August 11, 2011

The Deflationist Case

The following is a brilliant exposition of a deeply pessimistic view of our current economic predicament. The steep drop in equity markets raises again the specter of 2008, of runaway financial crisis built on the foundations of an unfair and unstable system. The Automatic Earth, the blog from which the following comes, has had many posts dealing with these matters, but none so powerful as this. In effect, says Stoneleigh, the Minsky Moment of 2008-09, distinguished by the liquidation of risky assets and the mad dash to preserve capital, is upon us again.

Whereas most commentators treat markets as being driven in some kind of rational fashion by external events, we have concentrated on the irrational endogenous dynamics and the role of sentiment in creating the perceptions that drive positive feedback loops - either virtuous or vicious circles. Sentiment, and therefore perception, can change very abruptly, with far-reaching effects. The events of this past week or so have been a prime example.

The rally of the past two and a half years continued longer than we had anticipated, but on balance of probabilities it is now over, and we are entering the next phase of the credit crunch - the period where a majority begins to appreciate what a credit crunch really means. The first phase, from October 2007 to March 2009, was little more than a mild introduction for many, although even that was enough to push  a large number of casualties silently over the edge.

With the dramatic end to the rally (and a loss of over $7.8 trillion in mere days) comes the end of the complacency it engendered. Fear is in the ascendancy once again, and fear is extremely catching. We are already seeing it spread like wildfire and begin to feed upon itself, creating self-fulfilling prophecies. The fundamentals have not changed materially, but the perception of them has, and that is the game changer.

When markets are rising, thanks to optimism and hope, people develop a false sense of predictability, as if events were somehow proceeding as they were meant to, and that they should, by rights, continue to do so. Under such circumstances, market volatility is typically low. In contrast, when markets decline, as fear tightens its grip, that comforting sense of pseudo-certainty evaporates very quickly. Fear breeds extreme volatility as investors try to second guess rapidly unfolding moves, and also each other. . . .

Initially investors look to buy the dips, on the assumption, born of three decades of expansion, that every decline represents a buying opportunity. Later that assumption will falter, and then fail, but residual optimism takes time to dissipate completely. Every temporary upswing all the way down will rekindle echoes of it. The only relative safety is to be found on the sidelines in cash. While there is money in volatility for some aggressive (and lucky, or well-connected) traders, there will be far more opportunities to lose a fortune than to make one for those who cannot stop playing the game.

Going forward, we can expect more of the stomach-churning market declines we have seen over the past week, but also apparently rocket-fueled, yet short-lived rallies. The sharpest and largest upswings happen in bear markets, interspersed with cascading movements to the downside. 

We advise our readers to proceed with great caution and to ignore rationalizations and spurious causation discussed in the mainstream media. In extrapolating past trends forward, failing to anticipate discontinuities, and propagating the smoke-and-mirrors posturing of central authorities desperate to obscure what is happening for as long as possible, they will be arriving at completely incorrect conclusions as to the financial consequences we are facing and what actions we may be able to take in order to protect ourselves. They will also be unhelpfully fanning the flames of fear.

Global commentators have focused recently on the pure political theatre of the rise in the debt ceiling in the US, and subsequently on the downgrade of the US by a single credit-rating agency, but these events do not presage what mainstream opinion has suggested at all. Quite the opposite in fact.

The debt ceiling debate was merely a staged game of brinkmanship, softening up the US population for austerity measures and coming cuts in entitlement programmes targeting the weakest members of society. Imminent default was never a risk. The real risk is the acceleration of the wealth and power grab that has been going on under the guise of quantitative easing for the duration of the rally.

The coverage of the ratings downgrade likewise obscures the real threat. Commentators boldly assert that the US will inevitably have to pay more to borrow, that treasuries are increasingly risky, that the US dollar is doomed and that inflation is an imminent threat. The Automatic Earth has long held diametrically opposed opinions with respect to the next few years, and those are already being vindicated by events. 

Our position has long been that the US will benefit from a flight to safety as the least worst option, initially at Europe's expense. Money will flood from where the fear is to where the fear is not, and one look at bond rates and credit default swap spreads is all it takes to see that the fear is concentrated in Europe, while the US is seen as a safe haven. 

