2009: Go for Gold! Beware the US Treasury Bubble

``The world is lurching through a serious monetary disorder. The proximate cause is the collapse of the housing bubble and the subprime-credit crisis, but the ultimate cause is the inherently unstable monetary system foisted upon us by a banking cartel. Central bankers are called upon to act as lenders of last resort, but in their efforts to inflate their way out of the credit collapse, they risk igniting a hyperinflationary bonfire that will destroy the world's major fiat currencies. Gold was money once, and could become so again.”- Robert Blumen, Is Gold Money?

Except for Ghana (up 60%), Tunisia (up 10.6%) and Ecuador, which escaped the wrath of a global financial meltdown, all of the stock market benchmarks were in the red for 2008.

Nonetheless the other asset outperformers had been the US dollar and US treasuries both of which benefited from the forcible liquidation and served as the “safehaven” amidst the present deflationary scare, see figure 2.

Figure 2: Bespoke Invest: Gainers and Losers

According to Bespoke Invest, ``While it has been a horrible year for stocks (S&P 500 down 39%), it's been much worse for oil, which as we all know was up nearly 50% for the year back in July. While most asset classes are down big, the US Dollar has risen 6%, and Treasuries have skyrocketed. As shown, the 10-Year Treasury Note is up a whopping 21% this year, prompting the majority of market participants to call it the next bubble.”

This chart excludes another winner though, gold which racked up 4.95% in 2008 based in US dollar terms.

Yet, gold didn’t just gain against the US dollar. It likewise gained against most of the major currencies except for the Japanese Yen and Chinese Yuan see figure 3.

Figure 3: courtesy of James Turk of goldmoney.com: EIGHT years in a row

Why our fancy with gold?

Why our fancy with gold?

While we can cite growing demand supply imbalances amidst the present turmoil, our focus is on how global central bankers have been dealing with the present crisis.

Again while major global central banks have been force feeding the banking system with record amounts of money which is basically being eaten up by the losses of the highly financial leveraged system, eventually the seemingly endless tsunami of money being fed will overwhelm such losses. Of course, all this could take time but that would be in the assumption that we can time the markets. Nonetheless, the obvious effect will be risks of HIGHER inflation if not HYPERINFLATION. And inflation’s reappearance could be dramatic.

In addition, not all of the global economy has been ravaged by debt deflation. Economies in Asia for instance have been less leveraged or less affected, yet global governments including Asia and Emerging Markets have been adopting the same policies of currency debauchment. Stimulus programs that can’t be paid for by taxes or borrowed from taxpayers domestically or internationally will have to be met by the central banks’ printing or digital presses. Basically this implies inflation.

Again in the US, government fiscal deficits won’t only be about recapitalization and support of the financial industry but also about plugging of the shortfalls in tax revenues.

Figure 4: Nelson Rockefeller Institute: Deteriorating Tax Environment

The Nelson Rockefeller Institute projects tax collections “likely heading into negative territory for the first time since the last recession in 2002”.

So the amount exposed yet by the US government is likely to be a downpayment among other possible future installments.

Again all these sums up to a potential massive spillage of unsterilized money being churned out by global central banks and governments which the entire economic system will have to absorb.

Moneyness of Paper Money

Moreover, in a world where central banks are working to devalue their currencies overtime, any other currencies aren’t likely to assume the role of safehaven again because of implicit political interests.

Remember, paper currencies are basically IOUs issued and stamped by governments as “legal tender” and backed by nothing but FAITH in the issuer. Because paper money is an IOU, it bears counterparty risks.

Where money as a medium of exchange requires these characteristics: durability, divisibility, scarcity, portability, uniformity and acceptability, unlimited issuance of paper money essentially diminishes the moneyness quality of paper currencies. As we cited earlier given the massive and full scale deployment of the printing press globally, such the raises the risk of a potential of disintegration of the present financial architecture.

The chafing the characteristics of the moneyness of paper money, the gradual erosion faith over its LEGAL TENDER status, global currencies in a race to the bottom, potential upheaval of the monetary structure or the plain universality of economic law where the growth of supply of money is greater than economic output simply collectively means a loss of purchasing power of paper money against gold (and other real assets).

At best, gold, which bears no counterparty risks and functions as no one else’s liability, will be your insurance against the vast stealth tax employed by global governments. At worst, gold will regain its monetary luster or play a renewed role in reshaping the next global monetary regime (worst because of the unfathomable distress that the world will possibly undergo first before rediscovering gold’s importance).

