Warren Buffett’s Greenback Effect Weighs On Global Financial Markets

``If it seems too good to be true, it probably is. Always look at how much the other guy is making when he is trying to sell you something. Stay away from leverage.” Warren Buffett, Three Rules for Average Investors

Hardly has the ink dried from the issues we dealt with last week when events unfolded almost exactly as anticipated, albeit in a fusion [see Will China’s Stock Market Correction Spread Globally?]

US Dollar Leads The Markets

Here is a summary of what we wrote:

1) We expected that China’s overextended markets to have some ripple or leash effect on global stock markets and the commodities markets.

2) The correction in the China’s markets would possibly trigger a correlation trade-where the US dollar would rise in conjunction with falling markets.

3) We also noted of a contingent provision-our suspicion that the US dollar’s rise wouldn’t find firm legs to stand on, ``if the US dollar fails to rally while global stocks weaken, then any correction, thus, will likely be mild and short.”

True enough during the early part of the week, global markets crumbled resonating China’s rapid fall. This initially prompted for a short rise in the US dollar index.

However, the US dollar index failed to maintain its bullish composure (can’t get to cross the 50-day moving averages) and eventually faltered steeply going into the close of the week.

Figure 1: Stockcharts.com: USD Dollar Index Leads The Markets

The result-global markets, especially in the US and Europe, came back with a vengeance. (see figure 1)

On the other hand, China’s market (SSEC down 2.83% week on week) appears to have hit our defined bottom range and has fiercely bounced back, while the commodities market caught fire- Oil (WTIC) sped back and drifts at its resistance levels!

And again we see some technical pictures failing to keep up with evolving market events.

All of these hyper volatile actions in just a span of one week! Amazing.

And when the US dollar leads the financial asset markets, it is no less than a symptom of inflation driving markets today.

Warren Buffett Warns On The Greenback Effect

Even the sage of Omaha Mr. Warren Buffett acknowledges the growing risk of inflation as the “greenback effect or greenback emissions”. Last week in the New York Times he wrote

(all bold highlights mine)

``Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent. Admittedly, other countries, like Japan and Italy, have far higher ratios and no one can know the precise level of net debt to G.D.P. at which the United States will lose its reputation for financial integrity. But a few more years like this one and we will find out.

``An increase in federal debt can be financed in three ways: borrowing from foreigners, borrowing from our own citizens or, through a roundabout process, printing money. Let’s look at the prospects for each individually — and in combination.

``The current account deficit — dollars that we force-feed to the rest of the world and that must then be invested — will be $400 billion or so this year. Assume, in a relatively benign scenario, that all of this is directed by the recipients — China leads the list — to purchases of United States debt. Never mind that this all-Treasuries allocation is no sure thing: some countries may decide that purchasing American stocks, real estate or entire companies makes more sense than soaking up dollar-denominated bonds. Rumblings to that effect have recently increased.

``Then take the second element of the scenario — borrowing from our own citizens. Assume that Americans save $500 billion, far above what they’ve saved recently but perhaps consistent with the changing national mood. Finally, assume that these citizens opt to put all their savings into United States Treasuries (partly through intermediaries like banks).

``Even with these heroic assumptions, the Treasury will be obliged to find another $900 billion to finance the remainder of the $1.8 trillion of debt it is issuing. Washington’s printing presses will need to work overtime.

``Slowing them down will require extraordinary political will. With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required. A revived economy can’t come close to bridging that sort of gap.”

Here Mr Buffett makes an elementary calculation. I have to admit my admiration for Mr. Buffett’s ability to explain or relate circumstances in very simple “layman connecting” terms.

Essentially, US savers “borrowing from our own citizens” ($500 billion) + Foreign surpluses “borrowing from foreigners” ($400 billion)= $900 billion. US debt initially estimated at $1.8 trillion, which has been scaled down to $1.58 trillion equals a deficit of still at least $680 billion-that would have to be financed out of “a roundabout process, printing money” or central bank money from thin air!

The US treasury is slated to sell $197 billion next week (CNBC). This means that the US sovereign bond markets will likely be tested anew and the US dollar index will likely remain under siege or under pressure.

Analyzing Inflation From A Political Dimension

While many have been saying that because of the deflationary pressures in bubble stricken economies inflation won’t take hold soon, for sundry mainstream reasons of money velocity, oversupply, output gap, excess capacity, liquidity trap, capital short banking systems, Federal Reserve paying interest rates on commercial bank reserves or a combination thereof, we aren’t sure of the interim impact.

We can’t be “timing” inflation because its impact has always been relative.

However we understand inflation to be an epochal problem of human society, which specifically constitutes a series of processes that makes up a cycle.

We can’t simply read through recent events and interpret them as the future.

Since inflation is a political process, it requires the understanding of the underlying motivations of the current crop of political leaders and their prospective actions. After all, politics revolve around economics.

And this has been a phenomenon that has haunted civilizations, kingdoms, governments or empires alike, which has always been expressed through the purchasing power of the underlying currencies.

