zero hedge

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Economics for the Muppet Generation

Mark McHugh of Across the Street provides a succinct summation of the problem America faces:

McHugh continues:

  • From 1947 to 1974 US income per capita grew more than National debt per capita 25 times.
  • In the last 30 years, National debt per capita has grown more than income per capita 24 times.
  • The last time income per capita grew more than national debt per capita was 2001.
  • Ben Bernanke arrived at the Federal Reserve in 2002.

So simple, even a muppet can understand what the problem is, right?

Not exactly. We know what the problem is: national incomes aren’t rising, even while we get deeper and deeper into hock trying to maintain our standard of living. We know that this pattern is totally unsustainable; unless incomes rise, that debt will become increasingly impossible to service. What is less clear is the cause of this stagnation.

So what changed between 1990 and 2005 that led the nation debt per capita to so quickly overtake national incomes per capita?

While I am mindful that correlation does not necessarily imply causation, that data fits pretty beautifully. The explanation for this trend would be that as America has become more and more consumptive, and less and less productive that more and more capital went offshore to pay for consumption, and thus less and less contributed to the national income, even as Bernanke ponied up trillions in new reserves, and even as the shadow banking system created trillions in pseudo-money.

So where’s America’s money?

Here:


So is this a criticism of free trade? Should America have been more protectionist of her industries and her domestic manufacturing? Not necessarily; what the Washingtonian elites refer to as “free trade” is heavily subsidised. The status quo that Washington has made seems to heavily favour China and disfavour America. Imports from China are subsidised by American military largesse; every dollar America pushes into its military-industrial complex pushes shipping costs like insurance a little lower. So while labour costs in the Orient are naturally cheaper (due to population density, and development level), that doesn’t necessarily mean that Chinese goods are naturally cheaper in the American market. Under a genuinely free system — where America was not subsidising shipping costs — would made-in-America be more competitive compared to Chinese goods? Would China have built up a less  mountainous supply of American cash? I think so.

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Rome & Central Planning

Central planning — like war — never changes. It has always been a powerful and effective way of achieving an explicit objective (e.g. building a bridge, or a road), but one that has has always come with detrimental side-effects. And the more central planners try to minimise the side-effects, the more side-effects appear. And so the whack-a-mole goes on.

This was true in the days of Rome, too.

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. “In every large town,” we are told, “the state became a powerful employer, standing head and shoulders above the private industrialists, who were in any case crushed by taxation.” When businessmen predicted ruin, 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.

The task of controlling men in economic detail proved too much for Diocletian’s expanding, expensive, and corrupt bureaucracy. To support this officialdom – the army, the courts, public works, and the dole – taxation rose to such heights that people lost the incentive to work or earn, and an erosive contest began between lawyers finding devices to evade taxes and lawyers formulating laws to prevent evasion. 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.

So much for the view that increasing aggregate demand is the recipe for wider prosperity; Diocletian surely raised it a lot. But that didn’t really accomplish much, either in terms of wider prosperity, or in terms of the sustainability of the Roman civilisation. Raised aggregate demand is only useful if it contributes to creating and producing things that society needs and wants. And as Hayek brutally demonstrated, central planning is notoriously useless at determining what people actually want.

Of course, no modern centralist (e.g. Krugman) explicitly endorses price controls although, I am sure some of the more Hayekian or Paulian-minded among us will point out among other things that the minimum wage and the setting of interest rates are both kinds of price control. Diocletian however, was far more expansive.

From Wiki:

The first two-thirds of the Edict doubled the value of the copper and bronze coins, and set the death penalty for profiteers and speculators, who were blamed for the inflation and who were compared to the barbarian tribes attacking the empire. Merchants were forbidden to take their goods elsewhere and charge a higher price, and transport costs could not be used as an excuse to raise prices.

