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.

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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:

There is No Such Thing as a Service Economy

It is often said that prostitution is the oldest profession. This is not true, and I know this with a very high degree of certainty. For a prostitute to subsist, there must be  a medium of exchange, and for a medium of exchange to exist — even in terms of barter — there must be a surplus of production (i.e. a person is producing more than they can consume). Thus, there must be pre-existing productivity, for example food that has been hunted, or gathered or grown, tools that have been created, etc.

The truth is that prostitution (or perhaps soldiery) is probably the oldest service profession.

What is a service profession? Well broadly there are two kinds of professions: goods-producing, and services-producing. Goods-producing professions produce things. Services-producing professions do things without producing any definable goods. Prostitution is a very good example. So is legal work, consulting, lobbying, graphic design, sales work, soldiery, musicianship, acting, etc. And yes — while I feel that writing creates a good — it too is widely considered a service.

At present, the Western economies are dominated by services.

From the World Bank:

Joe Sitglitz’s article in Vanity Fair late last year argued that we need to move even further into a service-led economy:

What we need to do instead is embark on a massive investment program—as we did, virtually by accident, 80 years ago—that will increase our productivity for years to come, and will also increase employment now. This public investment, and the resultant restoration in G.D.P., increases the returns to private investment. Public investments could be directed at improving the quality of life and real productivity—unlike the private-sector investments in financial innovations, which turned out to be more akin to financial weapons of mass destruction.

The private sector by itself won’t, and can’t, undertake structural transformation of the magnitude needed—even if the Fed were to keep interest rates at zero for years to come. The only way it will happen is through a government stimulus designed not to preserve the old economy but to focus instead on creating a new one. We have to transition out of manufacturing and into services that people want—into productive activities that increase living standards, not those that increase risk and inequality.

Now I’m not accusing Stiglitz of anything other than a misplaced zeal for fixing the American economy. His suggestion is merely emblematic of a wider misconception.

Service jobs come into existence as there are bigger surpluses of production. In an isolated national economy, the services sector will only grow if the productive sector grows in proportion. But in a global economy, with flows of trade and goods, illusions are possible.

The truth is that there is no such thing as a service economy. Our economy today (other than in places like, say, North Korea) is truly global. All of those service workers — and every cent of “services” GDP — is supported by real-world productivity, much of which takes place outside the West — the productivity of the transport system, the productivity of manufacturers, the productivity of agriculture.

The continued prosperity of the West is dependent on the continued flow of goods and services into the West.

This is an intentionally zany example (but certainly no less zany than Krugman’s babysitting co-op) of how moving to a “service-based” (pun-intended, you’ll see) economy can prove detrimental:

Imagine the centrally-planned society of War-is-Peace-Land, occupying one half of a large island, and led by an absolute King. The kingdom is very successful in warfare, and maintains a great advantage over its sole neighbour. 50% of its working subjects are conscripted into the military, in various roles — soldiery, tactics, smithing, horsemanship, etc. Of the other half of the population 30% work in collective agriculture, 10% work in light industry (e.g. making candles) and 10% are personal servants to the King (or in the case of females part of his large harem). Now, the King does not like the fact that his harem is not as large as it could be; he does not like that there are women and girls toiling the fields when they could be in his harem. Nor does he like that there are men toiling in the fields when they could instead be conscripted into the military.

Fortunately in the neighbouring kingdom of Productivity Land, they have huge surpluses of agriculture and productivity, as only 30% of their population is conscripted into the military, while 40% work in agriculture, and 20% in light industry. As they make such huge surpluses, they are willing to make up for any shortfall in War-is-Peace-Land. As a result of this, more and more workers in War-is-Peace-Land can be moved from agriculture to serving the King, either as a manservant (carrying his Royal chair, beating up anyone who insults him, tending to his elaborate gardens) or as a member of his harem. In return for this, the King sends promissory notes — which are often promptly lent back —  from Productivity Land to pay for their products. Productivity Land uses this money to acquire natural resources from other islands.