When fear rules, small relative differences are enormously amplified, leading eventually to record spreads between debts and debtors perceived to be risky and those perceived not to be, even if that perception is distorted or outright incorrect. As we have said, fear generates self-fulfilling prophecies. As interest rates spiral higher for supposedly risky borrowers, they become less and less able to pay, and default becomes a certainty.

Imposing austerity measures only makes the situation worse, as it forces a contraction that further impairs ability to pay. This is the situation the European periphery finds itself in, and the fear is spreading to include the centre. Today France is in the crosshairs, and even German bond rates are rising. 

In contrast rates in the US are falling into negative territory, reflecting the desperation of investors looking for a safe haven and prepared to pay for the privilege. Yields are low because the market is not asking for higher returns, but for a means to preserve capital. The market sets interest rates, not central bankers or governments who only chose a rate to defend, and not ratings agencies without a shred of real credibility left after their performance of recent years.

Interest rates on short term US government debt should stay low throughout the coming period of deleveraging. Short term treasuries represent one of the safest options available, as they are highly liquid, and liquidity will matter more than almost anything else in the depression we are rapidly descending into. Longer term debt may well be a different story, as that has the added risk of having to wait far too long to be repaid, or selling into the secondary market. 

Asserting that US treasuries are risky deters ordinary people from seeking the relative safety they offer, even while the insiders take full advantage of it. Similarly, warning people away from US dollars while telling them to hold their nerve in the markets, benefits only those insiders who seek to keep the bubble inflated for long enough to extract their own wealth from a collapsing system.

The US dollar (and other safe haven currencies such as the Swiss franc) is set to benefit, during the period of deleveraging, from the same flight to safety that treasuries will enjoy. It is still the reserve currency, and is likely to stay that way for several years at least. As dollar denominated debt (of which there is more than any other kind worldwide) deflates, demand for dollars, from those seeking to pay down that debt, will push up their value.

The inflation obsession, which central bankers are only too pleased to encourage, also continues to deter people from protecting themselves. Those who are afraid of inflation or hyperinflation will not address the threat of debt or hold the cash that will remain king as the debt bubble bursts and deleveraging aggravates the credit crunch. It is deflation - the collapse of a pyramid of excess claims to underlying real wealth - that we are facing. That is the inevitable result of a bursting bubble.

Widening credit spreads will send the interest rates payable on the debts or ordinary people, companies, banks and lower levels of government through the roof, even as the rate payable on the debts perceived to be safest falls and remains low. At the same time, monetary contraction, credit destruction, spiking unemployment, benefit cuts and skyrocketing bankruptcies will increase the burden that debt represents.

Actual cash will be scarce and few will have access to much of it. Under such circumstances, people will be forced to sell assets for pennies on the dollar to those who still have purchasing power. This is a recipe for extreme wealth concentration, and that, as we are already seeing around the world, leads to increasing social unrest. People need to protect themselves while they still can, but listening to the mainstream media and central authorities is emphatically not the way to do so.

The effect of the US downgrade is ironically far more likely to be felt in Europe than in America. Other triple-A sovereign debtors perceived to be riskier than the US are now at risk of being downgraded, and where fear has already a foothold with respect to sovereign debt default, such moves are likely to aggravate it. Attempts to restore confidence are likely to backfire badly, as existing adverse risk perception merely makes such moves appear desperate, so that they tend to be interpreted as evidence of major problems rather than as reassurance.

Failure is likely to be followed by overtly defensive moves such as the reimposition of capital controls and increasing protectionism, which will only encourage greater fear and greater capital flight. Confidence is ephemeral, and once damaged it can be almost impossible to revive until the underlying imbalance has been resolved, and we are years of deleveraging away from that point.

It is clear the the European Financial Stability Fund, recently increased but still obviously insufficient to cover even the sovereign debt problems already admitted to, cannot solve the rapidly escalating crisis. The scope of this is increasing dramatically as financial contagion spreads to larger states with more intractable debt problems. The European Stability Mechanism, intended to be implemented as a permanent solution in 2013, will never have a chance, as monetary union will long since have been overtaken by events before it can be established. 