The last third of the Edict, divided into 32 sections, imposed a price ceiling – a maxima – for over a thousand products. These products included various food items (beef, grain, wine, beer, sausages, etc), clothing (shoes, cloaks, etc), freight charges for sea travel, and weekly wages. The highest limit was on one pound of purple-dyed silk, which was set at 150,000 denarii (the price of a lion was set at the same price).

And how did it work out?

The Edict did not solve all of the problems in the economy. 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.

Bernanke of course is much more sophisticated; he uses the facility of the primary dealer banks to hide the currency inflation necessary to monetise government debt. Central planning wins again? No; central planning always comes with unpredictable boomerang side effects.

I suppose, though, that it is comforting that history is repeating itself. After the horrors of mediaeval feudalism, we pulled ourselves up anew from the wastes of history.

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Treasuries Still Not Cracking

Tyler Durden pointed out yesterday that just three weeks after Goldman made the case for equities relative to bonds, the muppets who had listened to their advice were getting skewered:

I wrote a while back that (unlike some others) I didn’t believe it was likely that  this was going to be a cataclysmic rate spike. Readers who want to detect one need to watch whether sovereign creditors especially Russia and China are selling, and at what pace — the faster the liquidation, the more rates may spike.

Of course, I am still convinced that the real fragility to America’s economy isn’t actually a rate spike or inflation.The Fed has a very good handle on both of these things (but not, perhaps on unwanted side effects. They can effectively do QE without really inflating the currency much; simply shoot the money to primary dealers for treasuries.

When volatility is artificially suppressed, there are always unwanted side effects. And that — the unwanted side effects, not the widely-reported fears of inflation and rate spikes — I believe, is the true danger.

One unwanted side effect could be provoking a damaging trade war with China, from which the West imports so much. That is my pet theory, and one I’ve devoted a few thousand words to over the last few months. But the trouble with side-effects is that it is very hard to tell what the weakest link (i.e. the point that will break) in a volatility-suppressed system is. Tyler Durden reports that systemic financial fragility (as measured by CDS) is at a recent-high, too:

Believers in technical analysis (I am very sceptical) are pointing to a head-and-shoulders top in the “recovery” (to go with the bigger head and shoulders top that is very much one of the stories of the last ten years):

I don’t know when the black swans will come home to roost and the strange creature that we call the present global economic order will go ka-put. I don’t even know if they ever will! But I see the fragilities caused by central planners suppressing the system’s natural volatility.

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Greece Defaults

From Sky News:

The talking is over; it is finally happening. For the first time since World War Two, a developed nation is going into default.

That’s the significance of the events of the past 24 hours, with Greece’s debt being classified as in “selective default” and the European Central Bank banning it from its cash window. Months of planning by both banks and policymakers have gone into ensuring that Greece’s negotiated default will be a smooth painless process. We are about to find out whether that planning pays off.

Now, we shouldn’t be surprised by Standard & Poor’s decision to cut the rating on Greece’s sovereign debt from CC to SD (which stands for “selective default”). The ratings agencies had always said that, given private investors are about to lose just over half the value of their debt (through a complex bond swap), this downgrade would be a natural consequence.

Nor should we be shocked that the ECB says it will no longer accept Greek debt as collateral: in fact, the only surprise is that it’s taken this long – on the basis of the ECB’s previous policy, the bonds should have become ineligible when were first downgraded from investment status two years ago.

Peter Tchir thinks all the hullabaloo is a lot of sound and fury, signifying nothing:

So far there are no dramatic consequences of the Greek default. The ECB did say they couldn’t accept it as collateral, but national central banks (including Greece’s somehow solvent NCB) can, so no real change. We will likely get a Credit Event prior to March 20th once CAC’s are used to get the deal fully done. Will the market respond much to that? Probably not, though there is a higher risk of unforeseen consequences from that, than there was from the S&P downgrade.

It just strikes me that Europe wasted a year or more, and has created a less stable system than it had before. A year ago, Europe was adamant about no haircuts and no default. I could never understand why. Let Greece default, renegotiate terms, stay in the Euro and move on.

