Will Previous Crisis Serve As Deserving Guidepost For Today’s Crisis?

At a social affair, last night, an acquaintance brought up the issue of how long this crisis could possibly last. [As usual this analyst stammered.]

Fortunately a study by Harvard’s Ken Rogoff and Carmen Reinhart over previous episodes of financial/banking, real estate crisis should give some clue. (Hat tip: John Maudlin)

Although it is best to be reminded that in reading history, things are always obvious after the fact. And that conditions that have led to the crisis may be “deterministic” to quote Nassim Taleb, whose conditions which have led to such may not be always be identified or observed.

So for those groping for an answer, here are some points or bullets from the Rogoff-Reinhart study (all quotes and charts from Rogoff-Reinhart study:

On the real estate bust:

-The cumulative decline in real housing prices from peak to trough averages 35.5 percent.

-The most severe real housing price declines were experienced by Finland, the Philippines, Colombia and Hong Kong. Their crashes were 50 to 60 percent, measured from peak to trough.

-The housing price decline experienced by the United States to date during the current episode (almost 28 percent according to the Case–Shiller index) is already more than twice that registered in the U.S. during the Great Depression

-Notably, the duration of housing price declines is quite long-lived, averaging roughly six years (with Japan 17 years!)

On the Effect to Equities:

-the equity price declines that accompany banking crises are far steeper than are housing price declines, if somewhat shorter lived.

-The average historical decline in equity prices is 55.9 percent, with the downturn phase of the cycle lasting 3.4 years

See below…On Unemployment:

-On average, unemployment rises for almost five years, with an increase in the unemployment rate of about 7 percentage points. While none of the postwar episodes rivals the rise in unemployment of over 20 percentage points experienced by the United States during the Great Depression, the employment consequences of financial crises are nevertheless strikingly large in many cases.

-when it comes to banking crises, the emerging markets, particularly those in Asia, seem to do better in terms of unemployment than do the advanced economies. While there are well-known data issues in comparing unemployment rates across countries, the relatively poor performance in advanced countries suggests the possibility that greater (downward) wage flexibility in emerging markets may help cushion employment during periods of severe economic distress.

-The gaps in the social safety net in emerging market economies, when compared to industrial ones, presumably also make workers more anxious to avoid becoming unemployed.

On GDP:

-The average magnitude of the decline, at 9.3 percent, is stunning.

-post– World War II period, the declines in real GDP are smaller for advanced economies than for emerging market economies. A probable explanation for the more severe contractions in emerging market economies is that they are prone to abrupt reversals in the availability of foreign credit. When foreign capital comes to a “sudden stop,” to use the phrase coined by Guillermo Calvo, Alejandro Izquierdo, and Rudy Loo-Kung (2006), economic activity heads into a tailspin.

-Compared to unemployment, the cycle from peak to trough in GDP is much shorter, only two years.

-the recessions surrounding financial crises have to be considered unusually long compared to normal recessions that typically last less than a year.

On debt buildup

-same buildup in government debt has been a defining characteristic of the aftermath of banking crises for over a century. We look at percentage increase in debt, rather than debt-to-GDP, because sometimes steep output drops would complicate interpretation of debt–GDP ratios.

-the characteristic huge buildups in government debt are driven mainly by sharp falloffs in tax revenue and, in many cases, big surges in government spending to fight the recession.

-The much ballyhooed bank bailout costs are, in several cases, only a relatively minor contributor to post–financial crisis debt burdens.

Their conclusion:

``An examination of the aftermath of severe financial crises shows deep and lasting effects on asset prices, output and employment. Unemployment rises and housing price declines extend out for five and six years, respectively. On the encouraging side, output declines last only two years on average. Even recessions sparked by financial crises do eventually end, albeit almost invariably accompanied by massive increases in government debt.

