Wonderful political tool

As discussed rather simply in Econ 301 – Clunker Economics macroeconomics rests on a false premise. Despite its fundamental flaw, it is a wonderful political tool in two ways. First, it provides the intellectual cover for politicians to do what they want to do — spend more money. Second, it provides political cover in the sense that it can be claimed that “we have taken massive ‘corrective’ actions to cure the problem(s).” The fact that a free-market economy is resilient and self-healing enables the scheme to appear to be valid. In that sense, it is almost a perfect scam. Like witch doctors who claim to heal their patients when the mere passage of time is responsible for the cure or the rooster who thinks his crowing brings the sun up, the government takes credit for something that occurred quite naturally. (They never think that the problem might have been caused by their prior actions.) Unfortunately sometimes the well-intentioned witch doctor kills an otherwise healthy patient. We may be at just such a moment in history regarding the current economic crisis.

So long as people hold onto the expectation that recovery could be brought about by fiscal measures, no national consensus can be built to proceed with the painful disposition of nonperforming assets. It is necessary to learn by firsthand experience that fiscal measures are only makeshift. In this context, the enormous fiscal deficit that will be built up in the US in the coming months may be the political cost for consensus building, which would be a replay of what Japan went through in the 1990s. [emphasis added]

Special Drawing Rights

SDRs, or Special Drawing Rights, are a synthetic currency originally created by the IMF to replace gold and silver in large international transactions. But they have been little used until now. Why does the world suddenly need a new global fiat currency and global central bank? Rickards says it because of “Triffin’s Dilemma,” a problem first noted by economist Robert Triffin in the 1960s. When the world went off the gold standard, a reserve currency had to be provided by some large-currency country to service global trade. But leaving its currency out there for international purposes meant that the country would have to continually buy more than it sold, running large deficits; and that meant it would eventually go broke. The U.S. has fueled the world economy for the last 50 years, but now it is going broke. The U.S. can settle its debts and get its own house in order, but that would cause world trade to contract. A substitute global reserve currency is needed to fuel the global economy while the U.S. solves its debt problems, and that new currency is to be the IMF’s SDRs.

The problem should be obvious

As a follow-up to the previous Econ 101 post, this article takes a broader look at the effects of Interventionism on an economy-wide scale.

By now, the problem should be obvious.  As pricing power declines, raw materials costs are rising (highlighted by the 65 prices paid number in the August ISM and 63 in September).  This should erode margins which were the source of the earnings beats of the 2nd quarter.  As prices fall, total revenue will continue to miss expectations.  Credit is contracting at historical rates with commercial real estate and option ARM resets looming.  Record foreclosures portend future losses and the shutdown of banks at an escalating rate.  Credit will not expand soon increasing the likelihood of further price decreases as consumers increase personal savings rates.
The government reflation experiment has ensured that company costs cannot reach equilibrium with weak final goods markets.  This is similar to the Great Depression except that artificial wage inflation has been replaced by artificial commodity inflation to create the disequlibrium.  To cut rising costs, the only option is to reduce salaried employees, or shut down completely due to losses in core operations.  Rising unemployment will create further weakness in final goods.  This portends continued macroeconomic performance below trend for a length of time not seen since the Depression.  Asset prices will eventually fall to the market solution, government intervention aimed at avoiding this harsh reality will only delay the inevitable and probably assure a more painful destination in the process.

Japanese banks’ bad loans

Here is an idea so absolutely idiotic that it is hard to believe our government didn’t implement it first. It is from the Japanese, perhaps reflecting the creative thinking responsible for their outstanding economic results of the past two decades. Apparently, if a bank customer is a deadbeat, the bank will not have to classify the loan as non-performing or set up loss reserves against it. Now that is a strategy that should produce stronger banks.

Japanese banks’ bad loans won’t be driven higher by a proposed moratorium on debt payments by struggling small companies, said Financial Services Minister Shizuka Kamei.
Lenders won’t have to classify loans encompassed by the plan as non-performing, Kamei, 72, said in an interview yesterday at his office in Tokyo. That means they won’t be forced to boost provisions when borrowers postpone repayments of interest or principal, he said. At the same time, Kamei vowed to push banks to extend more credit to small businesses after bankruptcies hit a six-year high in Japan.
“We’re going to get financial institutions to provide these firms with more loans,” said Kamei. “Banks won’t have to treat debt on which they provide a moratorium as bad.”
The moratorium, postponing repayment of principal and interest, will be extended to individuals as well as firms Kamei said. It will aim at giving relief to companies with about 100 million yen ($1.1 million) or less in capital.
“As long as I’m financial services minister, I’m not going to leave small companies in the lurch unable to get loans,” Kamei said. “If a bank takes that approach, I’ll hit them with a business improvement order.”

This may be one of the most asinine economic policies ever implemented, very high praise indeed given all the competition. A third-grader should be able to spot the fallacies in such policy. Weak banks will be made even weaker. Strong banks presumably would be able to stop pouring good money after bad and recognize the loss (although I have no idea how much being hit with “a business improvement order” hurts). Even more damaging will be the unintended consequences. The law effectively coerces banks to overturn contracts at the whim of the State. That has frightening implications for all business, not only banks. For banks, it dramatically raises the risks of lending money, ensuring that future loans will be more restrictive than they otherwise would have been.
The idea is so bad that we should expect to see it surface here. Oh yes, we have already heard it discussed in different variants — forced moratoriums and/or cramdowns on mortgages. Thus, our government has not lost its creativity, but appears to be a bit tardy on applying such ideas. Whether this tardiness reflects ineptness or the acquisition of a conscience should not be too difficult for the reader to figure out. On the other hand, perhaps our creativity is slipping. After all, cash for clunkers was not our idea. We copied others.

