By Simon Grey, on December 14th, 2011
The tax plan proposed by Republican presidential candidate Newt Gingrich would add $1.3 trillion to the U.S. budget deficit in 2015 alone, a new analysis shows, complicating his goal of balancing the government’s books. [That’s an understatement, to say the least. –ed.]
The analysis by the nonpartisan Tax Policy Center compares the federal government’s take under Gingrich’s proposal with projected U.S. revenue if current tax law ran its course and existing income tax cuts expired as scheduled after 2012.
Here’s the thing: Federal expenditures are always paid for by productive people. Always.
The options for funding are direct taxation, inflation, and debt. The taxing effects of direct taxation are obvious and well-known. The taxing effects of inflation, however, are a little more pernicious because they aren’t felt right away. In fact, some even find inflation to work as a subsidy. However, inflation causes the nominal price of goods to rise, generally before most people see their income rise at a corresponding rate, and the difference between increased prices and increased income is effectively a tax. And then debt is simply taxation deferred, wherein bonds are sold under the implicit promise that the government will pay them later, generally by direct taxation.
The key to actually reducing taxes, then, is to first reduce real spending, elsewise taxes will never truly go down. At best, they will simply be time-shifted. Thus, Gingrich’s tax proposal is nothing more than a farce because tax cuts are not accompanied by spending cuts. And, until taxes and spending are cut in tandem, Gingrich should be viewed only as a slimy charlatan, and nothing more.
By Ajay Shah, on October 24th, 2011
Suppose a government tries to boost demand in the economy by boosting the deficit.
A fascinating feature of the situation is: Households are not wood, households are not stones, but men. And being men, they will look forward, they will optimise. Households know that all government expenditure requires taxation: all that is achieved by running a deficit today is postponing taxes to tomorrow.
India’s fiscal stance is now likely to lead to increased taxation in the future. We have a nice wide deficit today, but it’s increasingly likely that fresh taxation will come up in the future.
A core feature of human beings is that we do not like to deal with fluctuations in our consumption. So faced with the prospect of taxation tomorrow, we are prone to cut back on consumption today.
Through this, when a government raises the deficit today, some of this effect is counteracted by households that pull back on expenditure. Raising the fiscal deficit is less expansionary than some would think.
Economists have a fancy name for this: it’s called Ricardian Equivalence. This was originally thought up by David Ricardo, but made famous by Robert Barro. It is one of the many ways in which forward looking households are of essence in thinking about macroeconomics. “You are not wood, you are not stones, but men; and being men, you will optimise”.  
By Doug Gentry, on July 20th, 2011
This is a time of the year when I meet new people or get reacquainted with old friends, and once we run out of the usual “status update” conversation, someone often asks about the economy and the current crisis about the debt ceiling. I’m going to break a self-imposed guideline for this blog, and actually represent my opinions in a pretty straightforward manner. Usually my goal is to help students reach their own, informed opinion. This time – straight to the punch line…
- The 2011 deficit (estimated at $1.5 trillion) and the accumulated national debt (over $14.3 trillion) are not the most pressing economic issues facing the country right now. They are important, but several notches down from the top of the list. This year’s deficit is just over 10% of GDP, which is high, but not crushing. There are ways to deal with these issues, as I’ll share further down. They are presented as a crisis only because the Republican Party and the Tea Party are using them to push a small government agenda. While I don’t agree with that goal, it’s fine for some to support it, but holding the economy hostage by manufacturing a crisis tied around the debt ceiling makes no sense.
- Investment in economic growth has slowed dramatically. This is particularly true in education – at all levels. It is also true in basic research. Up until the last 20 years or so the U.S. has surfed the wave of economic change, by investing in new thinkers, and making infrastructure and other investments that will improve productivity. These seem left out of current debate options.
- The slow recovery and weak demand for goods and services is the number one problem facing the country. The Federal stimulus is winding down, the Federal Reserve has decided that they don’t need more quantitative easing, and government at all levels is cutting employment. All the while personal consumption dropped in the most recent quarter, along with the fixed asset portion of Investment (inventories increased as a partial offset.) The uptick in unemployment and the very slow growth in employment drags down demand for goods and services. We are sliding down the same hill that the U.S. economy did in 1937-38, when Congress and President Roosevelt worried more about public concern for the debt than about sustained growth. Then we slid into a quick, nasty recession. That’s a danger now, too.
