Our Version of The Risks of A US Dollar Crash

``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system”- Ludwig von Mises Human Action p.555

The prospective shortfall from the frontloading of fiscal deficits has prompted accelerated concerns over a crash of the US dollar.

For some the definition of a US dollar crash is simply a wave of selling of US financial claims from major official creditor nations, i.e. central banks and sovereign wealth funds.

For us, the incentive to drastically and simultaneously unload US assets appears unlikely, because it won’t be to any country’s interest to foment a US dollar crash as this will be equivalent to mutually assured destruction. To quote Luo Ping, a director-general at the China Banking Regulatory Commission who spoke with levity over a recent public engagement, ``“We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.” [emphasis mine]

Moreover, many have been suggesting for the US to massively devalue by running up the printing presses, a step similarly undertaken by then US President Franklin Delano Roosevelt during the Great Depression. This should ostensibly reduce the real value of debt by reducing the currency’s purchasing power.

However, the privilege from “devaluing” translates to lost savings and a significantly lower standard of living and even more poverty. To quote money manager Axel Merk of Merkfund.com, ``Somehow policy makers have it backward. Many of us like our jobs, but not so much that we love to give up half our net worth for the opportunity to go back to work.”

Besides, the basic problem of the US dollar devaluation seems to be, “to devalue against whom or what”?

During the Great Depression, the US dollar was operating on a gold standard platform which allowed for it to devalue. Our paper money system isn’t tied to gold anymore.

I might add that to conduct an arbitrary massive devaluation can be construed also as a form of non tariff protectionism.

Therefore, it would seem rather unlikely for the US or for that matter to any major OECD country or regional economies to perhaps impose on such irresponsible protectionist stance without expecting the same punitive retaliatory measures.

This means, as we have repeatedly pointed out in the past, the likely scenario from unilateralist US dollar devaluation could be the risks of a currency war, which ultimately leads to the disintegration of the present paper money system, and possibly, a world at war.

While many countries appear to be itching towards adopting or gradually espousing non tariff populist protectionist policies such as export restrictions, import quotas, anti dumping duties, non automatic licensing, technical regulation to trade covering health and environment and subsidies to national industries, it is unlikely that governments could veer towards radicalism. Nations which depends on trade, together with the World Trade Organization and multinational companies will possibly lobby to maintain sangfroid temperaments.

Hence, an orderly coordinated devaluation may occur only if done under an international rapprochement similar to the 1985 Plaza Accord. The same multilateral approach can be undertaken when considering global debt restructuring or a reconfiguration of the monetary architecture.

Nonetheless we beg to differ from the conventional expectations of US dollar crash paradigm.

We concur with Brad Setser when he cites that the present dynamics as shifting from reduced significance of external based financing to increasing contribution from domestic savings.

Here is Mr. Setser, ``The overarching assumption behind the stimulus is that a rise in US household savings (linked to the fall in US household wealth) will create a pool of domestic savings that will flow, given the ongoing contraction in private investment, into the Treasury market. The rise in private savings and fall in private investment will allow the US government to borrow more even as the US economy as whole borrows less from the rest of the world. The key to the Treasuries rally in 2008 was the surge in private demand, not the strengthening of official demand. My guess is that the Treasury market will be driven by developments in the US – not developments in China – in 2009.”

This means a US dollar crash will probably occur if private creditors alongside official creditors instigate a run on the US banking system. That will happen only if a surge in inflation or the debt burden becomes intolerable. On the other hand the other possible scenario, as mentioned above, could be a currency war. Of course there maybe other possible scenarios, which at present, escapes our thought for the moment.

Will Deglobalization Lead To Decoupling?

``The most recent evidence shows that growth in emerging economies has started to moderate—partly in response to lower U.S. demand for their exports, and partly in response to the 2008 second-quarter tightening in monetary policy, designed to offset higher inflation pressures. This slowing has served to crystallize what, to date, has been an oversimplification of the debate about the evolving relationship between emerging and industrial economies. The debate should be framed not in terms of decoupling versus recoupling, but whether the decoupling is "strong" or "weak."- Mohamed A. El-Erian, A Crisis to Remember

In 2008, it became fashionable to debunk the so called “decoupling” theme. The kernel of the argument was that since world economies revolved around the US, which functioned as the only major source for “aggregate demand”, a slumping US economy would synchronize the slowdown everywhere. This phenomenon would naturally reflect on global financial markets. Of course, from the single dimensional perspective, they were right.