The banking system with fresh capital

Our society’s hierarchy rests in part upon the following assumption: that the intellectual capacity of the chairman of the Federal Reserve, with his PhD and his white papers, is superior to that of a mortgage broker from Orange County, California. I think we need an adjustment to this type of assumption. Because the spread I see opening up everywhere in the US economy is what I call the Prestige-Performance gap, whereby the assertions of our elite no longer comport with observable reality. If the chairman of the Federal Reserve will not allow that the greatest credit bubble ever has now burst, or that it ever existed, then this partially explains why he would think stuffing the banking system with fresh capital would revive the economy.

Asset reflation therefore, in equities and especially in gold, should be seen not as exuberance but merely as part of the same chaos in pricing unleashed by The Federal Reserve, starting earlier this decade. As so clearly outlined in the recent data on employment, credit demand, consumer spending, and our (in)ability to save there is little to no prospect for a sustained economic recovery for one simple reason: Americans are now trapped by their debt.

For those who recognize a rising stock market as evidence of disarray, what we should anticipate now is the recognition phase where the wider public finally comes to understand the nature of our inflationary depression. My marker has been 100 dollar oil and 15% unemployment in California. That should finally get the message across. But other combinations will do: 1300 dollar gold, 1300 on the SPX, and more problems with Commercial Real Estate will also suffice. Like the prestige-performance gap, the divergence between the economy and asset prices apparently has to become even more grotesque before people will understand.

Economic and political fundamentals

To paraphrase Houston Command Central: America, The Ego Has Landed. And not smoothly.

Today’s Copenhagen announcement was a political disaster heard around the world. It further raises issues concerning the  image and competency of the President. Regardless of one’s politics, another failed Presidency is not good. Given the current geopolitical and economic situation, it might be especially dangerous as discussed earlier. Unfortunately the  Copenhagen fiasco along with the disastrous job report today enhance the perception and probability of a failing Presidency.
One wonders at the level of stock and bond markets. How much longer can Alice-in-Wonderland financial markets continue in light of continuing deterioration in economic and political fundamentals? The Ego landing does not make it easier for markets to continue to levitate.
A harsh political evaluation was offered today by the American Thinker (a conservative website):

Chicago out of Olympics consideration

Thomas Lifson
Dude, where’s my charisma?
In a huge slap in the face for Barack, Michelle, and the Oprah, Chicago was the first city eliminated from Olympic consideration.
It turns out the world is getting sick of Mr. Know It All. The President of France openly mocks him, and now the Olympic Committee is unimpressed with his wonderfulness.
He is having even a worse day than David Letterman. He made it all about himself.  Ben Smith of Politico wrote before the decision:
Obama’s pitch to the International Olympic Committee this morning is very much about his and America’s identity, and not the IOC’s sometimes transactional politics, raising the stakes for the decision:

We stand at a moment in history when the fate of each nation is inextricably linked to the fate of all nations — a time of common challenges that require common effort. And I ran for President because I believed deeply that at this defining moment, the United States of America has a responsibility to help in that effort, to forge new partnerships with the nations and the peoples of the world….

Richard Baehr adds:
It would be hard to exaggerate how humiliating is the IOC vote with Chicago going out in the first round, with  the lowest score of the 4 cites. So much for the theory that the world loves America more under Obama.This is a huge embarrassment  for Obama, given he shoed up for the presentation. Obviously, he neither can count, or control votes on the IOC, the way he may in the Congress. This will not help him with any part of his domestic agenda.  A key part of his message has been that he is not Bush, and presents a different America to the world. Andrew Young won the 1996 games for Atlanta during the first Bush presidency. Obama could not do it for Chicago.
Ed Lasky adds:
He has done zero since elected — except cause some damage internationally.
Stimulus bill was cooked by Congress, not him. Health Care: stalled; Card Check: stalled; Cap and Trade: stalled.
He has empowered unions and the left wing-which is causing businesses to postpone investment and hiring. I have a radiologist friend who told me his practice and the hospital re postponing purchase of equipment because they have no idea how much they will earn in the future.
How is that for health care “reform”?

Trillion this fiscal year

The on-going deficits forecast for the US cannot be financed out of domestic savings.  The shortfall must be covered via  foreign funding or the Federal Reserve monetizing the debt. The Fed has announced that its purchase of Treasuries will stop at $300 billion. That limit was reached last week. If one believes the Fed, they are done (monetizing), and the safety net under Treasury auctions has been removed. Without this backstop, there is risk of a failed Treasury auction, an event that could prove cataclysmic to financial markets in this country and around the world. As discussed by Graham Summers:

A little known fact (and one totally ignored by the mainstream media) is that the Fed accounted for nearly half of all Treasury purchases in the second quarter ($164 billion out of $339 billion). In fact, the Fed bought more Treasuries than the next three largest purchasers combined!!
In simple terms, these numbers indicate that if it were not for the Fed, the US Treasury market would have almost assuredly had numerous failed auctions in the second quarter. It also shows us that foreign holders (China, Japan, etc.) are reducing their purchases of US debt at an incredible rate.

