The Down Staircase

The Stairway to Poverty

Several times I’ve said in this blog that I don’t expect the imminent collapse of the dollar. This isn’t because I’m blind to the dollar’s fatal flaws, but because of the time required for the unfolding of this nation’s budgetary and economic problems, and because the dollar is only one of a number of troubled currencies of declining developed nations.

But I don’t want to give the impression that the dollar is safe. We know that the dollar is on an unsustainable trajectory, and its decline seems inevitable. It’s just that the path isn’t necessarily straight down, and the timing of the dollar’s decline is highly uncertain.

The Dollar Cascade

There is no doubt that the direction is down. Even Chairman Bernanke has said that the US needs to reduce debt, and that the process of deleveraging will involve high rates of bankruptcy and unemployment. In such a spare environment, low rates of economic growth will force governments and individual citizens to adjust their expectations and economic activities downward. Because governments and citizens do not willingly adjust their expectations to reduced circumstances, we cannot expect the process to be a smooth one.

Until the financial crisis hit, the risk of financial collapse because of rising levels of private and public debt was met with official denial. When collapse became imminent, the official response was a bailout of key financial players, a policy of rock-bottom interest rates, and quantitative easing – all temporary measures that left the underlying issues untouched. Private debt was partially transformed into public debt, but the debt remained. The system was stabilized temporarily, but this was only the first step in a multi-year process of deleveraging and economic adjustment.

For these reasons, I see the continuing decline of the dollar as a sequence of stair steps. After falling down a step, the US finds ways to arrest its decline partially and sustain itself at a lower level for a few years. Eventually, the pressure on the US (declining economic competitiveness, value of the dollar, political influence) builds up to a point that resistance gives way and we fall down another step. Over a period of decades, some of the steps may be small and others large and catastrophic. However long we may loiter on any single step, the direction is down.

Printing Money Is Not the Answer, It Is a Symptom

There is a school of thought, based on Modern Monetary Theory, that the US cannot become insolvent. The thesis is that the Fed is not monetizing the debt, and a truly sovereign currency can not be debased into hyperinflation. This position posits that the government does not print money, but rather pushes buttons to create amounts in bank accounts or remove amounts from bank accounts. The blog Pragmatic Capitalism has published a number of articles supporting this position, which might be summarized as: “a sovereign government with monopoly supply of currency in a floating exchange rate system has no solvency issue.”

In my opinion the main problem with discussions of this point of view is that they discuss the wrong problem.  The real issues are this country's ballooning federal debt and its persistent negative balance of payments.  Those are the main forces driving this country to penury, not monetary policy. 

Easy monetary policy, however, exacerbates the problem because it distorts market prices, resulting is the allocation of resources into speculation rather than productive activities.  Nevertheless, I was still interested to read a critique of modern monetary theory in a recent series of articles in another blog that I enjoy, Jesse’s Crossroads Café (Jesse Part 1, Jesse Part 2, Jesse Part 3).  To quote Jesse, the critique might be summarized as “I can print money, therefore I can never go broke.”

A government with a monopoly supply of currency may remain solvent in the limited sense that it can pay its debts in its own currency, but that is such a myopic issue as to be meaningless. What is that currency worth in real terms? Not much, if that government’s debts expand without limit. If debt grows uncontrollably, no sovereign government can escape the consequences.

Theoretical solvency is a false issue if your currency declines against all others, and if everyone understands that the trend is going to continue indefinitely.

If debt grows uncontrollably, relative to the size of an economy, citizens and creditors will notice. What exchange rates will foreign trading partners demand, what interest rates will foreign creditors demand, and what rate of price inflation will domestic consumers experience? As Jesse put it:  “The limit of the Fed's and Treasury's ability to create money is the value and acceptance of the dollar and the bond in market transactions.”

And at some point, after exchange rates, interest rates, and price inflation have escalated to the point that the people are mostly in penury, who will accept that currency in exchange for any service or real good?  At that point such a government really does become insolvent.

The Runaway Fiscal Trajectory

The US and other advanced nations seem unlikely to take significant steps to bring their houses into fiscal order until catastrophe is staring them in the face, and by that time it will be too late. It may already be too late. Even holding social entitlements (such as Social Security and Medicare) at current levels (as a percent of GDP) may be insufficient, according to a study by the Bank of International Settlements.

Both monetary and fiscal policy now appear to be impotent, and there is an increasing risk that government policies may be unable to avoid financial collapse. As Charles Hughes Smith recently wrote in “Beyond the False Dawn: Global Crisis 2020-2022” in his blog Of Two Minds, the policy of easy money is a trap, because we cannot reverse it without catastrophe: “… the status quo is now addicted to unlimited flows of free money. If the flow continues, then inflation will destabilize it; if it's cut off, then rising interest payments will destabilize it.”

Although I mentioned inflation as a problem, this does not mean that every step forward will be inflationary.  Government budget cuts, recession, and falling real income are among the strong deflationary forces that lie in our future at some point.  Different steps on the down stairway will bring different conditions, whether  inflationary and deflationary, whether in the price sense or the monetary sense.  The overall direction is toward economic decline and monetary devaluation, however.

Despite political rhetoric, US fiscal policy is still on a runaway trajectory. Recently The Economist reported in its Daily Chart feature, "I O USA" that neither the Republicans or the Democrats are serious about the deficit:

“Both sides talk about cutting the deficit but are unwilling to risk losing voters by trimming the big budget items: pensions, Medicare, Medicaid and defence. Republicans, who were initially pushed to talk tough on cutting spending by the Tea Partiers, have backed away from what plans they had to take on entitlements since gaining control of the House.”

