Wednesday, April 14, 2004

Auerback - Stop This Runaway Train

It's going to be interesting to see how the near future plays out. We have China with a pegged currency - to low I might add - inflation bubbles and possible busts just around the corner, and the countries concerned - unconcerned! I can just picture it - China - Pop - and everyone rushing to damage control. If China does not allow its currency to rise befor trouble really sets in, she is positioned for a massive hyper-inflation, just because of her massive export potential which can do nothing but accelerate during a future bubble pop and crash. If this happens, her currency should be massively re-valued, but in all likely-hood will be de-valued further - the insane non-common sense of the world's present state of fictitious capitalism. The world's market foolishness will most likely rule during the next crash if present conditions are any measure. China should start re-valueing immediately to avoid the severity of a possible future market shock - but will she?

The U.S. Fed seems to encourage China's profligate path by possibly worrying more about real global deflation being the more serious problem - it is - but the Fed is caught in quite a conundrum. It can't raise rates for fear of deflation, yet it needs to set a better example for China's policy makers to take the right currency course. It is in the entire world's best interest, as well as China's, to re-value its currency befor it's too late for all of us. Even if the Fed did raise rates it would more than likely exacerbate the problem with China's currency stance, as it would simply make it more profitable for her to buy more treasury bonds and bills to continue further defense of its peg on the cheap, so we're in quite a pickle. My advise would be for all the world's central bankers to strong-arm China into re-valueing its currency, or the rest of the world simply re-valueing it for them - this is too serious a situation to let fester any longer. We have a choice - either develop the courage to solve the problem or go down with the sinking ship. It's too bad the world has to be so cowardly, not to do the necessary re-alignment of currencies - and I mean the serious re-alignment of all the world's currencies.

Now, many will argue that China can not hyper-inflate in its present deflationary stance. It is true that the majority of the country has a massive excess labor supply, and real lack of internal demand, contributing to holding it for the forseeable future in real deflation. I do not hold this view, as any economic history has shown, when a nation enters a true market collapse entirely new dynamic forces take over. These new forces of real inflation, mostly created by foolish emergency thinking, ie, under-valueing the currency by world markets when it should be re-valued - herein lies the problem. My guess is this will happen again if history is any guide. Markets act foolishly in dire emergencies - fear, extreme speculation, and capital flight guarantees this.

Now, others will argue that derivatives will hold the markets more in balance this time around. I do not believe this either, as market fears can overcome any insurance system ever devised by the simple mind of man - market history should be our true guide. Derivatives are only forward contracts in new clothes and fancy hats. Markets of fear will chew up any new ideas known to the minds of us all.

This is only a warning - I do not know whether China can survive the future in tact or not. It just doesn't look good to me - all around. I do know positively - we need true and full global currency reform - ASAP. ...And not that I agree with Auerback completely, as I do not, but he comes close to my thinking in many areas - have a look.

Nobody Can Stop This Runaway Train

....We cite these examples to illustrate that something is clearly giving way: pressure is building for the Fed to remove its overly accommodative monetary stance - despite the open recognition and admission by them that there is no easy way to back out of the credit morass they have created and nurtured over the past decade.

The risk, of course, is having read this report or seen references to it in the financial media, the leveraged speculating community may begin to try to hasten the arrival of some of these risks by betting the Fed has no easy way out, starting with a bet on a “spike in yields and volatility in the US Treasury market” which “could also trigger a widening of credit spreads”, as the IMF document suggests. If in fact aggressive professional investors do anticipate such repercussions, and begin to put on trades to benefit from them, they will have a good chance of initiating a self-fulfilling prophecy which would place the Fed in even more of a policy pickle. Such policy dilemmas, after all, can be the means to make a killing, as George Soros illustrated when he took on the Bank of England in 1992 in its sterling defence.

But they can also be the means to further huge financial disruptions, as any Asian policymaker around during the late 1990s can attest. Thus far in the US, credit expansion has proven so virile over the past two years that if the dynamics of the recent economic recovery become cumulative or self reinforcing, it may persist through a multi year expansion and the ultimate fallout could be much worse.

What are the driving factors here? For one thing, the recovery of house prices in the US since the days of “recession” in 2001 has metamorphosed into a fully-fledged real estate bubble. The re-establishment of a positive trend in equity prices has set into motion once again the full dynamics of rational destabilising speculation, except that, this time around, participants (as Leon Cooperman recently illustrated) no longer believe in the fantasies of new era never ending growth and profit miracles but are playing along cynically only because the Fed has orchestrated everyone else to do so.