The Treasury is scheduled to sell $78 billion in debt obligations this coming week. This number is large historically, but not large in light of recent and forecasted government spending/taxation. Deficits, including off-balance sheet items, will be about $ 2 Trillion this fiscal year. Additionally, about $2 Trillion of existing debt must be re-financed each year. Debt auctions must average about $80 billion per week, week after week after week ad nauseum or ad failed auction.
The dependence of the US on foreign governments to finance our deficit is the Achilles heel of both the dollar and the Treasury bond markets. Will it be possible for the Fed to stop buying Treasuries? Unlikely. If they stop and failed auctions occur, interest rates rise, damaging the housing and economic recovery. If the Fed continues to monetize (buy Treasuries), the dollar will continue to decline, perhaps precipitously. The Fed (and the US government) is nestled uncomfortably between the classic “rock and a hard place.” Chris Martenson’s take on this subject is summarized below:

The US government continues to have impressive borrowing needs, but the Federal Reserve has claimed to be done with its program of buying US government debt.
At the same time, the truly spectacular inflows of foreign dollars into US Treasury paper cannot logically continue forever, especially given the collapse in export markets.  There is even some mystery as to how they could have been as large as they’ve been.
Taken together, it would be logical to suspect that US Treasury paper and new debt issuances would come under some pressure, which we would detect as falling bond/note prices and rising yields.
However, that’s not at all what we are currently seeing, as indicated by the 10-year note yielding a paltry 3.2% and recent auctions have had more than three buyers biding for each bond.  The question before us is, can we see anything that might cause this to change?
I would submit that the US lacks sufficient domestic savings and productive capacity to finance its fiscal deficits internally so I propose that there are only two paths forward.  Either foreigners continue to finance the US deficits, or the Fed will resort to even more printing to cover the shortfall.
Where will the foreigners get the money?  Alternatively, how will they react if the Fed simply prints up the difference?

The dollar/bond market is unsustainable for the long-term, but may last for a while longer. It is highly unlikely that foreign Treasury demand will meet US deficit needs. It is even more unlikely that the Fed will allow the government to start bouncing checks.  Hence, the Fed will continue monetizing the debt, either openly or surreptiously. Eventually the unsustainable equilibrium represented by today’s dollar and interest rate structure will adjust to reality. Watch these markets closely because the next phase of the crisis will emanate from one or both.

There ought to be a law

The age-old argument of how much government is the right amount has no simple answer. In society it is always easy to point out some perceived inequity and conclude: “There ought to be a law!” But should there?

Each and every law steals a bit of freedom from society. The empirical data, at least in terms of per capita income, is clear. The more freedom, the higher the per capita income. While per capita income may not measure “quality of life” to anyone’s satisfaction, there is no objective measure that can. Per capita income is objective, albeit imperfect. It measures, in some manner, the range of options available to an individual. To the extent that one has more options, he is able to define “quality of life” in ways that are unavailable with fewer options. A rich man can choose to live as a poor man, but a poor man cannot succeed (at least for long) spending as if he were rich.
None of this discussion is meant to judge a person’s character or goodness by his net worth. As anyone with normal life experiences knows, there is no correlation between the two measures.
The chart below captures a relationship between freedom and per capita income. The disgruntled might argue against such data by attacking the definitional classifications. More likely they will argue that per capita income is a meaningless measure. But what is a better one?