Stumbling Down the Stairs

At some point people will not accept dollars without a suitable discount, or else they will not accept them at all. I agree with those who argue that the dollar is already unstable and that the present conditions supporting the dollar are unlikely to continue forever. As Jesse stated: “the question is when markets will start putting pressure on governments, not if.”

Apparently, people are catching on to this idea. Mohammed El Erian recently commented ominously about the failure of the dollar to rise in reaction to the crisis in Egypt, Libya, Bahrain, and other countries in the Middle East (my emphasis):

"It is a warning shot to America that we cannot simply assume flight to quality, flight to safety. That people are starting to worry about the fiscal situation in the U.S., worrying about the level of debt and what they're hearing about states and municipalities. I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past."

It does not matter whether the US dollar is or is not the world's reserve currency, as long as the world has confidence in the dollar.  Losing the dollar's status as the reserve currency does matter, however, because it signals that the world has recognized lost confidence in the US.  It signals that our underlying problems of debt and lack of competitiveness have become unmanageable.

As recognition of the fiscal and economic problems of the US become widely accepted, there will be little to restrain the fall of our currency. The debt has been accumulated, the industrial system has been eroded, and government policies are not being meaningfully directed to remedy the fundamental problems underlying the crisis. This mantra quoted from Jesse’s Crossroads Café is an insightful comment on the need for new solutions:

“Both austerity and stimulus will falter in the mire of imbalanced, broken systems and corruption. The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained recovery.”

The Old Always

The thing that hath been, it is that which shall be; and that which is done is that which shall be done; and there is no new thing under the sun.

Ecclesiastes 1:9

Last month, James Montier of GMO wrote a piece, In Defense of the “Old Always", questioning the concept of the "new normal" and what it means for the way we invest these days.  Perhaps not surprisingly for a value investor, his conclusion was that there is nothing new under the sun and that "old always" value investing principles still apply.  I especially liked his observation that the value investing concept of mean reversion still applies, contrary to what some "new normal" proponents have proposed.

What Is the "New Normal"?

Discussing the "new normal" is complicated by the variety of meanings that different writers have attached to the term.  Perhaps the most common interpretation is that the "new normal" refers to the current period of low economic growth in the developed world and the likelihood that this period will continue for years. This interpretation makes a lot of sense, because low growth seems likely to be with us for years, thanks to the unsustainably high levels of debt in the private and public spheres. Indeed, the growing convergence of the developed and developing worlds makes it unlikely that the "old normal" economic proposition will return.

Is the "New Normal" in Investing Returns?

To other observers the "new normal" refers to a shift in investing returns from a distribution with thin tails and more likely outcomes close to the middle to a more uniform distribution with fat tails, or more frequent extreme outcomes.  Bill Gross of PIMCO offered this interpretation in one of his monthly commentaries last year. 

I find this "fat tail" interpretation very hard to give credibility to, because the world has experienced high variance outcomes in the financial markets historically and with a frequency that is much higher than has generally been appreciated.  Bubbles, bankruptcies, and the ruin of old regimes have been fairly frequent companions of financial markets for centuries.  With samples taken over long enough periods of time or across enough kinds of  markets, financial returns have always looked non-normal with fat tails.

                              Joan Miro, Red Sun

Is the "New Normal" in Mean Reversion?

Another PIMCO manager, Richard Clarida, went even further and attacked the very basis of value investing, which is that one buys when a thing is cheap and sells when it is dear.  Clarida wrote, “Positioning for mean reversion will be a less compelling investment theme in a world where realized returns cluster nearer the tails and away from the mean.” 

Come on now, who could really believe that mean reversion is dead?  Not only does this statement ignore the historical fact that extreme outcomes are not that rare, but it also makes the logical mistake of saying that high variance is inconsistent with the mean reversion.  When markets go to extremes, they eventually revert to the mean and beyond, and patient value investors will profit if they wait for the bubble to burst.  This increases the chances for profit when reversion occurs.

Mean Reversion Is Alive and Well

I have to agree with Montier when he says "the concept of the new normal confuses the distribution of economic outcomes (and forecasts thereof) with the distribution of asset markets ... From the perspective of mean reversion, fat tails help to create some of the best opportunities."  Montier's letter also included a chart that illustrates his point very graphically.

History is littered with the remains of proclaimed, but unfulfilled, new eras. Exhibit 6 shows the long-run history for the Graham and Dodd P/E for the U.S. market. Over this time, we have witnessed some quite remarkable, and quite appalling, things – the deaths of empires, the births of nations, waves of globalization, periods of deregulation, periods of re-regulation, World Wars, revolutions, plagues, and huge technological and medical advances – and yet one thing has remained true throughout history: none of these events mattered from the perspective of value!

No One Says That It Is Going to Be Easy

None of this means that it is EASY to apply value principles to mean reversion.  No one can predict the future, which means that no one knows when the top or the bottom will occur. You have to understand the investing  world, and you need to apply valuation metrics, but is this possible today?  Zero Hedge suggested that the metrics have changed:

Yet in a universe in which true asset fair value can no longer be derived, and all valuations are wrapped in the enigma of trillions of monetary and fiscal stimuli, whose stripping is virtually impossible in a world in which everything is centrally planned, we just may have entered... the non-"old always" zone. 

