reduce these incentives.”

Finally as we previously said it is increasingly becoming a cash unfriendly environment.

Cartoon of the Day: Bernanke's Quantitative Easing

Nice cartoon from Prieur Du Plessis's Investment Postcards.com

Is Ben Bernanke Turning The US Federal Reserve Into A Dictatorship?

``The deepest policy errors are lodged in the public’s expectation and belief that central banks and governments can alleviate recessions and in the public’s giving these organizations the legal power to do what they do (or tolerating their power grabs). Further errors lie in listening to mistaken experts who continue to justify these counterproductive methods and laws, and in failing to learn from experience that the policies that central banks and governments use to fight recessions make them worse and turn them into deeper recessions and depressions.”- Michael S. Rozeff, The Fed’s Exploding Balance Sheet: What It Means and Reviving the Revolution

Dictatorship means absolute rule.

Given the recent turn of events, it is noteworthy to point out that the recent actions undertaken by the US Federal Reserve appear to be evolving towards such an end.

While one may argue that given today’s emergency conditions, rapid responses from central authorities may be required to help ease the crisis, such assumption is fallaciously grounded on the infallibility of the central authority, where wrong decisions may present as systemic risk for our globalized society.

To quote Friedrich A. Hayek in Pretense of Knowledge, ``To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm. In the physical sciences there may be little objection to trying to do the impossible; one might even feel that one ought not to discourage the overconfident because their experiments may after all produce some new insights. But in the social field, the erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority. Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous-ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims.” (italics mine)

Some of the recent events indicative of the dictatorial tendencies:

One, the Fed has activated the use of its emergency powers to bypass legal requirements or procedures,

This from Bloomberg, ``The Federal Reserve took advantage of emergency powers to authorize the auctions that officials felt were necessary to ease a credit squeeze, concluding it otherwise lacked legal permission to do so.

``The Fed bypassed requirements for prior notice and public comment when writing the regulations to implement today's agreement with the European Central Bank and three other central banks. The Fed's official notice today said any delay caused by following standard procedures would have been ``contrary to the public interest.''

``Such actions, while used ``sparingly'' over the years, were justified today because the new rules probably carry few costs, a former Fed attorney said. The action today was part of a coordinated effort with other central banks to alleviate a global growth slowdown, acting after interest-rate cuts failed to allay concerns that banks will reduce lending.

``It's something that they normally don't do,'' said Oliver Ireland, who worked as a Fed counsel for more than two decades and is now a partner at Morrison & Foerster in Washington. ``If you look at doing things to stabilize volatile markets, I don't think it's very hard to find good cause. There's no tangible harm to anybody.''

``The Fed uses the bypass powers regularly when changing the rate on direct loans to banks, though rarely when publishing broader rule changes. The Administrative Procedure Act requires federal agencies to give public notice and solicit comments on regulatory changes though with exceptions, Ireland said.

Two, the Federal Reserve has used its ‘war powers’ to also bypass its organization’s hierarchal decision making process.

Again from Bloomberg (italics mine), ``The district chiefs’ authority over borrowing costs has been marginalized in the past two months as Chairman Ben S. Bernanke and the Fed Board of Governors in Washington made their own decisions on emergency measures to flood the economy with cash.

“The Board has usurped authority,” said William Poole, former president of the St. Louis Fed and now a senior fellow at the Cato Institute in Washington. “This dramatic change in policy direction has not been announced or even acknowledged.”…

``A conference call last month showed how little say the central bank’s 12 regional presidents now have in some of the Fed’s biggest decisions…

``Regional bank presidents don’t have a vote when the Board uses emergency powers to lend to firms other than banks in “unusual and exigent circumstances,” as it’s done repeatedly this year.

``The district-bank chiefs by design are supposed to offer a counterbalance to the Board, and in the past haven’t been shy about challenging chairmen. In February 1994, former chairman Alan Greenspan had to argue against four presidents who wanted to raise rates at least a half percentage point, compared with his own preference for a quarter-point move.

Three, the Federal Reserve has remained intransigent to repeated requests for transparency or the disclosures on the recipients of the recently extended loans.

Again this from Bloomberg, ``The Federal Reserve refused a request by Bloomberg News to disclose the recipients of more than $2 trillion of emergency loans from U.S. taxpayers and the assets the central bank is accepting as collateral.