The salad days of the US debt driven consumption boom was buttressed by globalization, a trend which integrated trade, finance, investments to even labor-migration flows. This occurred because of concerted policies to “open” the national economies, although at varying scale.

Importantly, the boom conditions had been powered by the US Federal Reserve’s monetary policies which was transmitted to the rest of the world via the currency mechanism-dollar links, pegs, and “dollarized” economies and through its current account deficits, which allowed the US to export financial products in exchange for goods and services from the rest of the world.

Moreover, the plethora of credit, from the US and other advance economies, resulted to a diffusion of easy credit in the emerging markets. And because of the profusion of liquidity, capital flowed to rest of the world in search of higher yields (see Figure 1).

Figure 1: Institute of International Finance (IIF): Private Capital Flows

According to the IIF, the world's only global association of financial institutions with 375 members from 70 countries, ``In the previous two expansion phases (1978-81 and 1990-96) there was a dominant region that attracted more flows than other regions. In the early 1980s, the dominant region was Latin America. In the early 1990s, lending to Latin America surged once again, although this was tempered by the Mexican crisis in 1994-95 and its aftermath. Following that, lending surged to Emerging Asia, setting the stage for the Asian crisis in 1997-98. This time around, lending surged to all regions in 2007, before contracting sharply to all regions in 2008 and, most likely, in 2009.” (bold highlight mine). Thus financial markets across the globe and across diverse asset classes simultaneously zoomed.

So the operating framework of the recent globalization boom essentially encompassed liberalized trade and investment policies and fueled by an easy money “inflationary” environment emanating from the US.

From Globalization to Deglobalization

Now that the debt driven consumption bubble is unwinding, some of these trends are being reversed. Here are some of the contributing variables:

One, Forcible liquidations from Debt deflation. Since the center of capital flows came mostly from the US and advanced economies, a global ‘margin call’ from the debt deflation dynamics prompted the simultaneous forcible liquidations across asset classes.

Two, temporary scarcity of the US dollar. The imploding debt markets had been mostly denominated in the US currency, hence payment or settlement of these closed positions increased the demand for US dollars.

Besides, the severe losses in the in the US banking system accounted for as a financial “black hole”. This vacuumed out the US dollars in the system at a greater intensity than had been replaced by the US Federal Reserve.

Hence, the shortages of the US dollars exposed the internal deficiencies of many emerging markets (Korea, Russia, Pakistan etc.) and exacerbated the deteriorating economic outlook. To allay this predicament, the US Federal Reserve entered into currency swaps with most of the world’s major central banks [see How Does Swap Lines Work? Possible Implications to Asia and Emerging Markets]

Three, dysfunctional US banking system. As mentioned in last week’s What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis, like the traumatic 9/11 tragedy, the world basically was rendered dumbfounded or “shocked and awed” as the US banking system froze late last year. Trade and production fell from the cliff as credit windows were shut.

Four, dislocation of trade channels. The emergence of barter as a form of trade signified both the ongoing disorder in the operations of the global banking system and incipient signs of distrust over the present financial architecture.

In the recent tour of Europe, China’s Premier Wen Jiabao ``urged the international community to set up a new global economic system (bold emphasis mine)” (China Economic Net)

Five, national financing seems likely to turn inward.

Current account imbalances are likely to improve as deficits narrows in a LOW oil price global recessionary environment. In a HIGH oil price recessionary environment deficits might not materially improve. And deficit economies as the US will have to increasingly secure financing from its taxpayers than from previous vendor-financing scheme.

From Richard M. Ebeling of the American Institute for Economic Research, ``…the Chinese are becoming increasing leery of lending to the American markets. At the recent international meeting of bankers, businessmen, and bureaucrats in Davos, Switzerland, Chinese officials made clear their dissatisfaction with the American market, where they have suffered significant losses in banks and other financial institutions into which they had invested. In the last five months of 2008, the Chinese sold off almost half of the $46 billion is Fannie Mae and Freddie Mac bonds that they had purchased in the earlier part of the year.