``How relevant are historical benchmarks for assessing the trajectory of the current global financial crisis? On the one hand, the authorities today have arguably more flexible monetary policy frameworks, thanks particularly to a less rigid global exchange rate regime. Some central banks have already shown an aggressiveness to act that was notably absent in the 1930s, or in the latter-day Japanese experience. On the other hand, one would be wise not to push too far the conceit that we are smarter than our predecessors. A few years back many people would have said that improvements in financial engineering had done much to tame the business cycle and limit the risk of financial contagion.

``Since the onset of the current crisis, asset prices have tumbled in the United States and elsewhere along the tracks lain down by historical precedent. The analysis of the post-crisis outcomes in this paper for unemployment, output and government debt provide sobering benchmark numbers for how the crisis will continue to unfold. Indeed, these historical comparisons were based on episodes that, with the notable exception of the Great Depression in the United States, were individual or regional in nature. The global nature of the crisis will make it far more difficult for many countries to grow their way out through higher exports, or to smooth the consumption effects through foreign borrowing. In such circumstances, the recent lull in sovereign defaults is likely to come to an end. As Reinhart and Rogoff (2008b) highlight, defaults in emerging market economies tend to rise sharply when many countries are simultaneously experiencing domestic banking crises.”

Our observations:

-present crisis in the US isn’t just about a real estate crisis but a combination of both real estate and banking crisis since the real estate industry depended on Wall Street to fuel its bubble. This risks extending the duration of the economic slump! The previous averaged about 6 years (Rogoff-Reinhart) where today the US housing bust is only 3 years old!

-the US centric crisis hasn’t been just about real estate bubble bust and bank recapitalization issues but also about falling tax revenues and state deficits and importantly household balance sheet impairments. So it is going to be difficult to make precise assessment using past data.

-for the Philippines today, the decline of 56% squares with “the average historical decline in equity prices is 55.9 percent”. But since we did not suffer from a banking crisis but got unduly affected by the chain process of global forcible selling, “the downturn phase of the cycle lasting 3.4 years” has got to be lower.

-Rogoff-Reinhart: “the declines in real GDP are smaller for advanced economies than for emerging market economies. A probable explanation for the more severe contractions in emerging market economies is that they are prone to abrupt reversals in the availability of foreign credit.”

Previous crisis lumped as one was either “regional or individual” as rightly noted by the authors. Today’s crisis is global (also rightly pointed out). But the important difference is where the crisis emanated from.

Although the apparent fallout dynamics identified by the Rogoff-Reinhart study had been present in today’s crisis even when the epicenter had been in the US, it is because present dynamics has yet been exhibiting the privilege of the US dollar as the world' currency reserve.

But this seems to be changing, for the new year, a news report says that China is offering its neighbors to trade directly in their currency,

from BBC, ``China has said it is to allow some trade with its neighbours to be settled with its currency, the yuan. The pilot scheme was announced in a package of measures designed to help exporters hit by the global downturn…Officials did not say when the trial scheme would start. When it does, the yuan could be used to settle trade between parts of eastern China (Guangdong and the Yangtze River delta) and the territories of Hong Kong and Macau, and between south-west China (Guangxi and Yunnan) and the Asean group of countries (Brunei, Burma, Cambodia, Indonesia, Laos, Malaysia, the Philippines, Singapore, Thailand and Vietnam).”

In short, “abrupt reversals in the availability of foreign credit” could happen on a different context. As the common Wall Street precept says, ``Past performance may not guarantee future outcome."

-Very interesting commentary from Rogoff-Reinhart: ``The gaps in the social safety net in emerging market economies, when compared to industrial ones, presumably also make workers more anxious to avoid becoming unemployed.”

Could the welfare “mentality” of developed economies have contributed to the unemployment predicament, compared to “gap filled” or “less safety nets” in emerging markets? Or put differently, has free markets contributed to better employment recovery for EM during the past crisis?

