Does $7.76 trillion of US Government Guarantees Make The US Dollar A Safehaven Status?

US dollar bulls always insist that the US dollar dispenses its role as safehaven currency when global economies are under strain.

This view has been bolstered by the recent surge of the US dollar fuelling rambunctiousness in their convictions.

While we don’t dispute the US dollar’s role in the past, our belief is that the recent activities of the US dollar has been nothing more than the exercise of deleveraging or debt deflation, the unwinding carry trade and from its status as an international reserve currency standard (where most loans have been US dollar denominated) as discussed in Demystifying the US Dollar’s Vitality.

To consider, we recently cited that US taxpayers were faced with some $4.28 trillion (see The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…), a Bloomberg report now tabulates US government guarantees to hit $7.76 trillion or about 50% of the US GDP!

Excerpts from Bloomberg (HT: C. McCarty), ``The U.S. government is prepared to provide more than $7.76 trillion on behalf of American taxpayers after guaranteeing $306 billion of Citigroup Inc. debt yesterday. The pledges, amounting to half the value of everything produced in the nation last year, are intended to rescue the financial system after the credit markets seized up 15 months ago.

``The unprecedented pledge of funds includes $3.18 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, according to data compiled by Bloomberg. The commitment dwarfs the plan approved by lawmakers, the Treasury Department’s $700 billion Troubled Asset Relief Program. Federal Reserve lending last week was 1,900 times the weekly average for the three years before the crisis…

``Bernanke’s Fed is responsible for $4.74 trillion of pledges, or 61 percent of the total commitment of $7.76 trillion, based on data compiled by Bloomberg concerning U.S. bailout steps started a year ago…

``The Fed’s rescue attempts began last December with the creation of the Term Auction Facility to allow lending to dealers for collateral. After Bear Stearns’s collapse in March, the central bank started making direct loans to securities firms at the same discount rate it charges commercial banks, which take customer deposits.

``In the three years before the crisis, such average weekly borrowing by banks was $48 million, according to the central bank. Last week it was $91.5 billion.

``The failure of a second securities firm, Lehman Brothers Holdings Inc., in September, led to the creation of the Commercial Paper Funding Facility and the Money Market Investor Funding Facility, or MMIFF. The two programs, which have pledged $2.3 trillion, are designed to restore calm in the money markets, which deal in certificates of deposit, commercial paper and Treasury bills.

``The FDIC, chaired by Sheila Bair, is contributing 20 percent of total rescue commitments. The FDIC’s $1.4 trillion in guarantees will amount to a bank subsidy of as much as $54 billion over three years, or $18 billion a year, because borrowers will pay a lower interest rate than they would on the open market, according to Raghu Sundurum and Viral Acharya of New York University and the London Business School.

``Congress and the Treasury have ponied up $892 billion in TARP and other funding, or 11.5 percent.

``The Federal Housing Administration, overseen by Department of Housing and Urban Development Secretary Steven Preston, was given the authority to guarantee $300 billion of mortgages, or about 4 percent of the total commitment, with its Hope for Homeowners program, designed to keep distressed borrowers from foreclosure.

``Most of the federal guarantees reduce interest rates on loans to banks and securities firms, which would create a subsidy of at least $6.6 billion annually for the financial industry, according to data compiled by Bloomberg comparing rates charged by the Fed against market interest currently paid by banks.

``Not included in the calculation of pledged funds is an FDIC proposal to prevent foreclosures by guaranteeing modifications on $444 billion in mortgages at an expected cost of $24.4 billion to be paid from the TARP, according to FDIC spokesman David Barr. The Treasury Department hasn’t approved the program.

``Bernanke and Paulson, former chief executive officer of Goldman Sachs, have also promised as much as $200 billion to shore up nationalized mortgage finance companies Fannie Mae and Freddie Mac, a pledge that hasn’t been allocated to any agency. The FDIC arranged for $139 billion in loan guarantees for General Electric Co.’s finance unit.

``The tally doesn’t include money to General Motors Corp., Ford Motor Co. and Chrysler LLC. Obama has said he favors financial assistance to keep them from collapse.

Amazing stuff. From $4.28 to $7.76 trillion in guarantees, subsidies, bailouts, stimulus packages with more to come.

Our idea is once the deleveraging dynamics ebb, all the recent strength seen in the US dollar will immediately be sapped.

The epicenter or “cause” of the world’s miseries can’t simply account as our safehaven. Such is a delusion.

And all the Keynesian malarkey of falling demand =falling prices loop will likewise evaporate.

The US dollar index had a remarkable one day fall.

Courtesy of Bespoke Invest

According to Bespoke, ``As equity markets stage their second straight day of gains, the US Dollar index is having its worst day since 1985, and its 5th worst day ever (since 1970). And today's fall for the Dollar broke the uptrend the currency had been in over the last couple of months, although it is still in a longer-term uptrend off of its Spring lows. Falls in the Dollar are coinciding with gains in equity markets and economic stability worldwide, since the US currency is now being treated as a safe haven. Go figure.”

Courtesy of Bespoke

As you can see, the US dollar index has broken down from its interim trend, suggesting further liquidations ahead. Pls be reminded the US dollar index is principally weighted against the Euro with 5 other currencies making up the rest of the basket.

Our thought is that commodity and Asian currencies (possibly some EM currencies with current surpluses) could lead the rally.

How has the fall in the US dollar fared to other markets?

Courtesy of stockcharts.com

Well, it’s a contagion in reverse. Former “safehavens” now victims of liquiditations; it’s not just the US dollar but obviously across the Treasury yield curve 10 year note, 3 month bill, 1 and 5 year notes.

And most importantly, some quarters have attributed the recent vigorous stock market rally to the appointment of President elect Barack Obama of Tim Geithner to the post of Hank Paulson or the incoming Secretary of the US Treasury.