This is why signs of shortages in physical gold has been offsetting the huge short positions taken by a few government controlled big banks (see Influencing Gold and Silver Markets, Backwardations Imply Higher Gold and Silver Prices), which is in my suspicion have been attempts to manipulate gold prices as to refrain from exposing the inflationary effects of their actions. Unfortunately, markets are larger than government can permanently control where manipulation can only influence price signals over a limited period.

Debt Over Issuance Over Limited Capital Equals Treasury Bubble

Finally, it is obvious that in a world where losses have been mounting and where institutions have been seeking refuge in governments, that capital is in an apparent shortage. Yet, expected material slowdown of world trade and a projected global economic deterioration implies an erosion of economic output, and perhaps a reduction of real savings, especially as governments work to redistribute residual capital.

Nonetheless as global governments attempt to reinflate the global economy, this translates to an ocean of issuance of debt instruments which would effectively compete with the diminishing supply of “savings-based” capital. This means that the panic driven boom in US treasuries seems more and more like time bomb waiting to implode that could bring about the next crisis to US treasuries holders.

As an aside, the plan of the US Federal Reserve to buy long dated bonds in an effort to close the arbitrage windows for banks could bring opportunities for foreign owners of US treasuries, where about 55% of privately held US treasury securities are foreigners (CRS Report for US Congress), to gracefully exit the bubble. It’s a wonder if China and Japan will do so. And it is amazing how complex the world is and full of unforeseen possibilities.

Eventually capital will be seeking a premium over the sea of debts which means higher interest rates for the world.

Consumer Deflation: The New Fashion

``All the major institutions in the world trying to deleverage. And we want them to deleverage, but they’re trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that’s willing to leverage up. And there’s no one that can leverage up except the United States government.-Warren Buffett, Interview Transcript

This world is full of befuddling ironies.

Just last year, when consumer prices were rampaging skywards, we were told by media and their experts how “inflation” was bad for the economy. Today, as consumer prices has been falling, the same forces of wisdom explain to us how “deflation” has likewise been detrimental to the economy or perhaps even worst….

As example we are told that declining consumer prices “aren’t just symptom of economic weakness” but are “destructive in and of themselves”. Why? Because as demand weakens and prices decline, companies cut employment and investment, slowing economic growth even further. Thus the chain of inference includes “falling earnings, a weak economy, and the hoarding of cash, fewer investors are willing to buy stocks during deflationary times.”

And the “deflation” theme has grabbed the headlines see figure 1.

Figure 1: Economist: The Deflation Index

According to the Economist, ``Back in August, only six stories in the Wall Street Journal, International Herald Tribune and the Times mentioned “deflation”. In November, there have already been 50, and new figures released this week will mean many more. America's consumer-price index fell by 1% in October from September as oil prices plunged, the largest monthly fall since the series began in 1947. Britain's inflation rate has also fallen from its record high of 5.2% in September to 4.5% in October, the biggest drop in 16 years.

For starters, falling prices basically reflect demand supply imbalance, where supply is greater than demand. Such conditions may be further prompted by either supply growing FASTER than demand or demand declining FASTER than supply.

Paradox of Savings And Growth Deflation

When prices fall because of technological innovation such as the mobile phones, the internet and others, these items become affordable and have rapidly been suffused into the society enough to make it an economic staple.

For instance, mobile phones are expected to hit an astounding 61% global penetration level according to the UN (Europe News) or about 6 out of 10 people will have access or be using mobile phones by this year. According to high profile economist Jeffrey Sachs, the diffusion of mobile communications will revolutionize logistics and education that should benefit the rural economy.

Quoting Mr. Sachs, ``The mobile revolution is creating a logistics revolution in farm-to-retail marketing. Farmers and food retailers can connect directly through mobile phones and distribution hubs, enabling farmers to sell their crops at higher “farm-gate” prices and without delay, while buyers can move those crops to markets with minimum spoilage and lower prices for final consumers.

``The strengthening of the value chain not only raises farmers’ incomes, but also empowers crop diversification and farm upgrading more generally. Similarly, world-leading software firms are bringing information technology jobs, including business process outsourcing, right into the villages through digital networks.