I suppose the magnitude of the problem depends on just which kind of credit event. And that mostly depends on how well-insulated the financial system is, and market psychology. A full-blown Lehmanesque credit shock? Who knows — certainly banks are fearful. Certainly, the problem of default cascades has been out in the open for a while. But most of the attempts to deal with the prospect of such things have mostly been emergency room treatment, and not preventative medicine — throwing liquidity at the problem. Certainly, it is possible the system is in a worse shape than 2008.

  1. The derivatives web is (nearly) as big as ever:
  2. There are still a myriad of European housing bubbles ready to pop.
  3. American banks are massively exposed to Europe.
  4. China’s housing bubble is bursting Surely their reserves will go into bailing out their own problems, and not those of Europe and America?
  5. Rising commodity prices — especially oil — are already squeezing consumers and producers with cost-push inflation.

Meanwhile, the only weapon central bankers have in their arsenal is throwing more money at the problem.

Will throwing more money at the problem work? Yes — in the short term. The danger is that creditor nations will not be prepared to throw enough to shore up balance sheets.

Will throwing money at the problems cause more problems in the long run? Yes — almost certainly.

Ultimately, we must look at preventative medicine — to stop credit bubbles expanding beyond the productive capacity of the economy. We should also look at insulating the economy from the breakdown of any credit bubbles that do form.

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The Greek Non-Rescue

So Greece has been “rescued”.

Or, not.

From Robert Peston:

What we had overnight is an agreement in principle, not a final definitive rescue of Greece. Before we crack open the vintage Ouzo, let’s just see how it goes down with the relevant private-sector lenders, politicians in the only creditor country that really matters — Germany — and Greek citizens.

That “agreement in principle”?

From Zero Hedge:

  • Even under the most optimistic scenario, the austerity measures being imposed on Athens risk a recession so deep that Greece will not be able to climb out of the debt hole over the course of the new €170bn bail-out.
  • Even in best case scenario, the country will need at least €50 billion on top of €136 billion.
  • A German-led group of creditor countries – including the Netherlands and Finland – has expressed extreme reluctance since they received the report about the advisability of allowing the second rescue to go through.

The deeper truth emerges from the BBC:

“The funds that are coming in are not staying in Greece, are not being invested in Greece, are not here to help the Greeks get out of this crisis,” Constantine Michalos, president of the Athens Chamber of Commerce and Industry, told the BBC.

“It’s simply to repay the banks, so that they can retain their balance sheets on the profit side.”

This reminds me of a comment made by Andrei Canciu yesterday:

I think that even the original (i.e. current) architecture of the Euro would have been workable if it were not for the “innovations” in the banking system during the last 10 years. That is, overindebtedness would have always been solved through defaults by punishing the the irresponsible lenders (i.e. those tight spreads between Northern and Southern European countries), while the defaulting countries would have gotten some post-default aid.

I read somewhere that a Greek default would have been totally manageable 10 years ago. That’s no longer the case with the shadow banking system and the incomprehensible web of derivatives.

And there we have our problem: this isn’t really about Greece at all. It’s about the fundamentally perverse nature of the global economic system that cannot withstand a default or liquidation without bringing down the entire system. Even if China and Japan threw all their FX reserves into bailing out the Eurozone this would merely postpone the systemic breakdown. Because, the problem is the system. The global economic system needs to be able to withstand defaults, liquidations, crises. It needs to be robust. And the Byzantine workings of the shadow banking system — where everyone owes money to everyone else, and if one falls they all fall — is a hyper-fragile juggernaut that is bound to come down eventually. If it’s not Greece it will be something else. And that will be a good thing — because we will be abe to switch to an economic system less prone to absurd bubbles, hyper-fragility, and forced bailouts.

Anyway, I am still virtually certain that this bailout is a total sham, and — even if stomached by Germany and international creditors — is doomed to abject failure.

Why?

It’s demanding even greater and deeper austerity from an already-bleeding Greek nation. As I’ve said before, austerity in a depressed economy usually results in larger budget deficits as a result of falling tax revenues. Simply, this medicine is poison. Very shortly, Greece may well be back in the hole.

