black swans

by

The Welfare Kings of Europe

In spite of the fact that 85% of Greeks want to stay in the Eurozone, I was reasonably confident that Greeks would support Syriza to a first-place finish, and elect a new government willing to play chicken with the Germans. However Greeks — predominantly the elderly — rejected change (and possible imminent Drachmatization) in favour of the fundamentally broken status quo.

But although Syriza finished second, the anti-bailout parties still commanded a majority of the votes.

And New Democracy may still face a lot of trouble building a coalition to try to keep Greece in the bailout, and in the Euro . There has long been a rumour that Tsipras wanted to lose, so as to (rightly) blame the coming crush on the status quo parties. What fewer of us counted on was that the status quo parties wouldn’t want to win the election either. The pro-bailout socialists Pasok have thrown a monkey wrench into coalition-building by claiming they won’t take part in any coalition that doesn’t also include Syriza. This seems rational; when the tsunami hits, all parties in government will surely take a lot of long-term political damage. Pasok have already been marginalised by the younger and fierier Syriza, and Pasok presiding over an economic collapse (for that is undoubtedly what Greece now faces) would surely have driven Pasok into an abyss. The economy is such a poisoned chalice that parties seem willing to fight to keep themselves out of power.

And with more austerity, it’s only going to get worse. Once a society is hooked on large-scale debt-fuelled state spending, austerity in the name of government deleveraging is tough enough when the economy is booming, but during a depression as spending falls, tax revenues fall, very often producing (as has been the case in Greece, Spain, Portugal and the UK) even bigger deficits.

So let us not forget who the most welfare-dependent nations (i.e. the ones who would be hurt the most by attempting an austerity program during an economic depression) are in Europe (clue — it’s not Greece):

International economics is a fast game. It’s only sixty years since America was exporter and creditor to the world. It’s only fifteen years since the now-booming German economy was described as the “sick man of Europe”.

The same Euro system that is slamming Greece, Portugal, Spain and Italy today — in the aftermath of bubbles caused by easy money flowing into these countries as a result of the introduction of the Euro — could (if it were to somehow survive)  do the same thing to Germany in ten or twenty or thirty years.

A monetary union without a fiscal union is a fundamentally unworkable system and Westerwelle, Schauble and Merkel insisting that Greece play by the rules of their game is just asking for trouble. And trying to introduce a fiscal union over a heterogeneous, tense and disagreeable land as Europe is just asking for political trouble.

No matter how many nations are browbeaten by fear into committing to the status quo, it still won’t be sustainable. Greeks (and the other peripheral populations) can commit to austerity from here to eternity, but it won’t stop those policies resulting in deeper contraction, and more economic catastrophe.

But the collapse of the Euro would at most-recent estimates cost the core and particularly Germany a lot more than handing over the money to the PIGS. Eventually they will hand over the money to shield themselves from falling masonry. The real question is whether or not the entire system will spiral into pandemonium before Germany blinks.

by

The World Before Central Banking

In today’s world, there are many who want government to regulate and control everything. The most bizarre instance, though — more bizarre even than banning the sale of large-sized sugary drinks — is surely central banking.

Why? Well, central banking was created to replace something that was already working well. Banking panics and bank runs happen, and they have always happened as long as there has been banking.

But the old system that the Fed displaced wasn’t really malfunctioning — unlike what the defenders of central banking today would have us believe. Following the Panic of 1907, a group of private bankers led by J.P. Morgan successfully bailed out the system by acting as lender of last resort. The amount of new liquidity disbursed into the system was set not by academics like Ben Bernanke, but by experienced market participants. And because the money was directed from private purses, rather than being created out of thin air, only assets and companies with value were bought up.

The rationale of the supporters of the Federal Reserve Act was that a central banking liquidity mechanism would act as a safeguard against such events, to act as a permanent lender-of-last-resort backed by government fiat. They wanted something bigger and better than a private response.

Yet the Banking Panic of 1907 — a comparable market drop to both 1929 or 2008 — didn’t result in a residual depression.

As the WSJ noted:

The largest economic crisis of the 20th century was the Great Depression, but the second most significant economic upheaval was the panic of 1907. It was from beginning to end a banking and financial crisis. With the failure of the Knickerbocker Trust Company, the stock market collapsed, loan supply vanished and a scramble for liquidity ensued. Banks defaulted on their obligations to redeem deposits in currency or gold.

Milton Friedman and Anna Schwartz, in their classic “A Monetary History of the United States,” found “much similarity in its early phases” between the Panic of 1907 and the Great Depression. So traumatic was the crisis that it gave rise to the National Monetary Commission and the recommendations that led to the creation of the Federal Reserve. The May panic triggered a massive recession that saw real gross national product shrink in the second half of 1907 and plummet by an extraordinary 8.2% in 1908. Yet the economy came roaring back and, in two short years, was 7% bigger than when the panic started.

Ben Bernanke, widely seen as the pre-eminent scholar of the Great Depression thought things would be much, much better under his watch. After all, he has claimed that he understood the lessons of Friedman and Schwartz who criticised the 1930s Federal Reserve for continuing to contract the money supply, worsening the Great Depression; M2 in 1933 was just 72% of its 1929 peak.

So a bigger crash and liquidation in 1907 allowed the economy to roar back, and continue growing. Meanwhile, in today’s controlled, planned and dependent world of central liquidity insurance, quantitative easing and TARP, growth remains anaemic four years after the crash. Have the last four years proven conclusively that central banking — even after the lessons of the 1930s — is inferior to the free market?

Certainly, Bernanke’s response to 2008 has been superior to the 1930s Fed — M2 has not dropped by anything like what it did from 1929:


Industrial production has not fallen by as significant an amount as 1929, nor has homebuilding. And there are many other wide-scale economic differences between 1907 and 2008 in terms of the shape of the economy, and the shape of employment, the capital structure, and the wider geopolitical reality. But the bounce-back is still vastly inferior to the free-market reality of 1907. I think there are greater problems to central banking, ones of which Friedman, Schwartz and Bernanke were unaware (but of which Rothbard and von Mises were acutely aware).