Here we are reminded of Ludwig von Mises in Human Action, ``The policies advocated by the welfare school remove the incentive to saving on the part of private citizens. On the one hand, the measures directed toward a curtailment of big incomes and fortunes seriously reduce or destroy entirely the wealthier peoples power to save. On the other hand, the sums which people with moderate incomes previously contributed to capital accumulation are manipulated in such a way as to channel them into the lines of consumption.”

-Rogoff-Reinhart: “The much ballyhooed bank bailout costs are, in several cases, only a relatively minor contributor to post–financial crisis debt burdens.”

We can see now why Mr. Rogoff had been calling for inflating the value of debts away (see Kenneth Rogoff: Inflate Our Debts Away!). He believes that bailout costs would have a “minor” impact on the economy going forward, but his conclusions were premised upon comparisons made during the past crisis when they had been “individual or regional” in nature, whereas today’s crisis is global.

Thus, it is a wonder just how valid his thesis will be.

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.

2009: Asian Markets Could OUTPERFORM

``Is Asia decoupled from the U.S. economy? Only partially. About 60% of Asean's and Northeast Asia's exports are ultimately consumed in the G3 countries (the U.S., the EU and Japan). A U.S. recession will slow growth in the EU and Japan. However, at least 60% of the shoes, textiles, garments and other essential consumer products these countries import will come from Asia, providing a buffer for Asian manufacturers. Those Asian economies that export commodities, oil and gas will also benefit if these resources continue to command high prices. India and China are set for rapid growth. Both have the resources to increase spending on infrastructure and to stimulate consumer spending. Only 35% of China's economy is consumer driven. This could be pushed up to 50% to 60%, which is also true for India. We'll soon know if China will be able to rely more on domestic consumption for its growth. Once the Chinese are accustomed to spending more of their disposable income, trade imbalances will decrease.- Lee Kuan Yew, China's Olympics Journey

One of the seemingly implausible observations is for experts to suggest that any global economic recovery would likely originate from the US.

Since the US had been the epicenter of the crisis, whose malaise belatedly spread to almost the entire world, the aggressive policy actions are deemed to have aptly settled most of the balance sheet impairments and should pave way for normalization of its economic cycle. For us, this is putting too much faith over the efficacies of the actions of policymakers.

While true enough, the world is momentarily feeling the brunt of the real economic impact of the downturn, many parts of the world remain affected because of trade and capital flow channels than from a debt overhang in their national balance sheets. In other words, the recent synchronization of markets had been mostly because of forcible liquidations from the debt deflation process and isn’t representative of the same disorder suffered by many OECD economies as compared to Asia or other select emerging markets.

What we’d like to point out is that many balance sheets of Asian economies for instance remain lightly leveraged, (as we discussed in Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?) such that if the US seems having a hard time normalizing credit flows, I would venture a guess that once the effects from the trade nexus subsides, credit take up will most likely be more apparent in economies unhampered by the debt.

Since there are more unknowns than what can be known, we’d be operating from the standpoint of what we know based on what’s happening with the US, the largest and most influential economy of the world today, and its possible influence to the world.

What we know:

1. Inflationary policies are laden with unintended consequences.

2. Applying greater degree of inflation means a further loss of purchasing power of the currency or a lower standard of living.

3. More government intervention means suboptimal resource allocation which also entails suboptimal economic growth.

4. The shift in the leverage to government involve a “too big to fail” paradigm which only increases systemic risks. Governments cannot be viewed as “risk free”. Iceland’s fall should be a reminder (see Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?)

5. The US economy and financial markets are now “Housed” by Ben Bernanke who is playing the financial game with a loaded dice. Meanwhile, the US government is also playing the economic god.

6. Because life and death of industries depend on Washington’s blessings, lobbying has turned into a sunrise industry.

7. Policymakers are still struggling to figure out how to deal with the crisis and thus exhausting all creative means for instantaneous results at the expense of the future.

8. The US will be operating from the perspective of government consumption as driver of the economy since private consumption, investment and exports will likely remain soft. Yet, government spending doesn’t create value or raise aggregate demand because it has to get money from somewhere from the economy mostly via redistribution.