Mises Institute President Douglas French in recommending cigarettes as an inflation hedge enumerates on such cycle, ``one of Ludwig von Mises's outline of the typical inflation process: prices aren't rising nearly as much as the money supply… phase two of Mises's inflation outline: instead of a rising demand for money moderating price increases, a falling demand for money will instead intensify price inflation. Finally, we come to phase three, where prices go up faster than money supply, the demand for money drops to zero, and government fiat currencies collapse.” (bold highlights mine)

Currently we seem to be drifting in between the phases of “prices aren't rising nearly as much as the money supply” and “falling demand for money”.

Eventually, we should see a transition deeper into “intensifying price inflation” and most probably segueing into “prices go up faster than money supply” depending on the incentives driving policymaking.

And if consumer prices don’t immediately reflect on the impact of the intermediate inflation process, then most of the present political actions will likely be felt or manifested in the financial asset markets.

And so a boom in asset markets is in the first order, as what we’ve been seeing today, and may likely continue as the US dollar index falls.

In short, asset markets are likely to continue functioning as the immediate absorbers of the inflation process.

As Morgan Stanley’s Manoj Pradhan observed of the difference between today’s cyclical patterns with the previous,

``During this cycle, however, interest rates that matter for borrowers have fallen only very slowly while the flow of credit to the private sector is likely to be weaker than usual due to financial sector deleveraging. Only risky asset prices have been roaring forward since the rally began in March. This imbalance between the various channels creates complications for the prospects of returning monetary policy to neutral. If central banks decide to tolerate higher asset prices in order to compensate for the weaker impact of both the interest rate and the credit channel, they risk inflating another asset bubble. If they respond to rapidly rising asset prices while the other transmission mechanisms have only played a weak role, they risk tightening policy into a weak economic recovery.” (bold highlights mine)

Politically, further inflation is required to sustain the elevation of asset prices, however economically, the risks is that these surges will result to a bubble. So maneuvers for an exit from policymakers seem to be getting trickier by the moment.

Will they take the booze away from the party and allow “normalization” or will they further supply more booze to enliven the atmosphere?

Here, we will bet on another major policy miscalculation.

Yet this boom in financial asset prices won’t translate to sustainable “green shoots” of economic recovery. Instead today’s inflation process will heighten misallocation of resources that would eventually culminate into another enormous bubble cycle.

As Murray N. Rothbard in Money Inflation and Price Inflation wrote, (bold highlights mine)

``Even if prices do not increase, this does not alleviate the coercive shift in income and wealth that takes place. As a matter of fact, some economists have interpreted price inflation as a desperate method by which the public, suffering from monetary inflation, tries to recoup its command of economic resources by raising prices at least as fast, if not faster, than the government prints new money…there is a relative underinvestment in consumer goods industries. And since stock prices and real estate prices are titles to capital goods, there tends as well to be an excessive boom. It is not necessary for consumer prices to go up, and therefore to register as price inflation. And this is precisely what happened in the 1920s, fooling economists and financiers unfamiliar with Austrian analysis, and lulling them into the belief that no great crash or recession would be possible. The rest is history. So, the fact that prices have remained stable recently does not mean that we will not reap the whirlwind of recession and crash.”

So while consumer price inflation may still be currently subdued, this doesn’t exempt us from a prospective bust from the fast evolving malinvestments.

More Inflation Equals Greater Risks

Despite the recent crisis, the fractional banking sponsored debt driven economy conjoint with government policies to rev up the credit cycle has reflected on Mr. Buffett’s admonition of debts reaching record unsustainable levels.

Figure 2: AIER: US DEBT AT RECORD LEVELS

According to Mr. Kerry A. Lynch senior fellow of the American Institute of Economic Research, `` The total debt owed by Americans increased to $51 trillion in the first quarter of 2009. One way to put such a mind-boggling number in perspective is to compare it to the value of what Americans produce. Gross domestic product is roughly $14 trillion per year. Thus, Americans now owe $3.62 for every dollar of GDP. As can be seen in the chart below, this is a record.

``By comparison, in 1980 Americans owed just $1.55 per dollar of GDP. The ratio began to rise sharply in the 1980s, leveled off in the early 1990s, and surged again in the late ‘90s, continuing to do so through the past decade.”

While the recent crisis should have pruned down debt levels to the capacity where the economy may be able to handle it, however, the inherent fear by US and global governments of “deflation”, aside from the implied goal to sustain previous boom days, and the addiction towards inflation has prompted such continued accumulation of systemic imbalances.

As we said in the The Fallacies of Inflating Away Debt, the misleading notion of inflating away such debt levels would make the stagflation era of the 70s a virtual “walk in the park”.

Yet, Mr. Buffett seems quite optimistic on the resolve of the present administration to work this out, which we think could be attributable to the special political influenced privileges acquired from the administration, during the latest crisis, for his personal benefit [see Warren Buffett: From Value Investor To Political Entrepreneur?].

However, Mr. Buffett seems to seriously underestimate the political nature of the inflation process.