While we believe that this causal chain is tenuous at best, a Geithner as 'the messiah rally' will likely to be a sucker’s rally. Yet if the market continues to rally from the recent lows (and establish a bottom!) even with Mr. Geithner doing nothing, as he is yet to assume office in 2009, then he might just be anointed a ‘saint’!

But this doesn’t seem inspired from a Geithner rally…

But probably one from Gold. Gold appears to have provided the recent market leadership.

The recent equity rally during late October hasn’t been confirmed by a rally in the commodities markets or in gold.

This isn’t the case today and looks like a broad market rally. Essentially, it’s a rally among all those asset classes that have been massively sold.

Three thoughts:

1. US dollar’s fall reflects cyclical forces of overbought conditions and may be temporary as the deleveraging dynamics continue. Conversely, equities and commodity markets have been in patently oversold conditions that the present gains reflect simply an oversold bounce.

2. A rotation in deleveraging. Because the US dollar and US sovereigns have immensely gained during the recent market volatility, the deleveraging process could have transferred been into a profit taking carnage in the US Treasuries market and the US dollar and inversely a reverse flow into oversold assets.

3. Markets could incipiently be smelling inflation. With $7.76 trillion of taxpayer exposure in the US and $trillions more from governments elsewhere, perhaps markets are starting to realize that the sheer magnitude of concerted inflationary policies are beginning to have some impact.

To quote CLSA’s Christopher Wood in today’s WSJ Op Ed, ``In this respect the present crisis in the West will ultimately end up discrediting mechanical monetarism -- and with it the fiat paper-money system in general -- as the U.S. paper-dollar standard, in place since Richard Nixon broke the link with gold in 1971, finally disintegrates.

``The catalyst will be foreign creditors fleeing the dollar for gold. That will in turn lead to global recognition of the need for a vastly more disciplined global financial system and one where gold, the "barbarous relic" scorned by most modern central bankers, may well play a part.

Short Lessons from the Fall of Japan

Interesting article from Fool.com’s Bill Mann on “Falling Like Japan”, here is an excerpt (all highlights mine),

``In the aftermath of the bubble, Japan's government rushed in to prop up its banking system, which was teetering under the weight of non-performing loans. Rather than letting businesses fail, this has had the effect of propping them up to continue operating. To this day the scope of the problem is still not known.

``Without this information, investors both in Japan and outside have made a logical conclusion -- to take their investment dollars elsewhere. Japan's industrial sector has failed to meet its cost of capital over the last 20 years, in large measure because the government has allowed capital-destroying companies to continue to operate. Had these companies been allowed to fail, Japan long ago could have flushed out its system and gotten back on the road to economic health. In the name of protecting jobs, Japan's economy has continued to sputter, punctuated by spectacular bankruptcies in cases where the facade could not hold up. The cost of propping them up has been much, much more economic pain. Japanese call the long economic downturn ushinawareta jūnen, the lost decade.”

My humble two cents:

One, affected companies or industries which seek shelter from the government are likely to underperform simply because like in the Japan experience, productive capital won’t be allowed to flow where it is needed.

Thus, the unproductive use of capital in shoring up those affected by today's crisis will likely reduce any industry or company’s capacity to hurdle its cost of capital.

Two, since capital always looks for net positive returns then obviously capital flows are likely to go into sectors that aren't hampered by cost of capital issues from government intervention.

This probably means a NEW market leadership (sectoral) and or money flows OUTSIDE the US or from markets/economies heavily impacted by the crisis.

US Presidential Elections: The Realisms of Proposed “Changes”

``The facts: We have a $10.5 trillion national debt; $53 trillion of unfunded liabilities; a military empire that has US troops in 117 countries and has spent $700 billion on a pre-emptive war that has killed over 4,000 Americans; a $60 billion trade deficit; an annual budget deficit that will exceed $1 trillion in the next year; a crumbling infrastructure with 156,000 structurally deficient bridges; almost total dependence on foreign oil; and an educational system that is failing miserably. We can’t fund guns, butter, banks and now car companies without collapsing our system.” –James Quinn, “Baby Boomers Led Us Into Fiscal, Moral Bankruptcy”, Minyanville

In "The Decline and Fall of the Athenian Republic" 1776.", Alexander Fraser Tytler poignantly wrote, ``A democracy cannot exist as a permanent form of government. It can only exist until the voters discover they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising them the most benefits from the public treasury, with the result that a democracy always collapses over a loss of fiscal responsibility, always followed by a dictatorship. The average of the world's great civilizations before they decline has been 200 years. These nations have progressed in this sequence: From bondage to spiritual faith; from spiritual faith to great courage; from courage to liberty; from liberty to abundance; from abundance to selfishness; from selfishness to complacency; from complacency to apathy; from apathy to dependency; from dependency back again to bondage."

It will be the denouement of the US presidential elections this week. And most likely, the popular, based on polls and prediction markets, will prevail.

The Realisms and Illusions of Change

While “change” has been the key theme for both aspirants to the White House, considering the present economic and financial conditions, the only real change we are going to see seems to be what most of Mr. Tytler’s prediction 3 centuries ago.

And what “changes” would that be?

More debt, more government spending, more government intervention, more future taxes, more running down of present assets and more bondage. In short, the road to bankruptcy.

The popular idea is if people get the government to spend more, this should lift us out of the rut. And if Americans get to redistribute more wealth (see Spreading the Wealth? Market IS Doing It!), this should lead to even more progress.

Yet, if the same idea is correct, then Zimbabwe would have been the most prosperous among the all nations for unabated printing of money for its government to liberally spend and redistribute wealth. Unfortunately, Zimbabwe has been mired in a hyperinflation depression (some reports say 231,000,000% others at 531,000,000% inflation) that is continually felt by its countrymen through the apparent interminable loss of its currency by the millisecond to the point that some its citizenry has resorted to Barter (see The Origin of Money and Today's Mackarel and Animal Farm Currencies).