``Education will be similarly transformed. Throughout the world, schools at all levels will go global, joining together in worldwide digital education networks. Children in the US will learn about Africa, China, and India not only from books and videos, but also through direct links across classrooms in different parts of the world. Students will share ideas through live chats, shared curricula, joint projects, and videos, photos, and text sent over the digital network.” (underscore mine)

Moreover, falling prices should translate to more purchasing power.

So how can falling prices be all that bad?

The answer lies squarely on the Keynesian dogma of the “Paradox of Savings”. What supposedly signifies as virtue for individuals is allegedly (and curiously) a bane for the society. The idea is that when people save or withhold consumption, the underlying consequence would be a reduction in investments, employment, wages, etc. etc, thereby leading to a slowdown or even a contraction of economic growth. Seen from the aggregate top-down framework, less consumption equals less economic growth.

This has been profusely peddled by media and the social liberal school as basis for justifying GOVERNMENT INTERVENTION to conduct policies aimed at stimulating growth or rescue, bailout or other inflationary policies to avoid “demand contraction”.

Anecdotally, if savings is truly so bad for an economy then Japan should be an economic basket case by now, yet it holds some $15 trillion in household assets as of June, of which only 13.9% is in stocks and mutual fund and $7 trillion in bank deposits. This in contrast to the US where only 17% is in deposits and 50% is into stocks and pension funds (Washington Post). Japan’s high savings rate has even been reflected in public sentiment where a polled majority refuses to accept government offers to “stimulate” the economy (see Free Lunch Isn’t For Everyone, Ask Japan), as it had learned from its boom-bust cycle experience.

From the Austrian school perspective, the Japanese scenario can be construed as a “Cash Building Deflation” case. From Mises.org’s Austrian Taxation of Deflation by Joseph Salerno, ``Despite the reduction in total dollar income, however, the deflationary process caused by cash building is also benign and productive of greater economic welfare. It is initiated by the voluntary and utility-enhancing choices of some money holders to refrain from exchanging titles to their money assets on the market in the same quantities as they had previously. However, with the supply of dollars fixed, the only way in which this increased demand to hold money can be satisfied is for each dollar to become more valuable, so that the total purchasing power represented by the existing supply of money increases. This is precisely what price deflation accomplishes: an increase in aggregate monetary wealth or the “real” supply of money in order to satisfy those who desire additional cash balances.”

In addition, this Keynesian obsession with “aggregate demand” says economic growth should be associated with “inflation”.

Figure 2: American Institute For Economic Research: Falling US Dollar

Yet, if inflation is measured by means of the increase or loss of a currency’s purchasing power, then the US dollar’s appalling loss of purchasing power since the birth of the Federal Reserve in 1913 (see figure 2) shows that US economic growth hasn’t been primarily driven by productivity (productive economy=an environment of falling prices or “deflation” as more goods or services are introduced) but by inflationary policies or by money and credit expansion!

Note: the chart also exhibits that when the US dollar had been redeemable into monetary commodities (gold or silver), purchasing power of the US dollar tends to increase. Yes, this is defined as DEFLATIONARY ECONOMIC GROWTH or GROWTH DEFLATION (!)

Again from Mises.org’s Austrian Taxation of Deflation by Joseph Salerno, ``In fact, historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard.” (highlight mine)

Falling Markets: Debt Deflation Not Consumer Price Deflation

But savings isn’t about the absolute withholding of consumption. There is a very significant time dimension difference: it is a choice between spending and consuming today or in the future. Moreover, there are two types of consumption to reckon with; non productive consumption and productive consumption.

The definition of savings according to the Austrian School, excerpting Gerard Jackson, (underscore mine)``The full definition is that savings is a process by which present goods are transformed into future goods, i.e., capital goods, that produce a greater flow of consumer goods at some further point in time. In short, present goods in the form of money are used to direct resources from consumption (the production of consumer goods) into the production of capital goods.”

When we put cash balances into a bank, the bank functioning as intermediary parlays such deposits into loans (for business or for consumers) or as investments in securities (private e.g. corporate bonds or public-local government e.g. municipal bonds or national government e.g. Treasuries). So essentially, our savings are channeled into the private sector or as financing to government expenditures.

Thus, the paradox of savings or the anticipated rise of savings rate in the US or in countries severely impacted by the deflating mortagage backed credit bubble, given the magnitude of government efforts to “cushion” or “rescue” the financial system and the economy, will effectively be utilized to finance most of these government programmes.

