Saturday, October 2, 2010

A Night on Bald Mountain

Bald Mountain in Fantasia

A Mountain of Debt

In his latest monthly commentary, Bill Gross of PIMCO warns that there is no way back to the "good old days" of high returns in investing. Decades of double-digit returns were made possible because easy credit provided more money than could be put to productive uses in the real economy, but the credit bubble has burst. The bursting of the debt bubble means that days of easy credit are over, and it will be many years before debts are paid off or defaulted sufficiently for better days to return. This is the New Normal that PIMCO has adopted as its mantra.

As harsh as the New Normal sounds, I think that PIMCO does not go far enough. I would add that the buoyant economy we experienced ever since the end of World War II has never been normal. It was based on special circumstances and can never be the same. A generation of Credit Excess was preceded by centuries of Good Luck for America and the West. There is no way to get back to the "old normal," and the economy will never be the same.
Satan Contemplates the Mortal World

The Fantasy of Normalcy

Why can the economy never be the same? We had a long run of good luck in the US, and our luck seems to have run out. It's right there in our history. We exterminated entire peoples to conquer an entire continent and exploit its resources, we were in the right place to be beneficiaries of multiple industrial revolutions, our industries were relatively unscathed by global conflicts, and then we prospered even more by refitting the bombed-out industries of a war-broken planet. No wonder we believed in "progress."

The problem now is: Those advantages are gone. Information and capital can flow anywhere instantly. Former colonial subjects and former slaves of Communist ideology are no longer exploited but are now investing their sweat in modernization and increasing competition. They want the good things and they are willing to work for them. There is no more monopoly market for America or the West to exploit.

About three decades ago, when America started to find the going more difficult, we didn't scale back our inflated expectations. Instead, we clung to our outsized expectations and financed current consumption by borrowing from the future. In fact, our government encouraged borrowing by instituting a policy of easy credit. Citizens responded, used their housing ATMs, and piled up debt. It was an unsustainable process and the mortgage-credit-finance bubble was the terminal phase.

Satan Spreads the Seeds of Evil

Our only hope now is to get through the debt mess and -- probably after decades -- get back to a growing, sustainable economy. We are far from creditworthy now, and our competitors continue to grow lot more capable. There are no "good old days" to go back to.

Illusion Has Replaced Reality

No, the debt load does not mean that America is doomed, but it suggests that many or most of us are bound to be disappointed that our outsized expectations are not satisfied.

Debt is too high, and trust is too low to restart the economy. Time is the only real solution to deleveraging, but government and the people have no patience. QE will not work, and it will raise the level of risk to our national credit and currency, but the Fed will proceed anyway. Illusion has replaced reality in the minds of the policy makers.

The Spirits of the Dead Rise on All-Hallows Eve

A Declining Dollar and a Lower Standard of Living

In his latest monthly PIMCO commentary, Bill Gross pointed out that the economy is mired in the deflationary process of debt deleveraging and is likely to stay there for years. Quantitative easing (QE) is the Fed's attempt to jump-start a moribund economy by igniting a process of inflation. (More precisely, they want to bring about price inflation by increasing the velocity of money in an already inflated monetary base.)

After some years, price inflation should reduce the real value of debts to a more manageable level. The problem with inflating our way out of debt is that America will have to pay a very painful price:

"And the most likely consequence of stimulative government policies that strain to get us there will be a declining dollar and a lower standard of living."

If the dollar is worth less, we are poorer. We would have to cut back on what we import from the rest of the world, but rises in exports would be of little importance, because we export so little. A country that has invested so little in productive technologies would stand little chance of expanding the scope of its exports. Such lazy countries suffer a declining standard of living.

Gross's point of view isn't the only one with credibility, but the alternatives are also depressing. There are other kinds of "soft default," such as reneging on promised social entitlements. There are also ways that governments can "stick it" to creditors, such as revoking the terms of existing debt securities (perhaps converting inflation indexed securities to fixed rates). None of it would be pleasant.
Mere Toys in Satan's Power -- Satan Increases the Velocity of Money

Terminal Competitive Devaluation

As SoGen's Albert Edwards mentions in a recent report,
"Our economists made a very interesting point in the Economic News, 17 Sept. They believe the BoJ's actions may be the start of a more general period of competitive devaluation; with the US authorities tacitly allowing the US dollar to decline in an environment of QE2 (no wonder gold looks so perky!)."

According to Edwards, there is good precedent for using currency devaluation as a tool to combat presistent deflation, and good indications that the Chairman of the Federal Reserve, Mr. Bernanke, has considered devaluation seriously as a policy tool.  In his 2002 speech Deflation: Making Sure "It" Doesn't Happen Here, he said:
“The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt."
"Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange … 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."