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Changing the Rules of the Game

The ECB just changed the rules of the European debt game.

From Zero Hedge:

The ECB, on its own and without judicial or parliamentary review, has swapped their Greek debt for new Greek debt that is not subject to any “collective action clause.” They did this unilaterally and without the consent of any other sovereign debt bond owners of Greek debt. They did this without objection of any nation in Europe. They have retroactively changed the indenture, the contract made by Greece with all of the buyers of their bonds, when the debt was issued. There is no speculation involved in these statements, there is no longer any guesswork on what might be; the ECB swapped their bonds for new Greek bonds with the assent of the Greek government and it is now a done deal.

We know now that the ECB can retroactively change the rules, change an indenture, so that if the ECB can do this with Greece then it can certainly do it with any sovereign debt in Europe.

Since the ECB can now retroactively change any bond contract to whatever it likes and with any nation in its dominion then the valuation of European sovereign debt must be re-examined for what it really is which is no longer what anyone previously thought. Starkly put; the bonds issued by the sovereign nations in Europe are no longer pari passu, on equal footing, with the bonds issued in the United States. We have just passed a clearly defined “break point” where the legal rules were changed to the great disadvantage of all the private debt holders.

The European Central Bank, in a very misguided attempt to protect itself, has now opened Pandora’s Box. I doubt if they even realize what they have done; but they will, most assuredly they will. The consequences of their horrendous mistake will soon be upon them as institutions not coerced or forced into buying European sovereign debt will be leaving the playing field en masse as the realization dawns upon investors of just what has taken place.

The point of this is quite shocking.

From Bloomberg:

The European Central Bank is swapping its Greek bonds for new ones to ensure it isn’t forced to take losses in a debt restructuring, three euro-area officials said yesterday.

Bill Gross of PIMCO sums up:

Now perhaps the protestations are just the vain rumblings of creditors who don’t like having to take a haircut: after all, all investments carry such a risk. On the other hand, it’s one thing to duplicate money to pay back debt (the “normal option”) and it’s quite another to effectively enforce a change to the terms of private contracts by curtailing pari passu. But — in this case — the “normal option” of printing the money to pay back the debt is not available to Greeks.

The point is that if the ECB can do this it means that all debt denominated in Euros is subordinated. This will (eventually, once the market gets the message) cause a collapse of demand in European sovereign debt.

Either borrowing costs will massively spike, crashing the system, or the ECB will go on a money printing binge. These two options have been discussed above. German attitudes to monetary expansion are frosty to say the least, but at this stage I think all options are on the table.

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Where Gold is Going

Many will argue that — more or less — this reflects the U.S. government’s attempts to deal with broad and deep social and financial problems through monetary policy. The higher the price of gold goes, the more the market believes that monetary policy just isn’t working, and that the big problems in American and Western society — oil dependency, deindustrialisation, unemployment, regulatory capture and debt saturation — are just not being effectively addressed.

As I wrote last month:

Getting out of a depression requires debt erasure, and new organic activity, and there is absolutely no guarantee that monetary easing will do the trick on either count. Most often, depressions and liquidity traps are a reflection of underlying structural and sociological problems, and broken economic and trade systems. Easing kicks the can down the road a little, and gives some time and breathing room for those problems to be fixed, but very often that just doesn’t happen. Ultimately, societies only take the steps necessary (e.g. a debt jubilee) when their very existence seems threatened.

The simple expansionary recipe for getting out of depressions is a sad smile, a false promise of an easy route out of complex and multi-dimensional problems.

If these problems are fixed, then the correlation between the debt ceiling and the price of gold will go away. Gold is not necessarily going to the moon, and the gold speculators will be forced to give up the ghost as real broad-based economic growth returns. The trouble is, I don’t see any evidence that these problems are going away. Japan is still — more or less — in the same place it was twenty years ago. Now the whole world may be moving to the Japanese model. Readers are welcome to try and convince me otherwise.