The negative aspect is not that the consumption ripple effect will result to lower economic growth but instead savings channeled into public/government consumption effectively crowds out private investments which should lead to LOWER productivity and thereby lower economic growth prospects.

Furthermore, when media discusses about consumption, it focuses on the consumers which accounts as the non-productive aspect of consumption.

A productive consumption is where one consumes in order to be able to produce goods. A baker who consumes food in order to bake is an example of productive consumption.

And non-productive consumption, as defined by Dr. Frank Shostak, is ``when money is created "out of thin air." Such money gives rise to consumption, which is not backed by any production. It leads to an exchange of nothing for something.”

In short, the recent boom in consumer spending hasn’t been on the account of spending for production but representative of an explosion of “nothing for something” dynamics or where a policy induced free money environment impelled the US populace to go into a massive speculative orgy, thereby giving the illusion of wealth from producing nothing and limitless nonproductive consumer spending. Of course many of these nothing for something dynamics has also spilled over to many developed countries.

Likewise, the recent account of falling prices or economic weakness hasn’t been a direct cause of retrenching consumers but as an offshoot to a reversal in the free money landscape and a bursting bubble. Thus the apparent economic weakness from a slackening of consumer spending signifies as symptom and not the cause.

Put differently, what makes falling prices or what media or the Keynesian perception of pernicious deflation is nothing more than DEBT DEFLATION!

Once more from Joseph Salerno’s Austrian Taxation of Deflation [p.13-14], ``The most familiar is a decline in the supply of money that results from a collapse or contraction of fractional-reserve banks that are called upon by their depositors en masse to redeem their notes and demand deposits in cash during financial crises. Before World War Two bank runs generally were associated with the onset of recessions and were mainly responsible for the deflation that almost always characterized these recessions. What is called “bank credit deflation” typically came about when depositors lost confidence that banks were able to continue redeeming the titles—represented by bank notes, checking and savings deposit —to the property they had entrusted to the banks for safekeeping and which the banks were contractually obliged to redeem upon demand…

``During financial crises, bank runs caused many banks to fail completely and their notes and deposits to be revealed for what they essentially were: worthless titles to nonexistent property. In the case of other banks, the threat that their depositors would demand cash payment en bloc was sufficient reason to induce them to reduce their lending operations and build up their ratio of reserves to note and deposit liabilities in order to stave off failure. These two factors together resulted in a large contraction of the money supply and, given a constant demand for money, a concomitant increase in the value of money.”

As you can see Salerno’s description of a Debt Deflation landscape as “depositors lost confidence that banks were able to continue redeeming the titles”, “revealed for what they essentially were: worthless titles to nonexistent property”, “threat that their depositors would demand cash payment en bloc”, and “a large contraction of the money supply and, given a constant demand for money, a concomitant increase in the value of money” have been all consistent and cogent with today’s evolving activities in the banking system, the global financial markets or the real economy.

As we have pointed out in many past articles as the Demystifying the US Dollar’s Vitality or It’s a Banking Meltdown More Than A Stock Market Collapse!, the collapse in the US mortgage market which accounted for as a major source of collateral for an alphabet soup of highly geared structured finance (e.g. ABS, MBS, CMBS, CMO, CDO, CBO, and CLO) instruments which likewise underpinned the $10 trillion shadow banking system, resulted to a near cardiac arrest in the US banking system last October, where banks refused to lend to each other reflecting symptoms of an institutional bank run (see Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?).

The sudden surge or “increase in the value of money” in terms of the US dollar against the an almost entire swathe global currencies (except the Japanese Yen) reflected its role as international currency reserve where its dysfunctional banking system incited a systematic “hoarding” of the US dollar, the unwinding of the US dollar carry trade or almost a near contraction of money supply (until the US government’s swift response see The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…).

Similarly such dislocations have been transmitted via synchronous selling and an astounding surge in volatility across global financial markets and an intense disruption in the $14 trillion trade finance market, all of which has combined to impact the global real economy.

The present selloffs in the global equity markets as reflected by the activities in the US markets have reached milestone levels see Figure 3.

Figure 3: chartoftheday.com: US Stock Market Corrections

The meltdown in the US markets have been on short, in terms of duration, but whose magnitude has been more than the average of the typical bear market losses.

Why should it be that a selldown be remarkably drastic if it were to account for only a consumer recession? The answer is it isn’t.