Not that I necessarily agree, but Zero Hedge interpreted Bernanke's statements very liberally as "the blueprint for the endgame," meaning that a competitive round of international currency devaluation will soon be upon us:

"Hence Bernanke openly stated back in 2002 that the end game, especially when all else fails (fiscal deficit too high and QE shown to be impotent), is to print money to drive down the dollar. This is default in all but name. Investors ignore this at their peril."

I have no idea of whether or not the Fed can actually bring about currency devaluation and inflation, but there are ominous signs. As a likely program of QE II approaches, the dollar has been declining and gold has been rallying. Now, noted investment managers such as Bill Gross are warning of inflation and currency devaluation in our future.

Satan, Like the Fed, Can Extinguish His Creations

On the other hand, bonds are still performing well. They need to, because the Fed is enforcing low rates to keep banks solvent, to let debtors refinance, and to let the Federal government roll over its debt at affordably low rates. The strong dollar has been a big help in doing this. It is also fortunate for the US that no country wants to endanger its exports by letting its currency rise against the dollar. Since the dollar started sliding recently, countries around the world have intervened to weaken their currencies and maintain their export competitiveness.

If the Fed promotes currency devaluation, it will be walking a tightrope between driving down the dollar (to cheapen our debt) and keeping the dollar strong (so that we can afford to roll over our debts). Something will have to give.

Maybe the currency game is not a total standoff. As Edwards put it:

"The good news is that this is not the zero sum gain that most commentators suppose. For if all central banks are printing money to drive their currencies downward, exchange rates may not change, but the money supply does. It is easier for the US to "guide" down the dollar with its burgeoning current account deficit, and to the extent bond yields rise as foreigners back away, the Fed will just keep printing money to hold them down!"

So, maybe the US really can devalue the dollar relative to other currencies, at least those that are not pegged. In that case, there would be all those "printed" dollars waiting to enter the real economy and, if the velocity of money increases, the eventual inflation in prices.  That is what Edwards argues.

Of course, there are problems with this scenario.  To get inflation, individuals and businesses would have to want to borrow and spend, and it would take a lot of devaluation for that to happen (which hardly seems in the cards now that Congress has caught the austerity bug).  Not that I doubt the ability of politicians and bureaucrats to make mistakes, but it is hard to imagine an environment that would encourage much additional spending, short of some kind of currency crash or bond panic. 

Maybe a really repressive Fed policy (like incentivizing banks to charge negative interest on deposits) could do the trick, but that would have risks too.   Another problem is that devaluation would not help against currencies that are pegged to the dollar.  In fact, modest dollar devaluation would make China even more competitive against the rest of the world, as long as the dollar-yuan decline wasn't so great as to price them out of the commodities markets.

What Will Dawn Reveal?

The Fed has already responded to the slowing economy with one round of extraordinarily accommodative monetary policies, and they seem ideologically inclined to try it again. Extraordinary policies can be risky -- and we had better think hard about that risk.

The End Game -- Doomed Souls Return to Satan

What about the risks of accomplishing another round of QE?  Zero Hedge wrote that $1 trillion of Treasury purchases a year (as widely expected) means that the Fed will be purchasing nearly all of the net debt that the Treasury will issue this year. That means the Fed will be financing all of the Treasury's debt issuance, which might raise a few eyebrows, because the Fed would actually be monetizing the debt. Will anyone lose confidence in the US as a result? I don't know, but it sounds strange.

The most popular view in the media is that QE II will cause nearly all asset classes to rise in price, but will have only a very minor and transitory effect on the real economy. This is a very short term point of view. In contrast, Edwards takes a very extreme but more serious view. He believes that citizens of the mature Western economies are being pinched to the point of social unrest, and that the inflation resulting from competitive currency devaluation could be the breaking point: "what do devaluation, high unemployment, inequality and food prices spell? C-H-A-O-S."

I hope that everyone had a good time!

Despite worries about social trends, I certainly do not see social chaos affecting the US anytime soon.  Rather than some kind of social chaos, the risks at present seem more tilted toward policy mistakes.  Politicians do have a way of catering to the base needs of their constituents, no matter the long-term consequences.

Perhaps devaluation and inflation are future risks, but I am not sure if they can affect us greatly in the near term.   For the near-term future, disinflation and economic stagnation seem more likely to continue  as the dominant forces, but the destabilizing risks posed by QE II are worth contemplating very seriously. 

   Happy Halloween!!!