Or how could one easily forget the redistribution strategies of China’s Mao Tse Tung “great leap forward” or USSR’s Joseph Stalin “egalitarian” regimes whose only achievement is the combined death toll “democide” of 79 million citizens (Hawaii.edu) and a decrepit “everybody-is-poor-except-the-leadership” economy.

Many would argue that the US cannot be compared to Zimbabwe in the sense that America has institutions, markets, and a labor force that is more intelligent, flexible, effective and sophisticated. Maybe the recent Iceland experience should be a wake up reminder of how countries can suddenly go “richest-to-rags” story (see Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?) on major policy blunders. Here, the market idiom also applies, “Past performance does not guarantee future results”.

The fact that markets are meaningfully suppressed and substituted for government intervention effectively transfers resources from the economy’s productive sector to the non-productive sector. When people’s incentives to generate profits are reduced then they are likely to invest less. And reduced investments translate to lower standards of living.

As James Quinn in a recent article at Minyanville wrote, ``In our heyday in the 1950s, manufacturing accounted for 25% of GDP. In 1980, it was still 22% of GDP. Today it’s 12% of GDP. By 2010, it will be under 10%. Our government bureaucracy now commands a larger portion of GDP than manufacturing. Services such as banking, retail sales, transportation and health care now account for two-thirds of the value of the US GDP.

``Past US generations invented the airplane; invented the automobile; discovered penicillin; and built the interstate highway system. The Baby Boom generation has invented credit default swaps; mortgage-backed securities; the fast food drive-through window; discovered the cure for erectile dysfunction; and built bridges to nowhere. No wonder we’re in so much trouble.”

Yet while Americans seem to drool over future welfare spending (a.k.a. free lunch), nobody seems to ask who is going to pay for these or how will it be paid or funded?

The Emerging American Bailout Culture

It is my assumption that most of the Americans are aware of the current crisis, such that the US Congress rapidly passed a fiscal bailout package called the Emergency Economic Act of 2008.

In November of 2006, William Poole, president of the Federal Reserve Bank of St. Louis presciently noted in a panel discussion, “Everyone knows that a policy of bailouts will increase their number.”

How true it is today. Proof?

AIG, which had been originally been accorded a loan of $85 billion in exchange for a government guarantee on its liabilities and a management takeover, has now ballooned to $123 billion (New York Times).

Next are the Bond insurers currently seeking shelter under the current TARF program. According to the Wall Street Journal, ``Bond insurers are urging the government to reinsure their battered portfolios, the latest push by the industry to seek relief under the Treasury's $700 billion financial rescue.”

The US government bailout has expanded its reach outside the banking sector to include credit card issuer Capital One Financial (Australian News) which implies that as a precedent, the next step will probably be an industry wide approach.

Then you have a hodgepodge of interest groups vying for the next bailout. Excerpts from the Hill.com

-A diverse collection of interests — from city transit officials to labor unions to “clean tech” advocates — are clamoring to be added to the second stimulus package Congress may consider after the election.

-Labor groups, meanwhile, want the stimulus bill to pay for new road and bridge construction to put people to work.

-The National Governors Association and the National League of Cities among others on Tuesday wrote to House and Senate leadership, asking them to raise the federal matching rate for Medicaid payments and to increase the money spent on infrastructure projects.

-Lobbyists for these groups argue that more federal spending would help minimize the job losses from a recession. In a white paper being circulated on Capitol Hill, the American Shore & Beach Preservation Association, for example, says $5 billion for water resource projects would create 140,000 new jobs.

Then you have the US government indicating more guarantees for troubled mortgages. This from Bloomberg, ``The U.S. Treasury and the Federal Deposit Insurance Corp. are considering a program that may offer about $500 billion in guarantees for troubled mortgages to stem record foreclosures, people familiar with the matter said.

``The plan, which might put as many as 3 million homeowners into affordable loans, would require lenders to restructure mortgages based on a borrower's ability to repay. Under one option, the industry would keep lower monthly payments for five years before raising interest rates, the people said.”

The government gives in a finger, now everybody wants the arm. From one industry to another, from one interest group to another, everybody seems to be clamoring for a bailout. So who’s gonna pay for all these? When will this culture towards accelerated dependency stop?

Throwing Pack Of Meat To The Wolves

This reminds us of self development author Robert Ringer who, in his recent article, cites Nathaniel Branden quoting staunch liberal Bennett Cerf in his book Judgment Day: My Years With Ayn Rand, ``You have to throw welfare programs at people — like throwing meat to a pack of wolves — even if the programs don't accomplish their alleged purpose and even if they're morally wrong… Because otherwise they'll kill you. The masses. They hate intelligence. They're envious of ability. They resent wealth. You've got to throw them something, so they'll let us live."

In a political season, pandering to the masses is the surest route to seize power. But of course, the hoi polloi can’t distinguish between the real thing and the varied interests behind those propping the candidates or even welfare economics behind all the programs being tossed to the people (or its unintended effects).

Some officials in the US government are actually aware of the perils of too much government intervention. This noteworthy excerpt from the testimony of South Carolina Governor Mark Sanford before House Committee on Ways and Means (all highlights mine)…

``Simply throwing money into the marketplace in the hope that something positive will happen ignores the fact that the government has already put over $2 trillion into the system this year using various bailouts and stimulus packages: including $168 million in direct taxpayer rebates this past spring; an $850 billion bailout last month that cost more than we spend on defense or Social Security or Medicaid and Medicare annually; and myriad loans and partial nationalizations of institutions like Freddie Mac and Fannie Mae, JPMorgan Chase, Bear Sterns and AIG. This doesn’t even include the arguably most effective form of stimulus the country has seen over the past year, a market-based infusion of over $125 billion into the economy and taxpayers’ wallets caused by falling oil prices and subsequently lower prices at the pump.