``If foreign lenders do not come to the rescue, Uncle Sam will have to rely far more than in the recent past on the financial markets at home to finance its deficit spending dollars. A lot of new bank lending--with perhaps some of the billions already given by Washington to bailout many of these banks--will have to end up covering the federal government’s expenditures, rather than being available for private sector investment and employment creation.”

Meanwhile, current account surplus economies with huge forex surpluses will likely be used to defend national (e.g. Russia) or regional economies (China, Japan, and South Korea extend currency swaps to Indonesia-Bloomberg) than recycled to the US.

Another important noteworthy development is that China will be providing the currency swap arrangement with Indonesia with its own currency the remimbi, instead of the US dollar (WSJ). Combined with the recent attempt to use its currency as medium of exchange for the settlement of trade with ASEAN nations, China seems to be flexing its economic and financial muscles, which eventually may turn out to be the region’s currency standard.

Sixth, economic structures built upon unsustainable debt are being cleared. This will be reflected on reduced global trade which is expected to decline by 2.1% in 2009.

Lastly, there are budding signs of protectionism or the reversal of trade liberalization. See figure 2.

Figure 2: WSJ: Putting Up Walls

According to the Wall Street Journal, ``Countries grappling with global recession have enacted a wave of barriers to world commerce since early last month, scrambling to safeguard their key industries -- often by damaging those of their neighbors.

``The World Trade Organization is gathering nations in a special meeting Monday to try to stem the rising tide, just two weeks after saying protectionism was largely under control.”

In short, globalization seems being deglobalized.

Of course, deglobalization as a trend is likely to increase or intensify economic risks or worsen the current dilemma. The trade protectionism from the Smoot-Hawley Tariff Act in the US during 1930s was a major contributing factor which transitioned a recession to the Great Depression.

But unlike the Great Depression era, governments today seem likely to be aware of the negative consequences of such policies. The recent actions seem to signify knee jerk reactions out of domestic political exigencies. Hopefully, the actions undertaken by the WTO to mediate could help avoid the aggravation of such trends that risks a reprise of the 30s.

Structural Difference In A Deglobalized World

Nonetheless the collective government policies aimed to address today’s recession is to throw money at the economy. In other words, inflationary actions by governments will remain a pivotal force in driving asset markets and economic outcome.

Now if the essence of deglobalization is centered mainly on the market clearing of global credit bubble economic structure (and not on increasing trends of protectionist barriers) then once the portfolio outflows from forcible liquidations subside, excess capacities directed at the bubble demand are closed or bankrupted and surplus inventory are reduced, the likelihood is that all the convergent inflationary pressures applied by governments could have a distinct impact based on the nation’s capital or production structure.

Take for example the credit structure of major world economies, see figure 3.

Figure 3: US Global Investors: Credit as % of GDP

Credit as percentage of GDP is seen dissimilarly distributed across economies. For instance the UK and US has the highest household credit exposure, brought about by the recent boom in the securitization financed real estate bubble.

And the present financial crisis is forcing a market based “deflation” adjustment to such disproportionate levels of debt. Hence, under current conditions UK and US household debt levels will have to contract during the life of this crisis. Paradoxically, this unsustainable debt structure is what their governments have vigorously been trying prop up.

So unless the US and UK succeeds in destroying its currency to reduce the real value of debt, we can’t see material credit growth to produce the expected inflation based economic growth.

Now since global interest rates are being forced to approach to zero levels, which of these economies are likely to assume more debt?

The answer is that debt take up is likely to occur in emerging markets and Asia than on advanced economies, because of their low levels of exposure.

Plainly put, Asia and emerging has the capacity to absorb more debt than its contemporaries in the advance economies. Hence any bubble that could surface under the present negative interest rate regime will probably be in emerging markets and in Asia. Such assumes that the pangs of the adjustments (production and inventory) from the recent bubble structures have culminated.

Nonetheless to buttress our argument that Asian economies have the capacity to absorb more debt, the recent data on writedowns on bank losses and capital raised should illustrate the ongoing divergence in the underlying strength of global financial institutions (see figure 4).

Figure 4: ADB Bond: 3^rd Quarter writedowns and Capital Buildup

Asia’s hasn’t been immune from the crisis as shown by the chart from Asian Development Bank.

But the message is very clear, Asia’s losses is a speck compared to both Europe and America. This means Asia’s banking system is hardly impaired by the recent crisis and could function normally relative to its peers across the globe once the recession fears subside.