This from Daniel J. Mitchell, Cato Institute, ``This is a debate about Keynesian economics, which is the theory that the economy can be boosted if the government borrows money and then gives it to people so they will spend it. This supposedly "primes the pump" as the money circulates through the economy. Keynesian theory sounds good, and it would be nice if it made sense, but it has a rather glaring logical fallacy. It overlooks the fact that, in the real world, government can't inject money into the economy without first taking money out of the economy. More specifically, the theory only looks at one-half of the equation — the part where government puts money in the economy's right pocket. But where does the government get that money? It borrows it, which means it comes out of the economy's left pocket. There is no increase in what Keynesians refer to as aggregate demand. Keynesianism doesn't boost national income, it merely redistributes it. The pie is sliced differently, but it's not any bigger.” (highlight mine)

Thus, government consumption as driver of the US economy will likely be a short term fix but isn’t likely to provide the much widely expected support over the long term.

Overall, the operating environment of the post crisis US economy will be one with less degree of market openness, lesser productivity, greater regulation, higher taxes and lower leverage. Our view is similar to PIMCO’s top honcho Mr. William Gross where in his recent outlook wrote, ``My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner.”(bold highlight mine)

Thus the implied market and economic impact:

-This suggests that on the basis of recovery, Asian markets are likely to outperform the US markets if not recover earlier economically barring any further crisis.

-Asia’s economy or markets will not be immune to the volatility elsewhere especially from the US, as the recent events has shown. But over the long term it could be expected to build on its newfound “advantages” and would be perhaps less vulnerable.

-Over the short term, given the collective low interest inflation inducing environment worldwide, combined with the underperformance of Asian markets during the recent rout, any global market technical bounce should also likely reflect an outperformance of Asian markets relative to the US.

-Over the long term, the normalization of the economic cycle would translate to renewed appetite for risk taking, this means capital flows should revert to where economic growth remains least unimpeded by government instituted restrains. In addition, given the lack of leverage within Asia, our bet is that the next round of credit uptake will likely stem from the region.

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.

2009: Phisix and Peso Will Advance!

``Whenever you see a successful business, someone once made a courageous decision.”-Peter Drucker

Unless one believes that the world is headed for a great depression, then the Phisix is unlikely to head lower.

The Phisix has lost 48.29% over 2008 and has been in a bear market territory for about 17 months in conjunction with global markets. On a peak to trough basis the Phisix have reached losses of about 56% from October 2007 until November 2008. This makes the Philippine benchmark on track with its previous bearmarket cycles over the past 22 years as previously discussed in Phisix: Learning From the Lessons of Financial History.

To give a short account of what we previously discussed the past four bear markets can be divided into two parts see figure 5:

One, a cyclical bearmarket under a secular bull:

1. August 1987 to October 1988- the Phisix lost about 45% and consolidated for 13 months before recovering and resuming another attempt to the upside. The trigger for the bear market in 1987 – ex-Col. Honasan’s August 28^th Black Friday’s botched coup d'état against erstwhile President Cory Aquino.

2. November 1989 to October 1990- the Phisix lost about 62% in about 11 months before convalescing. The trigger for the bear market of 1989 -November 30^th Makati coup again by ex-Col. Honasan…

Figure 5: Phisix: Bear Market cycles

Second, the long term bear market…

3. February 1997 to October 1998-the Phisix lost 66% in about 20 months. But following the election of President Joseph Estrada, the cyclical Presidential honeymoon period led to the Phisix rebound of 120%. This could be interpreted as the cyclical bullmarket within the secular bear market.

4. July 1999 to November 2001- the Phisix lost 62% in about 28 months for the culmination of the secular bear market cycle. Oddly, the Phisix appear to trace the developments in the US markets or when the Nasdaq dot.com bubble imploded in 2000, for a huge chunk of this cycle.