``This year’s $2 trillion plus in bailouts and handouts seems that much more momentous when you consider that federal tax revenues last year were only $2.57 trillion. Simple math demands we ask ourselves if $2 trillion did not ward off the crisis in confidence we’re currently experiencing, then how much can $150 billion more help? Especially since we’re dealing with a $14 trillion economy and a larger $67 trillion world economy, meaning that this shot in the arm represents merely one-fifth of one percent of the world economy…

``Essentially, you’d be transferring taxpayer dollars out of the frying pan – the federal government – and into the fire – the states themselves. I think this stimulus would exacerbate the clearly unsustainable spending trends of states, which has gone up 124 percent over the past 10 years versus federal government spending growth of 83 percent. It would also dangerously encourage even more growth in governmental programs like Medicaid, which in state budgets across the nation already grew 9.5 percent per year over the last decade – certainly unsustainable in our state. Moreover, the United States Department of Health and Human Services just last week projected that spending on Medicaid will grow at an average annual rate of 7.9 percent over the next 10 years – and possibly faster if this stimulus package passes. State debt across the country has also increased by 95 percent over the past decade. In fact, on average every American citizen is on the hook for $1,200 more in state debt than we were 10 years ago. So if government gives in WHO pays for these?”

Soaring US Fiscal Deficits; Can The World Fund It?

Figure 1: Casey Research: US Fiscal Deficit could top $1trillion!

Remember, global trade as a result from today’s crisis seems likely to diminish, as the US, Europe and most OECD economies meaningfully compress from a recession.

This implies that any improvement from the US current account deficit may be offset by a surge in fiscal deficit which is already at a record $455 billion (Bloomberg) to over $1 trillion in 2009, see figure 1.

Yet improving current account deficits for the US translates to almost the same degree of reduction of current account surpluses for Emerging Markets, Asia and other current account surplus nations, which equally means less foreign exchange surplus.

The point is with diminishing accretion of foreign exchange surpluses; such raises the question of funding for US programs, which in the past had been financed by the world, mostly by Asia and EM through acquisition of US financial claims.

Back to basics tells us that governments can only raise revenues in 3 major ways: by borrowing money (issuing debts), by printing money (inflation) or via taxation.

But if global taxpayers can’t fund US programs, and if the world’s capacity to lend and borrow seems limited by the degree of improving current account imbalances, then this leaves one option for the US government; the printing press. And it is a not surprise to see US authorities recognize this option, as it has revved up its monetary printing presses of last resort (see US Federal Reserve: Accelerator to the Floor!).

So while it is true that in the present conditions nation states maybe able to take over the slack or imbue the leverage from the private sector, this isn’t without limits. Unless the world would take upon further risks of the extreme ends of either global depression or hyperinflation as the Austrian School have long warned it to be.

The Coming Super Subprime or Entitlement Crisis

And it doesn’t stop here; today’s crisis has been centered on the credit bubble largely as a function of the US financial sector. What hasn’t been spoken about is the risks of the Baby Boomer or Entitlement Spending Crisis from which David M. Walker, former U.S. Comptroller General, tagged as “super subprime crisis” as even more deadlier than the crisis we face today. (We earlier spoke about this in Tale of The Tape: The Philippine Peso Versus The US Dollar)

This excerpt (Hat tip: Craig McCarty) from David Walker’s article published at CNN/Fortune (all highlights mine),

``The entitlements due from Social Security and Medicare present us with that frightening abyss. The costs of these current programs, along with other health-care costs, could bankrupt our country. The abyss offers no assets, troubled or otherwise, to help us cross it…

``In fact, the deteriorating financial condition of our federal government in the face of skyrocketing health-care costs and the baby-boom retirement could fairly be described as a super-subprime crisis. It would certainly dwarf what we're seeing now.

``The U.S. Government Accountability Office (GAO), noting that the federal balance sheet does not reflect the government's huge unfunded promises in our nation's social-insurance programs, estimated last year that the unfunded obligations for Medicare and Social Security alone totaled almost $41 trillion. That sum, equivalent to $352,000 per U.S. household, is the present-value shortfall between the growing cost of entitlements and the dedicated revenues intended to pay for them over the next 75 years.

Figure 2: GAO: David Walker Fiscal Wake Up Tour in 2006

``Today we are headed toward debt levels that far exceed the all-time record as a percentage of our economy. In fact, by 2040 we are projected to see debt as a percentage of our economy that is double the record set at the end of World War II. Based on GAO data, balancing the budget in 2040 could require us to cut federal spending by 60% or raise overall federal tax burdens to twice today's levels.

``Medicare, Medicaid, and Social Security already account for more than 40% of the total federal budget. And their portion of the budget is expected to grow so fast that their cost, and the cost of servicing our debt, will soon crowd out vital programs, including research and development, critical infrastructure, education, and even national defense.

``The crisis we face is one of numbers and demographics but also of attitudes. Promises were made in an earlier time, when they seemed more affordable. Like homeowners borrowing against the value of their homes in the expectation that the values would go up forever, the American government borrowed against the future and assumed that the economy would grow fast enough to make that debt affordable.

``But our national debt is not limitless, and our foreign lenders are not fools. If we persist on our current "do nothing" path, our future will be jeopardized. Americans need to reconcile the government we want with the taxes we're willing to pay for it.

Mr. Walker’s concern is that unfunded entitlement liabilities will continually mount and take up a significant share of the expenditures relative to the GDP, which can’t be afforded by the US over the coming years. Compound this with the bills from the present programs to bailout the US economy.

Much of the incumbent and aspiring US politicians have had little to say on these matters.

Yet any resolution to this predicament will require vastly unpopular and stringent political decisions. Think of it, rising taxes in general and or cutting retirement benefits or a combination of both will be politically acceptable? Will the next president turn against his supporter to implement the much needed reform?

