Monday, February 28, 2005

Federal Reserve Governor Ben Bernanke: Warnings?

Federal Reserve Governor Ben Bernanke: Doug Noland

And the counterpoint view to this article: The Overstretch Myth

“The current account deficit is a concern. What that is basically – there are two ways of looking at the current account deficit. One is looking at it from the trading perspective, which most people are familiar with the idea that we are actually importing a lot more than we are exporting. So, in that sense we have a current account deficit. But another way to look at it is that we are investing more than we’re saving. If you look at investment in terms of capital investment by firms, you look at residential investment - that is building new houses. You have seen a lot of investment but we have a relatively low savings rate. And so, having a low savings rate, we have to borrow from foreigners to make up the difference between our saving and the investment we want to do. So, what’s called capital inflows – the money flowing in from foreigners to finance our investment is another way of looking at the current account deficit. So these different perspectives give you different ways of thinking about how you would address this problem. The trade perspective says, yes, part of the issue is getting balance in our trade. And that suggests that we should work with the world trade organization and other trade agencies to try to get fairer and free trade with other countries... On the other side, we have the savings and investing perspective. We have relatively low savings, we have a federal deficit which is subtracting from our savings. And that suggests that part of reducing the current account deficit would be to try to stimulate our savings. Reduce the deficit and take other actions that would increase our savings and therefore reduce capital inflows that are coming in – which is the other face of the current account deficit. Depending how you look at it, there are a variety of policies that should be undertaken. I think the current account deficit is going to be with us awhile. It will take a while to unwind. It can’t go on at this level for ever. It is going to eventually have to come down. And I think it will eventually come down. But policies like increasing our savings would probably be a step in the right direction to help that happen.”

The U.S. economy generates $600 billion-plus Current Account Deficits because we “invest” so much? Such econobabble from a prominent central banker does not inspire confidence. And, more than ever, instilling dollar confidence is an imperative. Tuesday the dollar was hammered on news of the Bank of Korea’s plan to diversify its dollar-denominated reserves. There was also the revelation of an Asian policymakers meeting this week to discuss “global economic imbalances” and how to deal with the faltering dollar. And from today’s Australian: “[Australia’s Treasurer] Peter Costello’s closest advisor fears the US is heading for a devastating financial crash that could ravage Australia’s economic growth. …Treasury Secretary Ken Henry likened the flood of money pouring into the US to support its budget and current account deficits to the stockmarket’s dotcom bubble of the late 1990s. Were it suddenly to stop, there would be shockwaves felt throughout the world’s economies.”

Languish over the likelihood that the U.S. is on course to precipitate global financial crisis has spilled out into the open. This is surely related ot the heightened appreciation by market participants and global policymakers that the Federal Reserve is not up to the task of reining in U.S. financial and economic excess. Moreover, the much anticipated marketplace-induced adjustment process has failed to materialize. Indeed, exuberant global markets and propagating asset Bubbles ensure a calamitous future “adjustment.” Global policymakers and central bankers should be apprehensive.

The weak dollar has certainly failed to rectify or even slow imbalances – global, domestic or otherwise - and there is little prospect that further devaluation will be any more successful. In the past, a weak currency would induce higher market rates – rates necessary to tighten financial conditions, temper over-consumption and undermine speculative dynamics. Yet the old rules no longer apply to contemporary finance, a momentous blow to the capacity for orderly market-based corrections and adjustments. The need for strong-minded central bankers to guard against inexorable market distortions has never been as great, while, ironically, never has a central bank (the Greenspan Fed) placed greater faith in the efficiency of market processes. And Dr. Bernanke’s comments above suggest that policy efforts to constrain American consumption aren’t on the table – “consumption” being a four-letter word not even open to discussion. Accordingly, the prospect of the Fed purposely precipitating a meaningful economic slowdown to assist the U.S. Current Account Deficit “unwind” is nonexistent. Commencing the arduous process of reestablishing Monetary Order is, then, at a logjam.

This week from Morgan Stanley’s Stephen Roach: “Global rebalancing does not occur spontaneously. It takes adjustments in economic policies and asset prices to spark a meaningful realignment in the mix of global growth. Shifts in currencies and real interest rates are the two major instruments of rebalancing… In the end, it will also require a narrowing of the growth differentials between the US and the rest of the world… A narrowing of the growth spread between the US and the rest of the world is key for a resolution of America’s trade- and current-account imbalances.”