Does central banking retard the economy by providing liquidity insurance and a backstop to bad companies that would not otherwise be saved under a free market “bailout” (like that of 1907)? And is it this effect — that I call zombification — that is the force that has prevented Japan from fully recovering from its housing bubble, and that is keeping the West depressed from 2008? Will we only return to growth once the bad assets and bad companies have been liquidated? That conclusion, I think, is becoming inescapable.

by

The Face of Corporatist Hypocrisy

From Bloomberg:

“Retirement ages will have to move to 70, 80 years old,” former AIG CEO Robert Benmosche, who turned 68 last week, said during a weekend interview at his seaside villa in Dubrovnik, Croatia. “That would make pensions, medical services more affordable. They will keep people working longer and will take that burden off of the youth.”

Now, as a guy who is living in a taxpayer-funded villa after his bank-insurance-derivatives-hedge fund-ponzi company blew up, we know Benmosche is a hypocrite. In my view, management should be held personally liable a long time before taxpayers. That’s right, I believe in personal responsibility and that means no hiding behind limited liability and bailouts, no matter how “systemically important” you claim to be.

But let’s set aside disgust at government for first setting up this scenario via Gramm-Leach-Bliley, and then in 2008 throwing money at hypocritical grifters like Benmosche.

Is he wrong about social security and medical services?

Spending costs money. You can spend as much as you like so long as you have the revenues to do so. But the US government is failing to fund its current spending, let alone the $61.6 trillion (that’s a low-end estimate — the high end estimate is $127.5 trillion or 737% of GDP) of future welfare liabilities that the US government is mandated by law to spend.

So can America get the money to match future commitments without significantly raising the retirement age?

In theory.

In theory the Federal government can squeeze taxpayers. Perhaps Occupy will get their wish of raising taxes on the 1% to whatever figure they have in mind (though the way corporations and lobbyists have successfully colonised Washington, that seems exceedingly unlikely). But this is a globalised world, and the higher they tax the more activity will leave to lower-rate jurisdictions, and the less activity will be taxable. Tax evasion and avoidance will soar.

In theory America could have an organic recovery and start generating significant amounts of organic GDP growth. But right now, that’s a fantasy. Pinning your hopes to potential future economic miracles like 3D-printing, nanoengineering, widespread solar energy and synthetic petroleum is hardly good accounting practice, even if they are realistically the best hope of a rosy future.

In theory taxpayers could agree to accept less spending, as Benmosche suggests. But Americans overwhelmingly support social security and medicare, and politicians hawking cuts make themselves into political pariahs. Promises are promises, and politicians have suckered the electorate by promising so much for so little. If Greeks rioting over the retirement age seems raucous, wait ’til a politician tries to slash SNAP, medicare or social security.

Much more likely is the current trend of escalating deficits and printing money to pay the bills — and bail out washed-up corporatists like Benmosche (and his “systemically important” equivalents in Europe). Policy-makers can balance the budget and raise aggregate demand and GDP to whatever level they like (the “highest” level presumably being toilet paper) by throwing newly-printed money out of helicopters.

Trouble is, with the US dollar no longer functioning as the globe’s reserve currency it’s going to get harder and harder to hide the inflation overseas or on primary dealer balance sheets. Welfare recipients will keep getting welfare, but in the long run it may not buy much.

No, nations chose their paths long ago. America chose the path of big spending, big warfare, big bailouts and big welfare, and bailout-recipients like Benmosche who plead “systemic importance” are heavily responsible for that slide into fiscal irresponsibility. It won’t be the politicians, bankers and corporatists who created the mess who will have to deal with the fallout; they have foreign villas, foreign ranches, foreign bank accounts, and barbed-wire-shrouded EMP-proof survival retreats. It will be the average American who has done nothing wrong other than believing the words of politicians.

by

Enter the Swan

Charles Hugh Smith (along with many, many, many others) thinks there may be a great decoupling as the world sinks deeper into the mire, and that the dollar could be set to benefit:

This “safe haven” status can be discerned in the strengthening U.S. dollar. Despite a central bank (The Federal Reserve) with an avowed goal of weakening the nation’s currency (the U.S. dollar), the USD has been in an long-term uptrend for a year–a trend I have noted many times here, starting in April 2011.

That means a bet in the U.S. bond or stock market is a double bet, as these markets are denominated in U.S. dollars. Even if they go nowhere, the capital invested in them will gain purchasing power as the dollar strengthens.

All this suggests a “decoupling” of the U.S. bond and stock markets from the rest of the globe’s markets. Put yourself in the shoes of someone responsible for safekeeping $100 billion and keeping much of it liquid in treacherous times, and ask yourself: where can you park this money where it won’t blow up the market just from its size? What are the safest, most liquid markets out there?

The answer will very likely point the future direction of global markets.

Smith is going along with one of the most conventional pieces of conventional wisdom: that in risky and troubled times investors will seek out the dollar as a haven. That’s what happened in 2008. That’s what is happening now as rates on treasuries sink to all-time-lows. And that’s what has happened throughout the era of petrodollar hegemony.

But the problem with conventions is that they are there to be broken, the problem with conventional wisdom is that it is there to be killed, roasted and served on a silver platter.

The era of petrodollar hegemony is slowly dying, and the assumptions and conventions of that era are dying with it. For now, the shadow of that old world is still flailing on like Wile E. Coyote, hovering in midair.

As I wrote last week:

How did the dollar die? First it died slowly — then all at once.

The shift away from the dollar has quickly manifested itself in bilateral and multilateral agreements between nations to ditch the dollar for bilateral and multilateral trade, beginning with the chief antagonists China and Russia, and continuing through Iran, India, Japan, Brazil, and Saudi Arabia.