But like typical politicians the likelihood is that the desire to avoid pain is politically paramount. Because a politician’s political capital or career will be at stake.

Thus, it is likely that the leadership will, once again, adopt a reactionary approach, because it is far more beneficial to game the present rules than to find a solution and enforce them.

Critical Policy Actions Will Draw The Fate Of The World

Steering the US political economy at this very sensitive and fragile stage will be very crucial.

Policies based on populism can set off a very dangerous chain of events. The great depression of the 30s was a result of a series of market stifling government policies that setoff massive waves of unintended consequences.

As analyst John Maudlin aptly points out in his latest outlook on the role of the new US president,

``One is a tax cut for 95% of Americans. The problem is that 47% of Americans do not pay taxes, so what you are really talking about it a massive expansion of welfare. But if you use that tax increase on the "rich" to pay for your "tax cuts" to other Americans, you have no money to pay for other programs, let alone get anywhere close to a balanced budget.

``And of course, as each year passes there is less net Social Security income to the government. If you use your tax increase to fund more expenses today, you will not have that to fund Social Security in 2017 when the program goes into a cash-flow deficit. Or, taxes will really have to rise later in the decade. But then again, that will be another president's problem.

``How do you offer the increased medical programs you propose if you use the tax increase for tax cuts for 95% of Americans (read: welfare for 50%) without really busting the budget? Or any of the $600 billion in programs that you want to see?

``And your serious economic advisors are going to point out (at least in private) that raising taxes on the 5% of wealthiest Americans is eerily similar to what Herbert Hoover did in his administration, along with legislation to restrict free trade and increase tariffs, which you have also advocated. Look where that got him and the country.

``75% of those "rich" you are targeting are actually small businesses that account for 50-75% (depending on how you measure growth) of the net new job growth in the US. When you tax them, you limit their ability to grow their businesses. Further, you reduce their ability to consume at a time when consumer spending is already negative.

``Reduced consumer spending will be reducing corporate profits and thus corporate tax revenues. Just when you need more revenues.

``A tax hike in 2010 of the magnitude you currently propose, in a weak economy, is almost guaranteed to create a double-dip recession. That will not be good for your mid-term elections. Given that the recovery from a second recession is likely to be long and drawn out, it would also make it difficult to get re-elected, as the economy would be the first and foremost issue.”

In short, policy actions will differentiate between the realization of an economic recovery or a fall to the great depression version 2.0.

As we have noted in the past, the 5 cardinal sins in policymaking that may lead to severe bear markets or economic hardships are; protectionism (nationalism, high tariffs, capital controls), regulatory overkill (high cost from added bureaucracy), monetary policy mistakes (bubble forming policies as negative real rates), excess taxation or war (political instability).

Populist policies without the consideration of unintended effects may result to an eventual backlash. Highly burdensome taxes to the productive sectors may lead to lost future revenues which will be inadequate to fund any present redistribution or welfare programs. Inflation will be the next likely path.

In addition, since the US is heavily dependent on the world for both trade (remember little manufacturing) and financing (selling of financial claims), any modern day form of resurrecting the Smoot-Hawley act will equally be disastrous for the US and for the world.

So we hope and pray that the next US President won’t be overwhelmed with hubris enough to send the world into a tailspin by attempting to shape the world in accordance to an unworkable paradigm or ideology or hastily taking upon policy actions without assessing the economic repercussions. After all, financial and economic problems today require financial and economic and hardly political solutions.

US Elections and the Philippines; Final Thoughts

We noted earlier (see Gallup Polls: Filipinos Say US Election Matters, McCain Slightly Favored) that Filipinos and Georgians have acted as the only TWO contrarians nations that has favored the underdog Senator John McCain in a world heavily tilted by 4-1 in favor of the leading candidate Senator Barack Obama.

There is nothing wrong with such contrarianism.

There are many reasons why various nations or even individuals favor certain candidates. Perhaps this could be because the candidate/s and or party aligns with their social-economic-financial political interest, has shared history or culture, agrees with proposed policies, have ties or association with the party or the candidates, shares similar ideology, influenced by the “bandwagon effect” or the desire to be “in” the crowd or captivated to the “charisma” of the candidate or just plain revulsion to the present system or the incumbent.

The latest Philippine senatorial elections (see Philippine Elections Determined by The Contrast Principle!) was an embodiment of the latter’s case from which we even quoted the precept of Franklin Pierce Adams, ``Elections are won by men and women chiefly because most people vote against somebody rather than for somebody.”

It looks the same for the US.

The worsening bear market in stocks and real estate which seems reflective of the prevailing economic conditions appears to be a key driving force which appears to have driven the US public into the open arms of the opposition. Also, the rash of the present bailout schemes appears to be feverishly fueling the “bailout culture” from which has boosted the opposition’s welfare based platform.

Whether or not this would seem as a right choice is called opportunity cost. A George Bush Presidency means a lost Sen. John Kerry leadership in the 2004 elections. We will never know what a Kerry Presidency would have been. But from hindsight we know what a Bush presidency is-“the Biggest Spending President since Lyndon Johnson” (McClatchy.com)-unbecoming of an ideal GOP conservative. Put differently, President Bush was more of a Democrat than a Republican in action or a Democrat in Republican robes.

Besides, Vox Populi Vox Dei –“voice of the people is the voice of God” isn’t always true. Just ask Alexander Fraser Tytler “promising them the most benefits from the public treasury” or Bennett Cerf “You have to throw welfare programs at people — like throwing meat to a pack of wolves”. Or assess the Bush administration or any of the previous Philippine administrations.

Reading into the politician’s actions today is like reading tea leaves during the George Bush versus Al Gore elections in 2000 or a George Bush versus John Kerry in 2004.