The Governator and the Market Operator

I’ll begin with an excerpt from Bill Gross’s latest Investment Outlook:
“But California’s problems, while somewhat unique and self-inflicted, are really America’s problems, and not just because the California economy is 15% of national GDP. While California’s $26 billion deficit is not directly comparable to the federal gap of $1 trillion-plus, they both reflect a lack of discipline and indeed vision to perceive that the strong growth in revenues was driven by the same excess leverage and same delusionary asset appreciation that was bound to approach cliff’s edge.”
It’s contagious. Both at the state and local level and in Washington, policymakers “lack discipline and indeed vision…” It is said that “bull markets create genius.” I’ll suggest that the downside of the Credit cycle fashions lousy policymaking. I feel for the “Governator” and the California legislature, and I feel for our new President and members of Congress. They confront the harsh post-Bubble reality of no win circumstances – wearing big bullseyes on their backs in an age of slings and arrows.
As much as I respect Bill Gross – and can’t take strong exception with much of what he has been saying and writing of late – I just can’t find it within myself to move on. Newer readers might be unfamiliar with my long-standing – and one-way debate – with the McCulley/Gross view of the financial world. They have over the years been leading proponents for the popular consensus ideology that I have labeled “inflationism.”
It is a basic tenet of Credit Bubble theory that if the system inflates the quantity of Credit it will be spent. Credit Bubbles are fundamentally about a lack of discipline – one could say a confluence of undisciplined behavior. Credit Bubbles evolve specifically because of undisciplined monetary system management, undisciplined lending, undisciplined borrowing, undisciplined investment, undisciplined speculation and, at the end of the day, undisciplined spending throughout. And there are some absolutes: Inflated mortgage Credit, home price gains, and elevated incomes will absolutely inflate the propensity for undisciplined consumption. Inflated tax receipts will absolutely inflate government expenditures – in California, Washington D.C., and all across the country. The discipline problem goes way back but commenced within the bowels of the Credit system.
Mr. McCulley, in particular, was a vocal proponent for post-technology Bubble reflation. This reflation doubled total mortgage Credit in about six years and unleashed Monetary Disorder all over the world. In the process, this historic Credit inflation inflated asset prices, incomes, corporate profits, and government receipts. The state of California was at the epicenter of this massive inflation. Going back to fiscal year 2002-2003, California general fund revenues were about $71 billion. By the beginning of the 2007-2008 year, the state was budgeting for general revenues of $101 billion.
In percentage terms, state revenues inflated about 40% during the five-year boom. And with receipts rising each year, of course legislators were going to extrapolate and increasingly inflate state spending. There’s no mystery here. Keep in mind that in typical Bubble economy form, much of the rising expenditure was the result of rising costs all along the chain of state services. Those campaigning earlier this decade for aggressive monetary ease to fight deflation got, not surprisingly, more than they bargained for.
In hindsight, it is amazing to contemplate the complete and utter lack of vision that afflicted policymakers throughout the golden state and all across the country. How could they not perceive that sophisticated Wall Street financial leveraging and resulting asset Bubbles were only temporarily inflating their coffers? When seemingly everyone bought into the notion of endless prosperity, why couldn’t they have kept their heads? Just because everyone believed the enlightened Federal Reserve had forever mastered the business cycle, why couldn’t they have been more skeptical? And that the economic community, the regulator community, the Federal Reserve and the marketplace all missed this Credit Bubble dynamic is, apparently, no excuse. As I have often written, I sympathize with post-Bubble policymakers.
It is a tenet of Credit Bubble theory that politicians – given the opportunity – will inflate. There is ample history illuminating the dangerous propensity to run the government printing press. Contemporary analysis gets more complex because of the nature of private-sector Credit and the penchant for government (explicit and implicit) guarantees. During the boom, “money” was burning a hole in policymakers’ pockets, but it was Wall Street and the GSEs commanding the electronic printing press 24/7. By far the most precarious absence of discipline and vision belonged to those Operating in and accommodating this historic private-sector Credit Bubble.
I disagree with the policy of massive deficits. Yet the California and U.S. budget quagmires are the direct consequences of the bursting of the Wall Street/mortgage finance Bubble. And as much as greed and leverage have provided easy scapegoats, responsibility lies first and foremost with the nature of contemporary unchecked finance and flawed “activist” monetary management (trumpeted, not coincidently, by our era’s preeminent market Operators). And as much as the consensus view believes that previous financial maladies have been largely rectified, I see a continuation of the same malignant Credit system dynamics. In short, massive government intrusion into the market pricing of Credit continues to fuel economic maladjustment and Bubble dynamics.
Why did Wall Street issue Trillions of ABS, auction-rates securities, CDOs, and private-label MBS? Because they could. Why did the hedge funds and others leverage so egregiously? Because they were making a bloody fortune and the marketplace was more than ok with it. Why did the GSEs increase their MBS guarantees by $400 billion over the past year, and why did the Treasury issue $1.9 Trillion of Treasuries the past twelve months – and will likely do only somewhat less over the next year? And why are cash-strapped state and local governments borrowing so aggressively these days? It’s because the marketplace continues to readily accommodate Credit excess. Who is demonstrating a lack of discipline and vision – the borrower or the lender? The “Governator” or the market Operator? Is this the way the market pricing system is supposed to function?
Why is the marketplace inherently incapable of disciplining the egregious borrower – whether mortgage debt during that Bubble or government debt today? First, there are no inherent system restraints on Credit creation. Recalling the mortgage finance Bubble, recent massive increases in the supply of government debt have been met with a collapse in borrowing costs. Second, the marketplace perceived that fiscal and monetary policymakers were backstopping mortgage Credit during the boom. Today, the market is confident that policymakers are firmly behind the Treasury and agency securities markets. Borrowers are undisciplined for one reason: the distorted market mechanism not only fails to discipline them – it accomplishes the exact opposite.
I could ramble on for pages on the myriad costs associated with unchecked, undisciplined and mispriced finance. Mr. Gross touched upon a key cost, noting today’s uncompetitive California and U.S. economies. This is a key aspect of Bubble economy distortions. The dangerous flaw in inflationism dogma is that the Federal Reserve and policymakers can manipulate the cost and quantity of Credit with positive systemic results. In reality, the consequence of increasingly bold policy activism over time include a more distorted and unbalanced economic structure, as witnessed today. And it is my view that a flawed Credit apparatus, ill-advised government intervention, and dysfunctional market dynamics ensure economic maladjustment gets worse before it gets better.

Investment strategy

Those who have been following this blog know that the US dollar is vulnerable. It may be the most important factor in determining an investment strategy over the next couple of years. This conclusion is based upon the mathematical impossibility of servicing government debt and obligations. Either the government must drastically curtail the welfare state (social security, medicare, etc.) or abandon the dollar. Politically, it is considered impossible to do the former. Hence, the most likely outcome is either a continuing or precipitous drop in the value of the US dollar.