So the ground seems to have fallen out from beneath the petrodollar world order.

Enter the Swan:

We know the U.S. is a big and liquid (though not really very transparent) market. We know that the rest of the world — led by Europe’s myriad issues, and China’s bursting housing bubble — is teetering on the edge of a precipice, and without a miracle will fall (perhaps sooner, rather than later).

But we also know that America is inextricably interconnected to this mess. If Europe (or China or both) disintegrates, triggering (another) global default cascade, America will be stung by its European banking exposures, its exposures to global energy markets and global trade flows. Simply, there cannot be financial decoupling, not in this hyper-connected, hyper-leveraged world.

And would funds surge into US Treasuries even in such an instance? Maybe initially — fund managers have been conditioned by years of convention to do so. But how long  can fund managers accept negative real rates of return? Or — much more importantly — how long will the Fed accept such a surge? The answer is not very long at all. Bernanke’s economic strategy has been focussed  on turning treasuries into a losing investment, on the face of it to “encourage risk-taking” (or — much more significantly — keep the Treasury’s borrowing costs cheap).

All of this suggests a global crash or proto-crash will be followed by a huge global money printing operation, probably spearheaded by the Fed. Don’t let the Europeans fool anyone, either — Germany will not let the Euro crumble for fear of money printing. When push comes to shove they will print and fiscally consolidate to save their pet project (though perhaps demanding gold as collateral, and perhaps kicking out some delinquents). China will spew trillions of stimulus money into more and deeper malinvestment (why have ten ghost cities when you can have fifty? Good news for aggregate demand!).

So Paul Krugman will likely get something much closer to what he claims to want. Problem solved?

Nope. You can’t solve deep-rooted structural problems — malinvestment, social change, deindustrialisation, global trade imbalances, systemic fragility, financialisation, imperial decline, cultural stupefaction (etc, etc, etc) — by throwing money at problems. All throwing more money can do is buy a little more time (and undermine the currency). The problem with that is that a superficial recovery fools policy-makers, investors and citizens into believing that problems are fixed when they are not. Eventually — perhaps slowly, or perhaps quickly — unless the non-monetary problems are truly dealt with (very unlikely), they will boil over again.

As the devaluation heats up things will likely become a huge global game of beggar thy neighbour. A global devaluation will likely increase the growing tensions between the creditor and debtor nations to breaking point. Our current system of huge trade imbalances guarantees that someone (the West) is getting a free lunch , and that someone else (the Rest) is getting screwed. Such a system is fundamentally fragile, and fundamentally unstable. Currency wars will likely give way to economic wars, which may well give way to subterfuge and proxy wars as creditors seek their pound of flesh, and debtors seek to cast off their chains. Good news, then, for weapons contractors and the security state.

by

The Fabled Greek Mega-Bailout

In a truly eyebrow-raising CNBC interview, Matthew Lynn alleges that Europe shall be saved! (As if by the grace of God!).

With Europe on the brink yet again Germany will act.

The Greeks can’t carry on with the austerity being imposed on them. No country can be expected to endure annualized falls in GDP  of 7 percent or more,” he said, “and 50 percent youth unemployment for years on end.

On Tuesday we learned that the Greek economy shrank by another 6.2 percent in the latest quarter. It simply isn’t acceptable” Lynn said.

But Germany and the rest of the EU could come up with a Marshall Aid-style package for Greece. Very little of the bail-out money so far has gone to the Greeks. It has all gone to the bankers.

Forget talk of a ‘Grexit’. There will be a mega-bail-out—a ‘Grashall Plan’—instead.

And when it happens, the markets will rally on the news.

At various stages in the last two years everyone from China, to Germany, to the Fed to the IMF, to Martians, to the Imperial Death Star has been fingered as the latest saviour of the status quo. And so far — in spite of a few multi-billion-dollar half-hearted efforts like the €440 billion EFSF —  nobody has really shown up.

Perhaps that’s because nobody thus far fancies funnelling the money down a black hole. After Greece comes Portugal, and Spain and Ireland and Italy, all of whom together have on the face of things at least €780 billion outstanding (which of course has been securitised and hypothecated up throughout the European financial system into a far larger amount of shadow liabilities, for a critical figure of at least €3 trillion) and no real viable route (other than perhaps fire sales of state property? Sell the Parthenon to Goldman Sachs?) to paying this back (austerity has just led to falling tax revenues, meaning even more money has had to be borrowed), not to mention the trillions owed by the now-jobless citizens of these countries, which is now also imperilled. What’s the incentive in throwing more time, effort, energy and resources into a solution that will likely ultimately prove as futile as the EFSF?

The trouble is that this is playing chicken with an eighteen-wheeler. While Draghi might be making noises about “continuing to comply with the mandate of keeping price stability over the medium term in line with treaty provisions and preserving the integrity of our balance sheet” (in other words, not proceeding with the fabled “mega-bailout” even if it fractures the Euro), we may well see a full-blown financial meltdown (and of course, the ramifications of that on anyone who is exposed to the European banking system) unless someone — whether it is the ECB, or the Fed, or the IMF — prints the money to keep the system liquid.

There are really two layers to bailing out the insolvent nations: the real bailout is of the banks who bought the debt, and the insolvent nations are just an intermediary. Should the insolvent nations become highly uncooperative, it seems more likely that the insolvent nations will just be cut out of the loop (throwing their citizens into experiencing a forced currency redenomination, bank runs, and even more chaos) while policymakers continue to channel money into “stabilising” the totally broken global financial system — because we know for sure that a big disorderly default will likely cause some kind of default cascade, and that is something I am sure that (based on past form) policymakers will seek to avoid.

How close to the collapse we will come before the money gets printed is another matter.