Eventually, the King decides that his pleasure gardens need to be greatly expanded, and so he moves the entire non-military workforce out of agriculture, and into manufacture terra cotta and bronze statues, to decorate his pleasure gardens. Of course, War-is-Peace Land has built up a humungous debt over the years, and Productivity Land feels short-changed in sending its productive output across to the other half of the island in exchange for increasingly-devalued pieces of fiat paper that buy increasingly less and less resources. But the King of Productivity Land is very smart. He recognises that winning a military confrontation with War-is-Peace Land will still be difficult, so he agrees to continue this arrangement so as to make War-is-Peace Land even more deeply dependent upon the produce of Productivity Land. 

One day, the King of War-is-Peace Land was out frolicking gaily in his pleasure gardens, smoking his pipe and contemplating a lazy afternoon molesting his harem. Alas, no. A messenger from Productivity Land arrived at the Palace to inform him that Productivity Land was sick of his devalued fiat currency, and so would no longer send agricultural products or other produce. That was it — War-is-Peace Land had no intent to pay back their debt, so they were out in the cold.

Nonsense!” cried the King, and promptly had the messenger arrested, tortured and killed. He rallied his generals, and declared war against Productivity Land. Alas, they did not get very far. It took three days for the army to be rallied together into a fighting force, and by that time War-is-Peace Land was running low on food and fuel. Armies — no matter how well-equipped — cannot march on an empty stomach. The tired and weary soldiers of War-is-Peace Land were more numerous and better equipped, but their hunger and subsequent tiredness got the better of them and they were massacred and beaten back. The King tried to escape, but was captured by Productivity Land’s forces and promptly executed.

Readers can read whatever they like into the above story; it is purely fictitious, and of course massively simplified. But I think it captures the essence of the problem of  outsourcing your productivity to foreign lands who might not always be as friendly as they appear to be today.

The bottom line here is that any proposals regarding transitioning to an economy even more dependent on services assumes that goods and productivity will keep flowing into the West, even though there is no guarantee of such a thing.

Governments in the West would do better to worry about the West’s (lack of) energy and resource independence.

Romneythink

Mitt Romney’s campaign is founded on a huge contradiction:

Out of one side of his mouth he claims he wants to balance the budget, and out of the other side of his mouth he claims he wants to vastly increase military spending:

Romney set himself apart on Friday, arguing that a weaker military and a smaller global footprint will compromise America’s leadership in the world.

“The United States should always retain military supremacy to deter would-be aggressors, and to defend our allies and ourselves,” he said.

Romney said he wants to increase the military budget, mentioning specific projects from naval shipbuilding to a missile defense system. It’s a traditional Republican view of defense that was music to this crowd’s ears.

Doesn’t he realise that military spending is already by far the largest component of non-discretionary spending?:

America is already the world’s greatest military spender:

In spite of this, America has struggled to defeat a bunch of Islamist lunatics and goatherders in Afghanistan — the same people that dragged down the Soviet Union. They too committed huge resources and capital to fighting absurd wars of imperial conquest (or should I say “proletarian liberation”) abroad, and subsequently their empire collapsed.

Americans make up less than 5% of the global population, but account for more than 50% of global military spending. America is already in massive debt, and the more America commits herself to policing the world, the bigger that debt seems to get. This situation is totally unsustainable. Cutting back on the imperialism will give America more manpower, brainpower, capital and resources to use at home to rebuild her domestic economy. The only Presidential candidate who talks about that fact — one which is in my opinion surely the most pressing of our time?

Ron Paul.

QE Infinity

A lot of hot air has shot about the internet about nominal GDP targeting, the brainchild of Scott Sumner.

Some (including the usual suspect) have said that it’s Bernanke’s next big bazooka in the (ahem) “war on economic instability“.