Sprott Asset Management has just issued a report entitled “Safe Haven No More” that is a MUST READ. It discusses why they believe the dollar must go down. It is entirely consistent with my reasoning. In the report, they nicely lay out their thought process, including a detailed look at Federal obligations. This is very valuable information because it is important that investors understand the magnitude of the problem the US government has created.  Whether or not you agree with the conclusions, it provides a perspective to judge unfolding economic and political events.
Their calculation of debt excludes virtually all stimulus that has not been reflected in the deficit already. Hence, it understates this problem to the extent of guarantees and funds committed but not yet spent. I agree with virtually everything in the report. However, I do not believe that the expected strategy can save the welfare state. If/when the dollar collapses, the welfare state does not suddenly become sustainable. It is the root cause of where we are and must ultimately be dealt with. The  government has  promised over $100 trillion (present value) dollars in social programs. The total wealth of the country is only around $50 trillion. If they confiscated every dollar of wealth from every citizen, firm, charity, etc. they would still be 50% short of being able to honor their promises. Such social promises are absurd and totally unfundable. They cannot be remedied by trashing the dollar. Hence, trashing the dollar may buy some time but cannot save an overly bloated welfare state. Either these committments will have to be cut drastically or they will be funded via a Zimbabwe-style inflation. 

Few signs of private sector recovery

A recovery in the economy can only occur via recovery in the private sector. Much of what has been hailed as “green shoots” results from government stimulus. It is not clear what is being stimulated other than reported GDP, because there are few signs of private sector recovery. One area that has received enormous stimulus is the housing market, even though its reported numbers are still dismal.

In the mortgage issuance area, the private sector has disappeared (see previous post by Chris Martenson). Is this because banks are unwilling to lend? Is it because there are no creditworthy borrowers? The answer to both of these questions is a resounding No! Then why is this happening? The government has driven down interest rates so low in a (foolish) attempt to support housing prices that they have made it unattractive for banks to risk money at these rates. In that sense, the government is subsidizing low interest rates with taxpayer money/risk. Private firms make mortgage loans at interest rates commensurate with risk. When interest rates are held artificially low, there are few loans that meet this requirement. Another way to state this is that the government is taking on risks with your money that prudent investors would not take on with their own money. It is precisely that strategy that gave us the Fannie and Freddie debacle. This is not rocket science. The results are predictable and inevitable as evidenced by the following quote:

Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. They force the general taxpayer to subsidize the bad risks and to defray the losses. They encourage people to “buy” houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared with other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief in the long run they do not increase overall national production but encourage malinvestment.

The above is a nearly perfect description of what happened in our housing market. Perhaps it could be marginally improved by adding references to “liar” loans and negative amortization loans. But this excerpt was written by Henry Hazlitt in 1948 as a prediction. Its veracity was as true then as it is today. Now it is, as Yogi might say, “deja vu all over again.” We are in the process of repeating the same mistakes. This time the vehicle will be the FHA  and the Fed. The results will be just as painful for taxpayers as Fannie and Freddie were (and continue to be).

The financial system still borders on collapse

For investors, markets are tough to navigate even in good times. But these are not good or normal times. Our economy is arguably in the worst shape it has been in 80 years. The financial system still borders on collapse with no apparent remedies to financial system insolvency. The Federal government is hopelessly insolvent, destined to default on its debts and social commitments. Ditto for many state and local governments. The international currency system is unsustainable, and it is difficult to foresee a resolution of this problem that does not disrupt world economies. On top of these negatives, markets appear to be grossly overvalued when viewed in terms of any fundamental metrics. These factors alone are reason to head for the hills or retreat to your figurative investment bunker (cash, gold and foodstuffs).

But it gets worse, possibly much worse. Like the economy, geopolitical problems might also  be akin to the 1930′s. Iran openly defies the United States and the world community by continuing its pursuit of nuclear weapons. Its leader appears half-crazed, driven by an apocalyptic vision. Israel believes its very existence is threatened and probably will act if no one else does. Russia is reasserting itself. North Korea is still a disoriented nuclear power that behaves like a child demanding attention. Chavez is creating problems in South America. And the US appears to be in another Vietnam-type quagmire with Afghanistan.
If this weren’t enough, we may be witnessing another rather astonishing collapse of a President, a condition anathema to financial markets.
From the standpoint of policy analysis, one would expect Obama’s (arguably incorrect) programs to fail. Yet failed programs, while necessary for a failed Presidency, are not sufficient. At this point, it is premature to even make the claim that his programs have failed. Yet, as time passes, the evidence tilts the scales in this direction. But a Presidency cannot fail unless public opinion turns negative. Trends in recent polls suggest that is happening, but polls can be fickle. Probably a better indicator is the reaction of supporters. Some of President Obama’s strongest supporters were in the media, so many in fact that the opposition claimed media bias. These complaints have continued into his Presidency, accompanied by charges that the press has treated his administration with kid gloves, slanting or not even reporting negative news. Political assessments from media supporters appear to be recently turning. One of many examples is the article below from Rich Moran, citing well-known liberal columnist Richard Cohen of  the NY Times. Whether this marks the beginning of the end for the Obama Presidency is moot, at least at this point in time.
These are truly dangerous times for both markets and the country. There is no historical precedent for markets performing well under these conditions. Be very cautious and expect to see things that you have never seen before or even imagined could happen.