Given that it is predominantly Germans who are in charge of Europe for the moment — with their unusual post-Weimar distaste for monetary expansion —  it seems to me like just as we have seen so far, the money will come at the last minute, and will just keep things ticking over rather than actually solving anything.

And ultimately, I think it is the social conditions — particularly unemployment levels — that matter more than whether or not the financial system survives. If the attendant cost of ad hoc bailouts (in the name of pretending to stick to the ECB mandate) is a continued depression, and continued massive unemployment and youth unemployment then politicians are focusing on the wrong thing.

The problem is that as conditions continue to fester and as solutions seem distant and improbable that Europe’s problems may become increasingly political. As the established (dis)order in Europe continues to leave huge swathes of people jobless and angry, their rage and discomfort will be channelled toward dislodging the establishment. As we have seen in Greece and France, that has already produced big lifts for both the Far Left and Far Right.

We already know, I think, that in Greece’s upcoming election the outsider parties will crush the establishment, with SYRIZA most likely emerging on top. A key metric for me in the next few weeks will be Golden Dawn‘s proportion of the vote.

Let’s not forget history:

by

The New European Serfdom

So let’s assume Greece is going to leave the Eurozone and suffer the consequences of default, exit, capital controls, a deposit freeze, the drachmatization of euro claims, and depreciation.

It’s going to be a painful time for the Greek people. But what about for Greece’s highly-leveraged creditors, who must now bite the bullet of a disorderly default? Surely the ramifications of a Greek exit will be worse for the international financial system?

J.P. Morgan — fresh from putting an LTCM alumnus in charge of a $70 trillion derivatives book (good luck with that) — is upping the fear about Europe and its impact on global finance:

The main direct losses correspond to the €240bn of Greek debt in official hands (EU/IMF), to €130bn of Eurosystem’s exposure to Greece via TARGET2 and a potential loss of around €25bn for European banks. This is the cross-border claims (i.e. not matched by local liabilities) that European banks (mostly French) have on Greece’s public and non-bank private sector. These immediate losses add up to €400bn. This is a big amount but let’s assume that, as several people suggested this week, these immediate/direct losses are manageable. What are the indirect consequences of a Greek exit for the rest?

The wildcard is obviously contagion to Spain or Italy? Could a Greek exit create a capital and deposit flight from Spain and Italy which becomes difficult to contain? It is admittedly true that European policymakers have tried over the past year to convince markets that Greece is a special case and its problems are rather unique. We see little evidence that their efforts have paid off.

The steady selling of Spanish and Italian government bonds by non-domestic investors over the past nine months (€200bn for Italy and €80bn for Spain) suggests that markets see Greece more as a precedent for other peripherals rather than a special case. And it is not only the €800bn of Italian and Spanish government bonds still held by non-domestic investors that are likely at risk. It is also the €500bn of Italian and Spanish bank and corporate bonds and the €300bn of quoted Italian and Spanish shares held by nonresidents. And the numbers balloon if one starts looking beyond portfolio/quoted assets. Of course, the €1.4tr of Italian and €1.6tr of Spanish bank domestic deposits is the elephant in the room which a Greek exit and the introduction of capital controls by Greece has the potential to destabilize.

A multi-trillion € shock — far bigger than the fallout from Lehman — has the potential to trigger a default cascade wherein busted leveraged Greek creditors themselves end up in a fire sale to raise collateral as they struggle to maintain cash flow, and face the prospect of downgrades and margin calls and may themselves default on their obligations, setting off a cascade of illiquidity and default. Very simply, such an event has the potential to dwarf 2008 and 1929, and possibly even bring the entire global financial system to a juddering halt (just as Paulson fear-mongered in 2008).

Which is why I am certain that it will not be allowed to happen, and that J.P. Morgan’s histrionics are just a ponying up toward the next round of crony-“capitalist” bailouts. Here’s the status quo today:

Greece no longer wants to play along with the game?

Okay, fine — cut them out of the equation. In the interests of “long-term financial stability”, let’s stop pretending that we are bailing out Greece and just hand the cash over to the banks.

Schäuble and Merkel might have demanded tough fiscal action from European governments, but they have never questioned the precept that creditors must get their pound of flesh. Merkel has insisted that authorities show that Europe is a “safe place to invest” by avoiding haircuts.

Here’s my expected new normal in Europe:

After all — if the establishment is to be believed — it’s in the interests of “long-term financial stability” that creditors who stupidly bought unrepayable debt don’t get a big haircut like they would in a free market.  And it’s in the interests of “long-term financial stability” that bad companies who made bad decisions don’t go out of business like they would in a free market, but instead become suckling zombies attached to the taxpayer teat. And apparently it is also in the interests of “long-term financial stability” that a broken market and broken system doesn’t liquidate, so that people learn their lesson. Apparently our “long-term financial stability” depends on producing even greater moral hazard by handing more money out to the negligent.

The only real question (beyond whether or not the European public’s patience with shooting off money to banks will snap, as has happened in Greece) is whether or not it will just be the IMF and the EU institutions, or whether Bernanke at the Fed will get involved beyond the inevitable QE3 (please do it Bernanke! I have some crummy equities I want to offload to a greater fool!).

As I asked last month:

Have the 2008 bailouts cemented a new feudal aristocracy of bankers, financiers and too-big-to-fail zombies, alongside a serf class that exists to fund the excesses of the financial and corporate elite?

And will the inevitable 2012-13 bailouts of European finance cement this aristocracy even deeper and wider?

by

Is China a Currency Manipulator?

Mitt Romney thinks so:

China has an interest in trade. China wants to, as they have 20 million people coming out of the farms and coming into the cities every year, they want to be able to put them to work. They want to have access to global markets. And so we have right now something they need very badly, which is access to our market and our friends around the world, have that same– power over China. To make sure that we let them understand that in order for them to continue to have free and open access to the thing they want so badly, our markets, they have to play by the rules.