The European centre has no mandate for further integration, bought, as it would have to be, through the centre agreeing to shoulder far more financial risk than it has done so far. That will likely prove to be politically impossible. The countries of the periphery, caught in a downward spiral of increasingly severe austerity measures and exploding debt, will ultimately resist, perhaps violently, the enormous loss of sovereignty greater integration would involve.

The goodwill necessary to build consensus or render burden-sharing acceptable does not exist, and acrimony is increasing as the situation continues to deteriorate. Larger political accretions become fissile as there is not enough to go around and divisions grounded in history become accentuated anew. This is clearly the risk for Europe.

While rallies are kind to policy makers, casting them in a gloss of apparent competence and effectiveness, declines abruptly strip away the comforting illusion of central control. Policy makers appear increasingly incompetent and out of touch with reality as events unfold far more rapidly than they can be responded to. In reality there is little they can do faced with a bubble blown over at least three decades. Once blown, bubbles always implode.

The demand artificially brought forward during the boom years must be repaid with years of falling demand for almost everything, as difficult as that is to imagine from the top of the pyramid. That is the last thing people are expecting, but it is already underway. Even commodities appear to have topped on speculation going into reverse, and falling demand will accentuate falling prices. The growth dynamic is going into reverse, and with it many of our preconceived and deeply held notions. 

* * *


What makes this piece so interesting, apart from the sheer doom and gloom of the thing, is the combination of systemic analysis and immediate market prognostication. But I have some reservations. 

First off, the immediate crisis in the markets. I think US Treasury bonds are grossly overbought and that a reversal will come soon. They've basically reached the levels of late 2008 and in some cases (2 year treasuries) gone beyond them. To buy them here would be chasing outsized moves. While the earnings of corporations may be overstated if seen in relation to five year averages, there is still a huge disparity between the measly 2% yield on ten year Treasury notes and the earnings power of stable corporations.There is no telling what further ranges panic may explore before confidence is restored, but I don't believe we will just slice through the floor, as in the fall of 2008. Generally speaking, it is seldom wise to sell into a panic, and you shouldn't be in a position (if you're in a position to care about these things) where you are compelled to sell because over-leveraged.

If we cast our sights not on the debt-burdened industrialized countries but on the world more generally, I also find it difficult to credit the forecast of protracted deflation and reduced demand. The hungry mouths will demand to be fed, and economic activity will proceed, even if at a reduced pace. Worldwide coal consumption grew 7.5% last year, to take one example of the secular increase in demand for energy and commodities. It would take some kind of gigantic bust to derail this world historical locomotive.

The interaction between the economic system and the energy system is complex. There have been signs since the spring of 2011 that the 2008 experience might be repeated, even if on a reduced scale. The rise in oil prices would inevitably produce a contraction in economic activity, such that the rise in prices would decrease demand for other goods and services (with our crack-induced financial markets magnifying these shifts). This oft-repeated pattern clearly should be viewed as greatly significant, but does it portend the collapse of the economic system and of the entire model of economic growth? I doubt that. 

The more general problem from the vantage point of this blogbook is whether the limits to economic growth are to be found more in resource constraints or the dynamics of debt deflation (such as was described by Irving Fisher in the 1930s, and whose model The Automatic Earth implicitly embraces). Basically, the great problem of contemporary political economy is whether there are political, economic, or technological cures for those two conditions.

Stoneleigh is exactly right in insisting that the immediate effect of the downgrading of US debt by Standard and Poor's is on Europe. If the US is downgraded, why not France? Such has been the question of the hour for the markets. Stoneleigh may also be right in insisting that no political will exists in the European center (i.e., Germany) to bail out peripheral nations; at the same time, there is little question that it is in Germany's interest to lead a rescue. What is needed is a European bond, raised on the authority of the EU, to backstop the governmental bond market in Europe. That should be combined with haircuts to creditors. This was the principle on which "Brady Bonds" were introduced in the 1980s to deal with the debt of insolvent South American governments, and it provides a good model for dealing with today's crisis.