So seen from the demand side, there seems to be a huge room for growth as the household and corporate sector have low credit coverage. From the supply side, the well capitalized, apparently healthier banking system in Asia, may oblige to fulfill such potentials.

Overall, the prevailing policies seem to present itself as an auspicious condition for the next bubble-here in Asia and or in emerging markets.

Government Financial Bubble=Banana Republic?

However, in contrast, the bubble taking place today is progressing under government finance, especially in the US, UK and the Euro zone, where governments have been absorbing the private sector losses in a seemingly futile attempt to support an indefensible bubble structure.

Yet oblivious to the proponents of the “inflation driven” economic growth model, for this to paradigm to successfully operate requires a vicious expansion of the leverage feedback loop cycle-leverage which will require further or larger leverage to support a reverse pyramid shaped bubble framework. We will need to bring back 20:1, 30:1, 40:1 and so forth leverage in the system.

Instead of allowing for debt to fall to the levels where the economy can sustain them, the popular underlying belief is to print money away to contain a deflating bubble. Yet sustained operations of the printing press are likely to cause even greater problems.

So we can expect more bailouts or stimulus to come on stream as earlier efforts fail to achieve the goals. The end result will be an untenable government financial bubble. And a reality check means ultimately, all bubbles meet their comeuppance.

London School of Economics Professor Willem Buiter has a better narrative (bold highlight mine), ``In a world where all securities, private and public, are mistrusted, the US sovereign debt is, for the moment, mistrusted less than almost all other financial instruments (Bunds are a possible exception). But as the recession deepens, and as discretionary fiscal measures in the US produce 12% to 14% of GDP general government financial deficits – figures associated historically not even with most emerging markets, but just with the basket cases among them, and with banana republics – I expect that US sovereign bond yields will begin to reflect expeted inflation premia (if the markets believe that the Fed will be forced to inflate the sovereign’s way out of an unsustainable debt burden) or default risk premia.”

So like Iceland, maybe the US and UK will unwittingly enlist itself in the membership roster of the third world economies or disparagingly, the Banana Republics. Or how about the Philippinization of America and England since the Philippines seems to be a Keynesian paradise?

P.S. there has been much chatter about the merits/demerits of adapting the bank nationalization model of Sweden, including some of our so called local experts.

One caveat everyone seems to miss, Swede banks dealt with traditional mortgages while US banks are stuffed with securitized or structured finance instruments. Put differently, the former has recoverable or redeemable future value while the latter’s future value could be permanently ZERO.

The Myth of the Great Rebalancing

The "great rebalancing" is a concept where trading partners of the US should be required to adjust domestic policies in order to "rebalance" the large discrepancies in the global current account.

The "Great Rebalancing" is a fantasy conjured by liberals.

We can’t have a “great rebalancing” under the US dollar standard. Why? Because the US dollar standard operates on the principle of FREE LUNCH. Back to basics tell us that US issues (bank) notes in exchange for goods and services of the world. So essentially the US gets something (real goods-imports) for nothing (Dollars as IOU-exports). And because it operates on a something for nothing platform, you’d naturally have DEFICITS because the US doesn’t need to or simply WON’T produce enough. Why produce when I can acquire goods with my IOUs? And to fund balance of payment (BoP) deficits means increasing sales or exports of more IOUs in terms of either US dollars, US treasuries/agencies or US private financial claims. This is elementary.

So the idea that China should follow the dictates of the Keynesians and Hamiltonists to revalue their currency to INCREASE internal demand is a fantasy. Why should China or the rest of the world need to do so if isn’t in their perceived interest? It’s like getting services of a prostitute, where after being satisfied I DON’T pay up. Naturally the next time around, either the hooker won’t agree to service me or ask to pay upfront first, unless she falls in love with me! For China and others to follow the advices of these sacrosanct liberals is like getting forcibly screwed repeatedly for FREE!

And the Chinese recognize this. Proof? From Gao Xiqing president of the China Investment Corporation in an interview by James Fallows ``People, especially Americans, started believing that they can live on other people’s money. And more and more so. First other people’s money in your own country. And then the savings rate comes down, and you start living on other people’s money from outside. At first it was the Japanese. Now the Chinese and the Middle Easterners.