They’re a currency manipulator. And on that basis, we go before the W.T.O. and bring an action against them as a currency manipulator. And that allows us to apply tariffs where we believe they are stealing our intellectual property, hacking into our computers, or artificially lowering their prices and killing American jobs. We can’t just sit back and let China run all over us. People say, “Well, you’ll start a trade war.” There’s one going on right now, folks. They’re stealing our jobs. And we’re gonna stand up to China.”

The theory goes that by buying U.S. currency (so far they have accumulated around $3 trillion) and treasuries (around $1 trillion) on the open market, China keeps demand for the US dollar high.  They can afford to buy and hold so much US currency due to their huge trade surplus with America, and they buy US currency roughly equal to this surplus.  To keep this pile of dollars from increasing the Chinese money supply, China sterilises the dollar purchases by selling a proportionate amount of bonds to Chinese investors.  Supposedly by boosting the dollar, yuan-denominated Chinese goods look cheap to the American (and global) consumer.

First, I don’t really think we can conclusively say that the yuan is necessarily undervalued. That is like assuming that there is some natural rate of exchange beyond prices in the real world. For every dollar that China takes out of the open market, America could print one more — something which, lest we forget — Bernanke has been very busily doing; the American monetary base has tripled since 2008. Actions have consequences; if China’s currency peg was so unsustainable, the status quo would have collapsed long ago. Until it does, we cannot conclusively say to what extent the yuan is undervalued.

What Romney is forgetting is that every nation with a fiat currency is to some degree or other a currency manipulator. That’s what fiat is all about: the ability of the state to manipulate markets through monetary policy. When Ben Bernanke engages in quantitative easing, or twisting, or any kind of monetary policy or open market operation, the Federal Reserve is engaging in currency manipulation. Every new dollar that is printed devalues every dollar out in the wild, and just as importantly all dollar-denominated debt. So just as Romney can look China in the face and accuse them of being a currency manipulator for trying to peg the yuan to the dollar, China can look at past U.S. administrations and level exactly the same claim — currency manipulation in the national interest.

While China’s currency policy in the past 40 years has been to attract manufacturing, technology, resources and investment into China (and build up a manufacturing base to provide employment to its low-skilled population) by keeping its produce cheap, America’s currency policy has sought to enjoy a free lunch made up of everyone else’s labour and resources. This has been allowed to develop because of America’s reserve currency status — everyone has needed dollars to access global markets, and so America has rested on her laurels and allowed her productive industries to decline. Why manufacture the bulk of your consumption when China can do it cheaper, and Wal Mart has no problem with slave labour? Why manufacture your military hardware when China can do it cheaper? Why produce your own energy when you can instead consume Arab and Latin American oil?

Former U.S. ambassador Jon Huntsman raised this issue in an article from China Business News in a cable that was eventually leaked via Wikileaks:

The U.S. has almost used all deterring means, besides military means, against China.  China must be clear on discovering what the U.S. goals are behind its tough stances against China. In fact, a fierce competition between the currencies of big countries has just started.  A crucial move for the U.S. is to shift its crisis to other countries – by coercing China to buy U.S. treasury bonds with foreign exchange reserves and doing everything possible to prevent China’s foreign reserve from buying gold.

If we use all of our foreign exchange reserves to buy U.S. Treasury bonds, then when someday the U.S. Federal Reserve suddenly announces that the original ten old U.S. dollars are now worth only one new U.S. dollar, and the new U.S. dollar is pegged to the gold – we will be dumbfounded.

Today when the United States is determined to beggar thy neighbor, shifting its crisis to China, the Chinese must be very clear what the key to victory is.  It is by no means to use new foreign exchange reserves to buy U.S. Treasury bonds.  The issues of Taiwan, Tibet, Xinjiang, trade and so on are all false tricks, while forcing China to buy U.S. bonds is the U.S.’s real intention.”

Romney and others of his ilk might brush this off, believing that China’s $3 trillion dollar reserve hoard was gained through unfair means — slave labour, cutting corners in quality, the aforementioned “currency manipulation”, etc, and that that somehow gives America the right to inflate away its debts and screw its creditors. To some degree, they have a point. If China had a problem with America inflating away its debts, it should never have put itself so deep into dollar-denominated paper. If China recognised that America’s debt position was unsustainable, it should never have put so much into something so unsustainable, irrespective of supposed American pressure.

In the short term, though, I think escalating the trade war through the imposition of tariffs is a very bad idea. America is a consumption-led economy, and with middle class incomes already squeezed, a constriction of the supply of cheap and readily available goods is likely to put a lot of downward pressure on consumption. And it’s not just consumption — in today’s hyper-globalised world, a huge proportion of manufacturing — including military hardware — at some stage flows through China.

As Vincent Fernando noted:

Most of America’s key military technologies require rare earth elements, whose production China holds a near-monopoly over.

It’s thus perhaps no surprise that China has made the threat of rare earth export restrictions a new political bargaining chip.

American corporations could gradually pull out of China and shift to manufacturing and extracting resources elsewhere including America (which has large rare earth deposits), but it would be a challenging process. Rebuilding an industrial base is hard: skilled and experienced labour takes time to develop (American labour is rusty and increasingly unemployed and disabled), and supply chains and webs have all agglomerated in China. Building up domestic supply chains takes time, expertise and entrepreneurial zeal. And any destabilisation could spook global markets.

So let’s make no mistake: in the short term America needs China far, far, far more than China needs America. The notion that China needs America as a consumer is totally false; anyone can consume given the dollars or gold, and China holds $3 trillion, and continues to increase its imports of gold.

Peter Schiff summarises:

The big problem for countries like China and India is that they still subsidize the U.S. They buy our Treasury bonds and lend us all this money so we can keep consuming. That’s a big subsidy and a heavy burden.