Cynically gaming a self fulfilling prophesy is surely a difficult and dangerous exercise. As for the US balance-of-payments and current account with the rest of the world, in such an environment Goldman Sachs’ chief global economist Jim O’Neill has simulated a likely outcome with US external debt, now at a hefty 25 per cent of GDP, rising into the 40 per cent – 50 per cent range - a level that is characteristic of LDC debt delinquents.

But how can the current dynamic be halted? How, for example, does one stand in the way of a housing bubble mischaracterised by Franklin Raines, as a “piece of the American dream”, even though the explosive growth in mortgage finance has, as our colleague Doug Noland has vividly demonstrated, become a hugely destabilising part of the American financial landscape? In this case, the ultimate investor purchases an instrument which he believes to be government guaranteed; consequently, the entire private credit risk is believed to be socialised through GSE intermediation or insurance. For all of the tough talk now meted out by Treasury Secretary Snow, or various members of Congress, when the crunch comes, will the government truly withdraw this implicit guarantee?

In fact, it is almost nonsensical to speak of a “credit system” in the US any longer, since the use of the term “system” implies that there is some underlying rational structure, ultimately controlled by a responsible regulating entity, such as a central bank. As Doug Noland has illustrated time and again, this is a completely fictional construct: the whole US system today in effect works toward credit “dis-intermediation”, rendering some form of external constraint virtually impossible. Asset backed securities, convertible bonds, financial commercial paper, structured finance, the proprietary desks of the commercial banks, and the hedge funds all slice and dice credit out of any recognisable classical form that is still taught in Economics 101 textbooks: we see nothing more than acts of financial engineering, which eventually drive a wedge between the ultimate borrower and the ultimate lender so as to render the whole process unrecognisable.

Similarly, the use of derivatives, particularly those of the OTC variety, are of such complexity and opacity, that it is virtually impossible for the market to exert any kind of discipline, since most do not understand the nature of the credit or the complexity of the risk being held in the portfolio, thereby engendering mis-pricing in the risk premiums. By the same token, for regulators to understand and thereby deter a huge potential source of destabilising financial speculation (assuming, of course, that they want to deter, which is questionable in the case of the Fed), they need to have some understanding of the underlying instruments which are the source of so much financial destabilisation. But in most instances, the authorities seem reluctant or unable to tackle the problem (as the examples of Enron and Parmalat vividly illustrate) until disaster strikes. So it is absurd (for the Fed in particular) to laud the use of derivatives as (in the words of Mr Greenspan) “more calibrated than before to not only reward innovation but also to discipline the mistakes of private investment or public policy”, when neither the market participants, nor the regulators, can properly calibrate the risks involved.

For all of the warnings of the IMF, it is clear that in today’s environment, both the Fed, and the leveraged speculating community whose interests it persistently champions, may have more instruments to keep the credit spigot open than most of us realise. This is why the rise in commodity prices has been so telling: something is finally cracking in the system in spite of persistent denials of its relevance. Whether this is occurring because of the increased activities of leveraged hedge funds or a surge in genuine end-user demand is almost beside the point because both are two sides of the same coin: global liquidity run amok. China is a prime example of this two-sided coin, as this where some of the consequences of the US policy strategy are being felt owing in part to the dollar/RMB peg. The unsustainable boom in productive capacity creation there (and the corresponding parabolic rise in commodity prices) can be traced back to the Fed-induced borrowing and spending boom over here, and the rock-bottom financing rates for risky ventures enabled by the sharply positive yield curve, precisely the sort of issues touched on by the IMF report. But no amount of warning, however well intentioned, is going to stop this runaway train until the wreck inevitably occurs. ...Link

An Addition: Kurt Richeb├Ącher - Policy Traction

“Policy traction” is an expression that lately has come into fashion. In essence, it refers to the relationship between the size of the monetary and fiscal stimulus injected into an economy...and its effect upon economic growth and employment.

In the past three years, America has experienced an interest rate collapse, a record fiscal stimulus and the loosest monetary policy imaginable...all of which fueled money and credit creation at a scale that has no precedent in history. Has it really worked?

Well, in one way this policy of stimulus has had fabulous traction: It has engendered the greatest credit and debt bubble in history. Total outstanding debt, financial and non-financial, in the United States has ballooned by almost $6,500 billion since 2000, as against GDP growth of $1,238 billion. For each dollar added to GDP, there were about six dollars added to indebtedness. ...Link

In an earlier post I mentioned speculative increases being related to the massive expansion in the derivatives markets. Maybe the two above posts add some clarity to my positions. At least I hope so.

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