- Inflation is not a pressing problem. The inflation we have seen this year is in food/commodities and energy. The food price spiral might well continue for awhile – I don’t have an independent sense of the true drivers. Even if food prices rise there are other elements of the Consumer Price Index that are holding steady. The rising energy prices are probably related to uncertainty about political conditions in the Middle East. Those concerns should soften soon.Inflation is something to watch out for, particularly with all of the money created by the Federal Reserve in the last three years – money created to help stabilize the economy. It is important that the Fed watch for signs of incipient inflation, driven by very high money supply, but I am confident they will act correctly and aggressively when that happens. That point is not now.
- Bond investors are not abandoning US Treasuries for fear of default. US bonds respond to typical market forces, though they have an element of future gazing in them. If you hold a 10 year bond, and a potential buyer thinks the US might default on that bond, then the buyer will expect a higher yield (lower price/higher interest rate). That isn’t happening now. The bond market for US Treasuries is not showing signs of investors being worried about US debt.
So, what to do….
- To tackle the most pressing problem – the slow recovery – the Federal government should be stimulating demand, through more government spending (on the part of Congress) and more quantitative easing (on the part of the Federal Reserve). Tax cuts can be part of this but they should not be across the board. The most effective, stimulative tax cut on the Federal level is the payroll tax for Social Security and Medicare. Those funds need help, and there are ways to fix them, but a payroll tax benefits mostly working people who will use the increased take home pay to consume.
- To help with the deficit, we should remove the Bush tax cuts, and speed our exit from Iraq and Afghanistan. The Bush tax cuts disproportionately benefited higher income families, who use the extra money for non-consumption activities. When some politicians complain that raising taxes on the wealthy takes money away from job creators, there is no empirical evidence and scant theoretical basis for that claim. Along with repealing those tax cuts there are plenty of opportunities to strengthen the tax code and reduce the dreaded loopholes. Despite what many politicians say and the media parrot, this is not hard. It just takes clear headed thinking and political courage.
- The real budget deficit challenge, at the Federal and State levels primarily, is the cost of healthcare. Increasing costs and inefficient uses of services put pressure on Medicare, Medicaid (which impacts states as well), the VA, the Dept. of Defense, and government employment costs at all levels. We should be strengthening and extending the healthcare reform efforts beyond just extending coverage – to include incentives for cost efficiency and efficacious treatments.
- Restore and enhance funding for education at all levels. Resist the temptation to make education accountable on a short term basis, while hobbling it from producing the long term benefits derived from basic research and liberal arts education. This is an area in particular where Federal spending, even if they result in deficits, is a good investment. Cutting taxes on the wealthy is not a good use of a deficit. Deficit spending should support short term stimulative needs and long term productivity enhancements.
By The Gold Report, on May 2nd, 2011
 One sure upshot of the quantitative easing money flooding the stock market will be further distortions, chaos and unpredictability that make the value-investing proposition difficult, if not impossible, according to Casey Research Chairman Doug Casey. On the eve of a sold-out Casey Research Summit in Boca Raton, Florida, Doug returns to The Gold Report. In this exclusive interview, he warns, “Like it or not, you’re going to be forced to be a speculator.”
The Gold Report: When the average investor turns on the news, even on financial channels, they hear that the U.S. economy is in the best shape it’s been in for three or four years. While the experts say the recovery is slower than anticipated, they expect its slow recovery will equate to a long, slow growth cycle similar to that after World War II. You have a contrary view.
Doug Casey: The only things that are doing well are the stock and bond markets. But the markets and the economy are totally different things—except, over a very long period of time, there’s no necessary correlation between the economy doing well and the market doing well. My view is that the market is as high as it is right now—with the Dow over 12,000—solely and entirely because the Federal Reserve has created trillions of dollars, as other central banks around the world have created trillions of their currency units. Those currency units have to go somewhere, and a lot of them have gone into the stock market.
As a general rule, I don’t believe in conspiracy theories and I don’t believe anything’s big enough to manipulate the market successfully over a long period. At the same time, the government recognizes that most people conflate the Dow with the economy, so it is directing money toward the market to keep it up. Of course, the government wants to keep it up for other reasons—not just because it thinks the economy rests on the psychology of the people, which is complete nonsense. Psychology is just about the most ephemeral thing on which you could possibly base an economy. It can blow away like a pile of feathers in a hurricane.
TGR: So, you’re saying we’re confusing the market’s performance with the economy’s performance?