The expanded cash for clunkers, the administration’s foisting of its socialized version of health reform (which means another $1.3 trillion through 2019), cap and trade policies and the potential bailouts from the next wave of mortgage resets, the prospective support on FDIC’s eroding funding base as more banks suffer from closure, and the Obama administration’s consideration of future stimulus programs are simply symptoms of MORE (NOT LESS) government addiction towards consolidating power by debt and inflation based solutions.

As Ludwig von Mises on The Truth About Inflation presciently wrote, ``But the administration does not want to stop inflation. It does not want to endanger its popularity with the voters by collecting, through taxation, all it wants to spend. It prefers to mislead the people by resorting to the seemingly non-onerous method of increasing the supply of money and credit. Yet, whatever system of financing may be adopted, whether taxation, borrowing, or inflation, the full incidence of the government's expenditures must fall upon the public.” (emphasis added)

Hence, the current political leadership adheres to the typical path of leaders opting for the profligate inflation route. Inflation is what they want, then inflation is what we get.

So in contrast to the mainstream who thinks inflation isn’t in the near horizon, we join the outliers who have been warning of the risks of a potential disorderly unwind.

The Newsmax quotes Nobel Prize economist Joseph Stiglitz, ``The "dollar now is yielding almost zero return," Stiglitz said in a speech at the United Nations regional headquarters in Bangkok. "The current global reserve system is fraying. It's falling apart. The issue isn't whether we go to a new system. The question is do we do so in an orderly or disorderly way.” (emphasis added)

Meanwhile, PIMCO’s CEO Mohamed El-Erian says the policy divergence or “disjointed approach” between the US and other global central bankers could risk leading “to volatile financial markets, a damaging drop of the dollar and slower global growth.”

The Bloomberg quotes Mr. El-Erian ``The question is not whether the dollar will weaken over time, but how it will weaken,” said El-Erian, a former deputy director of the International Monetary Fund whose firm runs the world’s largest bond fund. “The real risk is that you will get a disorderly decline.” (emphasis added)

Thus, we won’t underestimate or discount the odds of the growing risks of an inflationary pass through by a lower (or a possible meltdown of the) US dollar on asset, commodity or consumer prices.

Remember inflation isn’t only generated through the credit system but also through fiscal expenditures.

In Zimbabwe, where consumer credit is virtually inexistent, an output gap of -99% (Marc Faber) and unemployment of 94% didn’t stop hyperinflation (89,700,000,000,000,000,000,000% year on year basis in 2008 or a doubling of prices daily)!!!

So the obsession with all sorts of perverse math models by mainstream economics vividly manifest that they don’t have a clue on reality.

That’s the reason why they haven’t rightly predicted last year’s crisis and why they are unlikely to be dependable forecasters.

Does Growing World Barter Trade Suggests Of Bigger Cracks In Today's Monetary Order?

One possible sign of the accumulating distress from today’s monetary disorder is that trades are being conducted in the form of Barter, as previously discussed in Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?

This new development from the Financial Times (bold emphasis mine),

``In a striking example of how the global financial crisis and high food prices have strained the finances of poor and middle-income nations, countries including Russia, Malaysia, Vietnam and Morocco say they have signed or are discussing inter-government and barter deals to import commodities from rice to vegetable oil.

``The revival of these trade practices, used rarely in the last 20 years and usually by nations subject to international embargoes and the old communist bloc, is a result of the countries’ failure to secure trade financing as bank lending has dried up.

``The countries have not disclosed the value of any deals, and some have refused even to confirm their existence. Officials estimated that they ranged from $5m for smaller contracts to more than $500m for the biggest.”

The article mentions barter as ‘rarely’ used trade practice. Barter is actually a primitive form of direct exchange which culminated with the emergence of money.

According to Murray Rothbard in “Money: Its Importance, Origins, and Operations” from the Mystery of Banking,`` Before coinage, there was barter. Goods were produced by those who were good at it, and their surpluses were exchanged for the products of others. Every product had its barter price in terms of all other products, and every person gained by exchanging something he needed less for a product he needed more. The voluntary market economy became a latticework of mutually beneficial exchanges.”

But problems accompanied barter as a means of exchange, namely:

1. Double Coincidence of Wants-difficulty of matching specific wants

2. Indivisibilities-the problem of precise adjustments and exchange of supplies

3. Business calculation-determining profit or losses

Thus adds Mr. Rothbard, ``Barter, therefore, could not possibly manage an advanced or modern industrial economy. Barter could not succeed beyond the needs of a primitive village.”

``But man is ingenious. He managed to find a way to overcome these obstacles and transcend the limiting system of barter. Trying to overcome the limitations of barter, he arrived, step by step, at one of man's most ingenious, important and productive inventions: money.

So if barter is a primitive way of conducting trade without money, why do nations today embark on such activities? The article says “failure to secure trade financing as bank lending has dried up”. This means the gridlock in the banking sector has impaired the facility of exchange, particularly in the payments and settlements functions.

Thus, temporarily nations have resorted to direct exchange. One must be reminded that most of the problems of credit paralysis have been centered on the US banking industry, which essentially operates as the main conduit for the US dollar standard. This implies that prolonged disutility of credit from the present system could lead nations to adopt an alternative “medium of exchange”.