What the growing recognition for nominal GDP targeting reflects is a wider awakening to something I have been talking about for a long time: Irving Fisher’s theory of debt deflation. When monetary circulation drops, prices tend to drop and nominal debts tend to become much harder to repay. Therefore, the nominal value of those debts rises: workers and businesses have to produce more to pay down debts. Inevitably, this leads to more defaults. This can lead to what I (and a few others) have termed a “default cascade” — one set of large defaults leads to deflation, leading more defaults, and eventually resulting in systemic failure.

Nominal GDP targeting gives the Federal Reserve the scope to buy assets until they hit a nominal GDP target, ensuring that no such debt deflation will occur. It is — in my opinion — the most powerful monetary tool yet-imagined for reinflating burst bubbles.

As Scott Sumner puts it:

Now why is Nominal GDP so important? That’s the total dollar value of income in the economy. And if you think about it, most debts are contracted in nominal terms. So in a sense, the economy’s dollar income is a good metric for measuring people’s ability to repay these previously contracted nominal debts.

QE was — in terms of reinflating bubbles — a blunt weapon. It shot off an arbitrary amount of newly-printed/digitally-created money, with the explicit target of lowering net interest rates (and the implicit bonus of combating debt deflation). Nominal GDP targeting flips this on its head.

The problem is that this focus on monetary means will not solve the larger systemic economic problems that America and the Western world face.

As I wrote yesterday:

The problem is that most of the problems inherent in America and the West are non-monetary. For a start, America is dependent on oil, much of which is imported — oil necessary for agriculture, industry, transport, etc, and America is therefore highly vulnerable to oil shocks and oil price fluctuations. Second, America destroys huge chunks of its productive capital policing the world, and engaging in war and “liberal interventionism”. Third, America ships even more capital overseas, into the dollar hoards of Arab oil-mongers, and Chinese manufacturers who supply America with a heck of a lot. Fourth, as Krugman and DeLong would readily admit, American infrastructure, education, and basic research has been weakened by decades of under-investment (in my view, the capital lost to military adventurism, etc, has had a lot to do with this).

In light of these real world problems, at best all that monetary policy can do is kick the can, in the hope of giving society and governments more time to address the underlying challenges of the 21st Century. When a central bank pumps, metrics (e.g. GDP and unemployment) can recover, under normal circumstances that is great. But with underlying challenges like the ones we face, a transitory money-printing-driven spike is often not enough to address the structural problems, and these problems soon cause more monetary and financial woe.

What I can say about nominal GDP targeting is that it is probably the best monetary tool for buying more time. But that is completely and totally useless if America fails to address the real problems in the mean time, and assumes that the energy, military and social problems (e.g. zombification) that are the real cause of long-term economic woe will just disappear.

A larger problem is that this “solution” will probably do more (by duplicating their dollar holdings) to annoy America’s creditors, including China and Russia, who have significant scope to cause America real economic problems through a trade war.

Default & the Argentinosaurus

One thing is clear:

A huge mountain of interlocking, interconnected debt is a house of cards, and a monetary or financial system based upon such a thing is prone to collapse by default-cascade: one weak link in the chain breaks down the entire system.

But the next collapse of the debt-pyramid is a long-term trend that may be a long way — and a whole host of bailouts — away yet. A related but different problem is that of government spending. Here’s American government debt-to-GDP since the end of WW2:


After reducing the national debt to below 40% in the 70s and 80s America’s credit binges since that era have quickly piled on and on to the point that without a major war like World War 2, the national debt is above 100% of GDP, and therefore in a similar region to that period.

Simply, America’s government must find a way not only of balancing the budget, but of producing enough revenue to pay down the debt. This has inspired the current crop of Republican nominees to produce a slew of deficit-reduction plans, including Herman Cain’s hole-ridden 9-9-9 plan  which shifts a significant burden of taxation from the wealthy and onto the middle classes. Worse still, taxes on spending hurt the economy by discouraging spending. Want to expand your business with the purchase of new capital goods? 9% tax. Want to increase revenues through advertising? 9% tax. Want to spend your earnings on goods? 9% tax. That’s a hardly a policy that will encourage economic activity in an economy that is (for better or worse) led by consumption.