DC: Yes. The fact is that the economy, itself, is doing very badly. The numbers are phonied up. I spend a lot of time in Argentina. Anybody with any sense knows you can’t believe the numbers coming out of the Argentinean Government Statistical Bureau, nor can you (any longer) believe the numbers that come out of Washington D.C. The inflation numbers consider only the things the government wants to look at and are artificially low. It’s the same with the unemployment numbers. None of these things is believable.
TGR: Isn’t the unemployment figure a lagging indicator of a rebounding economy?
DC: If you look at the way unemployment was computed until the early 1980s—something that John Williams from ShadowStats does—the numbers would indicate about 20% unemployment today. Besides, even while the population keeps rising, the number of people reported as actually working is level or even lower. Most indicators of the economic establishment, in my view, don’t really make any sense. GDP, for instance, includes government spending—much of which amounts to paying some people to dig ditches during the day and other people to fill in for them at night. So-called “defense” spending is almost totally wasted capital. The practice of economics today is pathetic and laughable.
TGR: So, the economy is not rebounding?
DC: No. My take on this is that we entered what I call the “Greater Depression” in 2007. And now, because the government has printed up trillions of dollars in the last couple of years, we’re in the eye of the hurricane. We’ve only gone through the leading edge of the storm. People think this will just be another cyclical recovery like all the others since WW II. But it’s not. It’s going to wind up with the currency being destroyed. It’s going to be a disaster. . .a worldwide catastrophe.
TGR: You indicated that the government is using these mass infusions of made-up money to prop up the stock market due to the psychological factor—that people will think the economy’s doing well because the market is doing well. However, we hear that a lot of that money has been caught up in the banks. Would you comment on that?
DC: As I said, that money has to go somewhere. The banks have been borrowing from the Fed at something like 0.5% and investing it in government securities at 2%, 3% or 4%, depending on the maturity. So, much of that money has been a direct gift to the banks; and they’re basically making an arbitrage spread of 2%–4%. So, yes, that’s happening with some of the money. Still, it doesn’t all just sit in these Treasury securities. A great deal of it, inevitably, goes into the stock market.
TGR: You also said that psychology isn’t the only reason the government wants to see the stock market go higher.
DC: Right. Pension funds have a great deal of their assets in stocks. Certainly, many funds run by government entities, such as the state and city employee pension funds, are approaching bankruptcy despite the fact that the Fed has driven interest rates to historic lows, artificially pumping up both stocks and bonds. And, I might add, keeping property prices higher than they would be otherwise. When interest rates rise eventually—and they will go up a lot—it’ll be something to behold in the markets.
TGR: You mentioned John Williams who’s in your speaker lineup for the Casey Research Summit, The Next Few Years. Another of your speakers is Stansberry Associates Founder Porter Stansberry, who’s been making two points about the devaluation of the U.S. dollar. One point he makes in his The End of America video concerns the quantitative easing (QE) you mentioned—those trillions of dollars. But Porter also anticipates the U.S. government announcing a devaluation of the currency similar to what England did in 1970. Do you see that type of scenario occurring, as well?
DC: When the U.S. government last officially devalued the dollar in August 1971, it had been fixed to $35 per ounce to gold. In other words, before that, any foreign government could take the dollars it owned and trade them in at the Treasury for gold. Nixon devalued the dollar by raising it to $38/oz., and then to $42/oz. It was completely academic, anyway, because he wouldn’t redeem gold from the Treasury at any price.
But because the dollar isn’t fixed against anything now, the government can’t officially devalue it. It’s a floating market. The government’s going to devalue the dollar by printing more of the damn things and letting them lose value gradually—actually the loss will no longer be gradual, but quite fast from here on out. But it’s not going to do so formally by re-fixing the dollar against some other currency or against gold. I’m not sure Porter’s phrasing it in the best way, but he’s quite correct in his conclusion and his prescriptions as to how to profit from it. At this point, the dollar is nothing more than a floating abstraction, an IOU nothing on the part of a manifestly bankrupt government.
TGR: Another abstraction is the fact that the Treasury says the money it is printing has a multiplier effect when it gets into the U.S. economy, so it can pull those dollars back when the time comes. Is that a viable alternative to offset the devaluation caused by printing more money?
DC: You have to look first at the immediate and direct effects of what the government’s doing, and then at the delayed and indirect effects. And sure, just as it’s injecting all this money into the economy—mainly by the Fed buying U.S. government bonds—theoretically, it can take it out of the economy by doing the opposite. But I just don’t see that happening.