``Bloomberg filed suit Nov. 7 under the U.S. Freedom of Information Act requesting details about the terms of 11 Fed lending programs, most created during the deepest financial crisis since the Great Depression.

``The Fed responded Dec. 8, saying it’s allowed to withhold internal memos as well as information about trade secrets and commercial information. The institution confirmed that a records search found 231 pages of documents pertaining to some of the requests.

These acts of suppression of the access to information signify as common traits for dictatorships. To quote Ronald Wintrobe in “The Political Economy of Dictatorships”,

``Democratic institutions (such as freedom of speech, freedom of information, elections, a free press, organized opposition parties and an independent judiciary) all provide means whereby dissatisfaction with public policies may be communicated between citizens and their political leader. The dictator typically dispenses with these institutions and thus gains a freedom of action unknown in democracy.”

Lastly, the Federal Reserve is now mulling the path to issue its own debt instruments,

This from Wall Street Journal, ``The Federal Reserve is considering issuing its own debt for the first time, a move that would give the central bank additional flexibility as it tries to stabilize rocky financial markets.

``Government debt issuance is largely the province of the Treasury Department, and the Fed already can print as much money as it wants. But as the credit crisis drags on and the economy suffers from recession, Fed officials are looking broadly for new financial tools.

``Fed officials have approached Congress about the concept, which could include issuing bills or some other form of debt, according to people familiar with the matter.

``It isn't known whether these preliminary discussions will result in a formal proposal or Fed action. One hurdle: The Federal Reserve Act doesn't explicitly permit the Fed to issue notes beyond currency.

Figure 2: St. Louis Fed: Federal Reserve Bank Credit and Federal Reserve Holdings of US Treasuries

While others don’t see anything sinister to the possible intent of the Fed to issue debts in lieu of the rapidly depleting holdings of the US treasuries in its portfolio (see figure 2) or to “destroy” some of the paper it has recently been printing or as added arsenal for contingent use, the obvious consolidation of power seems to be giving rise to an all powerful “omnipotent” institution.

Why is this important to us even when are about 7-8,000 miles apart?

Because the world’s monetary system is anchored upon the de facto international currency standard in the US dollar. And anything that impacts the state of the US currency will likely send ripples across the world.

To quote Axel Merk of Merk Investments, ``The only leadership that seems to be emerging is from the Federal Reserve determined to print not just billions, but trillions of dollars to provide the backstop to all economic activity; at the same time the policies are an insult to any potential buyer of securities the Fed has targeted, as the intervention keeps yields artificially low. As China has been one of the premier buyers of these securities, namely Treasury bonds and agency securities, this is a clear message by the Fed that Chinese investments to finance U.S. deficits is no longer welcome; why else would the Fed depress the return for potential buyers during a time when unprecedented amounts of debt need to be raised? While we are provocative in our allegation, it is at best an unintended consequence, at worst highly deliberate. Intentional or not, it may coerce Asian buyers of U.S. debt to reduce their holdings to allow the U.S. dollar to weaken. The Fed may believe that it does not need the free market to set rates as it can use its own balance sheet to set economic policy; this ill-perceived view is also shared by economists that believe modern central banking is stronger than market forces.” (bold emphasis mine)

Figure 3: BIS: Central Bank Assets and Open Market Operations

And as we have long predicted, all these point towards more evidences of a seismic shift towards politically based actions than just targeted at economic concerns.

Central banks all over the world have been seemingly desperate enough to resort to “saving” the status quo, an attitude founded on the modern day central banking paradigm of economic growth brought about by credit or inflation and foisted to the public, by flooding the world with money (see figure 3), absorbing much these losses and adopting more innovative “socialistic” means to flex its recently acquired muscles in order to salvage a rapidly festering system.

As Jesús Huerta de Soto, professor of economics at the Complutense University of Madrid, wrote in Financial Crisis and Recession, “…nothing is more dangerous than to indulge in the "fatal conceit" — to use Hayek's useful expression — of believing oneself omniscient or at least wise and powerful enough to be able to keep the most suitable monetary policy fine-tuned at all times. Hence, rather than soften the most violent ups and downs of the economic cycle, the Federal Reserve and, to a lesser extent, the European Central Bank, have most likely been their main architects and the culprits in their worsening.”