``We—the Chinese, the Middle Easterners, the Japanese—we can see this too. Okay, we’d love to support you guys—if it’s sustainable. But if it’s not, why should we be doing this? After we are gone, you cannot just go to the moon to get more money. So, forget it. Let’s change the way of living.”

Today’s private sector deleveraging doesn’t change the equation. The leverage simply shifts to the public sector but the principle remains the same- a free lunch US dollar standard. Forcing adjustments on US trading partners to accommodate ‘rebalancing’ will only extend the unsustainable free lunch operations. It’s a beggar thy neighbor prescription, which only punishes those that have not engaged in reckless speculation in the same way present global central bank policies are doing. Yes sir, Pope Benedict, central bankers are FORCING PEOPLE to borrow and speculate or to be “greedy”!

Of course, because constituents benefiting from the “something out of nothing” privilege, the natural consequence is for them to turn into to speculation-that’s why the US had the “dot.com” bubble, and that’s why it shifted to today’s imploding “real estate bubble” and now to the US treasury bubble.There simply is little incentive to produce.

Thus, the principle of free lunch begets the illusions of perpetual wealth based on consumption over production, expanding leverage and speculation or the “inflation mentality”, all of which fosters a psyche of entitlement.

Besides, importantly the lack of self adjusting discipline mechanism from the US dollar standard ensures the perpetuity of humungous BoP imbalances.

In short, the free lunch principle of the US dollar standard means perpetual BoP deficits for the US, because there are less incentive to produce goods. And perpetual deficits mean that the US will depend on rest of the world to provide goods and financing. And because deficits means the continual selling of financial claims, it thus perpetuate bubble conditions. Remember, IOUs for goods and services.

Ultimately, the Mises moment deals with the structural imbalances of the free lunch principle of today’s currency standard, the ultimate Ponzi scheme. If the system can’t bear enough of free lunches then it will collapse, similar to the unmasking of Bernard Madoff and the unraveling of today’s Ponzi financing mortgage securitization credit bubble.

The "great rebalancing" is predicated on false premises and thus a fairy tale that can’t survive the real world order.

Nassim Taleb is right about these so-called experts, ``The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen.”

The US-China Symbiosis: The Natural Outcome of the US Dollar Standard

This is an interesting depiction of the tightly intertwined political economic dynamics of the US and China from Mark Mark Landler for New York Times and International Herald Tribune.

First the wonderful Charts….

Next, some excerpts from the article (emphasis mine)…

``A new economic dance

``The United States has been here before. In the 1980s, it ran heavy trade deficits with Japan, which recycled some of its trading profits into American government bonds.

``At that time, the deficits were viewed as a grave threat to America's economic might. Action took the form of a 1985 agreement known as the Plaza Accord. The world's major economies intervened in currency markets to drive down the value of the dollar and drive up the Japanese yen.

``The arrangement did slow the growth of the trade deficit for a time. But economists blamed the sharp revaluation of the Japanese yen for halting Japan's rapid growth. The lesson of the Plaza Accord was not lost on China, which at that time was just emerging as an export power.

``China tied itself even more tightly to the United States than did Japan. In 1995, it devalued its currency and set a firm exchange rate of roughly 8.3 to the dollar, a level that remained fixed for a decade.

``During the Asian financial crisis of 1997-98, China clung firmly to its currency policy, earning praise from the Clinton administration for helping check the spiral of devaluation sweeping Asia. Its low wages attracted hundreds of billions of dollars in foreign investment.

``By the early part of this decade, the United States was importing huge amounts of Chinese-made goods, toys, shoes, flat-screen televisions and auto parts, while selling much less to China in return.

``"For consumers, this was a net benefit because of the availability of cheaper goods," said Lawrence Meyer, a former Fed governor. "There's no question that China put downward pressure on inflation rates."

``But in classical economics, that trade gap could not have persisted for long without bankrupting the American economy. Except that China recycled its trade profits right back into the United States.

``It did so to protect its own interests. China kept its banks under tight state control and its currency on a short leash to ensure financial stability. It required companies and individuals to save in the state-run banking system most foreign currency, primarily dollars, that they earned from foreign trade and investment.

``As foreign trade surged, this hoard of dollars became enormous. In 2000, the reserves were less than $200 billion; today they are about $2 trillion.

``Chinese leaders chose to park the bulk of that in safe securities backed by the American government, including Treasury bonds and the debt of Fannie Mae and Freddie Mac, which had implicit government backing.