These excerpts do not do Mr. Roach’s exceptional analysis justice; they instead provide the opportunity to distinguish the focal points of my analysis: I have reached the point of having lost what little faith I had in the efficacy of “global rebalancing.” Imbalances simply cannot be rectified by heady non-U.S. global growth. Such a scenario would ensure myriad problematic bottlenecks, shortages and price pressures including significantly inflating global energy and commodities prices. At the same time, global policymakers – especially the Fed – refuse to take decisive action. They respectively missed their opportunities to act. The costs and risks are these days much too high for aggressive policy response – individually or in concert. There is no will to face The Bubble Issue.

Importantly, asset inflation has become a global systemic issue. Mortgage Credit is growing at double-digit rates in the U.S., Europe, and China (and elsewhere). Meanwhile, speculative securities leveraging and attendant liquidity creation is endemic internationally, and there is no international body or coordinated central bank policy response to moderate – let alone rein in - Global Wildcat Finance. Resulting uncontrolled liquidity excess is The New Global Phenomenon, nonetheless central bank balance sheets balloon on the back of unrelenting dollar flows. It is amazing that marketplace perceptions of quiescent inflation persist in the face of today’s unparalleled global backdrop of abundant liquidity and Endemic Easy Credit Availability.

Importantly, global interest rates have converged like never before, and they have consolidated right down toward artificially low U.S. levels. Moreover, the massive international liquidity pool offers an overhang of constant downward pressure on the converged price of global finance. Less appreciated but no less significant, financial systems internationally have “converged” toward the U.S. model. Depressed interest rates augment already intense worldwide asset-based lending and securities speculation, only exacerbating the Global Liquidity Bubble. The dysfunctional U.S. Credit system has now fully impaired the global financial system, leaving faint hope that market pricing mechanisms will instigate either a gradual or orderly “adjustment process.”

The bottom line is that the entire spectrum of international rates – the global price of finance - needs to shift meaningfully higher. This amounts to the only effective policy measure to rein in asset-based lending and speculating excess. The dilemma is that central bankers from the ECB to China and Asia are frozen by the vulnerable dollar and the prospect of financial crisis. To raise rates would only incite greater financial flows away from the U.S. and its ailing currency. There is, as well, the issue of massive speculative leveraging throughout. The Fed is locked into a policy of “baby steps” that ensures that U.S. rates at best stay barely a half-step ahead of rising inflationary pressures, while inciting only greater speculative excess.

There is much written these days referencing “real” and “neutral” rates, but these notions have little practical meaning without an effort to factor in asset inflation. Asset prices are, after all, the centerpiece of contemporary Credit and liquidity creation. To instead fixate on CPI – the misplaced contemporary inflation target – guarantees ineffectual monetary management. Having succumbed to this analytical misjudgment and, in the process, having fallen so far behind the curve, there is now the prospect that much higher Fed funds may be required to garner any meaningful impact on U.S. and global excesses and imbalances.

Dr. Bernanke is deluding himself if he actually believes that stronger global growth and more equitable trade treaties and practices will work to rectify our Current Account Quagmire. I also think he is too optimistic in expecting that today’s deficits can be sustained “for awhile” and “take awhile to unwind.” The inevitable adjustment period will commence only with the problematic bursting of the Mortgage Finance Bubble; no more, no less. And, not surprisingly, this Mighty Bubble scoffs at Cowardly Little Baby Steps. Are speculators suffering from higher financing costs? Are 4% ARMs to dissuade manic California, Florida, or Manhattan mortgage borrowers? Then how about even lower teaser and interest-only mortgages? And let’s not forget that 2004 saw the greatest inflation of home equity in history, and it’s there just waiting to be tapped to upgrade to a more appealing residence or to boost consumption. January then brought another $10,000 windfall to the average California homeowner. Credit conditions are easier today than they were a year ago – or ever were.