So aside from the prospects of massive inflation, a persistent dysfunctional banking system could risk jeopardizing the role of the US dollar as international reserve currency.

2009: The Year of Surprises?

``A profound restructuring of global capital has become unavoidable. Such a process is quite different from a recession in the traditional sense. In contrast to a sharp and typically short-lived recession, when, after the rupture, business as usual can go on, the restructuring of a distorted capital structure will require time to play out. Rebalancing the distorted capital structure of an economy requires enduring nitty-gritty entrepreneurial piecemeal work. This can only be done under the guidance of the discovery process of competition, as it is inherent in the workings of the price system of the unhampered market.”-Antony Mueller, founder of Continental Economics Institute, What's Behind the Financial Market Crisis?

2009 will surely be an exciting year.

How can it not be?

After markets got beaten black and blue in 2008, the world in terms of government policy actions have been responding in an unprecendented breadth and scale, using up all possible and known tools, to prevent the financial meltdown or debt deflation from filtering or spreading to the real economy on a global dimension.

Given the alarmist response of policymakers, fear appears to have given way to outright panic. This suggests that at worst, we could be at risk of walking the tightrope between a depression and a collapse of the world’s monetary standard. At best, this could signal a monumental shift to a new financial and economic world order.

Undue Panic? First, global central bankers of major economies have collectively been lowering rates at a frenzied pace. A few economies like such as the US Federal Reserve Bank, Bank of Japan and Swiss National Bank have now embarked on a Zero Interest Rate Policy (ZIRP) regime. Others are expected to play catch up.

Next, the same authorities have been taking up the manifold role of last resorts as lender, guarantor, liquidity provider, market maker, financiers and investor, all within the doctrinal confines of the monetarist approach led by the illustrious late Milton Friedman.

Third, global policymakers have been doing a John Maynard Keynes in adopting massive fiscal stimulus programs. This seems to be the largest D-Day like operations to ever take hold where national economies would be coughing up trillions of dollars to replace “lost” aggregate demand with government spending.

Meanwhile, some central bankers have now been resorting to the crudest of all central banking tools; the printing press. Under the technical label of “Quantitative Easing” some central banks would be intervening directly in the marketplace mostly bypassing the commercial banking system-by providing loans directly to end users or by buying assets directly (mostly bonds to possibly even stocks) with the goal to reduce interest rate gap arbitrage, buoy asset prices and forcibly pry open the banking system to “normalize” lending or by intervening in the currency market with the tacit goal of “depreciating” the currency-without sterilizing or mopping these up.

Essentially today’s primary practitioner of the printing press, a signature approach of Zimbabwe’s central bank governor Dr. Gideon Gono will in essence be given a boost, as central bankers of major economies will likewise be utilizing these as the NUCLEAR option.

Politics and Inflation As Drivers, Overcapacity Balderdash

As anyone should notice, to gloss over the political dimension as drivers of markets and of economies in 2009, when governments have arbitrarily bestowed upon themselves the divine privilege of administering life or death to which industries or companies it would deem as qualified or otherwise, would be a monumental mistake!

For instance, in the US, given the approval of General Motors’ financing affiliate, the GMAC, to upgrade its status into a bank holding company, which essentially grants license for it to access government loans, has used this extraordinary privilege to aggressively launch a market pricing offensive (how about predatory pricing?) by offering 0% financing to the public at the expense of other automakers as Ford, Toyota or others that have not availed of government loans and rescues programs. In short, the competitive edge seems shifting in favor of those closest to Washington.

And it is no wonder why political lobbying has now transformed as the de facto booming Industry in the US and elsewhere as governments rediscover their clout in the economic horizon.

And it would be no different when applied to any country, such as the Philippines which has slated to undertake its own P 300 billion stimulus program for 2009 (abs-cbn). Political pandering will mean beneficiaries of such inflationary policies would get a boost over and at the expense of the rest. It would be a heyday for politicos, cronies, the bureaucracy and those affiliated with them.

Altogether, a few trillions of US dollars will be earmarked to “stimulate” national economies around the world.

And this “political variable as determinant of economic and market output” will not be confined to the premises of domestic politics but one of geopolitics too.

Policies implemented by one country could have economic and political repercussions which could force a policy response elsewhere. For example, fearing the loss of its domestic automakers industry as consequence to the recent bailout extended by the US to its domestic auto industry, Canada had been compelled to match with its own bailout program.

The obvious risk from the rampaging streak of overregulation and excessive market intervention is to raise the level of protectionist sentiment at a time when global economies appear fragile and reeling from the deleterious contagion impact of the financial meltdown.

Moreover, the general deterioration of the economic landscape could also translate to a snowballing of public security risks. Growing societal discontent could translate to rising incidences of public disturbances or social upheavals. For example, this financial crisis has claimed its first victim in the Belgian government which had its third leader for 2008.

Then there have been emerging incidences of global financial crisis instigated rioting in Greece, Russia and in China.