This makes the present bear market losses slightly under the typical 60% depth (characteristic of the cyclical bear) while the duration of 17 months makes it near the secular cycle.

Since foreign participants account heavily or over half of the trading volume in the Philippine stock exchange, it is natural to expect the losses of the Phisix to track global markets on the account of forcible liquidations due to the unraveling US debt deflation.

Remember, the Philippine Stock Exchange have less than 1% of its population invested in it hence the recent financial markets meltdown should have limited impact to household and company net worth, as well as to the national economy.

Yet, most of the damage would likely come from export trade and remittance linkages which constitute about 40% and 11% of the Philippine GDP (by expenditure share) respectively.

Besides, the Balance of Payment standings of the Philippines remain in a marginal surplus, despite the sharp turndown of global trade, coupled with a foreign exchange reserve at near records see figure 6.

Figure 6: yardeni.com: Philippine US Dollar Foreign Currency Reserves

This makes the Philippines less vulnerable to a liquidity crunch aside from being one of the least exposed to the world compared to our ASEAN neighbors.

Besides as we have pointed out, since the Asian Crisis internal balance sheets have been improving see figure 7.Figure 7: IMF Staff Report: Real Private Sector Credit and External indebtedness have been improving

Thus if a boom did NOT happen then a bust will NOT happen, since there have been NO bubble. This could be interpreted as a mixed blessing.

Today’s downturn have been PRINCIPALLY due to the spillover effects overseas and isn’t likely to morph into a rapid deterioration of the economic environment (unless a depression environment occurs) as debt levels have been improving and mostly tailored over a distribution of medium to long term liabilities (right window).

And equally, as the Phisix cratered out of the impact of debt deflation triggered meltdown, the Peso fell 13% in 2008 hamstrung by the compression of liquidity globally, portfolio repatriation and the closure of the global carry trade arbitrages.

Our bet is if the debt deflation phenomenon subsides, even amidst a period of heightened volatility out of global recessionary pressures or even under greater inflation, the Peso and the Phisix are likely to improve year on year with steady acceleration of such advances going into 2010, the Philippine Presidential cycle.

2008 Trivia: Lobby, Bailouts and Losses

2008 ushered in a season for lobbying, bailouts and record losses…

First, amidst the present financial crisis, the lobbying business is now booming as Washington decides the winners and losers…

This from thehill.com, ``At the top of the economic agenda, however, is an economic stimulus package that could reach $850 billion, ranking among the biggest federal expenditures in history. Democratic leaders are drafting the package now in hopes of passing it before Obama takes the oath of office.

``With so much money on the table, lobbyists are working late into the holiday season to pitch their clients’ needs to the bill’s authors…

``Tony Podesta, a high-profile Democratic lobbyist, said it’s too risky for companies to cut their lobbying budgets when Congress is poised to pass landmark legislation. If anything, he said, it’s time to increase spending.

“Lobbyists and discounters may be the only people who grow,” he said"

Two, the lobbying interests has been expanding to cover almost every industry.

Some projects or programs floated or proposed by state and local officials include (Washington Post):

· $4.8 million for a polar bear exhibit in Rhode Island.

· $100 million to redevelop land for a casino in Philadelphia.

· $13 million in improvements in Las Vegas, much of it for a pedestrian bridge at the Tropicana hotel-casino.

· A yet-to-be-determined amount for a proposed $50 million museum in Las Vegas devoted to organized crime.

· $6 million for snow-making and maintenance facilities at Spirit Mountain, Minn.

So former President of Federal Reserve Bank of St. Louis, William Poole is absolutely right when he said, “Everyone knows that a policy of bailouts will increase their number.”

Next, across the pond, the bailout response has likewise been a contagion; the floundering “native” cheese making industry of Italy is getting rescued too! Italy’s government will be buying nearly 200,000 wheels cheese to be distributed to charity.