Yet, projecting present actions from the candidates’ appearances, slogans, sponsorships, endorsements, proposed platforms and speeches as tomorrow’s policies is a mirage! Many of what both candidates had been saying today, in order to get one’s votes, will probably be reversed once they get elected! Like almost all politicians, voters will eventually get duped.

But elections are atmospheres of entertainment. And people love to be amused by demagoguery to the point of fanatically “believing”. Or to quote Bill Bonner of Agora’s Daily Reckoning, ``People come to believe what they must believe when they must believe it.”

Understand that there will be many painful tough calls which will be politically unpalatable. Think super-sub prime crisis, think the deepening bailout culture. All these are unsustainable over the long run. Combined, they are lethal enough to prompt for a global economic and financial nuclear winter from either a US dollar crash (hyperinflation-yes a Zimbabwe model applied on a world scale!) or a global depression. And all these will need some painful reform or adjustments in American lifestyles sometime in the near future. By then, it wouldn’t matter whether one’s vote would count unless it is time for reelections.

Alas, to believe in purported “change” from today’s imagery is nothing but an unfortunate self-delusion.

Jim Rogers: Massive Inflation Ahead, Buy Agriculture!

This great Bloomberg interview with Jim Rogers..

Some noteworthy end quotes...

On Government bailouts: ``It’s like an insanity if you ask me; the government is going to run the banking system now? They can’t even run the postal. What’s wrong with these people? Why don’t they just let them fail and start over? That's the way the system works out."

On market bottom: ``When people say it is over and when we you see more bad news and stocks stop going down. But when they go up on bad news, that’s when we are gonna hit bottom. We are not gonna scream I don't know." (Hat tip: goldofthemoon)

It’s a Banking Meltdown More Than A Stock Market Collapse!

``The argument that the government is somehow pumping new capital into the market is absurd. Government is actually borrowing the money from the capital markets that it is in turn injecting into the capital markets. There is no additional source of funding; there is only a diversion of funds from more-productive outlets to less-productive outlets, with government acting as the middleman.” -Scott A. Kjar, University of Dallas, Henry Hazlitt on the Bailout

It’s amusing how many people believe that today’s financial crisis is just a “headline” material. They carry this notion that the meltdown seen in the stock market are just confined to within the industry. They believe in media’s assertion that these are all about just banking related losses and perhaps a prospective recession. Yet, importantly governments will successfully come to the rescue. And that banking deposits will be safeguarded by sanctity of government guarantees. We hope that such smugness is correct and don’t turn out to be chimerical.

From our side, the current global stock market meltdown is like utilizing a thermometer to a gauge the body temperature of a patient. From which the mercury’s position indicates of the degree of normality or abnormality in the patient’s temperature than of its cause. Hence, the thermometer signifies as the medium and the mercury’s position the message. In the stock market we see the same message See Figure 1.

Figure 1: Mercury Indicator: Stock Market Meltdown or Banking System Meltdown?

The Performance chart from stockcharts.com shows that since the whole bubble bust cycle episode unraveled, the losses of world equity markets have been far less than the damage suffered by the housing and the entire swath of financial and banking sector.

True, everyone directly or indirectly involved in the financial sector seems to be afflicted. But some are suffering more than the others. This means that like the thermometer, the public’s attention have been on inordinately transfixed to the freefall in global equities but have glossed over the significance of the ongoing risk dynamics in the US financial sector.

From our point of view, the stock market “meltdown” has been a symptom of a deeper underlying disease: the risks of a US banking sector collapse. And this is not just about your typical banking losses, but a representation of the real risks of a total freeze of the entire global banking network system as we discussed in Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

As had been pointed out, the US dollar standard monetary system has been anchored upon a global banking system from which operates on a fractional reserve banking platform from where the entire global banking network revolves or interacts upon. In short, deposits, credit intermediaries, clearing and settlement, maturity transformation, asset markets etc… are all deeply interconnected.

Since the US dollar standard banking system has been at the core of our troubles, all the network of banking nodes connected to such intertwined system have likewise been bearing strains, see Figure 2 from the IMF.

Figure 2: IMF’s GFSR: The Evolution of the US Banking System From Deposits to the Shadow Banking

According to the IMF’s Global Financial Stability Report (emphasis mine), ``Banks have been shifting away from deposits to less reliable market financing. “Core deposits” dominated U.S. banks’ liabilities in the past, but have been gradually replaced by other “managed liabilities”…At the same time, near-banks—which are entirely market financed—have grown sharply. This is related to the “originate-to-distribute” financing model that relies heavily on sound short-term market liquidity management. Euro area and U.K. banks also rely more on market financing than in the past, as in the United States. Similarly, the share of deposits by households (defined roughly the same as U.S. core deposits) has been gradually declining over time, while deposits held by nonfinancial corporations, other financial intermediaries, and nonresidents have steadily increased. In addition to these “managed deposits,” financing through repurchase agreements and issuance of debt securities, both in domestic and foreign markets, have expanded, indicating that European banks are also increasingly exposed to developments in money markets. At the same time, the share of household deposits for Japanese banks has been stable and even increasing over time. This may partly reflect the prolonged low interest environment since the late-1990s.”

In other words, from a depository based banking system the US has evolved into gradual dependency on “near banks” or what is known as the “shadow banking system” (we previously featured a schematic chart from the Bank of International Settlements The Shadow Banking System) which basically relies on short term financing or maturity transformation borrow short and lend or invest long.

Thus, when the collaterals backstopping the entire short term financing channels began to deteriorate, whose chain of events included the Lehman bankruptcy, this resulted to a collapse in the commercial paper market (forbes.com) and the “breaking the buck” in the money markets (edition.cnn.com) as banks refused to deal (borrow and lend) with each other on perceived “rollover risks”.

