``The premise that a president can affect the economy in a positive way is ludicrous on its face, yet the vast majority of voters accept it as a premise. The reason for this can be found in French philosopher Michel Montaigne's observation that "Men are most apt to believe what they least understand." The vast majority of the population knows nothing about macroeconomics (and some would argue that the same is true of most professional economists), so they are ripe to believe almost anything — especially if it sounds like it's going to put dollars in their pockets.”- Robert Ringer, Ted Koppel and the False Premise, Part II
Normally, the concept of stock market investing can be construed as claim to very long-term stream of future cash flows. But these days don’t seem like normal times.
Especially not when government actions risk severely impacting the economic environment or the financial marketplace enough to possibly distort future revenue streams.
To consider the US taxpayers tab has now reached some estimated $7.36 trillion or about half of the US economy. To quote CNBC, it’s a ``complicated cocktail of budgeted dollars, actual spending, guarantees, loans, swaps and other market mechanisms by the Federal Reserve, the Treasury and other offices of government taken over roughly the last year, based on government data and news releases. Strictly speaking, not every cent is a direct result of what's called the financial crisis, but they're all arguably related to it.”
While one may contend that government actions seem directed towards “normalizing” the business cycle and or appear targeted to cushion the angst from the adjustments in the present financial and economic conditions, we are seeing this from a different light-this looks more about politics.
The Credit Driven Growth Mentality; Moneyness Of Credit
First of all we must understand the mainstream viewpoint.
Figure 1 from American Institute for Economic Research, is a chart from the last issue, but this time they are marked by reference periods depicting the architectural framework of the US monetary system.
The period covered by the red ellipse manifests of mostly a gold standard regime that spanned across two failed central banks (First and Second Bank of the United States (1791-1836), a free banking era (1837-1862) and the rise of national banks through the National Banking Act in 1863 (wikipedia.org).
Whereas the blue region, exhibits the value of the US dollar under the US Federal Reserve system introduced in 1913 via the Federal Reserve Act (wikipedia.org).
Some observable developments:
1. Periods where the US dollar had been redeemable to Gold saw its purchasing power rise relative to goods (as measured by the Wholesale Price Index). In other words, the economic nirvana brought about by the Industrial Revolution had been mostly from “growth deflation” as the supply of goods grew more than the supply of money.
2. Intermittent periods that saw an impairment of the gold standard automatically led to a depreciation of the US dollar.
3. While even under the gold standard, financial panics occurred-but for different reasons: the ramifications of over issuance of paper money (1837) or bank notes (1819), attempts to corner gold supply (1869), restrictive monetary policies (1873), war reparations, protectionism and shortage of gold (Long Depression 1873-1896) and bank run related panics of 1884,1893 and 1907-they had mostly been in relation to the repeated attempts by authorities to inflate the system.
4. The introduction of the Federal Reserve and the central banking system shifted the structural drivers of economic growth from one of productivity driven “growth deflation” to one of expansionary credit driven inflation.
The point is, the public has been indoctrinated to believe that economic growth can only be generated by (to borrow Prudent Bear’s Doug Noland’s terminology) the “Moneyness of Credit”; credit not just driven by the central bank’s printing presses, but likewise from Wall Street’s “unbounded capacity to inflate Credit instruments that are perceived as safe and liquid. (Doug Noland)”
That is why you always hear experts associate rising prices of goods and services (consumer inflation) with economic growth, when the truth is a sustained rise of consumer goods can only be propelled by persistent money and credit expansion.
And most importantly, this is why the overall thrusts of collective government actions seem directed at the restitution of the severely impaired credit mechanisms, simply because this has been the dogma that has underpinned the modern day global political economy.
Yet, the fundamental problem missed by most (governments and experts) is that the world has generated and absorbed far too much debt than it can pay for. We have reached a level where debt or the leveraging process had been totally dependent on the appreciation of the value of assets as means of refinancing; Economist Hyman Minsky in his Financial Instability Hypothesis calls this the Ponzi finance.
The ensuing episode of market revulsion and intensive credit distress has reflected a phenomenon of the crumbling debt structure or “debt deflation”-as a consequence to previous massive inflationary actions.