In other words, increasing signs of political instability at home is likely to induce policies that are “nationally” oriented than from a “global” perspective.

Thus, experts advocating for the “great rebalancing” of the global balance of payments asymmetries are like operating in the field of dreams- inapplicable under the realities of the US dollar standard system, (see The Myth of the Great Rebalancing), aside from the ongoing dynamics in the geopolitical sphere.

Aside, such “noble intentions that don’t square with reality arguments” seem to justify Black Swan Guru Nassim Taleb’s denunciation of the economic industry’s ‘intelligent nonsense’, this time for playing up the pious hype of using “exporting overcapacity” as rationale for compelling policymakers to be seek globally oriented interventions to correct current account imbalances.

A lucid example to debunk such theories comes from empirical evidence accounted for by a report in the New York Times, ``Through August, steel production was actually up slightly for the year. The decline came slowly at first, and then with a rush in November and December. By late December, output was down to 1.02 million tons a week from 2.1 million tons on Aug. 30, the American Iron and Steel Institute reported. The price of a ton of steel is also down by half since late summer.

``“We are making our steel at four mills instead of six,” said John Armstrong, a spokesman for the United States Steel Corporation, adding that two mills were recently idled and the four still operating are running at less than full capacity…

``Foreign producers no longer have an advantage over the refurbished American companies. Indeed, imports, which represent about 30 percent of all steel sales in the United States, also are hurting as customers disappear.” (underscore mine)

The point is unless the economic agents driving the supposed "overcapacity" is the government itself, the reality is that if private businesses can't get enough orders or not enough demand, then they simply will have to reduce output or suffer accrued losses, or at worst, fold up as in the account of the US Steel industry’s woes. Even when supported with indirect incentives as “exports subsidies, subsidized financing, import tariffs or currency devaluation”, if demand falls enough to render businesses unviable then the supply side will need to adjust.

It isn’t overcapacity as the problem but excess supply. Yet falling prices around the world seems to account for the market clearing adjustment process of such surpluses.

Moreover, excess capacity in a world of scarcity is a misnomer. We simply don’t have enough of anything. And that’s why a pricing system exists for goods or services. And that’s why poverty still exists. Excess capacity thrives only in a relative sense, and is mainly due to government interventions designed to prop up certain industries.

Finally, geopolitical tensions have likewise been apparently increasing, possibly aggravated by the present global financial and economic conditions. Some recent examples include:

-The mounting tensions between India and Pakistan. Following the terrorist attack in Mumbai India, which India has pinned the responsibility to Pakistan, the latter’s reaction had been a remobilization of troops along the Indian border. This raises the risk of another outbreak of military conflict from which the belligerent South Asian neighbors had suffered 3 wars over the past 70 years (1947-48, 1965 and 1971).

-Russia’s arbitrary shut down of gas supplies to Ukraine came amidst an acute financial crisis in the region. Russia supplies 25% of Europe’s energy requirement with about 80% of natural gas imports coursed through Ukraine. Given the recent military victory of Russia over Georgia, Russia’s exploits could be deemed as another attempt to reassert geopolitical control over the crisis stricken Eastern Europe (Ukraine recently secured $16.4 billion in loans from the IMF). On the other hand, given Russia’s domestic crisis, the Ukraine gas supply episode may be construed as an attempt to deflect the public’s attention towards regional concerns. Nonetheless, an acrimonious environment could again raise the specter of another war conflagration.

-The recent spate of bombing by Israel of the Hamas controlled Gaza strip and its possible escalation have also added to geopolitical jitters.

Political Motives Allude To INFLATION As Resolution To Ongoing Debt Deflation

Over $30 trillion of market capitalization have vanished last year as a result of the 2008 meltdown while write downs from financial firms have been estimated to have topped $1 trillion (IHT). With $8.6 trillion of US taxpayer money pledged to guarantee and support the financial system, possibly plus another $1 trillion for the inaugural stimulus package for incoming US President Barack Obama many have been optimistic about a quick turnaround in the US economy.

For us, it is highly unlikely that a “normalized” credit recovery would happen the same way as it did in the recent past.

In a credit cycle the relationship of lending and collateral values becomes a self-reinforcing feedback loop. In a boom phase, increases in lending prompts for higher collateral values which fosters even more lending or gains beget even more gains, until such trends tips over to the inflection point. And when debt deflation ensues, the decrease in lending prompts for a similar reduction in collateral values which further impels for a decline in lending activities, thus, losses fuel even more losses.

This means that “normalization” should extrapolate to a “resurrection” of the previous 20-1, 30-1 or 50-1 leveraging seen in the securitization –derivatives market and the over $10 trillion shadow banking system! Unfortunately, with roughly 20% of US banking now owned by the US government, we won’t see the same degree of leverage, unless the US government and other governments will assume such a role.