Consequently, major financial institutions dumped the banking channels and stampeded into US treasuries. This exodus or flight to safety set a record yield of .0203% for 3 months bills last September 17^th (Bloomberg), which we described last week as an “institutional run”. And these strains reverberated throughout the network of banks all over the world which raised credit spreads and resulted to a dearth of US dollars and lack of liquidity in the system as banks and companies hoarded cash. Thus as a result to the credit gridlock the liquidity crunch inspired the sharp selloffs.

So while the defensive mechanism for the global banking system has been designed against isolated instances of retail depositors run via a depositors insurance (e.g. FDIC, PDIC etc…), an institutional run has not been part of such contingencies.

Hence what you have been witnessing is an unprecedented monumental development which has a potential risk of a downside spiral.

To consider, the assets of Shadow Banking system was estimated at some $10 trillion dollars which is almost comparable to the assets of traditional banking system. According to a report from CBS Marketwatch (all highlights mine),

``By early 2007, conduits, structured investment vehicles and similar entities that borrowed in the commercial paper market and bought longer-term asset-backed securities, held roughly $2.2 trillion in assets, according to the Fed's Geithner.

``Another $2.5 trillion in assets were financed overnight in the so-called repo market, Geithner said.

``Geithner also highlighted big brokerage firms, saying that their combined balance sheets held $4 trillion in assets in early 2007.

``Hedge funds held another $1.8 trillion, bringing the total value of asset in the "non-bank" financial system to $10.5 trillion, he added.

``That dwarfed the total assets of the five largest banks in the U.S., which held just over $6 trillion at the time, Geithner noted. The traditional banking system as a whole held about $10 trillion, he said.”

So as hedge funds continue to shrink from redemptions, TrimTrabs estimates a record $43 billion in September-liquidity requirements, margin call positions, maintaining balance sheet leverage ratio or plain consternation could risks triggering more negative feedback loop of more forced liquidation.

Besides, risk of a deep and extended recession could imply larger corporate bankruptcies and larger defaults from corporate leveraged loans that could trigger credit events in the CDS market that could give rise to new bouts of forcible liquidations. All these could similarly shrink the capital base of existing banks, even under those buttressed by capital from the US treasury.

In addition, the risks of heavy damages in the asset markets could spread to the insurance and pension funds which risks reinforcing the downside spiral. In short, the shadow banking system poses enough risk to destabilize the entire US banking system.

Global Governments Throws The Kitchen Sink And the House

Governments have virtually thrown not just the proverbial kitchen sink but the entire house to deal with such outsized dilemma. The US government pledged to “deploy all of our tools” as the G7 counterparts have “committed to a global strategy”.

Specifically the US government will earmark some $250 billion for its “capital purchase program” to be infused as capital to the banking system in return for preferred shares of which 9 of the major banks have “agreed” or “coerced” to participate, a temporary guarantee by the FDIC on the “senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest bearing deposit transaction accounts”, the broadening scope Commercial Paper Funding Facility (CPFF) program which will “fund purchases of commercial paper of 3 month maturity from high-quality issuers” (Federal Reserve) and unlimited swap lines or “Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction” with major central banks as the Bank of England (BoE), the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank (SNB) as “necessary to provide sufficient liquidity in short-term funding markets”. (Federal Reserve)

Figure 3: Wall Street Journal: Europe’s Bailout Package

Of course, it’s no different with the European counterparts which have committed aggressively some €1.8 trillion (US $2.4 trillion)-AFP.

So overall, including the US Congress’ contribution of $850 billion plus the Federal Reserves liquidity infusion via US dollar swaps these should amount to over $3 trillion or over 5% of global GDP (2007) of $54.62 trillion based on official exchange rate-CIA.

Such astounding financial theater of operations reminds us of the D-Day 1944 Normandy Landings. Bernanke’s helicopters have not only been operating on round the clock sorties, but they are also flying all over the globe as the Fed has essentially outsourced its printing press functions to international Central banks!

The Illusions of Government Guarantees

If only those unlimited injections of liquidity can translate to REAL capital.

The unfortunate part is that government guarantees depend on the hard currency that backs the system.

For instance, in the case of Iceland which basically guaranteed deposits of its financial system and nationalized its major banks, the lack of hard currency has precipitated a crisis (See our Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?).

As the Icelandic government operated on a huge current account deficit in the face of a paucity of global liquidity, rising risk aversion, global bear markets, global deleveraging and the monumental debt incurred by its banking system, investors withdrew funding and sold the currency aground. Last October 9^th the Iceland Prime Minister even pleaded to the public to restrain from withdrawals (Reuters).

Now goods shortages have emerged and consumer price inflation has soared. If Iceland can’t obtain the sufficient funding from overseas lenders (IMF or Russia or etc.) soon enough, then it would have to resort to the printing press or our developed country equivalent of Zimbabwe.

In a varied strain, Pakistan’s economy and banking system has allegedly been suffering from “some” depositor’s run (thaindian.news) on rumors that the government might impose withdrawal restrictions. Global volatility has exposed Pakistan’s vulnerability to its heavy dependence on short term debt financing and huge current account deficits (see our Increasing Signs of Pakistan's Depression?). Pakistan is now seeking a bailout package from China.

In both examples, government guarantees won’t serve any good if governments can’t support such claims.

Think of it, government revenues basically derive from three channels: taxpayers, borrowing through debt issuance or the printing press.

Even if your government guarantees deposits or other loans, assets etc…, if taxpayer’s can’t pay up, or if the government can’t raise enough borrowings to fund its present expenditure or settle its liabilities seen via fiscal or current account, your government ends up using the printing press to meet its needs.

This means that in the assumption that your government remains functional under a banking system collapse, whatever money guaranteed by the government will surely have its purchasing power evaporated!

If for instance the Philippine government allows deposit guarantees to increase at P 500,000 per depositor (from the present Php 250,000-PDIC) and our doomsday scenario occurs, such an amount which can momentarily buy a second car will eventually (perhaps in just months) buy up only a bottle a beer! That is if government even allows you to withdraw your money. In Argentina’s case during its 1999-2001 crisis, particularly in December of 2001, the Argentine government restricted depositors from withdrawing money to only a specified amount (BBC).