The inflation-deflation battle

There are many in both camps of the inflation-deflation battle. Knowing how this ends is important because of the long-run investment implications. I believe that the government, unequivocably, is attempting to engineer inflation. But knowing what they are aiming at is not enough. Their track record in all areas is quite abysmal, rivaling the Keystone Cops. Final results are often 180 degrees from intended.
I believe it is still too early to make a final judgment regarding inflation or deflation. Calls made now are only predictions. As Rosenberg points out, some prices are declining. That, however, is a symptom of deflation rather than deflation itself.  Other prices are increasing (symptom of inflation), financial assets being the most obvious . The Fed is flooding the system with liquidity (inflation), while credit implodes (deflation). In the battle between Fed liquidity injections and market credit contraction, the Fed is currently behind. Whether the final score reflects that or not is still moot.
Apparent deflation at this point is not necessarily inconsistent with future deflation or inflation. An unrecognized adjustment downward in the standard of living is often mistaken for deflation. I think a lowered standard of living for this country is inevitable. My guess is that inflation, some time in the future, is also.

ECONOMY LOOKING CLUNKY

Despite all the hoopla regarding an economic recovery, there can be no recovery until the economy sheds the excess debt. The consumer is tapped out and is adjusting his balance sheet to reduce leverage. That is good, despite what the government wants (another credit bubble).

The so-called stimulus programs can mask economic performance for a limited time only. They may produce increased GDP reports in the third and fourth quarters, not unusual in the middle of recessions. The media and Bernanke have already proclaimed that recovery is underway. Supporters will only become louder if positive GDP stats show up soon. Do not fall for this hype.

The statistics will be hailed as confirmation of a recovery. However, they are merely statistics produced by government that have more to do with GDP methodology and reporting bias than real growth or real recovery. They cannot go on forever, and they do not produce real growth or balanced economic activity. David Rosenberg, in his daily eletter, exposes the effects of stopping such programs:

POST-CLUNKER ECONOMY LOOKING CLUNKY

Edmunds.com just reported that U.S. motor vehicle sales so far in September are running at an 8.8 million annual rate — a 28-year low and a 38% plunge from the incentive-induced 14.1 million tally in August. If this is what autos do, imagine what housing does once the $8,000 first-time homebuyer tax credit expires (if it does) at the end of November (not to mention what the Fed does in terms of extending its mortgage purchase program beyond the December expiry too — it has had a hand in financing 80% of all new mortgage issuance. But look at the good news — at least we will be able to see what the economy can do without the walker.

What is coming will not be pretty! If the government renews these programs or implements new ones targeted at other sectors of the economy, it may be able to produce a short-term effect. However, this “benefit” is only created by pulling demand forward. That is, it pumps up current results at the expense of future results as Rosenberg discussed above. Even if one were to (erroneously) argue that these programs did some good, we are fast approaching the limits of what can be done. Each involves government subsidies of one sort or another. As such, each involves widening the deficit and increasing Federal debt, whether it be via tax rebates or increased spending. There is a limit to Federal debt. We have already passed the tipping point of being able to service government debt and promised social benefits. Our creditors know this better than we do and periodically scold us for our fiscal irresponsibility. We have become the Blanche du Bois of the world economy, dependent upon the kindness of strangers. At some point, when it best fits their interests and not ours, these strangers will cut us off.

Less economic than political

Has a grownup finally shown up?

Paul Volcker dropped a bombshell on Friday. The importance of his pronouncement is less economic than political. It appears to indicate a serious rift between him and the Administration. A post by Larry Doyle provides some details and analysis of the economics. Here is an extract from Doyle’s piece:

Mr. Volcker takes on the White House and Congress with his proposal. We know Volcker is no favorite of Larry Summers. Knowing the explosiveness of his proposal, Volcker is not bashful in addressing the discomfort his proposal would create for the Washington insiders who are in Wall Street’s pocket. The WSJ sheds further light on this point:

Mr. Volcker said he would appear before Congress next week to discuss his views in more detail. A Treasury Department spokesman declined to comment.

Asked after his speech if his comments represent a break with the White House’s proposal, he replied: “Nothing I said today should be a surprise” to the administration.

In the future, this announcement may viewed as the beginning of the end of Obama’s presidency. While other factors will certainly play roles, the importance of this event is easily overlooked. The event’s importance derives as much from the messenger as it does the implications of the message. It is the first shot fired from a highly qualified and credible figure, who also happens to be on the Obama team. First some background on the messenger, and then an explanation as to why Friday might be so important.

Paul Volcker and Warren Buffet were early supporters of Obama. They appeared often during the campaign and were widely represented as his economic advisers. After the election Volcker was appointed to a titular position as Chairman of a new economic committee with no power, seemingly no purpose and little reason to meet. Whether Volcker and Buffet still support Obama is unknown, but both men seem removed from the president. Buffet’s move was probably by choice, while Volker seems to have been exiled.