Yet the US government has so far absorbed or cushioned much of the losses in collateral values but has been unable to push prices higher in order to spur the release of the huge stash of bank reserves in the system (see figure 1)

Figure 1: St. Louis Fed: Spike in Adjusted Monetary Base

Ironically too, while the US government has been trying to reignite the borrowing lending or credit cycle in the banking system with a gigantic infusion of funds into the system, calls for tighter regulation in the financial system is apparently offsetting all these efforts. In short, what the right hand is doing, the left hand is taking away.

For us, what seems most likely to occur is a back to basics lending template than a sudden reinvigoration of the credit system which is hardly going to successfully reverse the debt deflation process.

In addition, today’s housing and securitization bubble bust has been transforming the American psyche to a cash building deflation psychology (a.k.a. Keynesian term: slowing monetary velocity). In other words, US savings which has been nearly zero over the recent years will be improving as households and the financial sector repair their respective balance sheets. There would have to be an immense force strong enough to reverse such psychological trend.

This brings us to the basics: the fundamental problem of the US economy is simply having too much debt. Or debt levels more than the economy can afford, with most of these unsustainable liabilities tacked into the balance sheets of the financial industry and the US households. Today’s losses have reduced some of the imbalances but have not been enough to normalize credit flows with or without government interference. And the obvious solution is to bring debt levels down to where the economy can be able to sustain them.

Unfortunately given the severity of the situation the alternative solutions to the problem we could see are: Default, Debt forgiveness and or market based deflation or inflation.

As we have noted before default isn’t likely to be a favored option because it would entail a severe geopolitical backlash:

-The most probable response to the US government debt repudiation would be an outright collapse of the US dollar standard and the US banking system as every creditor nation would possibly disown or seize the US dollar and US dollar based assets when available.

-Protectionist walls will rise everywhere which would lead to the modern day great depression and possibly a world at war.

-given the US sensitivity to import dependence, the severance of trade will create extreme shortages in the economy.

On the other hand, market based debt deflation is representative of today’s meltdown.

Market based debt deflation seems an anathema to the existence of global central bankers, or seen alternatively, for debt deflation to succeed means the loss of justification for the existence of modern central banking. Thus, central bankers will likely exhaust all possible means to prevent deflation from succeeding with every available or known tool as we have been witnessing today.

Again this leaves us with two likely alternative paths:

In an inflation dependent economy (see Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?), structural economic growth requires the sustained acceleration of money and credit expansion similar to a pyramiding structure. This means that with the private sectors hands tied, only government can take its place by massively inflating the system from which they can implement through the banking system or outside the banking system (see Welcome To The Mises Moment)

In addition, the only possible way to reverse a deepening transition to a cash building deflation mindset is to debase the currency enough to incite people to seek an alternative “store of value” (as example see The Origin of Money and Today's Mackarel and Animal Farm Currencies).

Next, while the promulgated political incentives will be targeted to (hopefully) resuscitate the economy, the tacit incentives for authorities like US Federal Chair Ben Bernanke (and other central bankers who seem stooges for the Bernanke Doctrine) could be to erode the real value of existing liabilities echoing the calls of Harvard Professor and former IMF economist Ken Rogoff (see Kenneth Rogoff: Inflate Our Debts Away!) or simply to defeat inflation by all costs to validate Bernanke’s thesis as the “qualified” expert of the great depression (plain vanilla hubris).

Finally, central bankers have this notion that once they unleash the inflation genie out of the proverbial lamp, having to use it according to their desires, they can easily control, recapture and return it.

Yet the Federal Reserve could be overestimating their powers, according to Robert Higgs at the independent.org, ``So much potential new money is now impounded in the commercial banks’ holdings of excess reserves that it is difficult to see how the Fed will be able to stem the flood once the banks begin to transform those excess reserves into normal loans and investments. If the Fed attempts to sell enough government securities to soak up the growing money stock, it will drive down the prices of Treasury bonds and hence drive up their yield, increasing the government’s cost of borrowing to finance the huge budget deficits the government will be running because of its various bailout commitments and so-called stimulus programs. This scenario holds the potential for a complete monetary crackup.”

This implies that perhaps the risks that the markets or global economies could be faced with in 2009 will be tilted towards GREATER inflation if not HYPERINFLATION.

And for those who expect such a risk transition to be in a gradual phase, we just might get flummoxed. Let us take a clue from Murray Rothbard on 1923 Weimar Germany’s experience in his Mystery of Banking,

``When expectations tip decisively over from deflationary, or steady, to inflationary, the economy enters a danger zone. The crucial question is how the government and its monetary authorities are going to react to the new situation. When prices are going up faster than the money supply, the people begin to experience a severe shortage of money, for they now face a shortage of cash balances relative to the much higher price levels. Total cash balances are no longer sufficient to carry transactions at the higher price. The people will then clamor for the government to issue more money to catch up to the higher price. If the government tightens its own belt and stops printing (or otherwise creating) new money, then inflationary expectations will eventually be reversed, and prices will fall once more—thus relieving the money shortage by lowering prices. But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races. Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,” doing something like tripling every hour. Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and Phase III’s runaway psychology is as follows: “The value of money is disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it matters not what, so long as it isn’t money.” A frantic rush ensues to get rid of money at all costs and to buy anything else. In Germany, this was called a “flight into real values.” The demand for money falls precipitously almost to zero, and prices skyrocket upward virtually to infinity. The money collapses in a wild “crack-up boom.” (bold highlight mine, italics-Rothbard)

When governments decide that the risks to the real economy would require a dramatic reduction of debt levels then they may resort to massive devaluation which independently may lead to a currency war, hyperinflation, severance of the dollar links or dollar pegs, and a disorderly unraveling of the US dollar standard.