Thus, the so-called destructiveness isn’t about US consumers retrenching but an intense deleveraging process backed by the heuristic reflexivity concept of a self-feeding loop of falling prices=falling demand and vice versa.

Eventually false premises tend to be corrected.

The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…

In the face of this crisis, how much money has the US government thrown to “save the system” so far?

CNBC has this tabulation…

``Try $4.28 trillion dollars. That's $4,284,500,000,000 and more than what was spent on WW II, if adjusted for inflation, based on our computations from a variety of estimates and sources.”

Incredible. $4.28 trillion +++ as the days go by! And that's about 30% of the US GDP.

Makes you wonder who's gonna pay for all these and how one can be bullish on the US dollar, except when considering the recent spate of the deleveraging process-which is a short term dynamic.

Table below as of November 18, are CNBC’s estimates (see article)…

Great stuff from CNBC

Also, CNBC made a nifty comparison of how this bill has dwarfed the other major taxpayer programs in the past as shown through this slideshow.

Here are 3 of the ten, courtesy of CNBC.

World War II

Original Cost: $288 billion

Inflation Adjusted Cost: $3.6 trillion

NASA (Cumulative)

Original Cost: $416.7 billion

Inflation Adjusted Cost: $851.2 billion

Vietnam War

Original Cost: $111 billion

Inflation Adjusted Cost: $698 billion

(Pictured: Pres. Lyndon Johnson and Sen. Richard Russell)

Check CNBC slideshow for the write up and the rest of the other largest taxpayer bill

(Hat Tip: Mr. C. McCarty)

Demystifying the US Dollar’s Vitality

``The Achilles Heel of the United States is the dollar. The reserve status of the US dollar is absolutely critical to the health of the US. If the dollar begins to lose it's reserve status, the US economy will be in shambles.”-Richard Russell

Some have found the recent rise of the US dollar as mystifying while the others have found the surging US dollar as a reason to gloat.

While there are many ways to skin a cat, in the same way there are many ways to interpret the US dollar’s vigorous advance, see figure 3.

Figure 3: stockcharts.com: US Dollar’s Rise Coincided with Market Breakdowns

From our end, we read the action of the US dollar index (geometric weighted average of 6 foreign currencies of major trading partners of the US) by looking at its relationship across different asset markets.

And as we can see, the dramatic surge of the US dollar index coincides with an astounding symmetry-the collapse of the oil market (lowest pane) and the equivalent breakdown of critical support levels (vertical arrows) of stock markets of the US (signified by the S&P 500- pane below center) and Emerging Markets (pane below S&P).

And market actions have fantastically been too powerfully synchronized for us to ignore its interconnectedness or the apparent simultaneous cross market activities.

While we can discuss other possible influence factors such as the shrinking trade deficits which may have contributed to a narrowing current account deficit or an improvement in US terms of trade or the ratio of export prices over import prices, the fact that the US dollar behaved in a spectacular fashion can’t be interpreted as a sudden market epiphany over some unlikely radical improvement in trade fundamentals.

What we understand was that by mid July, cracks over the financial markets began to surface with the US Treasury publicly contemplating to inject funds to support both Fannie Mae and Freddie Mac. From then, the deterioration in the financial markets accelerated which inversely prompted the skyward ascent of the US dollar. Fannie and Freddie were ultimately taken over by the US government in September.

DEBT DEFLATION Dynamics In Progress

So what could be the forces behind such phenomenon?

``Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Hoarding and slowing down still more the velocity of circulation.

``The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”

This according to Irving Fisher is what is known as the DEBT DEFLATION theory dynamics. As you would notice the chain of events leading to the current market meltdown and the precipitate rise in the US dollar have closely shadowed Mr. Fisher’s definition.

How?

Figure 4: Bank of International Settlements: CDS and Foreign Exchange Derivatives Market

One, a significant market of the structured finance-shadow banking system (estimated at $10 trillion) and derivatives ($596 trillion, Credit Default Swap $33.6 trillion down from nearly $60 trillion-left pane- see figure 4) have mostly been denominated in US dollars (foreign currency derivatives also mostly US dollar denominated-right pane), thus deleveraging or debt deflation means the closing and settlement of positions and payment in US dollars.

This also implies whether the counterparty is from Europe or from Asians settlement of such contract means payment in US dollars. Thus, the sudden surge in demand for US dollars can be attributed to the ongoing debt deflation-deleveraging process.