I agree that it isn't easy to apply familiar valuation metrics when the Fed has flooded the market with liquidity, but I don't think that it is impossible.  You just have to adjust your metrics so that they reflect the determining forces at work in a debt-laden world.  If the government assumes private debt to attain financial stability, you need to attend to the political risks as well as the industry fundamentals.  But mainly you need patience.  I'll let Montier answer in his own words. 

It is also worth noting that in order for mean-reversion-based strategies to work, it is not required that the mean be realized for long periods of time, but that markets continue to behave as they always have, swinging pendulumlike between the depths of despair and irrational exuberance, or, from risk-on to risk-off. As long as markets display such bipolar disorder and switch from periods of mania to periods of depression, then mean reversion should continue to merit worth as an investment strategy.

Unstable Equilibrium

Woodblock print by Utagawa Hiroshige

Freeze and Thaw

An increasing number of analysts are forecasting better time ahead for the economy and the stock market. Elaine Garzarelli daid on CNBC that there will be better economic growth and stock market performance next year as a result of the money put into action by QE II.  PIMCO's Mohammed El-Erian also raised his US growth forecast for 2011, to between 3.0 and 3.5 percent from an earlier estimate of 2.0 to 2.5 percent, based on the prospect that Bush-era tax cuts will be extended for another two years. However, he added that further stimulus would be needed to sustain growth.

To be sure, not all of the optimism is US-centered or long-term. Byron Wien just came out with a warning that investors need to be invested in emerging markets, and he recommended a portfolio allocation that emphasizes emerging markets, high yield bonds, and hedge funds.  Bill Gross just advised fixed-income investors to look to emerging markets like Brazil where they can earn an attractive real interest rate, rather than the pittance offered in the US.

Also, many structural factors are against the US in the longer term. Gross added: “The U.S. is being out-trained, out-educated and out- maneuvered in the global competition for employment.”  About his forecast of higher US economic growth, El-Erian wrote: "Maintaining such a growth rate beyond 2011 requires additional measures to enhance competitiveness and achieve medium-term fiscal consolidation."

Risk Probabilities Remain Tilted Toward Recession and Deflation

Despite recent talk in the press about signs of an improving economy, a look at a broader range of evidence shows persistent and underlying economic weakness. Combined with underlying conditions, including high levels of debt in both the private and public sectors, the economic and financial evidence suggests that the way out of this country's troubles will be a long slog and fraught with risks.

Fed Chairman Bernanke said last Sunday that the economy is barely expanding at a sustainable pace and that it’s possible the Fed may expand bond purchases beyond the $600 billion announced last month to spur growth. “We’re not very far from the level where the economy is not self-sustaining,” Bernanke said in an interview broadcast yesterday by CBS Corp.’s “60 Minutes” program. “It’s very close to the border. It takes about 2.5 percent growth just to keep unemployment stable and that’s about what we’re getting.”

Indeed, this country is not alone in its troubles. Around the developed world, financial systems burdened by high levels of debt and stagnant economies are highly dependent on government policies for their maintenance. Certainly, the economies and financial systems of the US, EU, and Japan are supported only by extraordinary monetary policy, and errors in these countries' policies could have negative repercussions that would reverberate around the world. As Hugh Hendry says in his December 2010 Eclectica Fund commentary, "This is an environment rich in policy error contingencies."

Hendry also made the very practical point that serious dislocations can also present serious investment opportunities. In the spirit that our wealth is only as safe as our ability to prepare for an uncertain future, I'd like to review recent commentaries about these risks and uncertainties.

Is Santa Coming to Your House?

In case anyone thinks that the economy and financial system actually are making progress, he or she need look no farther than recent news headlines. As an example, consider the headlines from the news stories reprinted in The Automatic Earth blog, last Saturday, December 4, 2010:

Senate Republicans Defeat Reauthorization Of Jobless Aid, Tax Cuts

4 Million Americans Set To Lose Unemployment Benefits Even If Congress Passes Extension

Here Are The The AWFUL Details Behind Today's Big Jobs Report Miss

Value Sinking Fastest on Homes Priced Low to Start

Homes Prices are Plunging: Let's Talk About the Deficit

Distressed Homes in U.S. Sell at Biggest Discount in Five Years

The con of the century – Federal Reserve made $9 trillion in short-term loans to only 18 financial institutions. Since 2000 the US dollar has fallen by 33 percent. The hidden cost of the bailouts.

ECB bows to German veto on mass bond purchases

Angela Merkel warned that Germany could abandon the euro

The details within these stories are no better than the headlines. For example, consider the imbalance between good and bad news in this list of employment facts from the above-mentioned jobs report article:

1. First, the headline: Nonfarm payrolls barely move upward.

2. And the unemployment rate is now creeping up again.

3. Those unemployed for more than 15 weeks is now near 2010 highs.

4. And those unemployed for more than 27 weeks is moving higher.

5. The civilian employment ratio is back at the post recession low.

6. Civilian employment numbers have given up the past few months' gains.

7. The civilian participation rate is now at a new low.

8. Weekly hours have slipped as well.

9. Now, a look at the industries hardest hit: Manufacturing employment in non durable goods now below 2010 lows.

10. And durable goods manufacturing jobs don't look too much better.

11. Government jobs have dipped again, although only slightly.

12. Construction jobs remain low, and flat.

13. BRIGHT SIGN: Total private industry jobs are still moving higher.

He's Making a List

Maybe we can muddle through with a weak economy, or maybe not. For my part, I'm worried about all the risks we fact before (if ever) we get out of the woods. Pragmatic Capitalism made this point forcefully: "I still believe we are mired in a balance sheet recession that will result in below trend growth, deflationary risks and leaves us extremely vulnerable to exogenous risks that could exacerbate the current malaise."