Paul Volcker is not one to take lightly. He combines brains, gravitas, integrity and courage. He is an icon of Central Banking. He literally walked softly and carried a big stick in the late 1970′s. As Chairman of the Federal Reserve he faced the worst inflation in our country’s history (save possibly the Civil and Revolutionary Wars). Economic experts believed it would take a decade or more to tame inflation. He stopped it overnight, despite the political uproar over the unavoidable recession. Recent administration economic policies are so foreign to Volker’s economic thinking and methods as likely to be abhorrent to him. He knows the oligarchy that is Washington and Wall Street and clearly disapproves. While Volcker’s standing in history is established, to be associated (in an entirely passive role) with the economic debacle that is being imposed on this country cannot set well. As a proud and capable man, the manner in which he was used as a political prop and figurehead is likely to be even more disturbing.

Does Volcker’s apparent break represent a tipping point for the Obama administration? It might in the sense that it was a the-emperor-has-no-clothes moment. On Friday, he confronted the administration, directly challenging their philosphy regarding the regulation of the banking industry. Less appreciated was the indirect challenge to the philosophy of government which goes to the heart of Obama’s declining popularity. Implicit in Volcker’s talk were questions regarding the proper role of government and corruption, the primary motivating forces behind recent protests. The perceived corrupt partnership between Washington and Wall Street is believed by most on Main Street. Volcker seems to provide support this perception. His great reputation and the fact that he is/was an Obama guy only adds to the potential political ramifications.

Will other business and/or political figures follow Volcker’s lead and speak out? While Volcker cannot be hurt at this stage, it will take extreme courage for the next critic. The fear and reality of government retribution is an enormous deterrent, yet Volcker has provided some “cover.” As the damage of the Administration’s policies become more apparent, it is likely that others will follow. Not only on banking regulation but in other areas as well. Once this criticism starts, a snowball effect is likely, and another failed presidency will occur sooner rather than later.

The risk to one’s purchasing power

One last paragraph we want to focus on is Ackman’s brief mention of the risk to one’s purchasing power. Due to quantitative easing and money printing by the Fed, he acknowledges that there are concerns about future buying power of the dollar. Ackman highlights that many investors have turned to gold to hedge these risks, but not Pershing Square. Instead, they have decided to fight this risk by owning “high quality businesses that have pricing power due to market position and/or business model, and/or that earn their profits globally.”

This is interesting to see his stance on the matter as we can’t really recall him addressing it before. You’ll remember that David Einhorn and Greenlight Capital made a large gold investment and now are storing physical gold. Additionally, John Paulson’s hedge fund Paulson & Co bought gold via GLD (the exchange traded fund) to hedge their share class denominated in gold. It’s interesting to see each fund manager’s individualistic approach and hedging vehicle of choice. However, the main thing to take away from all of this is the fact that they see inflation as a potential threat in the future and are trying to mitigate this risk accordingly.

The economy and financial markets

“New Normal,” a term coined but not yet copyrighted by the principals at Pimco, is bandied about to describe the prospects for the economy and financial markets. It is undefined and hence irrefutable. It provides a glib way to state the obvious: the future will differ from the past. Its definitional elasticity ensured its widespread acception.

A more appropriate term might be the “New Abnormal.” While this term could be criticized in the same manner, it offers one significant advantage. It more strongly implies lack of continuity with the past. This “advantage” is in the eye of the beholder. If you are the common investor, this message is the one that should be absorbed. If you are part of the sell-side hucksters of Wall Street, you prefer the current euphemism, because it is wonderfully clever. It conveys the obvious – things have changed – in a somewhat soothing way. Optimism (the purpose of the sell-side) is promoted in the sense that “understanding” will be enable you to “manage” the future. It turns lemons into lemonade. It advances the “Lipstick on a Pig” tactic from boiler rooms to the entire economy/stock market . It is pure Marketing genius.

Despite the “genius”, I am not buying this “used car.”

Views on inflation and deflation

The referenced article is a talk given at the Chicago Fed. It discusses the Monetarist vs. “Output-gappers” views on inflation and deflation. Monetarists are probably represented best by the late Milton Friedman. Output-gappers are best represented by Keynesians such as Paul Krugman.

I favor Friedman as opposed to the output-gap position. Implied in the output-gap position is the “incorrect” definition of of inflation/deflation as rising or declining prices. The Friedman position tends to fail empirically in recent years because of technological improvements and financial innovations. That is, the very definitions of money are blurred and changing. Does one include the “shadow-banking” system or not? Does one adjust for sweep accounts that effectively reduce reserve requirements in the banking system? These are merely two of the examples that muddy the empirics and destroy what had been long- standing correlations.

Neither position has an adequate theory of the business cycle. Output-gappers tend to be entirely ad hoc, usually pointing to some external event such as a supply shock. Monetarists always blame recessions on a slowdown in the rate of money creation.
The Fed’s dual mandates of sound money and high levels of employment have placed them in a role as a Central Planning Authority. These mandates, although not necessarily conflicting, become so in a politicized democracy. Every “blip” in the data becomes important and pressures the Fed to do something. It is impossible for them to admit that they have limited control, don’t know when policy actions will affect the economy or how much of an effect they will have. Monetarists such as Friedman argued that these unknowns resulted in Fed remedial actions greatly exacerbating the conditions they intended to solve.
The same commentary can be offered regarding fiscal policy. It too is burdened with unknown lags and effectiveness. Because it is directly a part of the political process, it has enormous front-end lags while the program is endlessly debated, pork inserted, etc. The emergency stimulus bill is a good example. While it passed quickly, only a small amount of the money has been spent. It is estimated that it will not all be spent until the end of 2010 or beyond.