TGR: Why not?
DC: One of the reasons is that the U.S. government, itself, is running annual trillion-dollar deficits as far as the eye can see. I think those deficits will go higher—not lower. So, where’s that money going to come from? Where will it get trillions of dollars to fund the U.S. government every year?
China isn’t going to buy this paper and Japan will be selling its U.S. government paper because, if nothing else, it’ll need to buy things to redo the northeast part of the country. Nobody else is going to buy that trillion-dollar deficit either, so it’ll have to be the Federal Reserve. In fact, the Fed will have to buy much more and, therefore, create more money. That’s what happens.
TGR: This currency crisis isn’t unique to the U.S. You just brought up Japan. And aren’t all the European countries doing the same thing?
DC: The U.S., unfortunately, is not unique. This is going to be a worldwide catastrophe. It’s been a disaster for every country that’s done this in the past—Zimbabwe, Germany, Hungary, Yugoslavia and countries in South America—but those were within only those particular countries. In most of those cases, people never trusted their governments; so, they had significant assets outside the country in a form other than the local currency. The problem now is that the U.S. dollar is the world’s currency and all of these central banks own USDs as the backing for their own currencies. All these other countries will wind up finding that they don’t have any assets after all. That’s going to happen all over the world.
TGR: With countries around the globe facing the same issue, should anyone hold currencies?
DC: No. Sure, you need local currency to go to the store and buy a loaf of bread. But for liquid assets you’re trying to save, it’s insane to own currencies at this point because they’re all going to reach their intrinsic value. I’ve been recommending for many years that people buy gold and own gold for their savings—serious capital they want to put aside in liquid form. With gold now over $1,500/oz. and silver at $48, people who followed that advice have made a lot of money. That’s the good news. The bad news is that very few people have done so. Newbies to the game are paying $1,500/oz. for gold. It’s going higher, but it’s no longer the bargain that it was. The important thing to remember, though, is that gold is the only financial asset that’s not simultaneously someone else’s liability. That’s why it’s always been used as money and why it’s likely to be reinstituted as money.
TGR: From your viewpoint, how does a person with any wealth preserve it during this tumultuous period other than by investing in gold?
DC: Frankly, I don’t know. I own beef and dairy cattle, which are a good place to be; but that’s a business, and it’s not practical for most people. I think it boils down to gold.
TGR: But what investments should they be looking at these days?
DC: There really aren’t investments anymore. With trillions of newly created currency units floating around the world, things will become very chaotic and unpredictable shortly. It’s very hard to invest using any kind of Graham-and-Dodd methodology when things are that chaotic. Whether you like it or not, you’re going to be forced to be a speculator in the years to come. A speculator is somebody who tries to capitalize on politically caused distortions in the marketplace. There wouldn’t be many speculators, or many of those distortions in the marketplace, if we lived in a free-market society. But we don’t.
TGR: So, speculation will supplant value investing?
DC: Well, investing is best defined as allocating capital in a way that it reliably produces more capital. The government is going to make that quite hard in the years to come with much higher taxes, much higher inflation and draconian regulations. You will actually be forced to speculate. That’s a pity, from the point of view of the economy as a whole. But I kind of like it, in a way. Few people know how to be speculators, so I should be able to make a huge amount of money in the next few years. Unfortunately, it’ll be at a time when most people are losing their shirts. But I don’t make the rules. I just play the game.
TGR: As you look over the next year or two with your speculator hat on, what sectors do you expect to experience the most distortion and, therefore, offer the most opportunity for the speculator?
DC: One sure bet is the collapse of the U.S. dollar. Always bet against the USD and you’ll be on the winning side of the trade. A very direct way to make that bet is by shorting long-term U.S. government bonds because, eventually, interest rates will go to the moon, which means bond prices will collapse.
You can also look at the precious metals because, at some point, when people panic into them, their price curves will go parabolic. Mining stocks are likely to draw a lot of money, so they could go wild as they have many times over the last 40 years.
TGR: Your summit has presentations scheduled on silver, gold, currencies, Asia, real estate, agriculture and even more. What do you expect to be the major takeaway this time?