Figure 5: Investment Company Institute: World Mutual Fund

Two, cross currency arbitrage or 'carry trades' have also significant US dollar denominated based exposures.

For instance US mutual funds in 2007 totaled US $12 trillion (see Figure 5 courtesy of ICI) with 14% of the total allocated to International Stock funds or $1.68 trillion.

We may not know exactly how much of these funds flows were borrowed in order to buy into international stock funds, but the idea is, once the margin call came, highly levered funds were compelled to liquidate their positions in order to repay back their loans in US dollars.

Isn't it ironic that the epicenter of the present crisis emanated from the US and yet the debt deflation dynamics prompted a gravitational pull to the US dollar? Had these been something resembling like an Asian crisis then such dynamics would have been understandable.

The US Dollar’s Hegemon and Threats To Its Dominion

Figure 6: Bill Gross: Going Nuclear

Lastly, we have always described the architectural platform of the US dollar standard as pillared upon the cartelized system of US banking network which extends to a syndicate of peripheral banks abroad or global central banks.

PIMCO’s chief Bill Gross in his latest outlook wrote a good analogy of this as a function of nuclear energy see figure 6.

From Mr. Bill Gross (all emphasis mine), ``Uranium-238 has something like 92 electrons circling its nucleus…And, importantly, uranium-238 is metaphorically quite similar to the global financial system of the past half century. At its nucleus was the overnight Fed Funds rate which, when priced low enough, led to an ever-increasing circle of productive financial electrons. The overnight policy rate led to cheap commercial paper borrowing and then leapfrogged outward and across the oceans to become LIBOR. In turn, government notes and bonds as well as markets for corporate obligations were created, leading to their use as collateral (repos), which fostered additional credit and additional growth. The electrons morphed into productive financial futures and derivatives of all kinds benefitting all of the asset classes at the outer edge of the #238 atom – stocks, high yield bonds, private equity, even homes and commodities despite their being tangible as opposed to financial assets.”

``This was how the scientists, the financial wizards with Mensa IQs, visualized the financial system a few years ago: leverageable assets held together by a central bank policy rate at its nucleus with institutional participants playing by the rules of conservative self interest and moderate government regulation. Out of it came exceptionally high returns on assets with minimal risk – the highest returns occurring with the most levered electrons farthest from the nucleus.”

Since financial flows appear to have revolved around the foundations of the US banking system with its core at the US Federal reserve, the recent logjam in US banking sector caused a ripple effect to the peripherals via shortages of the US dollar, a liquidity crunch and a subsequent scramble for US dollars which triggered several crisis among EM countries whose balance sheets have been vulnerable (excessive exposure to foreign denominated debt or currency risks, outsized current account deficits relative to GDP, excessive short term loans or highly levered domestic balance sheets).

Thus, the paucity of US dollars has compelled some nations to bypass the banking system and utilize barter (see Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?) such as Thailand and Iran over rice and oil. Whereas Russia and China have announced plans to use national currencies for trade similar to the recently established Brazil-Argentina (Local Currency System).

The recent crisis encountered by South Korea (heavily exposed to short term foreign denominated debt) and Russia (corporate sector heavily exposed to foreign debt) seem to be prominent examples of the US dollar squeeze.

Figure 7: finance.yahoo.com: South Korea Won-US dollar

Understanding the present predicament, the US Federal Reserve quickly extended its currency Swap lines to some emerging nations as South Korea, which has so far resulted to some easing of strains in the Korean Won, see figure 7. However, we are yet uncertain about its longer term effects although it is likely that access to the US dollar should demonstrably reduce the liquidity pressures.

The important point to recognize is that some nations have began to acknowledge the risks of total dependence on the US dollar as the world’s reserve currency and/or its banking system. A furtherance of the crisis with the US as epicenter can jeopardize global trading and finance. Hence, some countries have devised means of exchange around the present system or have been mulling over some alternative platform.

Such developments are hardly positive contributory factors that would buttress the value of the US dollar over the long term especially as the US government has been throwing much weight of its taxpayer capacity to resuscitate and bolster the present system.

Mr. Ronald Solberg, vice chairman and lead portfolio manager of Armored Wolf, in an article at Asia Times online articulates more on this (emphasis mine),

``According to Goldman Sachs estimates, the US Treasury faces an unprecedented financing need in fiscal year 2009.2 Excluding funding requirements under the Supplemental Financing Program (SFP), they estimate 2009 FY issuance at $2 trillion compared to last year’s $1.12 trillion, which itself was already outsized. This prospective amount is driven by an estimated budget deficit reaching $850 billion, funding TARP purchases of up to $500 billion and the rollover of maturing debt equal to $561 billion.