Again we quote Mr. Noland (emphasis mine), ``The severity of today’s crisis is not the result of policies – good, bad or otherwise – implemented over the past few months. The greatest Bubble in the history of mankind – nurtured by decades of flawed economics, flawed finance, flawed policymaking and irresponsible behavior throughout – is bursting and there is little our authorities can do about it. Everyone was content during the boom to buy into the notion of all-powerful Fed reflation and Washington stimulus, and we must now come to grips with the reality that the entire framework advocating post-Bubble “mopping up” strategies was specious.”
But the basic problem seemingly unseen by authorities and experts today is that we cannot simply restore a dysfunctional credit system in the US by myopically expecting the resuscitation of the previous bubble structure (e.g. structured finance-ABS, MBS, CMBS, CMO, CDO, CBO, and CLO instruments that collateralized the $10 trillion shadow banking system, derivatives).
Even as global governments have been rapidly anteing up on claims to taxpayers’ future income stream by a concoction of “inflationary” actions such as lender of last resort, market maker of last resort, guarantor of last resort, investor of last resort, spender of last resort and ultimately buyer of last resort, a credit driven US economic recovery isn’t likely to happen; not when governments are tightening supervision or regulatory framework, not when banks are hoarding money to recapitalize, not when borrowers are tightening belts and suffering from capital losses on declining assets and certainly not when income is shrinking as unemployment and business bankruptcies rise on falling profits, and most importantly not when the collective psychology has been transitioning from one of overconfidence to one of morbid risk aversion.
Thus the best case scenario for the credit driven “economic growth” will be a back to basics template-the traditional mechanisms of collateralized backed lending based on borrower’s capacity to pay. But these won’t be enough to reignite the Moneyness of credit. Not even under the US government’s directive.
So the problems can be viewed from a fundamental angle and most importantly the psychological dimension.
Why the US Government Is Determined To Use The Inflation Path
We see the resolution to the problem of having too much debt in only two ways:
One, by allowing debt deflation to run its course; by bringing these to levels where its economy can sustain or pay for them.
But this isn’t likely a politically palatable idea because of the pain associated with the losses especially by the politically connected-Wall Street and Banking industry. And most importantly, the risk of an implosion of the US banking industry could undermine the operating pillars of the present monetary architecture known as the US dollar standard. Thus, the US can’t afford such an option because it poses a serious risk to its geopolitical hegemony.
Two by reducing the real value of its debt levels through the inflation mechanism-where creditors will get paid by a greatly diminished purchasing power of the US dollar. Again one must be reminded that the unstated function of central bank is to generate growth by inflating the economy.
Of course, the US government is looking at the optimistic side or hoping that they might buy enough time for parts of the globe to assume the credit intermediation role.
For instance, the banking system and economies of Asia though having been equally hurt but to a lesser degree by the recent deleveraging phenomenon, hasn’t been as equally leveraged or has seen its credit system damaged by the forcible liquidation, see Figure 2.
Since the debt exposure of the Asian economies are low in terms of corporate and consumers, the transmission channels from the combined policies of global central banks to "reflate" the system could possibly emerge or impact Asia’s economy by fostering an earlier recovery via inducing more borrowing (relative to the US). This may materially help ease the debt burden of the US by restoring trade and the continued financing of the US rescue policy programmes by the purchasing of US financial claims.
But this is the optimistic view.
If the US government is indeed on its way to inflate with the stated “hope” for a recovery and or implicitly reduce it’s the real value of financial claims, it would 1) continue to bailout companies, 2) nationalize companies or industries, 3) influence (or compel) banks to “lend” via its ownership stakes 4) extend fiscal stimulus and subsidies directly to homeowners, debtors (mortgage payers) who signify most of the voting public 5) expand bureaucracy 6) use the nuclear option of the Federal Reserve through a bypass of the banking system and buying public IOUs or assets and lastly 7) devalue the US dollar via the printing press to deflate the real value of its debts.
The fact that the Bernanke’s US Federal Reserve has embarked on a full scale “quantitative easing”-further expanding balance sheet, printing money by buying debts or officially monetizing government debt- as the US Central Bank announced measures to acquire $500 billion in Mortgage-Backed securities (MBS) backed by Fannie Mae, Freddie Mac and Ginnie Mae and $100 billion in direct debt obligations from the Government Sponsored Enterprises Fannie Mae, Freddie Mac and the Federal Home Loan Bank with the goal of reducing relative borrowing cost as reflected by the high spread in the yields of government agency debt over Treasury debt-means that the Fed has began to activate its nuclear option ( also previously discussed in Will Debt Deflation Lead To A Deflationary Environment?)