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The Shape of Eurasia

Western journalists might denounce it as stump rhetoric. But I don’t think Vladimir Putin is beating a drum or rattling a sabre. I think he is deadly serious: what’s more, I think he is in a position of strength, not weakness.

From Bloomberg:

Russian Prime Minister Vladimir Putin is stepping up rhetoric against the U.S. as his campaign for the March 4 presidential election intensifies after the biggest protests against his rule.

The U.S. “wants to control everything” and takes decisions unilaterally on key questions, Putin said on a campaign stop yesterday in the Siberian city of Tomsk, 3,100 kilometers (1,900 miles) east of Moscow. “Sometimes I get the impression the U.S. doesn’t need allies, it needs vassals.”

Putin, 59, is seeking a new term in the Kremlin amid the biggest challenge to his 12-year rule after fraud allegations at parliamentary polls sparked mass protests. The Russian leader, who has repeatedly accused the U.S. of interfering in other countries’ affairs, said last week that reports by a state-owned Moscow radio station supported American interests.

“The No. 1 reason Putin is doing this is elections,” Jan Techau, director of the European Center of the Carnegie Endowment for International Peace in Brussels, said yesterday in a phone interview. ‘‘It’s pre-election saber-rattling. This is vintage Putin.’’

Alas, it is all about context. This isn’t 1992; the end of history is finished. America is not an invincible hegemon, but instead has been taxed and weakened by two big wars and a myriad of small ones, a huge financial blowup, and the fallout of losing a huge hunk of its manufacturing sector to Asia. America’s monopoly over the global oil trade — and its ability to acquire oil and components with newly-printed dollars — is threatened by the current shape of Eurasia, where a coterie of authoritarian leaders, united by their shared anti-Americanism is moving to displace the dollar as the global reserve currency.

Vladimir Putin was very explicit about this.

From Rianovosti:

Russian Prime Minister Vladimir Putin accused the US of hooliganism on Monday [July 2011] over the US government’s efforts to ease its financial problems by injecting hundreds of billions of dollars into the economy.

“Thank God, or unfortunately, we do not print a reserve currency but what are they doing? They are behaving like hooligans, switching on the printing press and tossing them around the whole world, forgetting their main obligations,” Putin told a meeting of economic experts at the Russian Academy of Sciences.

The Russian authorities have said they would like to see a basket of currencies including the ruble replacing the dollar as the main reserve currency, although most analysts have said a more realistic target for Russia would be if the ruble became a regional reserve currency for the CIS.

Regular readers will know that this is not just rhetoric. These Eurasian leaders are taking direct action to displace the dollar.

From Zero Hedge:

Yuan bonds have spread across the planet, China has dropped the dollar in bilateral trade with Russia, the ASEAN trading bloc has formed into a tight shell of export partners, and that is just the beginning. Two major announcements in 2011 have solidified my belief that a complete dump of the dollar by eastern interests is near…

First was the announcement that China was actively and openly pursuing the establishment of a central bank for the whole of ASEAN, with the Yuan utilized as the reserve currency instead of the dollar:

http://www.reuters.com/article/2011/10/27/us-china-asean-financial-idUST…

This news, of course, has barely been reported on in the mainstream. As I discussed at the beginning of this article, the terminology surrounding economic developments has been diluted and twisted. When China states that an ASEAN central bank is in the works, we need to point out what this really means; the ASEAN trading bloc is about to become the Asian Union. The only missing piece of the puzzle is something that I have been warning about for at least a couple years, ever since my days at Neithercorp (see “Migration Of The Black Swans” as a recent example). This key catalyst is the inclusion of Japan in ASEAN, something which many said would take five to ten years to unfold. News released this Christmas speaks otherwise:

http://www.bloomberg.com/news/2011-12-25/china-japan-to-promote-direct-trading-of-currencies-to-cut-company-costs.html

Japan has indeed entered into an agreement to drop the dollar in currency exchange with China and has expressed interest in melting into ASEAN. Japan has also struck somewhat similar though slightly more limited deals with India, South Korea, Indonesia, and the Philippines almost simultaneously:

http://www.bloomberg.com/news/2011-12-28/japan-india-seal-15-billion-currency-swap-arrangement-to-shore-up-rupee.html

This means that the two largest foreign holders of U.S. debt and Greenbacks will soon be in a position to tap into an export market far more profitable than that of America, and that all of this trade will be facilitated by currencies OTHER THAN THE DOLLAR. It means the end of the dollar as the world reserve and probably the end of the dollar as we know it.