My fear that we are heading toward financial crisis is not rooted in the mindless ranting of an embittered permabear – but from the discipline of my analytical framework. The U.S. Credit Bubble is creating unrelenting and unwieldy dollar liquidity that continues to inundate global financial systems. The marketplace pricing mechanism for global finance is severely impaired, while speculative dynamics are empowered. Excess is only begetting greater excess, and policymakers, meanwhile, function like deer caught in headlights.

The question I ponder this evening is how this expected crisis manifests. Does it unfold first in the currency or interest-rate markets? Is it precipitated by a spike to $60 or $70 crude and a panic “melt-up” in global commodity markets? What market “accident” could set off a chain reaction of speculator unwind? Are spreads an accident in wait? The ten year? MBS? And, of course, the dollar is certainly vulnerable to a marketplace dislocation, although we can also assume that global central bankers are now on heightened alert. I will admit to being absolutely intrigued by the degree of complacency that is now ingrained in The Bulletproof Bond Market. All the recent talk of a shortage of bonds recalls major Bubble tops of years past. The reality of the situation is that it would require only a marginal bout of de-leveraging to create way more than adequate supply.

Out of Aces - 1907

Thursday, February 24, 2005

Wednesday, February 16, 2005

Debt Trap Dynamics: Time To Think The Unthinkable

Marshall Auerback

With the government and external deficits both so large and the private sector so heavily indebted, it is said that satisfactory growth in the US cannot be achieved without a large, sustained and discontinuous increase in net export demand. After perusing the trade data from last year, it is doubtful whether this will happen spontaneously through a continuous fall in the external value of the dollar, and it certainly will not happen without a cut in domestic absorption of goods and services by the US which would impart a deflationary impulse to the rest of the world.

The truth of the matter is this: Across three decades, only one economic event has been guaranteed to produce balanced US trade: a recession. When the economy is contracting, people naturally buy less of everything, including imports. Historically, on the four occasions when the line of exports briefly converged with the line of imports in the post-war period, the country was in recession. Each time economic growth was restored, the trade deficits resumed. A more ominous contradiction occurred during the 2001 recession: The trade gap was so enormous it persisted throughout. Again, in 2004, despite a significant fall in the dollar’s trade weighted index, the external account continued to haemorrhage. This suggests that American dependency on foreign producers has advanced to a dangerous new level.

Economists, politicians, and business executives have repeatedly voice unease about the imbalances in the global financial system, which have been reflected in the dollar's steep fall against the euro and other currencies until recently. But most expressed skepticism that the Bush administration would reduce the trade and budget deficits, which have fed those imbalances. The White House has said that it does not view these issues as a major problem because foreigners still view the American economy as an attractive investment, and Mr Greenspan has recanted some of his earlier expressed concern about the dangers of ignoring America’s mounting imbalances.

The scope of the global imbalances and the potential for crisis makes piecemeal, orthodox solutions to the global imbalance problem unworkable and far too slow. The U.S. service-based economy, with more limited economies of scale than those of newly industrializing economies such as China, will not be able to export its way out of the problem. The only demand left for US goods is largely concentrated in industries such as aerospace and high technology. But these are industries where exports pose national security risks, particularly if the exports are directed toward “strategic competitors” such as China, which generally have extremely poor records in terms of safeguarding intellectual property rights.

As we have noted many times before, there is a danger that over time, the US economy will find itself in a “debt trap”, with an accelerating deterioration in its net foreign asset position and its overall current balance of payments (as net income paid abroad begins to explode). We have never been in a position before where the world’s leading economy has been subject to this condition, so it is difficult to make the case for traditional remedies, such as trade devaluation (where the corresponding knock-on effects would invariably create a huge international growth shock, thereby throwing into doubt the strategy of the US achieving net export growth). Because the US is such a vast economy, it cannot eliminate its current account deficit as readily as a smaller economy. When it tries to improve its trade balance through devaluation or through restrictive demand management, its sheer size affects the economies of its trading partners adversely and to an appreciable degree. Understandably, they object and resist. When foreign economies resist dollar devaluation and the dissipation of their current account surpluses, the U.S. may have to raise interest rates in order to induce creditors to continue financing its debt build-up.

So the problem is likely to get worse, which could ultimately lead to “solutions” that prove highly disruptive to the existing system of multilateral trade and cooperation which has developed over the past several generations. A resort to out and out military force cannot ultimately be ruled out.