DC: What we’re facing now is something of absolutely historic importance—the biggest thing that’s gone on in the world since the industrial revolution. Many things will be completely overturned in the years to come. What’s happening now in the Arab world, with all of these corrupt kleptocracies being challenged and overthrown, is just the beginning. We haven’t seen the end of this in any of these countries—Tunisia, Egypt, Syria, Algeria. Of course, Saudi Arabia will be the big one. Everything’s going to be overturned. And all these stooges that the U.S. government has been supporting for years could very well lose their heads. It’s going to be the most tumultuous decade for hundreds of years, bigger than what happened in the 1930s and 1940s.
TGR: Any last things you’d like to tell our readers?
DC: Yeah. Hold on to your hats. You’re in for a wild ride.
Editor’s Note: For more of Doug’s views—from his take on nuclear power in the wake of the tragedy in Japan to niche investing in upscale agricultural enterprises—check out his 4/28/11 interview with The Energy Report.
For the complete audio collection of the Casey Research Summit, click here.
Doug Casey, chairman of Casey Research, LLC, is the international investor personified. He’s spent substantial time in over 175 different countries so far in his lifetime, residing in 12 of them. And Doug’s the one who literally wrote the book on crisis investing. In fact, he’s done it twice. After The International Man: The Complete Guidebook to the World’s Last Frontiers in 1976, he came out with Crisis Investing: Opportunities and Profits in the Coming Great Depression in 1979. His sequel to this groundbreaking book, which anticipated the collapse of the savings-and-loan industry and rewarded readers who followed his recommendations with spectacular returns, came in 1993, with Crisis Investing for the Rest of the Nineties. In between, his Strategic Investing: How to Profit from the Coming Inflationary Depression broke records for the largest advance ever paid for a financial book. Doug has appeared on NBC News, CNN and National Public Radio. He’s been a guest of David Letterman, Larry King, Merv Griffin, Charlie Rose, Phil Donahue, Regis Philbin and Maury Povich. He’s been the topic of numerous features in periodicals such as Time, Forbes, People, US, Barron’s and the Washington Post—not to mention countless articles he’s written for his own various websites, publications and subscribers.
By Simon Grey, on April 19th, 2011
The House on Friday passed a Republican budget blueprint proposing to fundamentally overhaul Medicare and combat out-of-control budget deficits with sharp spending cuts on social safety net programs like food stamps and Medicaid.
The nonbinding plan lays out a fiscal vision cutting $6.2 trillion over the coming decade from the budget submitted by President Barack Obama. It passed 235-193 with every Democrat voting “no.” [Emphasis added.]
This story brings up another reason I dislike democracy. The system encourages political leaders to posture instead of actually solve problems. I do not blame politicians for working within the confines of the system. Rather, I blame the voters who have absolutely no grasp of reality. There will be plenty of people who will make a big fuss over this legislation. Conservatives will use this point out how liberals aren’t serious about addressing government spending; liberals will point out how this measure doesn’t actually address government spending either (because it’s non-binding), and the problem will remain unsolved. Then this cycle will be repeated endlessly for every issue henceforth: politicians will propose meaningless half-measures to solve serious problems, and such measures will fail.
This bill specifically, though, has nothing to love. It’s non-binding, extremely partisan, and doesn’t do enough to actually solve the problem. This is a farce of a solution.
First, what value is a non-binding solution in the face of such a significant problem? To test the waters? Americans know that the current situation is no longer tenable. Businessmen and economists know the situation is untenable. Even Bernanke, in the back of his brain, knows that we are no longer able to continue the excessive borrowing even though he will never say this publicly. Besides which, everyone already knows that Democrats are only good for the most feckless of proposals anyway. The Republicans should have simply offered a binding proposal and let it play. Go big or go home.
Second, there is no hope for permanent reform if the Democrats aren’t on board, at least at this time (which is of the essence, by the way). The fault for partisanship, in this case, lies not with the Republicans but rather with the Democrats. If the Republicans are unserious about reigning in spending, then the Democrats must think this a new opportunity to practice their stand-up routine. At least the Republicans are making an effort, albeit a futile one. All the Democrats have to offer is refusal and non-solutions. Actually, they don’t even offer the latter. All they can really do is hope that they can wish hard enough to change reality. Good luck with that.
(Note: I do have one minor criticism of the Republican’s political maneuvering in this matter. They should have suggested a considerably more drastic reduction in government spending in order to make $6 trillion look like a reasonable compromise. But that’s just a minor complaint, for it does not seem likely that Democrats would have accepted it or even negotiated in good faith. Still, the Republicans could have at least made the effort.)