They can use their money to develop their own economy, produce better and more abundant products for their own citizens. It’s a farce to think that the only thing China can do with its output and savings is lend it to the U.S. government, especially when we can’t pay it back.

Mitt Romney seems intent on destabilising this fragile relationship. American policy that incentivised globalisation and the service economy has very foolishly drawn America into this fragile position where its economy is increasingly fuelled not only by energy coming out of the politically and economically unstable middle east, but also by goods coming from a hostile and increasingly politically and economically unstable power.

And make no mistake — although China has done well to successfully transform itself into the world’s pre-eminent industrial base and biggest creditor, it has a lot of bubbles waiting to burst (particularly housing), stemming from the misallocation of resources under its semi-planned regime. Which makes this entire scenario doubly dangerous. Any shock in China would surely be transmitted to America, simply because it is becoming increasingly pointless for China to continue subsidising American consumption (through buying treasuries) when they could instead spend the money raising the Chinese standard of living. That could mean a painful rate-spike.

The real problem is that Romney is trying to address a problem that is very much in the past. If Romney was elected as President on this platform in 2000, things might be different. But China got what it wanted: by keeping its currency cheap and its labour force impoverished it became the world’s pre-eminent industrial base, the spider at the heart of the web of global trade, and a monopoly on important industrial components and resources. China used American demand, technology and investment during the 00s to develop. Now the imperative is not to grab a bigger share of global manufacturing, or a bigger hoard of dollars, it’s to leverage that position toward the ultimate aim of returning China to its multi-millennial superpower status. The promise of Chinese primacy is quite simply the strongest tool for the CPC to retain its (increasingly shaky) grip on China.

However we should not discount the possibility that bursting economic bubbles may stoke up some kind of popular rebellion against the Communist authorities in some kind of Chinese Spring. A new more pro-Western regime is surely America’s best hope of containing China, while gradually manoeuvring itself out of dependency on Arab oil and Chinese goods. But that may just be wishful thinking; it is possible that a new Chinese regime may be vehemently anti-Western; the Opium War and China’s 20th century humiliation still ring deeply in the Chinese psyche.

So it is unclear what is next for China, and the relationship between China and America. But having the world’s biggest manufacturing base and a monopoly over rare earths is a strong position to be in if your ultimate aim is to manufacture huge quantities of armaments in the pursuit of an aggressive, expansionist foreign policy…

by

Paul vs Paul: Round #2

Bloomberg viewers estimate that Ron Paul was the winner of the clash of the Pauls (Ron Paul fans, of course, are very studious at phoning in their support him for). But that is very much beside the point. This wasn’t really a debate. Other than the fascinating moment where Krugman denied defending the economic policies of Diocletian, very little new was said, and the two combatants mainly talked past each other.

The first debate happened early last decade.

To wit:

And so, round two. Krugman wants more inflation; Paul is scared of the prospect. From Paul’s FT editorial yesterday:

Control of the world’s economy has been placed in the hands of a banking cartel, which holds great danger for all of us. True prosperity requires sound money, increased productivity, and increased savings and investment. The world is awash in US dollars, and a currency crisis involving the world’s reserve currency would be an unprecedented catastrophe. No amount of monetary expansion can solve our current financial problems, but it can make those problems much worse.

Or, as Professor Krugman sees it:

Would a rise in inflation to 3 percent or even 4 percent be a terrible thing? On the contrary, it would almost surely help the economy.

How so? For one thing, large parts of the private sector continue to be crippled by the overhang of debt accumulated during the bubble years; this debt burden is arguably the main thing holding private spending back and perpetuating the slump. Modest inflation would, however, reduce that overhang — by eroding the real value of that debt — and help promote the private-sector recovery we need. Meanwhile, other parts of the private sector (like much of corporate America) are sitting on large hoards of cash; the prospect of moderate inflation would make letting the cash just sit there less attractive, acting as a spur to investment — again, helping to promote overall recover.

Ron Paul believes that inflationary interventions into the dollar economy will have unpredictable and dangerous ramifications. Paul Krugman believes that a little more inflation will spur economic activity and decrease residual debt overhang. Krugman gives no credence to the prospect of inflation spiralling out of hand, or of such policies triggering other deleterious side-effects, like a currency crisis.

The prospect of a currency crisis is a topic I have covered in depth lately: as more Eurasian nations ditch the dollar as reserve currency, more dollars (there are $5 trillion floating around Asia, in comparison to a domestic monetary base of just $1.8 trillion — the dollar is an absurdly internationalised currency) will be making their way back into the domestic American economy. Will that have an impact?

I don’t really know how much of this is to do with the Fed’s reflationary policies, and how much is to do with the United States’ endangered role as global hegemon. I tend to think that the dollar hegemony has always been backed by American military force, and with the American military overstretched, the dollar’s role comes into question. If America can’t play the global policeman for global trade, why would the dollar be the currency on global trade?

However it must be noted that America’s creditors do believe that their assets are threatened by the Fed’s inflationism.

As the Telegraph noted last year:

There has been a hostile reaction by China, Brazil and Germany, among others, to the Federal Reserve’s decision to resume quantitative easing.

Or as a Xinhua editorial rather bluntly put it:

China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets.

Of course, China may be totally bluffing, or getting it wrong on the danger of inflation to its assets.

If the reflationism is angering the exporter nations perhaps it is a cause for concern. After all, if America’s consumption-based economy is dependent on China’s continued exportation, and Krugman is advocating inflating away their debt-denominated financial assets, then to what extent do Krugman’s suggestions imperil the trans-Pacific consumer-producer relationship?

And this is a crucial matter — there is nothing, I think, more crucial than the free availability of goods and resources through the trade infrastructure. Getting into a fight with China is risky.