If the current stagnant situation is being propped up only with extraordinary monetary policy, then surely the situation is actually quite fragile. A world delicately balanced between debt disaster and policy overreach must surely be fraught with numerous, serious risks. Niels Jensen, Managing Partner of Absolute Return Partners LLP listed 12 risk factors for the attention of readers of his latest Absolute Return Letter.  Here are the risk factors, each accompanied by my own short exegesis:

High yield priced for perfection? Are spreads getting so tight that one could even talk of a bubble, and could that bubble burst, should the US (and/or European) economy fall back into recession?

The risk of double dipping. Just consider the economic news that I listed earlier.

The sinking ship of Japan. This refers to the high and growing level of government debt, the funding of which is endangered by an old and aging population.

Beggar thy neighbor mentality. Just consider administration talk of devaluing the dollar to increase exports (as if anyone needed our products), complaints from various emerging countries about manipulated interest rates in the US, and China's policy with the Renminbi.

Capital flows too hot to handle. We read every day about the risks of overheating in China and other emerging economies. Capital controls would damage both overseas investors and internal growth. Not imposing controls would risk high inflation and runaway bubbles in commodities and other assets.

Chinese inflation out of control? Although the leadership has said that it is considering price controls on food, lax monetary policy is pushing up prices of a variety of goods and assets.

Food inflation induced civil unrest. Based on the last food price peak in 2008, it may not be too much to expect civil unrest across Asia if food prices continue to climb.

Is India an accident waiting to happen? Although India is financing its external deficit with ease at present, due to the positive capital flows into emerging markets, tighter overseas monetary policies or a change in investor risk perceptions could endanger those flows.

European contagion and solvency risk. Current efforts to avert a crisis are just kicking the can down the road. Banks are in trouble, and the underlying solvency problems are not being solved by adjustments in liquidity.

Massive refinancing program. "This programme poses the biggest risk to my benign outlook for bond yields ...", because of the huge financing needs that are approaching, according to Jensen. Zero Hedge ventured that the problem is even bigger: "Simply put, it's not just fiscally-challenged nations in the eurozone that are suddenly being forced to address the threat posed by too much borrowing. Over the next 12 months, countries across the world, including the United States, will be looking to roll over approximately $10 trillion worth of debt."

Premature withdrawal of monetary support. Not only are the indebted peripheral nations of Europe dependent on continuous support, but the US economy is in danger if Congress follows through on Republican promises to rein in the Federal budget, seemingly without any consideration of the consequences.

Israel launching a pre-emptive strike on Iran’s nuclear facilities. The world is full of political-military risks, and this is just one risk that happens to be a current focus of attention.

I don't know if these are exactly the risks that I would focus on, but they serve to convey the general notion that the present unstable equilibrium could easily be disturbed and send the system sliding off into a new trough of worse conditions.

He's Checking It Twice

Naturally, David Rosenberg has taken his turn listing risks to economic recovery, and out of his list, I think that these two pose particular domestic threats next year:

Massive tightening in U.S. fiscal policy coming via spending cuts and tax hikes. This is the part of the macro forecast that is not given enough attention.

Many goodies will expire at the end of the year and question marks linger over whether they will be extended. These range from the Build America Bond program that subsidized municipal issuance, the Bush-era tax cuts, the extended/emergency jobless benefits, and the little-known Obama tax benefit called the Making Work Pay Credit.

Pragmatic Capitalism reviewed Rosenberg's list and added another domestic risk : "The one major risk that Rosenberg and the market is largely overlooking at this juncture is the housing double dip. This has the potential to be THE most important story of 2011. As I've previously explained, declining asset values are highly destructive during a balance sheet recession."

Tighter fiscal policy will do no good for the economy, and it also brings into question how much money the states might receive from the Federal government should states continue down their present road to budgetary crisis. In "Mounting Debts by States Stoke Fears of Crisis" The New York Times noted just a few examples of how bad the situation has become:

"The State of Illinois is still paying off billions in bills that it got from schools and social service providers last year. Arizona recently stopped paying for certain organ transplants for people in its Medicaid program. States are releasing prisoners early, more to cut expenses than to reward good behavior. And in Newark, the city laid off 13 percent of its police officers last week."

Given continued problems with the national economy, many states could be overwhelmed by debt in a few years, if they are not already at the brink of the precipice. Worries about Federal willingness to aid the states may not be mere fear mongering. The Times added: "Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones, much as the turmoil in Europe has spread from country to country."

Felix Rohatyn, the financier who helped save New York City from budget problems in the 1980s warned that while municipal bankruptcies were rare, they appeared increasingly possible. Mr. Rohatyn added that the imbalances are so large in some places that the federal government will probably have to step in at some point, even if that seems unlikely in the current political climate.

In noting the likelihood of legislative deadlock in 2011, David Rosenberg wrote:

Folks, we are on life support. We have been since 2008. Nothing will change in 2011. QE has been extended, the tax cuts will be extended, BABs and the Agency loan limits are being extended. The IV is full and inserted into the arm. The juice that is keeping us alive is still flowing. But make no mistake about this. Without the IV the lights will go out very quickly. 2011 is the last year for these extensions. When we wake up to the fact that we are alive only as a result of medicine we take on a daily basis there is going to be another “event”.