However, if global central bankers decide to resolve this problem collectively they may opt for “debt forgiveness” which may entail a reconfiguration of the world’s monetary architecture similar to one floated in yesterday’s Wall Street Journal Editorial over the seeming success of the Euro as a model, ``the lessons point to the eventual need for a single global currency. That may be a political leap too far. But the world could still harness the benefits of exchange-rate stability if its political and economic leaders began to discuss how better to coordinate monetary policy.” Not that we support such theme but our intention is to depict of the growing recognition of the cracks in the present monetary system by the mainstream.

Nonetheless, any new monetary architecture will effectively translate to a diminished role of the US dollar as the world’s currency reserve or the world’s economic and financial hegemon. So 2009 could be the advent for a new world order.

Will Debt Deflation Lead To A Deflationary Environment?

``Let's get to the bottom line. A deleveraging process is under way. It can happen against a background of bankruptcy, deflation, declining cash flows and bank bankruptcy or in a slower way against a background of inflation. Both reduce the debt burden, but one is socially jarring and led in the past to mass unemployment and arguably WWII. Democracies will choose the inflationary approach. This is not evident today, but it will be more evident soon enough as the BoJ, ECB, BoE and others realise that their current monetary policy is driving them not to slower growth and lower inflation but to deflationary calamity. Today, you can see the calamity of the deflationary disease but what will you see tomorrow, or the day after, if the monetary cure pours from the medicine jars of the global central banks?”-Russell Napier of CLSA (courtesy of fullermoney.com)

Not if you ask, Dr. Frank Shostak, ``We however, maintain that it is not the size of the debt that determines the severity of a recession, but rather the aggressiveness of the loose monetary policies of the central bank. It is loose monetary policies of the central bank that cause the misallocation of resources and the depletion of the pool of funding and in turn can be manifested in over-indebtedness. So to put the blame on the size of the debt as the key factor in causing depression is no different to blaming the thermometer for causing the high temperature.” (underscore mine)

Or Joseph Salerno in Austrian Taxation of Deflation, ``Bank credit deflation represents just such a benign and purgative market adjustment process.”

Many have cited the Great Depression as a prospective model of today’s deteriorating environment as having a deflationary character. Yet, the reason debt deflation transformed into the Great depression wasn’t due to the deleveraging process itself, instead it was debt deflation aggravated by economic policies which crushed profit incentives.

Again Mr. Salerno (highlight mine), ``Unfortunately such benign episodes of property retrieval have been forgotten in the wake of the Great Depression. Despite the fact that the bank credit deflation that occurred from 1929 to 1933 was roughly proportional in its impact on the nominal money supply to that of 1839-1843, the rigidity of prices and wage rates induced by the “stabilization” policies of the Hoover and early Roosevelt Administrations prevented the deflationary adjustment process from operating to effect the reallocation of resources demanded by property owners.”

Myths of Liquidity Trap and Pushing On A String

Deflation proponents have further used the Keynesian concepts of “liquidity trap” and or “pushing on a string” to advance their Armageddon theory.

The concept of “pushing on a string” suggests that US Federal Reserve policies will be rendered ineffective or impotent and won’t jumpstart the economy by stimulating lending.

While the US Federal Reserve have the boundless powers to add into bank reserves by purchasing assets (usually government liabilities), commercial banks might not lend money to take advantage of this. It’s like leading a horse to a pool of water, but doing so won’t guarantee that the horse will drink from it.

A liquidity trap environment is seen almost similar to the “pushing on a string” concept, but here, as interest rates nears or is at the zero regime, traditional policy tools might also be unsuccessful to spur lending (again!).

So should we fear these as media and Keynesian experts paint them to be?

We doubt so.

Why?

First is to understand how Central banks operate, according to Murray Rothbard in Man Economy and State (emphasis mine), ``The central bank can increase the reserves of a country’s banks in three ways: (a) by simply lending them reserves; (b) by pur­chasing their assets, thereby adding directly to the banks’ deposit accounts with the central bank; or (c) by purchasing the I.O.U.’s of the public, which will then deposit the drafts on the central bank in the various banks that serve the public directly, thereby enabling them to use the credits on the central bank to add to their own reserves. The second process is known as discounting; the latter as open market purchase. A lapse in discounts as the loans mature will lower reserves, as will open market sales.”