Moreover, the losses from the current debt deflation-asset deflation process have led to cash building deflation. This has prompted consumer price index to fall in the developed economies which had been mainly attributed by media and experts to “falling demand”.
And this signifies as a change in public psychology, from an overconfidence boom to risk aversion bust psyche, which many have attributed to as the fatalistic deflation bogeyman. Hence, the only way to oversee a radical swing in such a mindset is to reduce the incentives of holding cash balances. And the only way to do it is by invariably diminishing the purchasing power of a currency.
Government Policy Cycles
The other important matter is that of the understanding of the mutually reinforcing dynamics of inflation and deflation. Deflation and inflation is like assessing the virtues of right and wrong- an ex-post measure of a previous action taken. An action and an attendant reaction. Yet, you can’t have deflation when there have been no preceding inflation. At present times, the reason government has been massively inflating is because they have been attempting to combat perceived threats of equally intense debt deflation.
One action requires the presence of the other action. In terms of Sir Isaac Newton’s Third law of motion, “To every action there is an equal and opposite reaction.”
So you have a feedback loop mechanism where more perceived risks of deflation in the marketplace would prompt for more inflationary policies to counter the perceived menace, which is again what we have been seeing today.
Ergo, the circular loop of money and credit inflation boom and debt deflation bust isn’t just a representation of a market or economic cycle but also signifies as government policy cycles, under a fiat standard central banking system.
Markets As Unreliable Indicators
Yet since global governments have been exhausting their arsenal to absorb much of the world’s losses, it hopes that domestic taxpayers, global taxpayers and the ability to source financing from other entities by borrowing will remain unrestricted. We hope so.
Otherwise, failing to do so suggest that while systemic deflation might be the perceived risk today for the US and several OECD economies (not the world), the coming risks could be one of greater than expected inflation and if not the risk of hyperinflation via a US dollar crisis.
Also while it is also true that yields of US treasuries maybe at record levels, one of the nuclear options is for the Fed to buy these long term debt instruments to keep the interest rate environment low, in the hope of stoking a revival of credit use.
So near record low yields shouldn’t be entirely construed as “safehaven” buying from fears of deflation, since government actions have been heavily distorting these markets. The fact that US Credit default swaps are at record high levels also indicates of the increasing probability of default risk or perhaps higher inflation. So both signals appear to be offsetting each other.
Russell Napier of CLSA in a recent audio interview at McAlvany says that reading the treasury market is unreliable because it is 50% owned by bureaucrats whose incentives are non-economic. We would like to add that the same markets are susceptible for government manipulation as part of the deflation fighting tactical approach.
Figure 3: Economagic: 10-year TreasuryYet looking at the longer term, 10 year US treasury constant maturity has been on a downtrend for about 26 years. Combine today’s predicament with the coming Baby Boomer entitlement crisis, as discussed in US Presidential Elections: The Realisms of Proposed “Changes”, you have a recipe for high rates in the future. And as inflation picks up we should expect a reversal of this trend.
Nonetheless, it is equally hazardous, if not ludicrous, to suggest that risk taking should be avoided simply because what follows hyperinflation will be deflation. As example, if we have Php 1,000,000 today, whose purchasing power affords us to buy a second hand car, a hyperinflation similar to Zimbabwe in scale suggest that in less than a month that Php 1,000,000 would only buy a stick of cigarette, so keeping the money in cash and waiting for deflation is like Waiting For Godot!
Ultimately, hyperinflation results to a death or disintegration of a currency as in the case of Brazil, which had many changes to its currency [e.g. Cruzeiro, Cruzeiro Novo, Cruzado, Cruzado Novo, Cruzeiro, Cruzeiro and the Real]. So if you’d be holding a Cruzeiro issued in 1964 today, in the hope of a deflation, you’d end up with a piece of paper with absolutely no value except for as wallpaper or memento.
Reading Political Tea Leaves
Charles Krauthammer is dead right when he says that you don’t read balance sheets today to invest in the stock market, you need to learn how to read political tea leaves.