In the current political climate, we have to wonder what kind of price the Republicans might try to exact in exchange for eventual bailouts of the states. Breaking public employee unions would surely please the Republicans, but they might have to provoke a state bankruptcy crisis in order to get their way. Financial systems don't like crises, unfortunately.

In Wednesday’s NYT, David Leonhardt commented: “Mr. Obama effectively traded tax cuts for the affluent, which Republicans were demanding, for a second stimulus bill that seemed improbable a few weeks ago.” It seems likely that any resulting stimulus will be too little to make a difference.

It is to be hoped that the recent extension of tax breaks for the wealthy will prompt those who are often referred to as the "job creators" to get with it and start hiring. Given that the demand for goods from the masses is lacking, there is little reason for more hiring, but we can all hope. At least there are some modest increases in prospective hiring surveys for the first quarter of next year.

The Neighbors Have Been Naughty Too

David Rosenberg has a good way with words, so I'll let him express the nature of the risks with Europe: 

"All these “rescue” packages in euroland really do is provide bridge financing — they do not resolve the underlying structural problems in these countries or the deflating asset values in bank balance sheets."

"The massive selloff in government bond markets, even in countries like Belgium and Italy (let alone Portugal and Spain), is a clear sign that the bond vigilantes are now targeting the supposedly stronger governments in the eurozone. These bond vigilantes are also speculating that the national purse will be needed to keep their banks afloat and the relentless widening in CDS spreads is an added suggestion from the markets that these governments may not have the resources to fully repay their creditors once they have moved to support their banking systems."

The Washington Post commented last Tuesday that bond markets are not the only worry with Europe:  "A greater danger is that a full-blown debt crisis in Europe could put new pressure on the region's banks, tightening credit and potentially slowing growth in one of the world's largest economic engines. It could also send the euro plunging against the dollar, making the greenback stronger on world markets and undermining the efforts of the Obama administration to boost U.S. exports overseas."

In a guest editorial in Naked Capitalism, the author of Washington's Blog wrote: "...... by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don’t have, central banks have put their countries at risk from default."

Nouriel Roubini put it this way, “So at some point you need restructuring. At some point you need the creditors of the banks to take a hit —otherwise you put all this debt on the balance sheet of government. And then you break the back of government—and then government is insolvent.” There remains the question of what kind of restructurings will take place, but Europe seems to be kicking the can down the road at present. The transfer of risks onto government balance sheets is already being reflected in the widening of sovereign credit default swaps.

Should there be a systemic breakdown in Europe, it could bring a banking crisis of the same kind that we saw in 2008. Banks in the US, Europe, and elsewhere could face sudden lack of liquidity if European banks take a hit.  Investors on the whole are probably not prepared for such an event.



The Bond Vigilantes May Beat Santa to Town

CNBC reported Wednesday that Nouriel Roubini voiced concern over the compromise on extending tax cuts between President Obama and Republican Congressional leaders. Roubini said that the agreement could expose the US to bond vigilantes who will drive up bond yields. The Fed has kept short-term rates as rock-bottom levels to support the fragile economy, and an increase in bond yields could damage any chance of a recovery

Roubini said on Twitter: “Obama-GOP tax deal costs $900 billion over two years. US kicking the can further down the road. Are bond vigilantes starting to wake up?”  Bond prices have fallen from the highs of a few weeks ago when speculators were anticipating the Fed's purchases under QE II, and renewed worries about US government debt levels could send Treasury prices even lower.

Worries about the debt positions of other advanced economies, which seem to be in even worse condition, might be a mitigating condition preventing any abrupt break in US bond prices. Nevertheless, given the seeming intractability of the debt problem, it would not be surprising to see recurring periods of worry about US debt levels over the next few years, accompanied by occasional declines in bond prices.

Progress on reducing the national debt will require both steady tax revenues and reduced budget expenditures. The weak economy will make progress on both fronts very difficult, since it will increase demands for fiscal and monetary intervention. As Jesse's Crossroads Cafe put it, "For a nation that is a net debtor, deflation is tantamount to suicide."

Despite criticisms of its monetary policies, the Fed seems unlikely to allow deflationary suicide anytime soon.  In his CBS interview, Federal Reserve Chairman Ben Bernanke did not rule out buying more than $600 billion of bonds in further quantitative easing. Once the idea of an imminent QE III gets into the consciousness of Wall Street, we should not be surprised to see even more money piling into commodities, emerging markets, and other "risk" assets. Perhaps this time the weakness of Europe will help to support the dollar ... perhaps.  A weaker dollar would help exporting industries in the US, if the Fed could engineer it.

According to the New York Times, financial markets have interpreted the tax cut deal, which was announced this week between the administration and Congress, as contributing to economic growth over the next couple of years but also increasing the federal deficit and raising borrowing costs. Higher borrowing costs would not help in funding extant debts, and the elephantine issue of reducing the federal debt is being pushed off to the future.  Whatever happens on the fiscal side, the monetary side of policy seems likely to keep levitating financial asset prices. When that levitation will end it hard to tell, but at some point the bond vigilantes will likely have their say.

An increasing number of analysts is saying that it makes no sense for the Fed to keep monetary conditions so loose when the economy is enjoying growth in excess of 2 percent.  They may have a point, because the bond market has responded to better growth prospects, and bond prices have declined recently.  Given all of the risks that we have enumerated in this article, we have to wonder if that growth spurt will be short-lived.