America might well be expected to throw a wrench into the changing chape of the global system. A (messy, prolonged and expensive) war with Iran — to disrupt Eurasian co-operation and re-assert American hegemony — might suffice in the minds of hawks, but will in reality do more harm than good, perhaps driving Russia and China into explicitly and directly defending their ideological ally. Even if this was not the case, American military power runs thin on manpower, and is  funded not by American productivity, but by debt acquisition. More debt will just strain the status of the dollar as reserve currency even more.

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The Wasteland

The BBC presents an interactive debt chart to demonstrate who owes what to whom:

This morass of interconnected debt rather reminds me of T.S. Eliot’s Wasteland:

That corpse you planted last year in your garden,
Has it begun to sprout? Will it bloom this year?
Or has the sudden frost disturbed its bed?

No flowers shall bloom from the stinking cadavre of interconnected debt . As I have explained, the lack of any real debt liquidation or deflation post-crisis has turned much of the global economy into a walking zombie, weighed down by an excessive debt load, and politically and socially incapable of addressing structural issues.

Dead bodies cannot return to the earth to grow anew unless they are allowed to decompose. But policymakers cannot countenance any kind of decomposition.

So the corpse sits in a tank of formaldehyde:

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Eurotrash & Fragility

I haven’t covered the nascent European Financial Stabilisation Fund (EFSF) much lately, in spite of all the bureaucratic & ministerial scrabbling and wrangling to rescue the European status quo.

That’s mainly because I have grown (or shrunk?) to see most developments as irrelevant can-kicking.

At best, they can muster an American-style response: kick the can far into the future. But unless the underlying problems are solved (clue: they won’t be) then the system remains fundamentally broken.

That’s because monetary integration without integrated budgeting is a recipe for insolvency. Banana Republics can print money to pay their debts because they control their currency. Nations who don’t control their currency can’t devalue to pay their debts. They have to default, or hope for a bailout from the powers-that-be. And the problem at the heart of Europe is that fiscal integration is politically impossible (sorry Frau Merkel), for a myriad of reasons including (among others) nationalism, incompatibility, and the perception that the Mediterranean nations will leech off the more productive northern nations.

Of course, most of these constraints wouldn’t be there if the system was less fragile. In a fractional reserve banking system where (and this is crucial) the money supply (M2) is determined by private lending, a number of situations can lead to Irving Fisher’s debt deflation problem — with a shrinking money supply, debts become unrepayable, triggering a default cascade. These situations include bank failures, bank runs, credit contractions, price deflation and sovereign default — five phenomena that history teaches us are quite common. The scale of indebtedness makes systemic reform very difficult — creditors will demand that debts are honoured, so central banks continue with the instruments they have — competitive debasement, low-rates, expansionary monetary policy.

All that the sovereign debt crisis in Europe is revealing is the fragility in the systems — the fragility of the European political union, and the fragility of the fractional reserve banking system.

And if a fragile system isn’t allowed to collapse (or is not effectively reformed) when the problems are comparatively small (insert nonsensical rubbish about “systemic importance“, “economic infrastructure” and “too-big-to-fail” here) it will rumble on through many bailout-crisis-bailout-crisis cycles until it becomes too-fucked-to-bail, at which point the entire system collapses, and the debt is razed (either by default of hyperinflation or both).

The problem is that such climactic events usually have geopolitical implications: war, famine, upheaval, etc.