To Austrian economics, such restriction is equivalent to “Confiscatory Deflation”, which according to Joseph Salerno in his Austrian Taxonomy of Deflation, ``There does exist an emphatically malign form of deflation that is coercively imposed by governments and their central banks and that violates property rights, distorts monetary calculation and undermines monetary exchange. It may even catapult an economy back to a primitive state of barter, if applied long and relentlessly enough. This form of deflation involves an outright confiscation of people’s cash balances by the political and bureaucratic elites…

``Confiscatory deflation is generally inflicted on the economy by the political authorities as a means of obstructing an ongoing bank credit deflation that threatens to liquidate an unsound financial system built on fractional-reserve banking. Its essence is an abrogation of bank depositors’ property titles to their cash stored in immediately redeemable checking and savings deposits.” (highlight mine).

Yet when government mandated money loses trust among its constituents people tend to find a substitute, as example see our previous, The Origin of Money and Today's Mackarel and Animal Farm Currencies.

So as shown above, government guarantees do not constitute as an outright safety net. These will all depend on government’s access of available financing at future costs.

Under the same line of thought, the idea that the US dollar as the international foreign currency reserve with unlimited lending capacity is another mirage.

The US economy has been supported by the financing of its current account deficits by foreign exchange surpluses of current account surplus countries mostly found in Asia and Gulf Cooperation Council (GCC). This vendor financing scheme effectively recycles money earned from exports of EM economies by buying into US financial papers to keep their currencies from appreciating.

Hence, the US economy’s ability to provide unlimited finance is moored upon the willingness of foreigners as China, Japan and GCCs to sustain the present system. Said differently, for as long as these financers continue to buy US financial claims, they automatically provide the wherewithal or the “quiet bailout” to the US government.

So China, Japan and others essentially determines the guarantee provisions the US extends to its financial institutions aside from the world’s faith on its printing presses.

Besides, guarantees in the banking system as we previously discussed represent as “beggar-thy-neighbor” policy which keeps at a disadvantage countries offering less amount of guarantees, like the Philippines, since the former tend to attract more capital or savings because of the higher amount of safety.

Hence, guarantees signify as subsidies to those who apply more and a tax to nations who apply less. Thus, the policy regime of surging guarantees on deposits by Europe and the US tend to put into the downside pressures to the Philippine Peso.

Yet, our discussions above are some examples of isolated banking crisis and not of a systemic banking collapse, a domino effect from a prolonged cardiac arrest of the US banking system, the ultimate recipe for a global depression, where guarantees will just be that- a political rhetoric.

US Banking Collapse: You Can Run, But You Can’t Hide; Revival of Bretton Woods?

We proposed last week that this could mark the beginning of the end of the current form of paper money system or even signify as a harbinger to a new paradigm shift from our present monetary system.

Perhaps European Central Bank’s Jean Trichet heard our whispers and began to talk about the revival of a modern version of a “Bretton Woods” (see Did ECB’s Trichet Fire The First Salvo For A Possible Overhaul Of The Global Monetary Standard? and Bretton Woods II: Bringing Back Gold To Our Financial Architecture?)

So aside from the rapid aggressive policy response (bailouts, liquidity injections, nationalization, blanket guarantees), some European leaders have also raised the idea for a shift in the global financial architecture.

As the Reuters report indicates ``Italy's economy minister said a reform of the Bretton Woods institutions should also review trade, foreign exchange and capital markets and questioned whether the dollar should remain the reference currency under a new system.” (highlight mine) So it won’t be a far fetched idea for a movement among nations to address the need to reform the present monetary system.

Yet as the crisis continues to unfold, everything now seems to depend on how the global markets will respond to the massive stimulus applied and how it will measure up to remedy the apparent weakening of the foundations of the US banking system.

Nonetheless the threat remains real.

This means that should the US banking system collapse, there will probably be no escape for almost everyone dependent directly or indirectly on the global banking system, not even for those who aren’t invested in the stock market. While it is true that alternative sources for financing such as microfinancing and trade finance may be picking up on some of the slack, it won’t be enough for it to replace the rapidly mounting losses in the financial system that risks becoming a financial black hole.

We can only guess what implications of a global depression as an offshoot to the US banking collapse could be: pension, insurance, and other money market funds will perhaps evaporate, stock markets will close, a collapse in the international division of labor means each country will have to fend for themselves or dominant “protectionist” policies will prevail (hence some countries will experience hyperinflation and others will suffer from deflation), a run of the US dollar or the present paper money system, rising crime and security risks, civil wars, return of authoritarianism etc…

On the other hand, some sectors would be quite happy- the extreme left will glee with the resultant equality from a depression, as well as bureaucrats and political leadership who will benefit from more government spending. Outside these sectors, everyone will probably be equally poor!

Sorry for the gloom.

Conclusion

Thus, it is an arrant misguided fairy tale to suggest that today’s stock market meltdown is just seen for its “media feed”.

Today’s stock market meltdown is representative of the real risks of a US banking collapse. While I am not betting that this devastation is gonna happen, a US banking collapse would have deep adverse repercussions to our domestic and global banking system, aside from the global economy which practically means the ushering in of the great depression (version 2008) . Why would global central banks have earmarked over $3trillion of bailout money? Why would Bernanke’s Federal Reserve Helicopters be doing simultaneous missions globally to drop “helicopter money”?

So it is equally myopic to suggest that our banking system will be “immune” to such extreme risk scenario. If the issue is only about banking losses and some disruptions in the system then yes the Philippine banking system will escape with some bruises.

Nonetheless if the US banking industry does collapse, not even those out of the stock market will be spared unless their money is stashed under their pillowcase or buried underground.

That is if street muggers don’t figure them out.