Finally, $600 billion dollar budget reduction per year isn’t even forty percent of the projected deficit for 2011. The reality is simply that we can no longer continue to run any deficits. Period.
The projected deficit for 2011 is $1,645 billion, and the projected savings are $600 billion. That means we’re still running a TRILLION DOLLAR DEFICIT. This sort of thing is not sustainable. And, frankly, it’s completely unacceptable. Reality will eventually kick us in the face if we do not stop this immediately. And when it does, we will deserve it.
The time has come to get serious. The time has come to end the half-measures. I sincerely hope both parties are up to it.
By The Gold Report, on January 28th, 2011
 Marshall Auerback, corporate spokesperson for Toronto-based Pinetree Capital, is a so-called “hedge fund” strategist. He believes that deficit spending is not bound by anything other than inflation, which, he says, is of limited consequence right now. Marshall believes the U.S. government’s main goal should be to reduce unemployment, and he predicts the gold price is likely to remain rangebound between $1,100 and $1,400 an ounce in 2011. However, his long-term outlook for precious metals remains rosy given that “casino capitalism” is setting the stage for a new bubble. In this exclusive interview with The Gold Report, Marshall reveals some of Pinetree Capital’s precious metals holdings and explains why he fears for the global economy.
The Gold Report: Marshall, let’s talk macroeconomics. You, like Economist Warren Mosler, believe that government spending is not limited to how much a government can tax the population or borrow. Essentially, you believe government spending is limitless and that deficit spending ultimately creates jobs. Please explain how that works.
Marshall Auerback: That’s a slight mischaracterization of our position. It’s not so much that people like Warren, myself or some of these so-called “hedge fund” economists like Randall Wray or Jan Kregel, say deficit spending is limitless; we say deficit spending is not operationally constrained by any external or financial constraints. We don’t exist under a gold standard. Under the gold standard, your spending was limited by the gold in your central bank. If you started running low on gold, then the gold would start to leave the country.
Interest rates would rise to attract additional gold inflows whilst higher interest rates would slow down domestic economic activity and thereby prevent overheating. Effectively, it would become a self-correcting mechanism. That sounds wonderful except that it didn’t deal adequately with the huge demand shocks of the sort that we had in 2008, the Great Depression or several of the depressions that we had during the 19th century.
As far as government deficits go, what we argue is that there are no financial constraints—there is a real resource constraint. In other words, inflation is the ultimate constraint. We shouldn’t be constructing fiscal policy with some sort of vague, undefined notion that it’s fiscally sustainable. Nor should we define “fiscal sustainability” via some arbitrary number as Kenneth Rogoff and Carmen Reinhart have done in their recent book, This Time Is Different: Eight Centuries of Financial Folly, wherein they say if a debt-to-GDP ratio gets above 90%, then bad things start to happen. That’s not an accurate way to look at it because you have to consider the economic context and the institutional arrangements governing the economy. A pure fiat currency regime, as we have in the U.S. or Canada, for example, is vastly different than a country which operates a currency peg system, such as Latvia or Argentina in the 1990s.
The United States also experienced six periods of depression that began in 1819, 1837, 1857, 1873, 1893 and 1929.Therefore, every significant reduction of the outstanding debt, with the exception of the Clinton surpluses, has been followed by a depression, and every depression has been preceded by significant debt reduction. The Clinton surplus was followed by the Bush recession, a speculative private-debt-fueled euphoria, and then the collapse in which we now find ourselves.
The jury is still out on whether we might yet suffer another great depression. While I cannot rule out coincidences, seven surpluses followed by six and a half depressions (with some possibility for making it the perfect seven) should raise some eyebrows. And, our less serious downturns in the postwar period have almost always been preceded by reductions of federal budget deficits. This brings me back to an obvious point: the federal government is big—especially since WWII—and movements of its budget position have a big impact on the economy. That’s the point we are trying to make.
Under the type of regime we have in Canada or the U.S., there is no inherent reason why any level of government spending should be fiscally unsustainable over a longer period. You have to look at the economic context; clearly, you shouldn’t have deficits of the magnitude you have now when you have unemployment down at, say, at 3% or 4%, or if you’ve got a capacity-realization rate close to 90% or 95%.
Clearly, in these circumstances government spending should be reined in. In fact, it will be because tax revenues rise sharply, social welfare expenditures come down and deficits tend toward balance. This is exactly what happened during the 1990s. However, what we’re seeing right now is that the private sector has demonstrated a large propensity to save and deleverage. That decision, in many respects, can be facilitated by the government running larger budget deficits. Absent that, you get 1930s-style debt deflation.