Afterword

Pundits who make point predictions about the economy and the markets are absolutely foolish, because any alert observer will admit that the future is a swirling sea of variables.  No one knows what is going to happen.  On the other hand, we all need to protect our assets and prepare for the future.  To do that, we need to consider a range of alternative futures and form judgments about their relative plausibilities.   You can tell in which direction I think the probabilities are pointing.

The Beginning of the End

The End of a Bull Market in Bonds

PIMCO's Bill Gross shook me up the other day with his October commentary. Bond investors do not like it when a bond guru writes that the Fed's announcement of renewed quantitative easing next Wednesday "will likely signify the end of a great 30-year bull market in bonds."

Whoa! I've been raking in easy if modest returns with a portfolio tilted toward high credit quality bonds. That's what you do in a debt deflation, isn't it?

"Safe Spreads"

Always prone to hyperbole, Gross softened the message toward the bottom of his commentary, when he said that PIMCO had no intention of suffering a bear market in bonds, and that they could maneuver around this little problem of no more bond bull. Specifically, he intends to invest in what he calls "safe spread" securities that offer higher yield "without taking a lot of risk" of inflation.

One example is emerging market debt with higher yields and non-dollar denominations, and another is high quality global corporate bonds. Gross added: "Even U.S. Agency mortgages yielding 200 basis points more than those 1% Treasuries, qualify as 'safe spreads'.”

You know, I wouldn't call a bond portfolio exactly safe it includes a lot of securities sensitive to highly correlated risks like currencies and emerging market economies. So, how does this square with the "end of a great 30-year bull market in bonds?" Well, with Gross we know that he likes to engage in a hyperbole and that he doesn't tell the whole story.

Bonds Are Not "Over the Cliff"

Gross appeared on Bloomberg Surveillance Thursday and was more nuanced in his explanations. By an end to the bond bull he means "not over the cliff" for the entire market but a recognition that "certain maturities can't go much lower." Two-year maturity Treasuries, for example, are yielding near the overnight rate. Not much opportunity for return there. He explained that Fed purchases make it mathematically impossible for bonds to do much better.

He also explained that "safe spreads" refer to securities that offer yield without being vulnerable to inflation expectations. This concern with inflation sensitivity seems an important point.

Gross added that he hasn't shortened the maturity of his Total Return portfolio, which is still in the vicinity of four to four and a half years. This is in contrast to Dan Fuss, who said on Bloomberg Surveillance the day before that he had reduced the average maturity of his Loomis Sayles portfolios.

Rather than reducing PIMCO's bond maturity, Gross has gone "to a space not vulnerable to inflationary expectations."  A lot of securities are much less sensitive to inflation than are Treasuries, and he is focusing on the "safe space.".

It is interesting that Gross is concerned with vulnerability to inflation. Inflation is what the Fed is trying to achieve with QE, and with the suggested 2.5% inflation target. If PIMCO takes it seriously, perhaps there is a risk that they will succeed, or at least that investors will be spooked by the expectation.

Higher Rates in Three to Five Years

Another reason that Gross hasn't changed his portfolio's average maturity yet is that "the Fed isn't changing its target rate." So, he isn't expecting inflation soon, but apparently he thinks that it is a possibility sometime in his planning horizon. He believes that the Fed will tighten eventually.

The timing of inflation is influencing the maturities in his portfolio. Gross said that he is avoiding the 10-year Treasury because policy rates may go higher. The "safe maturities are five years and in, not five years and out." So apparently five years is approximately the horizon at which the Fed is expected to tighten. (I have no idea how anyone can predict if and when the Fed will tighten, but there it is.)

Gross reinforced this estimate of a five-year "safe" period when he said that CD investors could go out in maturity to three or four years. Five-year CDs might appeal a risk taker. Just to make it clear that he is willing to make a prediction, he added: "The Fed won't raise for three years, maybe four or five."

Stagflation Coming?

Given that the Fed is unlikely to restart the economy with monetary policy, it is natural to wonder why the Fed might raise rates within three to five years. The answer may be stagflation. If the Fed creates inflation through dollar devaluation or speculative bubbles, it would probably result in stagflation rather than ordinary wage-price inflation, given the likelihood that the economy will remain weak. Stagflation would be very negative for Treasuries. Rates would rise in general, and the Fed would have to follow.

It would take something very serious, like stagflation, to get the Fed to raise rates with the economy still weak. We have to wonder how badly higher rates would affect the economy and the servicing of US debt, which suggests that recovery through inflation is a self-limiting process.

No Inflation at Present

However, inflation risks are for the future and not the present, according to Gross. He sees even the low yields of short Treasuries as "safe" at the present time. "A two-year Treasury and a three-year Treasury only yield 37 to 60 basis points, but that's safe yield because the Fed isn't going anywhere."

Gross also suggested that the Fed may not be able to go much farther with monetary policy, and that fiscal policy will have to take over soon. "We've been willing to accept the lower yield in anticipation of a hand-off to federal officials maybe six months down the road."  Gross didn't say, but this would be after newly elected Congressmen have taken office in what is expected to be a more Republican House. Given the likely stalemate in Congress, it is hard to understand exactly how this "hand-off" is to work.

Does This Mean Anything?

Gross loves to dampen his clients' expectations by expressing caution. A look at his past commentaries shows that he has called for the end of the bond bull before, only to be followed by huge bond rallies. Maybe this is another of those times, but on the other hand, maybe his remarks are justified and even prudent at this time.  No one knows what the Fed is going to announce next week or the market reaction. The stakes of the anticipated QE II are huge, and it would make sense to hedge bond portfolios ahead of the meeting. Gross's comments aren't much at odds with the fears that most bond investors hold these days, and at least we have another plausible scenario for consideration.