Back then, it was the United States government (together with the IMF and others) that stood behind the Brady bonds. What would stand behind such a European bond today? While many observers have proffered some variant of the following answer--"fiscal federalism," or the creation of a United States of Europe--it seems to me that a more limited set of steps might be sufficient. Instead of moving toward a European system with a general power of taxation, such as was created by the U.S. Constitution, specific taxes--amounting, say, to 3 to 4 % of Europe's GDP--might instead be pledged to the European bond. The taxes pledged would be a "sinking fund" for the debt (to use the eighteenth century expression).

Without descending too far into particulars, let us estimate that Europe's total gdp is around $15 trillion, about the same as the United States. A 30 year European bond worth $1 trillion, at a 4 percent rate of interest, would require monthly payments of $4.8 billion, or $57 billion a year. That works out to about 3.8 % of Europe's GDP (taking a fraction of the $15 trillion figure, which is only approximate.)  Taxes on energy consumption could be pledged to the common fund, involving commensurate reductions in energy taxes at the national level. In conjunction with the United States and Japan, a small tax on financial transactions would also serve well as a general fund for the EU. Whatever the precise details, a common European tax to support a common European bond is a logical next step for Europe.

Europe lacks the institutions to come up with such a remedy overnight; in the absence of such institutions, it must rely on German leadership.

The German public is royally sick of the idea that it should bailout the rest of Europe, though its banks hold a significant percentage of the dodgy debt (making any "bail out" of the periphery a "bail in" of the big European banks). The forces poisoning the relationship--German resentment against deadbeats, and the resentment against Germany for the terms that come with German bailouts--are all too real. At the same time, it seems no less true that Germany cannot prosper if its European neighborhood is on fire, and that the peripheral nations like Greece and Ireland cannot afford to let their resentment get the better of their interests. The Europeans are bound together in a doomed relationship, as in some tragic Italian opera. Within that dysfunctional relationship, it is Angela Merkel who must "man-up" and propose a limited but forceful European solution.

The larger question is whether America and China will join Europe in "turning Japanese," with deflation conquering growth and leading to the collapse of equity markets. It would be foolish to rule out that grim prospect, given the experience since 2008, but I think it would constitute a fear-driven and irrational response, unless we are postulating the end of our economic system. We are also most unlikely to get there, if that is indeed our final destination, in a straight line. Here is an extract from Jeff Saut, the investment strategist, whom I have slightly edited [in brackets] to make my own related points. Saut notes that earnings estimates for the S and P 500 are
nestled around $100 and pushing towards $114 for 2012. If those estimates prove correct, at last week’s intraday low (1168.09), the SPX was trading at a PE multiple of 10.3x next year’s earnings, with an Earning’s Yield of ~9.8% ($114 ÷ 1168), leaving the Equity Risk Premium for stocks at ~7.4% (Earnings Yield – 10 year T’note yield of 2.4%) for the highest ERP in a generation. . . .
When asked how he made his money, [Jim] Rogers answered, “I sell euphoria and buy panic.” The way he determines that is to wait until prices are “gapping” in the charts. Gapping on the upside is “euphoria,” while gapping on the downside is “panic.” Currently, gold and Treasuries [plus Swiss franc and Japanese Yen] are gapping on the upside; and, stocks are gapping on the downside. The implication . . . suggests positions should be sold in [precious] metals [and Treasury bonds, Japanese yen, and Swiss francs!] and the freed-up cash should be used to buy sound stocks with decent dividend yields. . . . The time to panic, and raise cash, was months ago. Now it is time to selectively redeploy that cash into select equities.
I think Saut overdoes the earnings picture--the 2012 estimates are in all probability seriously inflated--but his overall point is valid and convincing. Because of the surge in prices for gold, bonds, yen, and francs, "safe" assets have become risky; because of the collapse in equity values, "risky assets" have become much safer.

Update: Via Felix Salmon, this chart from Reuters on the divergence in yields between stocks and Treasury bonds speaks volumes:


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