``This not only allowed the United States to continue to finance its trade deficit, but, by creating greater demand for United States securities, it also helped push interest rates below where they would otherwise be. For years, China's government was eager to buy American debt at yields many in the private sector felt were too low.

``This financial and trade embrace between the United States and China grew so tight that Ferguson, the financial historian, has dubbed the two countries Chimerica.

Finally, my comment:

One very important matter missed out by this insightful article is that these prevailing dynamics operate under the principle of FREE LUNCH or “something out of nothing” concept of the US dollar currency standard.

Basically, the US issues its notes backed by the “full faith and credit” of the US government in exchange for real goods and services from the rest of the world. Thus the natural consequence from the operating platform is to see enormous current account imbalances from the global economy framework-again, where the US exports financial claims (US dollar and US dollar assets) to fund its balance of payment debt driven deficits while it import goods and services elsewhere.

And one major consequence has been the aberrant global “vendor financing scheme” which had been quoted by Mr. Landler at the prologue of the article as…``Usually it's the rich country lending to the poor. This time, it's the poor country lending to the rich."- Niall Ferguson.” (Hey Pope Benedict, don’t you think your campaign against greed should to start with this greed fostering "something for nothing" system?)

And it is also the principal reason behind the serial bubble (inflate-deflate) cycles around the world...

In Japan then…

[M. Landler] ``At that time, the deficits were viewed as a grave threat to America's economic might. Action took the form of a 1985 agreement known as the Plaza Accord. The world's major economies intervened in currency markets to drive down the value of the dollar and drive up the Japanese yen.

``The arrangement did slow the growth of the trade deficit for a time. But economists blamed the sharp revaluation of the Japanese yen for halting Japan's rapid growth…

And in the world today...

[M. Landler] ``This not only allowed the United States to continue to finance its trade deficit, but, by creating greater demand for United States securities, it also helped push interest rates below where they would otherwise be. For years, China's government was eager to buy American debt at yields many in the private sector felt were too low.”

And because of the boom bust character emanating from such framework, trade policies have accordingly been shaped to the operating environment.

[M. Landler] ``But in classical economics, that trade gap could not have persisted for long without bankrupting the American economy. Except that China recycled its trade profits right back into the United States.

``It did so to protect its own interests. China kept its banks under tight state control and its currency on a short leash to ensure financial stability. It required companies and individuals to save in the state-run banking system most foreign currency, primarily dollars, that they earned from foreign trade and investment.

And so the idea being peddled by some experts that trade protectionism needs to be raised via the currency “lever”, aimed at improving the state of global balance of payments, doesn’t square with the realities of the operating framework of the present system which NATURALLY prompts for these anomalies. The fundamental reason is that the present monetary system lacks the self-adjusting mechanism traditionally seen in the gold standard.

Blaming simplistically the US for “overconsumption” or China for “exporting overcapacity” via the currency "manipulation" channel seems like the proverbial “pot calling the kettle black” and deals with cosmetic issues.

Yet the policy prescriptions from these experts appear directed at salvaging the statusquo of inflation driven economic growth models of the US dollar standard system. [M. Landler] ``"It is sometimes hard to change successful models," said Robert Zoellick, who negotiated with the Chinese as a deputy secretary of state. "It is prototypically American to say, 'This worked well but now you've got to change it.' "

In short, for as long as the US dollar functions as the backbone of the world's financial architecture, we should expect to see the persistence of the phenomenon of highly skewed global balance of payments and “mercantilist” policies which help shapes them.

Desires to remedy such imbalances without dealing with operating platform of the present global currency standard seems likely a "tooth fairy" approach. This unsustainable system will likely persist until it crumbles under its own weight (like a Ponzi house of cards), possibly fast tracked by the adoption of destructive policies recommended by the "omniscient" liberals, or by a concerted political thrust to overhaul the system.

But since governments are typical reactive agents and where a systemic reconfiguration translates to an admission of a shift in the distribution of geopolitical power, the latter option seems unlikely.

This makes a crisis as the only catalyst for change. Here Secretary Paulson got it right, [M. Landler] ``"One lesson that I have clearly learned," said Paulson, sitting beneath his Chinese watercolor. "You don't get dramatic change, or reform, or action unless there is a 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.