If a full-blown crisis does occur, the macroeconomic challenge would be unlike anything the United States has faced in more than half a century. While this would be a time of wrenching, painful change, the new adverse circumstances might also inspire a great shift toward radically different political solutions than have hitherto been considered within the realm of acceptability.

The first imperative--an unavoidable necessity--would be to suppress consumption through credit-restraining measures, fiscal caution or tax reform, and to stimulate greater domestic savings, yet somehow to keep the economy growing. If this great adjustment is left to market forces alone, the predictable consequences will be to punish the innocent--struggling households and small businesses--first.

The jump-shift strategy may ultimately take the form of a “wartime strategy” – not the phony “war on terror” strategy invoked after the September 11, 2001 attacks (in which Messrs O’Neill and McTeer, amongst others, exhorted Americans to go back to the shopping malls, to show the terrorists that they “couldn’t win”). A more accurate precedent is World War II, an extraordinary era of economic development that virtually shut down many forms of domestic consumption (cars and housing) while the government's spending on war production launched major new industries (electronics, petrochemicals, modern aircraft and many others). Essentially, accelerated investment and forced savings replaced consumer spending as the leading fuel for economic growth. After the war, pent-up desires and needs became the economic demand that drove the long postwar era of prosperity.

Of course, an important difference from the World War II example is that it is difficult to see how reconstruction could be financed primarily through deficit spending, given that the country is already burdened by growing indebtedness. This leads to the possibility of the US repudiating its existing debt obligations to external creditors. A decisive President might start by bringing up a taboo subject--tariffs--and inform the world that the United States is prepared to impose a temporary general tariff of 10 or 15 percent on all US imports. Every multinational would have to rethink its industrial strategy, because some of its production might be stranded in the wrong country.

The idea of tariffs is so alien to conventional wisdom it probably sounds illegal. In fact, there is provision for “temporary adjustments” under the new World Trade Organisation rules. It is also worth noting in any case that the legal technicalities of a global multilateral system didn’t stop Richard Nixon, who stunned the world in 1971 when he abruptly announced a 10 percent import surcharge, devalued the dollar and unilaterally discarded the Bretton Woods monetary system. Nor did it stop President Roosevelt in the 1930s, during which he declared it illegal to own circulating gold coins, gold bullion, and gold certificates. In essence, the federal government forced itself into the position by refusing to repay its bond holders in gold coin, forcing them to accept US dollars instead. Hence, subsequent to FDR’s executive order, all holders of such bonds were forced to accept legal tender currency instead of "gold coin of the present standard of value." The act of confiscating gold itself was a violation of private property rights and was illegal – but the taboo was broken. As author Eric Englund notes, “[B]y not paying bondholders in gold coin, the U.S. government has technically defaulted on past Treasury bond obligations.” Americans (and their foreign creditors) might come to see more of these types of actions from future American President.

It is true that such actions on the part of the US may well provoke reactions in kind. On the other hand, given the lack of restraint evident in the country’s current foreign policy aspirations, it is hard to envisage that an economic response to the Americans’ abrogation of existing obligations would come without some possibility of a robust military response (or at least the threat of one). The US has already show itself willing to address the problem that it does not make enough of what the rest of the world wants by going to war to monopolise control of the supply and distribution of what the world needs, petroleum. There are other war aims, of course, but control of the global hydrocarbon net is certainly the most important. As market strategist Chris Sanders has noted, “The truth is that the dangerously destabilising idea has rooted in Washington that, in the words of Vice President Cheney, ‘deficits don’t matter (we proved that in the 90s).’ He is right of course in pure power terms; a fuller expression of Cheney’s dictum might well add, ‘as long as we are able to force everyone else to accept them (deficits).’”

Already, it appears clear that the US is driven to rely more on military adventure because the economic house is in disarray and "overstretched". They can't just bludgeon their way economically anymore. They have to use the stick. Any close look at the inauguration speech bears out the reliance on forcing the world to conform to us dictates. Why should this not extend ultimately to existing debt arrangements if the US finds itself facing an Argentina-like predicament? All these outcomes may sound quite improbable at this moment. Certainly, the establishment would brush them aside. But do not dismiss the possibility that dramatic change and epic political reforms lie ahead. As we have said many times before, Washington’s elites will not go down without a fight.