Why? Because of the extensive government intrusions, there will be some sectors that would benefit or lose from major political decisions, in the same manner where there will be vast economic effects.
Quoting Townhall.com’s Charles Krauthammer,
``We need to face the two most important implications of our newly politicized economy: the vastly increased importance of lobbying and the massive market inefficiencies that political directives will introduce.
``Lobbying used to be about advantages at the margin -- a regulatory break here, a subsidy there. Now lobbying is about life and death. Your lending institution or industry gets a bailout -- or it dies.
``You used to go to New York for capital. Now Wall Street, broke, is coming to Washington. With unimaginably large sums of money being given out by Washington, the Obama administration, through no fault of its own, will be subject to the most intense, most frenzied lobbying in American history.
``That will introduce one kind of economic distortion. The other kind will come from the political directives issued by newly empowered politicians…
``Bank presidents are gravely warned by one senator after another about "hoarding" their bailout money. But hoarding is another word for recapitalizing to shore up your balance sheet to ensure solvency. Is that not the fiduciary responsibility of bank directors? And isn't pushing money out the window with too little capital precisely the lending laxity that produced this crisis in the first place? Never mind. The banks will knuckle under to the commissars of Capitol Hill. They control the purse. Prudence will yield to politics.”
As we have repeatedly said, a government determined to inflate will inexorably inflate, regardless of the agenda of economic recovery, because political survival is at stake.
For instance, we noted how the victory of President elect Barack Obama in the recent elections had greatly been influenced by the development in the financial markets, where the Lehman Bros. debacle decidedly shifted voters preference to his camp (as discussed in Has The Barack Obama Presidency Been Driven By Market Dynamics?). Yet the history of US elections shows that the fate of the market and the economy has had some significant influence over elections outcomes (see US Political Economy: History Repeats Itself)
The point is that the Obama leadership, whose election came about from the need for a rescue, but packaged as “The Change We Need”, needs to be seen by the public to do something. Hence, the public will expect more government intervention and correspondingly nourish the illusion of a messianic based recovery. And President Obama will simply oblige.
And like Mr. Krauthammer’s exposition, lobbying will likely become THE BUSINESS. And that puts the United States on the path of the Philippines of imbuing third world policies and outcomes of having rent seeking oligopolies, political client-patron relations, and crony capitalism which essentially breeds dependency culture and corruption.
Conclusion
The US government will continue to choose the path of inflation, as it has been clearly doing today, because it feels the need to do so. It is primarily a political choice. The economic and financial agenda, while much publicized as justification for the inflationary actions, are subordinate. Any ensuing economic growth recovery might just be incidental.
It is a political choice because this will deal with the public’s addiction to a credit driven economic growth environment, long inculcated by the government and academicians through the central banking system, hence the prerequisite to fight forces of debt deflation with even more inflation. This is also going to be about the furtherance of the government policy cycle of inflation-deflation and a populist leadership expected to deliver economic and financial salvation by adopting more intensified inflationist policies.
It is a political choice because government actions will work for the alleviation of the pain and distress of the politically connected, thus lobbying efforts will be become the fundamental order of business. The political leadership will play the role of Gods who will determine which entity survives or perishes.
And yet the sheer magnitude of government intervention will likely foster the emergence of more rent seeking oligopolies, deepen crony capitalism, and advance political patron-client relations which will only intensify the dependency culture and corruption, aside from furthering economic distortions, which may put at risk productivity, capital investments, innovation, cost of money, the US dollar’s purchasing power and economic growth.
And most importantly it is a political choice because it deals with the sine qua non objective of protecting the US geopolitical hegemony through the preservation of its privilege as the monetary architecture of the world, even at the risk of continued depreciation of the US dollar.
Seen from the investment aspect, no market indicators look consistently reliable because of the intensive actions of global governments, which are heavily distorting market signals. But given the collaborative power exerted to inflate the economic and financial system, we should expect asset markets to recover not because of “recovery” but due to the sheer might of inflation. But you can expect any sustained asset inflation to be rationalized as “recovery”.
Besides, you don’t need economic growth drive up stock prices, as evidence look at Zimbabwe. A substantial dose of inflation will be enough do it.
Thus, reading political tea leaves seem likely a better gauge in determining how to invest in the stock markets.