We also tend not to view government spending in isolation the way a lot of people do, but rather on a stock-flow, sectoral-balances approach. If you want government spending decreased, where are you going to get the offset? In other words, is the current account going to move into surplus (as is the case in Asia, for example), or are you going to start seeing private debt increase? Those are the kinds of variables one has to examine.
I think that the real central flaw in most macroeconomic analysis is it doesn’t incorporate these sorts of accounting flows when considering government spending. Therefore, you get all sorts of misconceived policy approaches like you have right now across the globe.
TGR: Isn’t your approach somewhat counterintuitive?
MA: It’s counterintuitive to the extent that we normally compare government spending to household spending. People say we can’t spend beyond our means, and that way of thinking fits into people’s own intuitive experience. But you and I are not the same as a government. A government is a monopoly. It’s controlling the currency. If you and I had printing presses in our basements and we were able to print $20,000 whenever we needed, we wouldn’t be debt constrained in the same way that private businesses or individuals are today.
Clearly, a government is in a unique position because it’s the only entity that issues currency and, in effect, creates new net financial assets. The household analogy breaks down because we fail to distinguish between users and issuers of currency.
TGR: But if you keep printing money you’re going to devalue your currency and no one is going to lend you money.
MA: Not necessarily. That is another flawed argument. By definition, if you are the monopoly—it’s your currency. You don’t need to have people lend you money. Again, this is a case where people have the causation wrong. Consider the argument that one always hears about China “funding” our deficits because they buy our bonds. Okay, so China decides to sell us a billion dollars’ worth of T-shirts. We buy a billion dollars’ worth of T-shirts from China. And the way we pay them is somebody pays China. And the money goes into their checking account at the Federal Reserve. Now, it’s called a reserve account because it’s the Federal Reserve, and they give it a fancy name. But it’s a checking account. So we get the T-shirts, and China gets $1 billion in their checking account. And that’s just a data entry. That’s just a one and some zeroes.
Whoever bought them gets a debit. You know, it might have been Disneyland or something. So we debit Disney’s account and then we credit China’s account.
In this situation, we’ve increased our trade deficit by $1 billion. But it’s not an imbalance. China would rather have the money than the T-shirts, or they wouldn’t have sent them. It’s voluntary. We’d rather have the T-shirts than the money, or we wouldn’t have bought them. It’s voluntary. So, when you just look at the numbers and say there’s a trade deficit, and it’s an imbalance, that’s not correct. That’s imbalance. It’s markets. That’s where all market participants are happy. Markets are cleared at that price.
Okay, so now China has two choices with what they can do with the money in their checking account. They could spend it, in which case we wouldn’t have a trade deficit, or they can put it in another account at the Federal Reserve called a Treasury security, or bond, which is nothing more than a savings account. You give them money; you get it back with interest. If it’s a bank, you give them money; you get it back with interest. That’s what a savings account is.
The example here clearly illustrates that bonds are a savings alternative which we offer to the Chinese manufacturer, not something that actually “funds” our government’s spending choices. It demonstrates that rates are exogenously determined by our central bank, not endogenously determined by the Chinese manufacturer who chooses to park his dollars in treasuries (credit demand, by contrast, is endogenous).
So, in fact, the bond is offered as a Certificate of Deposit (CD) savings alternative. It’s not actually used as a means of funding government expenditure. Bonds are also used to help drain reserves from the banking system. Because, as I said, government spending works toward increasing the amount of reserves in the banking system because when you spend, you credit the reserves into the banking system. If you want to drain those reserves for any particular reason, you issue a bond. People who buy the bond will have their bond accounts credited and their reserve accounts debited. Effectively, they’re there as an interest rate maintenance operation or as a reward to enhance savings. But they are not necessarily there to fund.
TGR: If you were Ben Bernanke, what course would you chart for the U.S. economy at this point?
MA: To me, the more important figure is not Ben Bernanke—it’s U.S. Secretary of the Treasury Tim Geithner. Monetary policy per se is a very ambiguous tool in terms of managing aggregate demand. Fiscal policy is more effective. The only thing I’d like to see Ben Bernanke stop saying is that we have to deal with the long-term deficit problems, because I don’t think they are problems. I’d like to see government spending reach a point where we start seeing unemployment decrease substantially. If that starts to happen—surprise, surprise—t he deficits will start to come down because tax revenues will increase. Social welfare payments will decrease and the economy would be on much sounder footing. I’d like to see a much more aggressive fiscal policy, but see it directed toward genuine job creation rather than a series of financial subsidies for zombie financial institutions.