Natural tendency of government

We are embroiled in a great debate over health care reform. There are two aspects of the debate that are often not identified. The first is whether healthcare is a “right.” The second is the best way to deliver healthcare. When one does not separate the two issues, one biases the solution.

While I do not agree that healthcare is a right (you cannot morally produce a “right” for some by violating the rights of others), let us assume for the moment that it is so deemed. Then the issue becomes how is this “right” best delivered. It seems that the US has answered the first question and now struggles with the answer to the second.
It is the natural tendency of government to want to run things, hence we have the preoccupation with the single payer system or a competing government insurance company. The latter, using the concept of competition and government, is oxymoronic. Is there anyone outside of Washington DC that believes the government at the Federal or local level can run anything efficiently? The empirics regarding this issue are devastating — social security, Amtrak, medicare, medicaid, financial system regulation, the school system, potholes in the streets, the post office, infrastructure maintenance, the court system, garbage collection, department of motor vehicles, etc. etc. ad nauseum. One might reasonably argue that everything government touches deteriorates.
Back in the days of the Cold War, a joke that was popular in Europe went something like this: QUESTION — What would happen if the Soviet Union took control of the Sahara Desert? ANSWER — Initially no changes would be apparent; eventually there would be a shortage of sand.

The banking system is insolvent

The FDIC is broke (although not without additional Fed/Congress credit access) so is not closing banks that should be closed. Bank closures are occurring when they collapse under their own weight rather than FDIC guidelines. Thus, losses are bigger and taxpayers pay more as this game of pretend and extend goes on. I believe we are in much worse shape than we are being told and that it is a bigger problem than the government can handle. I also think the government knows this and that facing up to it would destroy the dollar and/or country). Hence the pretend game. Unfortunately the extend strategy will not work because underlying asset collateral continues to decline and will probably do so for the next several years. The pretend cannot go on for that long.
The banking system is insolvent, period! Using honest accounting would reveal that condition and expose the house-of-cards economy created via credit over the past 2 or 3 decades. The problem is probably still economically solvable but politically intractable so the government hopes to paper it over. Enron-type accounting is allowed to enable banks to keep exposure on non-consolidated subsidiary books. Banks are allowed to value assets at whatever they deem them to be worth rather than accounting standards that have been in place for centuries. Condoning this fraud may defer the political problem. It cannot solve the economic problem and likely makes it unsolvable at some point. Market forces will eventually overwhelm the charade, and put our entire economic system at risk of implosion.

Possibility of escaping the economic

There is no mathematical possibility of escaping the economic bind we face without reducing the welfare state. The current financial crisis only exacerbates a situation which long ago passed the tipping point. The Federal government’s total liabilities exceed $100 trillion (most of that from the unfunded liabilities of the welfare state: social security, medicare, etc.). With the financial crisis, we now have an additional black hole, our banking system. The condition of the banking system has been covered up, but that is becoming harder and harder to do as banks collapse under their own weight as a result of deteriorating conditions.

To the government and the Federal Reserve the only tool they have ever possessed (or learned to use) was a hammer. Thus, all problems look like nails. They only know how to spend and inflate, exactly the actions that brought us to this point. This approach has never succeeded economically, but it has managed to cover up past crises. Of course that was acceptable for virtually all politicians.
The present economic thrust is an attempt to (temporarily) save the welfare state at the expense of destroying the dollar. Unfortunately, that will not prove possible. At some point, probably not too far off, the dollar will collapse. Once the dollar is emasculated our standard of living will dramatically shrink, and future economic growth will approximate that of Old Europe. Under such conditions the carrying costs of the welfare state will be impossible to bear. We will lose both the dollar and the welfare state. In dangerous times such as these, governments are often overthrown with new entities appearing that look nothing like the structure they replace.
There is no way to reasonably estimate the timing of the dollar collapse which will trigger the entire process. A catalyst will probably be the Treasury market where interest rates will start to increase to reflect higher default risk. Regardless, it appears as though we are getting close. The dollar has been very weak, and the anti-fiat currency, gold, appears strong. If (when?) the event occurs, it likely will come very quickly. Too many Central Banks are holding too many dollars and Treasuries. At some point a panic to get out of the dollar is likely. Once the first domino falls, the entire global system is apt to implode swiftly. These are indeed dangerous times.

Technology and financial innovations

Inflation is usually misdefined as a period of generally rising prices. Inflation, properly defined, is an expansion of the money supply. The problem is what we mean by “money supply.” Traditional definitions such as M1, M2, etc. have become less useful as a result of technology and financial innovations. Currently traditional measures of money are increasing while private sector debt is contracting and government debt is increasing. On balance, I believe total debt has actually increased, although there appears to be substantial contraction to come in the banking system as a result of overstated assets.

Rising prices is one of the effects produced by the “cheapening” of money. No index is capable of properly measuring these effects. All indices are subject to measurement errors. More importantly, all indices suffer from weighting and inclusion decisions. The Consumer Price Index (CPI) is published by the BLS and assumed to be a proxy for the effects of inflation. It purports to measure the rate of price changes for a typical consumer. It does so imperfectly, even with honest and accurate measurements. Inflation effects are not limited to consumer goods. Often they are felt in financial assets and capital goods (housing, capital investments by business, etc.) long before they show up at the consumer level.