Next, Murray Rothbard in Making Economic Sense tells us why deflation isn’t likely to occur given the innumerable powers of Central Banks, ``What deflationists always overlook is that, even in the unlikely event that banks could not stimulate further loans, they can always use their reserves to purchase securities, and thereby push money out into the economy. The key is whether or not the banks pile up excess reserves, failing to expand credit up to the limit allowed by legal reserves. The crucial point is that never have the banks done so, in 1990 or at any other time, apart from the single exception of the 1930s. (The difference was that not only were we in a severe depression in the 1930s, but that interest rates had been driven down to near zero, so that the banks were virtually losing nothing by not expanding credit up to their maximum limit.) The conclusion must be that the Fed pushes with a stick, not a string.”

Figure 4: Dshort.com: US Monthly Inflation Chart

A dainty chart from dshort.com shows of the historical bouts of deflation in US history. Most of the incidences of deflation came on a post war basis after a massive expansion in money supply and artificial demand from a war economy resulted to massive adjustments during in the post war economy.

Since the gold has come off the monetary standard in 1971, despite the strings of crisis during the period (Savings and Loans, Black Monday 1987, LTCM, & dot.com bust), there has been no incidence of deflation.

The Nuclear Option: Currency Devaluation

Another, US Federal Reserve Chairman Ben Bernanke in 2001 spelled out his unorthodox “helicopter” means of avoiding a deflationary recession.

The Fed has always the luxury to use its printing presses, this from Mr. Bernanke’s speech Deflation: Making Sure “It” Doesn’t Happen Here, ``To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”

Or even consider massive devaluation as its nuclear option (emphasis mine), ``Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”

About fifty years ago, in his magnum opus the Human Action, Mr. Ludwig von Mises presciently elucidated of the endgame option available to central banks wishing to escape a credit bubble bust, ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Our Mises moment.

In short, a government single-mindedly determined to inflate the system won’t actually need a functioning private credit system to do so. As we previously said, it only needs the bureaucracy and 24/7 operational printing presses, or it can simply invoke massive devaluation as its nuclear option.

Proof?

Zimbabwe should be the best living testament of such government driven tenacity.

From Albert Makochekanwa, Department of Economics, University of Pretoria, South Africa “Zimbabwe’s Hyperinflation Money Demand Model”

``Borrowing from Keynes (1920) suggestions, namely that ‘even the weakest government can enforce inflation when it can enforce nothing else’; evidence indicates that Zimbabwean government has been good at using the money machine print. Coorey et al (2007:8) point out that ‘Accelerating inflation in Zimbabwe has been fueled by high rates of money growth reflecting rising fiscal and quasi-fiscal deficits’. As a result of that, the very high inflationary trend that the country has been experiencing in the recent years is a direct result of, among other factors, massive money printing to finance government expenditures and government deficits. For instance, the unbudgeted government expenditure of 1997 (to pay the war veterans gratuities); the publicly condemned and unjustifiable Zimbabwe’s intervention in the Democratic Republic of Congo (DRC)’s war in 1998; the expenses of the controversial land reform (beginning 2000), the parliamentary (2000/2005) and presidential (2002) elections, introduction of senators in 2005 (at least 66 posts) as part of ‘widening the think tank base’ and the international payments obligations, especially since 2004, all resulted in massive money printing by the government. Above these highlighted and topical expenditure issues, the printing machines has also been the government’s ‘Messiah’ for such expenses as civil servants’ salaries.”

As you can see, no consumer or industrial or any sorts of borrowing-spending Keynesian framework. It's plain vanilla print and distribute, where money supply exponentially outgrows the supply of goods and services, hence hyperinflation.

So even as US government policy tools have seemingly been unsuccessful to stoke up on its much desired rekindling of the inflationary environment after coughing up about $4.28 trillion of taxpayers money (see The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…), to quote Asha Banglore of Northern Trust, ``The lowering of the Federal funds rate, the Fed’s innovative programs to provide liquidity to financial institutions – PDCF, TSLF, and other programs – and more lenient rules for borrowing through the discount window appear to have exhausted the gamut of possibilities routed through monetary policy changes to influence aggregate demand. The provisions of the Emergency Economic Stabilization Act of 2008 allow for recapitalization of banks. The FDIC is working on obtaining an approval for the anti-foreclosure plan to address the housing market issues that are central to the current crisis. In conclusion, the probability of a hefty fiscal stimulus package with the Fed buying these securities is growing everyday,” the nuclear option or our Mises Moment endgame seem likely a looming reality as the day goes by.

Conclusion: Preparing For The Mises Moment

Finally, as shown above deflationary fears under a Paper money standard seems unwarranted and is not a likely scenario, given the unrestricted powers of the central bank to either use the printing press or its nuclear option- massive debasement of its currency.

Debt deflation in itself is a salutary process which involves the cleansing of malinvestments or the excesses of “exchange of nothing for something” dynamics.

The Great Depression was a product not of debt deflation dynamics only, but was exacerbated by the adaptation of rigid economic policies by the incumbent leadership that crushed business profits and the economic system’s ability to adjust.

Governments determined to inflate don’t need a functioning private banking or credit system as the Zimbabwe experience shows. All it needs is a printing press and an expanding bureaucracy.

Once the inflation process starts to gain ground be prepare for the next bout of inflation!