``On top of these needs, it would not be unreasonable to expect additional SFP funding requirements of $500 billion, the amount already issued to date in FY 2008 used to recapitalize the Fed’s balance sheet. The magnitude of such funding requirements will test the operational efficacy of the Treasury, requiring increased auction size, frequency and expanding maturity buckets on debt issuance, and will likely extend through FY 2009 and into FY 2010, prior to these pressures abating. Perhaps even more ominously, issue size will severely test market demand for such an avalanche of debt.”

Conclusion

All these demonstrate the two basic factors on why US dollar has recently surged.

One, this reflects the US dollar’s principal function as international currency reserve and importantly,

Second, most of the leveraged assets markets had been denominated in US dollars. And in the debt deflation dynamics as defined by Economist Irving Fisher, ``Debt liquidation leads to distress selling and to Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes A fall in the level of prices, in other words, a swelling of the dollar.”

Finally, with US government printing up a colossal amount of money within its system (yes that includes all swap lines extended to other countries as de facto central bank of the world), financing issues will be tested based on the (supply) issuance of its debt instruments and the (demand) market’s willingness to fund the present slew of government programs from internal sources (US taxpayers and corresponding rise in savings) and or from external sources (global central banks amidst normalizing current account imbalances).

We don’t buy the idea that US debt deflation will spur hyperinflation abroad which could further bolster the US dollar. Monetary inflation doesn’t necessarily require a private banking system to extend credit and inflate, because the government in itself as a public institution can inflate the system through its web of bureaucracy.

Zimbabwe is an example. Its banking system seems dysfunctional: savers don’t trust banks, the government has been using such institutions to pay for government employee salaries yet have suffered from government takeovers, while some of the banks have engaged in forex accumulation than operate normally.

Basically, Zimbabwe’s inflationary mechanism is done via the expansion of its bureaucracy to a leviathan and the attendant acceleration of the printing press operations.

Fiscal Bailout, US Monetary Policies To Ensure Inflation Transmission To Global Economies

``It seems clear that much of the current crisis has been exacerbated by mark-to-market accounting, which has created massive, and unnecessary, losses for financial firms. These losses, caused because the current price of many illiquid securities are well below the true hold-to-maturity value, could have been avoided. The current crisis is actually smaller than the 1980s and 1990s bank and savings and loan crisis, but is being made dramatically worse by the current accounting rules." Brian Wesbury, FT Advisors, Mark-to-Market Mayhem

As we have repeatedly been saying, the US Federal Reserve hopes to inflate the world through its currency pegs or dollar links in the hope that the monetary stimulus applied will revive global growth to support its export sector as the local economy is being battered by the deflating debt storm.

Chairman Ben Bernanke understands that without exports the US economy would even be more vulnerable. Thus, the United States’ over reliance on foreign trade underscores the need for such stimulus transmission. It had been an unintended consequence before it looks like an unstated policy goal today.

Of course, another reason for passing the inflation buck is that EM countries have been more than willing to take on the real currency and interest rate risk-which means EM economies can afford to suffer from real value losses (via inflation) of their US portfolio holdings.

Since the Bretton Woods II framework has been driven by political objectives-for EM countries keeping currency undervalued for mercantilist goals- than by economic ones, as EM economies continue to support the US economy by buying into US treasuries despite the extremely low yields or expensive bonds, the risk is that perhaps the changing political objectives might lead to a shift in the global currency framework and consequently a US dollar crisis.

In the same plane, the fundamental reason why the US financial markets are being rescued is probably because Chairman Ben Bernanke understands that the current account deficit has been continuously plugged by foreign financing via the acquisition of paper claims on US assets. First it was Fannie and Freddie. Next it was AIG.

Now signs of growing political heft by foreigners into shaping domestic US policies, from an article in the New York Times,

``Foreign banks, which were initially excluded from the plan, lobbied successfully over the weekend to be able to sell the toxic American mortgage debt owned by their American units to the Treasury, getting the same treatment as United States banks.”

Another reason why? Because Chairman Bernanke understands that the US needs to get its feet back on the ground by having foreigners to provide the much required recapitalization of its severely impaired banking system aside from its present actions to cobble enough resources for a system wide bailout long enough to buy time for the world to recover.