As commenter Thomas P. Seager noted yesterday:

[The situation today] is directly analogous to the first Oil Shock in 1973. In the decades prior, the US had been a major oil producer. However, efficiency gains and discoveries overseas resulting in an incrementally increasing dependence of foreign petroleum. Price signals failed to materialize that would caution policy makers and industrialists of the risks.

Then, the disruption of oil supplies from the Middle East caused tremendous economic dislocations.

Manufacturing is undergoing the same process. The supply chain disruption from the Japanese earthquake and Tsunami was merely a warning shot. Imagine if S Korean manufacturing were taken off-line for any length of time (a plausible scenario). The disruption to US industry would be catastrophic.

In the name of increased efficiency, we have introduced brittleness.

Time will tell whether Krugman’s desire for more inflation is wise or not.

by

Krugman, Diocletian & Neofeudalism

The entire economics world is abuzz about the intriguing smackdown between Paul Krugman and Ron Paul on Bloomberg. The Guardian summarises:

  • Ron Paul said it’s pretentious for anyone to think they know what inflation should be and what the ideal level for the money supply is.
  • Paul Krugman replied that it’s not pretentious, it’s necessary. He accused Paul of living in a fantasy world, of wanting to turn back the clock 150 years. He said the advent of modern currencies and nation-states made an unmanaged economy an impracticable idea.
  • Paul accused the Fed of perpetrating “fraud,” in part by screwing with the value of the dollar, so people who save get hurt. He stopped short of calling for an immediate end to the Fed, saying that for now, competition of currencies – and banking structures – should be allowed in the US.
  • Krugman brought up Milton Friedman, who traversed the ideological spectrum to criticize the Fed for not doing enough during the Great Depression. It’s the same criticism Krugman is leveling at the Fed now. “It’s really telling that in America right now, Milton Friedman would count as being on the far left in monetary policy,” Krugman said.
  • Paul’s central point, that the Fed hurts Main Street by focusing on the welfare of Wall Street, is well taken. Krugman’s point that the Fed is needed to steer the economy and has done a better job overall than Congress, in any case, is also well taken.

I find it quite disappointing that there has not been more discussion in the media of the idea — something Ron Paul alluded to — that most of the problems we face today are extensions of the market’s failure to liquidate in 2008. Bailouts and interventionism has left the system (and many of the companies within it) a zombified wreck. Why are we talking about residual debt overhang? Most of it would have been razed in 2008 had the market been allowed to liquidate. Worse, when you bail out economic failures — and as far as I’m concerned, everyone who would have been wiped out by the shadow banking collapse is an economic failure — you obliterate the market mechanism. Should it really be any surprise that money isn’t flowing to where it’s needed?

A whole host of previously illiquid zombie banks, corporations and shadow banks are holding onto trillions of dollars as a liquidity buffer. So instead of being used to finance useful and productive endeavours, the money is just sitting there. This is reflected in the levels of excess reserves banks are holding (presently at an all-time high), as well as the velocity of money, which is at a postwar low:

Krugman’s view that introducing more money into the economy and scaring hoarders into spending more is not guaranteed to achieve any boost in productivity.

As I wrote last month:

The fundamental problem at the heart of this is that the Fed is trying to encourage risk taking by making it difficult to allow small-scale market participants from amassing the capital necessary to take risk. That’s why we’re seeing domestic equity outflows. And so the only people with the apparatus to invest and create jobs are large institutions, banks and corporations, which they are patently not doing.

Would more easing convince them to do that? Probably not. If you’re a multinational corporation with access to foreign markets where input costs are significantly cheaper, why would you invest in the expensive, over-regulated American market other than to offload the products you’ve manufactured abroad?

So will (even deeper) negative real rates cause money to start flowing? Probably — but probably mostly abroad — so probably without the benefits of domestic investment and job creation.

Nor is it guaranteed to achieve any great boost in debt relief.

As Dan Kervick wrote for Naked Capitalism last month:

Inflation only reduces debt overhang in a significant way for households who are fortunate enough to see their nominal wages rise along with the general rise in prices. In today’s economy, workers are frequently not so fortunate.

Again, I have to bring this back to why we are even talking about debt relief. The 2008 crash was a natural form of debt-relief; the 2008 bailouts, and ongoing QE and Twist programs (which contrary to Professor Krugman’s apologetics really do transfer wealth from the middle classes to Wall Street) crystallised the debt burden born from a bubble created by Greenspan’s easy money policies. There would be no need for a debt jubilee (either an absolute one, or a Krugmanite (hyper)inflationary one) if we had simply let the market do its work. A legitimate function for government would have at most been to bail out account holders, provide a welfare net for poor people (never poor corporations) and let bankruptcy courts and markets do the rest. Instead, the central planners in Washington decided they knew best.

The key moment in the debate?

I am not a defender of the economic policies of the emperor Diocletian. So let’s just make that clear.

Paul Krugman

Actually you are.

Ron Paul

Ron Paul is dead right. Krugman and the bailout-happy regime for which he stands are absolutely following in the spirit of Diocletian.

From Dennis Gartman:

Rome had its socialist interlude under Diocletian. Faced with increasing poverty and restlessness among the masses, and with the imminent danger of barbarian invasion, he issued in A.D. 301 an edictum de pretiis, which denounced monopolists for keeping goods from the market to raise prices, and set maximum prices and wages for all important articles and services. Extensive public works were undertaken to put the unemployed to work, and food was distributed gratis, or at reduced prices, to the poor. The government – which already owned most mines, quarries, and salt deposits – brought nearly all major industries and guilds under detailed control.

Diocletian explained that the barbarians were at the gate, and that individual liberty had to be shelved until collective liberty could be made secure. The socialism of Diocletian was a war economy, made possible by fear of foreign attack. Other factors equal, internal liberty varies inversely with external danger.