Courtesy of the Independent.co.uk

According to the Independent, ``Parmigiano Reggiano, Italy's King of Cheese, is in trouble. Robust in flavour and crumbly, it is a classic of Italy's artisan food traditions, made by hand by 430 craft producers around the city of Parma. But with Italian consumption falling as costs soar, almost a third of producers now face bankruptcy. Now Italy's Minister of Agriculture, Luca Zaia, has come to the rescue, promising to buy 100,000 Parmigiano Reggiano cheeses, and also 100,000 of its less costly competitor, Grana Padano.

``This is Italy's big cheese bailout. Essentially, the government will be gobbling up 3 per cent of Parmesan production at an estimated cost of €50m (£44.7m) and distributing it to the needy. Each 35kg wheel of Parmigiano costs between €8 and €8.50 to make, but the wholesale price has declined for the past four years even as the cost of milk and energy has soared.”

Of course, not everyone will be pleased since others belonging to the same industry won’t be as privileged. From the Telegraph, ``Producers of Italy's other celebrated cheese - buffalo mozzarella - are looking on enviously after suffering an 18 per cent drop in sales in the last year. "We've asked for help too," said Vincenzo Oliviero, the head of Italy's mozzarella producers association, which has yet to receive an injection of state aid."

See what we mean by government deciding the winners and losers?

Going back to the US, the government spending binge has also been creating some sets of new problems in terms of project efficacies, transparency and accountability.

This from Yahoo.news, ``Government officials overseeing a $700 billion bailout have acknowledged difficulties tracking the money and assessing the program's effectiveness.

``More broadly, the officials discussed "the difficulty of isolating the effects" of the bailout program "given the variety of policy actions taken by the U.S. government to support financial stability and promote economic growth."

``The officials also noted the "difficulties associated with monitoring the use of specific funds" provided to individual financial institutions, according to the document…

``The government has pledged to provide $250 billion to banks in return for partial ownership. The goal is for banks to use the money to boost lending. However, a recent review by The Associated Press found that after receiving billions in aid from U.S. taxpayers, the nation's largest banks can't say exactly how they're spending the money. Some wouldn't even talk about it.

``The idea behind the capital injection program is for banks to use the money to rebuild reserves and lend more freely to customers. However, banks do have leeway to use the money for other things, such as buying other banks, paying dividends to investors or bonuses to executives. That's touched a nerve with some lawmakers and other critics."

Talk about first few signs of unintended consequences.

The year won’t be complete without the tabulation of government money earmarked for rescue and stimulus programs and of estimates for market and economic losses from the financial crisis.

Some excerpts from the tally sheet of Bloomberg’s Alexis Leondis,

``$30: Approximate amount, in trillions, erased from the value of stocks worldwide.

Bloomberg: World Market Cap index

``$8.6: Amount, in trillions, of taxpayer money the U.S. government has pledged to prop up cash-strapped financial companies as of Nov. 25, according to data compiled by Bloomberg.

``$61,871: Maximum amount the bailout could cost each taxpayer, based on 139 million tax returns filed last year.

``$882: Amount, in billions, of U.S. currency in circulation, according to Bloomberg data.

``$613: Amount, in billions, listed as liabilities when Lehman Brothers Holdings Inc. filed for the biggest bankruptcy in U.S. history.