We definitely need some scenarios to think about to protect our portfolios.  Another PIMCO guru, Mohammed El Erian, also said this week that Federal Reserve purchases of Treasury securities likely will spur inflation, while leaving unemployment untouched.

Bond Risks and Opportunities

"This was a great nation until the robo-signers came."


Following a run-up in response to prospects for further Fed asset purchases, the bond market has turned more cautious. Perhaps this caution is in response to prospects of an intensified round of currency devaluations, with its implications for domestic inflation, or maybe the advance was just getting ahead of itself. Let's look at what people are saying about bonds.

Portfolios Shift Out of Short Term Treasuries

On October 8 PIMCO's Bill Gross gave in interview on Bloomberg television, in which he described how the advance in parts of the Treasury curve had caused him to adjust his portfolios. I watched part of the interview of Bloomberg Surveillance, where Gross said the yields of 2-, 3-, and 4-year Treasuries are getting so low that alternatives are now preferable in terms of taking on a little more duration or credit risk in return for more yield. In fact, he found no advantage for 2-4 year Treasuries over the money market. Instead, traders are moving out to the "belly" of the curve, and Gross said they should buy 5-, 6-, or 7-year maturities if they buy Treasuries.

"Look, Timmie, Someone Spent a Dollar!"

This move seems consistent with the prevailing pubic view that the Fed has gone as far as is practical in lowering yields in the shortest maturities, and that we can expect to see the Fed gradually walk its way out the yield curve, lowering rates in longer and longer maturities until the curve is flat.


Seeing the End of the Bond Rally

Then on October 14 Bloomberg summarized an interview with Douglas Hodge, the COO of PIMCO, about recent changes in their portfolios. The basic message was a little stronger than Gross's earlier statements, and Hodge warned that the strong bond gains of recent months are unlikely to continue:

“From where we sit, it’s very hard to suggest there’s going to be that kind of price appreciation that we’ve seen in bonds over the last 12 to 24 months.”


“Even if the QE process is large and rates decline further, in our view we’re approaching the end of the bond market rally.”

Hodge reinforced Gross's earlier message about the portfolio implications, saying that “We have reduced our Treasury holdings, the lowest yielding instruments.” Hodge mentioned that increased positions included emerging markets, such as India, China, and Brazil, with infrastructure debt looking particularly attractive. They are buying high-quality corporate bonds in India and are making investments in China via the non-deliverable forward market.

"This meeting of the Federal Open Market Committee will come to order!"

Seeing Increasing Credit Risks

In an email to Bloomberg, Bill Gross described the strategy underlying these portfolio changes, which involves much more than simply moving out the Treasury yield curve:

“Pimco Total Return currently is employing what we call a ‘safe spread’ strategy, which seeks to identify sovereign countries best able to handle a new normal global economy that envisions slower growth and therefore increasing credit risks in fixed-income markets.”

Perhaps PIMCO is expecting the Fed to keep the world's financial bubble primed through eternal quantitative easing.  As ridiculous as that sounds, maybe we should consider the possibility that the Fed is not going to let the US slip back into recession, no matter the inflationary consequences.

He also remarked that this has definite implications for portfolio allocation:  It looks like they are moving gradually away from the US to where the growth and improving creditworthiness may lie. This would be a good strategy if the emerging markets are not hurt when the economy of the developed world again takes a dive, which seems likely at some time in the next few months or years. Unfortunately, emerging economies like China are still extremely dependent on their more developed customers.

"The printing press is out of control!"

The worrying part of these pronouncements is that Gross's email emphasized the "increasing credit risks in fixed income markets" in a world of low growth. They still have a lot of their portfolio in the low growth US, but the percentage of the money there has been gradually reduced in recent months, particularly in the Treasury component. Many people are worried that high government debt problems will eventually catch up with the US and other advanced economies, and it would appear that PIMCO is starting to adjust its portfolios incrementally in that direction.

Buying Mortgage Backed Securities

If you look at PIMCO's most recent portfolio statistics, the message is a little different from that given by Hodge. Bloomberg published an article an article about this just the past week. You see that they still have large amounts of Treasuries, but the relative mix has been shifting in the past few months in favor mainly of mortgage-backed securities, which are the largest category in their funds (and which Hodge did not mention). Increases in emerging markets were much smaller.  This move is quite consistent with Bill Gross's statement that Treasury yields are so low as to be unrewarding in some parts of the curve, and that it is necessary to look elsewhere.  Apparently their thinking is that, with the US government backing them, agency-issued MBS offer more yield reward with only little more risk than Treasuries.

"These oddballs are ruining the neighborhood."

There is another, more speculative issue with MBS.  The general press is that QE II will focus on purchasing Treasuries somewhere out the curve, extending the flattening of yields that has already occurred at the short duration end. However, the Fed may have reasons for including considerable amounts (a billion or so) of MBS in QE II, especially now that there is a crisis brewing with rotten MBS that the big banks sold to investors at the height of the mortgage boom. With so many investors pressing the banks to make good on their agreements to buy back such rotten MBS, there is some increased level of risk to the survival of some of the big banks, and the profitability of others. The Fed may want to help the banks get rotten stuff off their balance sheets sooner rather than later, so as to avoid another possible financial crisis. Just maybe we might see some mortgage backed securities included in the Fed's asset purchases during QE II.