Whichever way the tax burden falls, the sad reality is that any plan that focuses on taxing-more-than-disbursing is just sucking productive capital out of the economy, constraining growth. The other “remedy” inflating the currency (to inflate away the debt), punishes savers, whose investment is necessary for productive growth.

Dean Baker shows a historical case of such an event. Argentina, crippled by its peg to the dollar, defaulted on its debt since 2001:

All the crushing weight of taking productive capital out of the economy crushed growth. Then Argentina defaulted on its debts, and rebounded, astonishingly. Of course, most of blogosphere is looking at Greece in this debate. I am not, because I recognise the Argentinosaurus in the room: America’s foreign-held debt load (payment for all those Nixonian free lunches) is undermining the dollar’s status as global reserve currency, a pattern of development that will ultimately force exporters — on whom America relies — out of exporting to America for worthless sacks of paper and digital. International trade has always been on a quid pro quo basis — and since 1971 that has worked fine for America — dollars have been a necessary prerequisite to acquire oil, other commodities and supplies and pay dollar-denominated debts.


So I think the time has come to explicitly advocate a radical solution to save the dollar — but just as importantly to save the middle classes, and productive capital from the punitive taxation (and welfare cuts) required by austerity.

America needs to balance its budget by gradually (and with negotiation) defaulting on its debts. The first prong of this is totally defaulting on the debt held by the Federal Reserve — this is simply just a circuitous way of cycling money from government to a private agency and back again to the government, while the private agency (the Fed) pays member banks 6% annual no-risk dividends. The second prong is to begin negotiations with international creditors to revalue American debt proportionate to what America can afford to pay in the long run.

Far from infuriating creditors, I think that the evidence shows that this move would benefit everyone. A strong American economy is important to Eurasian producers and exporters. An American-economy dragged down by debt-forced-austerity means a smaller market to sell to, and to gain investment from. The only significant counter-demand for such an arrangement might be a balanced-budget amendment, so that America could no longer borrow more than it can raise in revenues.

Of course, there are other avenues to explore: slashing military spending (and giving the money back to the taxpayer, or to the jobless, or to infrastructure programs) is one such avenue: as I have explained at length before, American military spending is subsidising a flat-market, and making non-American goods artificially competitive in America.

But the real issue today is that liberals mostly want to talk about higher taxes, and conservatives mostly want to talk about austerity. They’re missing the Argentinosaurus in the room: the transfer of wealth from the American public — and the productive American economy — to foreign (and domestic) creditors, and the downward pressure that this is exerting on American output.

Debts — even AAA-rates debt (or AAAAAAAAA as an Oracle once put it) — all carry risk: the risk that the debtor is getting into too much debt and won’t be able to pay back his obligations in a timely or honest fashion. Creditors are making a mistake to be ending money to a fiscal nightmare whose only economic refuge is money printing.

So will America continue to tread the bone-ridden road of austerity, high taxation and crushing economic contraction, leading to excessive money-printing, and ending in the death of the dollar and an inflationary firestorm? Or will it choose the sustainable route of negotiated default, low taxes, a return to productive, organic growth, and the opportunity to decrease reliance on foreign energy and goods?

What’s that sound? No, not the crashing Argentinosaurus.

The Housing Bubble Priced in Gold

In the United States, the post-sub prime housing crash has meant that consumer spending has stagnated. People are simply not remortgaging their homes to buy boats or other such consumer goods anymore, because there is no longer the expectation that price rises will pay for the boat. This is because prices are slumping due to excess supply built during the peak years. For people who don’t own property in the United States, this price crash has allowed them to get a foot on the property ladder, which is broadly a good thing. Keynesians might argue that the slump in consumer spending is broadly a bad thing, but it’s not: it was never sustainable in the first place. Boosting GDP through unsustainable spending is a short recipe for bubbles.

In the United Kingdom, the story is different. Property prices haven’t really crashed:


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