While Krugman does not by any means endorse the level of centralism that Diocletian introduced, his defence of bailouts, his insistence on the planning of interest rates and inflation, and (most frighteningly) his insistence that war can be an economic stimulus (in reality, war is a capital destroyer) all put him firmly in Diocletian’s economic planning camp.

So how did Diocletian’s economic program work out?

Well, I think it is fair to say even without modern data that — just as Krugman desires — Diocletian’s measures boosted aggregate demand through public works and — just as Krugman desires — it introduced inflation.

Diocletian’s mass minting of coins of low metallic value continued to increase inflation, and the maximum prices in the Edict were apparently too low.

Merchants either stopped producing goods, sold their goods illegally, or used barter. The Edict tended to disrupt trade and commerce, especially among merchants. It is safe to assume that a gray market economy evolved out of the edict at least between merchants.

And certainly Rome lived for almost 150 years after Diocletian. However the long term effects of Diocletian’s economic program were dire:

Thousands of Romans, to escape the tax gatherer, fled over the frontiers to seek refuge among the barbarians. Seeking to check this elusive mobility and to facilitate regulation and taxation, the government issued decrees binding the peasant to his field and the worker to his shop until all their debts and taxes had been paid. In this and other ways medieval serfdom began.

Have the 2008 bailouts done the same thing, cementing a new feudal aristocracy of bankers, financiers and too-big-to-fail zombies, alongside a serf class that exists to fund the excesses of the financial and corporate elite?

Only time will tell.

by

Austerity & Extremism

I noted yesterday that anything the government gives you, the government can take away, and that dependency on government services — which might be withdrawn — leaves citizens weak and unfree.

One cause for the withdrawal of government that I neglected to mention (intentionally, as I hoped someone would pick it up in comments) was the matter of austerity. While the example I was bouncing my ideas off — of denying treatment to smokers or the obese — remains theoretical, the withdrawal of government services and spending as a result of austerity is very much a reality, especially in Europe.

To wit:

That more austerity produces less GDP (and very often bigger deficits due to falling tax revenues — as exemplified by Portugal) is self-evident. That society is — for lack of a better word — pissed with this outcome is the clear reality on the ground. Made dependent upon government largesse, society now finds the crutch of services, spending and government jobs withdrawn. And of course, this has political blowback.

As Tyler recently put it “nationalism is back with a bang”. But it’s not just the nationalists who are doing well, so too are the far left. Just as in the 1930s many people who have been failed by the mainstream parties are angry, and their instinctual reaction is to reject the political mainstream and look to the fringes.

Let’s look at Greece.

From the WSJ:

Two political mavericks—one a soft-spoken former Communist, the other a firebrand nationalist—are tapping into public anger at incumbents and the harsh austerity measures Greece must adopt to stay in the euro, as support for mainstream parties withers ahead of May 6 elections.

Right-wing economist Panos Kammenos and left-wing lawyer Fotis Kouvelis are poles apart ideologically. But they are currently among the most popular party leaders in Greece, and their parties have sprung from nowhere to challenge Greece’s political establishment and the austerity policies that many Greeks blame for deepening their country’s economic crisis.

Between them, Mr. Kammenos’s Independent Greeks and Mr. Kouvelis’s Democratic Left could win around 20% of the vote. Their rise is cutting deeply into support for Greece’s two mainstream parties — the conservative New Democracy party and the center-left Socialists, known as Pasok — that share power in a fractious coalition government.

Given the utter train wreck that the Greek economy is, it is shocking that these figures are not significantly higher. In the recent first round of the French Presidential election, the far left and far right polled over 30%, a post-WW2 high.

All over Europe, the unemployed and dispossessed are becoming increasingly frustrated with the status quo.

From Bloomberg:

Europe’s front against austerity has expanded in recent weeks after Spain struggled to meet European Union-imposed deficit targets, election campaigns in Greece faced anti- austerity rumblings and a revolt against extra spending cuts in the traditionally budget-conscious Netherlands propelled Prime Minister Mark Rutte’s coalition toward an early breakup.

Europe has been here before. Hitler came to power, lest we forget, on the back of a devastating period of German austerity.

As I noted in November:

After just two years of “austerity” measures, Germany’s economy had completely collapsed: unemployment doubled from 15 percent in 1930 to 30 percent in 1932, protests spread, and Bruning was finally forced out. Just two years of austerity, and Germany was willing to be ruled by anyone or anything except for the kinds of democratic politicians that administered “austerity” pain. In Germany’s 1932 elections, the Nazis and the Communists came out on top — and by early 1933, with Hitler in charge, Germany’s fledgling democracy was shut down for good.

It’s the same story; more austerity means more misery, means more political and social rumbling, means a greater support for radical political parties. We haven’t gotten anywhere near the scope or magnitude of the 1930s (yet), but the present European contraction has not dampened the technocratic fervour for deeper and faster cuts and tax hikes (which, quite obviously lead to bigger deficits, which trigger more austerity, ad infinitum). Could this at some point mean revolutions that put radicals into power? It becomes increasingly plausible.

And the initial problem in my view is excessive dependency on the state and centralisation. If the state makes up 50% of GDP, cutting spending in the interests of paying down debt will cause a severe contraction throughout the entire economy. If the state makes up 15% of GDP, less so. If the state is only a small fragment, austerity in the interests of paying down debt — even during a recession or depression — is feasible. If the state is a goliath, it will lead to a crippling economic contraction (and of course, the attendant realities of public fury and politcal extremism).

Centralised systems are always and by definition fragile to shocks and mismanagement, because the activities at the centre are transmitted throughout the entire system; poor decisions at the centre metastasise throughout the system. In a robust decentralised system, mismanagement only hurts at the local level, because there is less of a mechanism for the transmission of shocks.

The lesson sticks: anything the government gives you, the government can take away (sometimes deliberately, sometimes not). That could be healthcare, that could be security, that could be economic growth. If it’s delivered by central fiat, it’s fragile.