Timing the End of the Bond Bull

Bloomberg published a worrying article on October 21. It reported that Mark Kiesel, global head of corporate bond portfolios at PIMCO, said in a CNBC television interview that he sees interest rates going higher. He also said that PIMCO is increasing its stakes in investment grade companies. There was no word about whether this was a cyclical or secular rise.

"Is this the food stamp line?"

Other PIMCO pronouncements convey a different slant and suggest that the bond bull still has some chances of continuing in their opinion. Just prior to Kiesel's comments, a senior VP of PIMCO, Tony Crescenzi, said on Bloomberg television that bonds will suffer only when bankers start to lend money and when businesses and individuals ask for loans. Further, a "Keynesian endpoint" will really come only when all major economies "max out" their balance sheets. Given the likelihood that this event is some years in the future (albeit highly uncertain), the time for bond suffering is evidently not just around the corner.

The Risk of a Liquidity Trap

Perhaps a more serious threat to bonds is the threat posed by the Fed itself. Or, more properly, the threat is that the financial crisis has only been patched over, and could arise again to drag the economy and the financial system down in a deflationary liquidity trap.

This past weekend's New York Times carried an article on the dangers that the Fed sees with deflation, which the article referred to euphemistically as "persistently low inflation."  It is widely expected that the Fed will respond to this risk by attempting to lower long term interest rates. It is also expected that the Fed will do this by announcing of another asset purchase program -- QE II -- at its meeting in November.

The problem may be worse than generally appreciated until recently. Charles L. Evans, president of the Chicago Fed, said plainly at a recent conference that the economy is in a "liquidity trap." He announced his support for a strategy known as “price-level targeting,” in which the Fed would permit inflation to run at higher-than-normal rates in the future to make up for inflation being lower than desired today. In other words, Evans was proposing inflation targeting.

"Don't pull on your leash, Timmie."

Evans did not say how the Fed would accomplish this at a time when no one wants to spend money, and it seems unlikely that ordinary monetary policy (or asset purchases) could do this. However, even an official Fed statement saying that it is targeting higher inflation rates would raise considerable fears in the bond market that the Fed might embark on reckless actions.  Unfortunately, such actions would be self-defeating to the Fed's goals of keeping credit easy and cheap.


The Risk of Repressive Monetary Policy

Many commentators have commentated on the likely fruitlessness of further quantitative easing, which raises the question of what happens next. Maybe it is just idle speculation, but some of these commentators raised the possibility that the Fed will eventually be forced to turn to more repressive measures to force people to spend their money. By "repressive" they mean such things as motivating banks to charge their depositors for holding funds at the bank, rather than giving them interest on deposits. (Perhaps the Fed would charge a fee for holding banks' required reserves.) This means that the Fed would force negative short-term interest rates on the public and business.

There's nothing like seeing your money disappear before your eyes to motivate people to convert their money into real things, like cars, houses, or gold bullion. Would this restart the economy? It seems doubtful. But it would get money moving.  Money would flee the country and go to places that have saner central banks.

"We'll get those lazy bums off Social Security and Medicaid!"

Repressive monetary policy seems unlikely from today's perspective. The majority of observers seem to think that the Fed will simply continue with QE until it debases the dollar, and the recent drop in the dollar seemed to be tied to that worry. That would be another way of targeting inflation, which gets us back to the stopping problem of when to sell bonds and dollars ... and presumably buy gold and wheat.

Betting on the Inevitable

Not everyone is convinced that the Treasury bull is over. Gary Shilling, for example, still expects years of a deflationary environment and a continuing Treasury rally at the long end of the curve. David Rosenberg of Gluskin-Sheff has a similar view. Rosenberg believes in deflation, and he remarked in a recent newsletter that, despite all of the Fed's intervention, consumer prices have continued to fall, and core inflation is at four-decade lows. His reasoned:

"Therefore, it would make sense to assume that once we get pass this bump in the form of a weaker U.S. dollar and surging commodity prices, the risks of deflation will intensify again."

"Right now, the long bond yield provides a 150 basis point premium over 10-year Treasury notes at the price of taking on nearly nine extra years of modified duration. Sounds like a handsome trade-off ... a 3% real yield still looks fairly attractive from our lens."

"This wll give us exactly 3% inflation."

The Prospect of Fiscal Prudence Next Year

A problem with the deflationary argument is that many forces point to a different environment next year: That's when questions of fiscal austerity will start to come to the fore, and when we can expect real discussion of how to cut back on the US fiscal deficit. If this results in fiscal prudence, we can look forward to a slowing economy but perhaps also to a relaxing of worries about government debt, which could be good for the dollar and the long bond. On the other hand, if a Republican win in the elections should produce a political stalemate, there arises the prospect of a Congress unable to do much to reduce the fiscal deficit. A continuation of the present trajectory of budget deficits would heighten worries about the US, weaken the dollar and the bond, and raise again the specter of increasing inflation.

What to make of this dichotomy?  One point of view is to go with the inevitable. What is the most inevitable, unstoppable force affecting our society today? Why, it's the faltering economy. And what is ailing the economy? Why, it's debt, of course. It is hard to argue with trillions of dollars in debt (manifested in foreclosures, unemployment, and budget cutbacks) as an inevitable force.  Particularly when the deleveraging of the consumer sector has hardly begun, and when banks are still constrained by bad debts.  Driven by the weight of all this debt on our collective backs (and by its political masters), what else can the Fed do than feed the asset bubble until it bursts ... again?

"They bought it.  Only billionaires can vote, now."

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!!!