From Kenichi Amaki of Matthews Asia, ``This week, two Japanese financial institutions stepped out of the shadows of the past to pick up stakes in some of their more recognized competitors. Japan's largest securities firm and investment bank announced the acquisition of Lehman Brothers' Asia Pacific, European and Middle Eastern businesses, including Lehman’s 5,500 employees in those regions, for an undisclosed amount. At the same time, Japan’s largest bank, announced that it had agreed to take an equity stake of up to 20% in Morgan Stanley for roughly $8.5 billion. These deals are expected to significantly boost both firms’ investment banking capabilities in geographic regions traditionally weak for them.”

Think of it this way, if the overall outstanding mortgage debt on non farm homes is $11.2 trillion where Fannie and Freddie holds $5.4 trillion, a 10% loss is easily equivalent to $1.12 trillion. This does not include the $2.4 trillion of “other mortgage debt” (corporate farms et. al.) and the $2.5 trillion outstanding consumer credit, which could likewise be impacted by a slowing economy and the ongoing credit crunch (hat tip: Brad Setser). So the proposed $700 billion package for the bailout will probably be insufficient.

Figure 4: The Economist: Cost of Previous Bailouts

Anyway, there had been greater amounts of bailouts as measured by the fiscal cost in % the GDP. According to the Economist,

``CONGRESS is under pressure to approve the Treasury's proposed $700 billion rescue package. Lawmakers, however, are conscious of the cost to the taxpayer: together with loans to AIG and Bear Stearns, public backing so far approaches 6% of GDP. This is well above the 3.7% of GDP of the savings-and-loan bail-out in the late 1980s and early 1990s. But some 6% of GDP is still much less than the average cost of resolving banking crises around the world in the past three decades, which a study by Luc Laeven and Fabian Valencia, of the IMF, puts at 16%.”

In nominal terms the present bailout would be gargantuan but the justifications using historical average cost of 16% could mean there might be more in store in the future as the weakness in US economy spreads.

Thus, my view is slanted towards the idea that any possible rescue package will tacitly be directed to stimulate global economies to enable them to fund the US current account deficit by buying into US financial claims on a guarantee aside from attracting potential financing flows from overseas state and private institutions to recapitalize the floundering US banking system.

There has been a barrage of thoughtful solutions on how to go about the bailout scheme some of which had been suggested by noteworthy figures as Raghuram Rajan suspend dividends and rights offering on solvent banks, Nouriel Roubini New HOLC, Luigi Zingales Debt for equity swap and debt forgiveness, Charles Calomiris Preferred stock assistance, Steve Waldman nationalization, Brian Wesbury temporary suspension of FAS 157 mark-to-market rules and Bill King create a new system parallel with the existing dysfunctional system and decentralization of liquidity (hat tip: Barry Ritholz) among the others.

It’s a wild guess on how the US Congress will go about configuring this package.

Nonetheless, it does seem that most of the world markets have been anxiously awaiting for the details of the US Congress led fiscal bailout of the US banking system.

This poignant New York Times quote from an anonymous Wall Street broker seems to have captured the essence of the markets abroad (highlight mine), ``People have definitely been saying that this is no longer an investor’s market, nor even really a trader’s market — it’s all entirely speculation on what the government is going to be doing next…Anyone who thinks they have a handle on where things are going is deluding themselves.” Indeed, since the credit crisis surfaced last year, the market has been living off from the onslaught of speculations to what government actions would be to done to stave off to magically vanquish the crisis.

Unfortunately, after over a year and upon waves after waves of government actions through assorted means of bridge financing and rescue takeovers this hasn’t prevented its financial markets or of most of the world markets from falling.

However, I think that as the contagion selling should eventually wear off despite the continued pressures in the US markets, aside from the indirect policy stimulus applied to foreign economies, which might give rise to a recovery of ex-US markets first in 2009.

Besides, the streak of selling has been ferocious enough to bring valuations to extremely oversold levels, see our last chart figure 5 from Daily Wealth,

Figure 5: Daily Wealth: Markdown on Emerging Market Valuations In Overshoot Mode!

From Chris Mayer ``The selloff is making things striking on the valuation front... which makes me bullish here. As you can see from the chart below, emerging markets haven't looked this cheap on a forward earnings basis in 20 years...”