``$150: Amount, in billions, of taxpayer money pledged to help American International Group Inc.

```11.7: Number, in millions, of households that owe more on their mortgages than their homes are worth, according to Zillow.com

Read the rest here.

From New York Times

Additional losses from hedge funds and stock mutual funds, as noted by Bloomberg, ``It has been a year of record misery: the largest bankruptcy, bank failure and Ponzi scheme in U.S. history; $720 billion in writedowns and losses by financial institutions; $30.1 trillion in market valuation wiped out.

``Hedge funds lost 18 percent of their value for the year through November, the worst year since record-keeping began in 1990, according to Chicago-based Hedge Fund Research Inc. Morgan Stanley estimated that, by year end, at least 620 hedge funds will have closed.

``At bottom, the debacle amounted to a loss of faith, especially for individual investors. They pulled $215.7 billion from stock mutual funds in the first 11 months of the year, according to Investment Company Institute, a Washington-based association. That compares with a $91 billion inflow of funds for the same period of 2007.

``As a result of those withdrawals and market losses, the total net assets in all types of mutual funds fell by $2.67 trillion in the first 11 months of 2008, the institute reported.”

Yet to complete the year’s amazing finish, Forbes presents a list of Billionaires shedding some of their networth with isolated accounts of billionaires going to a net worth of ZERO. (no intentional schadenfreude here but to depict that today's crisis hurt even those at the highest strata)

From Forbes “Billionaire Blow ups”,

``More than 300 of the 1,125 billionaires we tallied on our annual list last March have since lost at least $1 billion; several dozen lost more than $5 billion. The 10 richest from our 2008 rankings dropped some $150 billion of wealth, dragged down by steel tycoon Lakshmi Mittal, estranged brothers Mukesh and Anil Ambani and property baron K.P. Singh, who together dropped $100 billion. America's 25 biggest billionaire losers of 2008 lost a combined $167 billion.”

Click here for

In Pictures “Billionaire Blow Ups”

In Pictures “America's 25 biggest billionaire losers”

Jim Rogers: 2009 Preparing For the Worst

Jim Rogers outlook for 2009 in an interview at Bloomberg (hat tip Barry Ritholtz )

Some interview highlights:

-This is probably gonna be the worst since the second world war…it’s gonna be very bad for all of us.

-In 1929….the politicians around the world started to make horrendous mistakes which turned it into a Depression, it would have been a normal recession otherwise…everybody got into act and that seems to be happening this time too.

-I am certainly prepared for the worst and if it happens I hope I take the appropriate actions…

-Our new President Mr Obama has said…he is going to tax capital. This is a period where the world is desperately short of capital what a genius! And then he is going to protect America, protectionism lead to the great depression in the 1930s, so we’ve got a man now who says, he is in favor of protectionism and taxing capital. If that happens then…it’s all over.

-[on world economic order] If America continues to make mistakes you’re gonna see that quick a transition.

-I did move to Asia because I see enormous opportunities there…I am convinced that China is the great country of the 21<sup>st</sup> century.

-The American government is printing gigantic amounts of money, that in the ends is going to be the worst problem…it has led to inflation and in some cases to runaway inflation

-Faith is a terrible way to invest…I hope I don’t invest on faith, at least invest on facts.

-I like to own things forever

-Oil is going to make a huge comeback when it does. The international energy authority, who makes the studies of much of every oil field in the world came to the conclusion that oil reserve are declining at the rate of 7% a year…in 15 years there won’t be any oil left! Unless somebody discovers a lot of oil quickly at very accessible areas, the price of energy has to go to the roof again!

-Basically agriculture is agriculture and the force of one affects the other…so they are interconnected but maybe not directly

-You know, we have now nearly a shortage of everything in agriculture…shortage of tractors, tractor tires, fertilizers, seeds, farmers…

-I see a rally for awhile into 2009…then I expect to see more problems again in the markets into 2009. So, I am holding off these things as prices go up, I hold off buying if I see selling climaxes again or panic selling then I’d probably buy more.

-the last bubble left…the Federal Reserve is buying bonds, everybody’s pumping bonds like crazy, it’s clearly a bubble.

-The best way to buy China is to buy commodities, because you don’t have to worry about corporate governance or money supply…

-Mao Tse Tung ruined agriculture. The Chinese government is now spending hundreds of billions to repair agriculture, infrastructure, rebuilding China….

-Many areas of the Chinese economy which are going to be unaffected by the recession in the West, they won’t care what happens in the West.

-I wish they [Chinese Central Bankers] were running our central bank instead of Dr. Bernanke who doesn’t have a clue what’s going on. So far the Chinese have done a better job.