TGR: John Williams of ShadowStats believes that true unemployment numbers in the United States are somewhere closer to 20%. Where do you peg unemployment?
MA: Williams could well be right. If you look at unemployment coupled with underemployment, you probably get something close to 16% under the so-called “U6″ measure. Of course, that discounts the fact that a lot of people have just given up looking for work, so we could be closer to Depression-like levels.
TGR: He actually does take that into account.
MA: He does, but most conventional statistics do not. There are people between the ages of 55 and 65 who will likely never find decent long-term employment again. It’s a tragic position. I don’t see it getting sorted out given the current configurations of policy and the current political configuration in the U.S. Congress.
TGR: You’ve penned a number of articles about the economic situation in the EU. In one entitled, The United States of Europe, or Full Exit from the Euro?, you discuss the growing disconnect between various EU countries and the possible end of the euro as a currency. How is the situation in the EU with the euro affecting the gold price?
MA: I think it has had a benign impact on the gold price in that we’ve got a situation wherein the very existence of a major currency union has come into question. I think a number of people have decided to buy gold as a consequence, as a kind of insurance policy. They’ve said, “We don’t know if we’re going to have a euro. We don’t know if we’re going back to a debased drachma or a Portuguese escudo, so let’s buy gold.” It helps to create a marginal bid in the marketplace.
In fact, the overall macroeconomic backdrop has been very positive for gold in the sense that you’ve now destroyed the myth of the omnipotent central banker. I think a rising gold price is generally associated with a vote of no confidence in the official sector. There has also been some concern about all this so-called monetary expansion being a precursor to some form of hyperinflation, which I think is highly misconceived. But all those things have helped gold in the short term.
TGR: What about inflation’s impact on the gold price?
MA: I don’t think inflation per se is a problem. Food and energy price increases have been significant and they are real. I’m not trying to diminish their importance; but in the absence of income and job growth, people have to heat their homes, fuel their cars and feed their families. That just means more discretionary income is tied up in those areas, which means less discretionary income for retail, restaurants, etc. I think the ultimate impact is deflationary rather than inflationary.
Also, the high rates of unemployment are not going anywhere. Labor has no pricing power. There’s no generalized increase of consumer price inflation. As that perception grows, the marginal bid could be taken out of the gold market for a while, which is why I am cautious on the gold price short term.
In addition to that, there’s a growing perception that the European monetary union countries are beginning to get their collective act together in dealing with this so-called solvency problem. If they do, that takes another marginal bid out of the gold market. In the short term, I think other commodity areas are more interesting than precious metals—notably the agricultural and energy sectors—and Pinetree is positioning itself accordingly.
TGR: In light of those thoughts, how do you see gold and silver performing in 2011?
MA: I think the gold price is actually going to be rangebound this year. Ultimately, I can see it going much higher because I think the response to these crises will be the creation of yet another financial bubble, which would enhance the value of gold. But right now, we’re in this benign spot wherein we’ve got inflation, which looks to be under control, and the Eurozone doesn’t look like it’s about to blow up. It wouldn’t surprise me if gold fell back to the $1,100 level and consolidated for awhile before it took off again. These things never go in a straight line.
TGR: What are those ranges?
MA: Let’s say $1,100–$1,450; that would be my guess, but it’s not a house view. We have a very heterogeneous shop at Pinetree and I’m sure various people have different views.
TGR: Precious metals are the assets to which Pinetree has the most exposure. Could you tell us about some of Pinetree Capital’s more promising gold and silver holdings?
MA: Sure. Here are a few names that Pinetree likes: First, Gold Canyon Resources Inc. (TSX.V:GCU), which is a Canadian-based unique mineral exploration company with a long history of exciting projects in both Canada and the United States. It completed a diamond drill program in the summer of 2010 at Springpole Gold Project, 110km northeast of Red Lake Mining Camp, Ontario, and a winter drill program is in progress. Springpole, which shares many similarities with deposits such as the Cripple Creek Gold deposit in Colorado, is an alkaline intrusion hosting a gold system that represents a potentially new style of Canadian Archean Shield gold deposit. At Springpole, the weighted average grades of the Portage Zone intercepts from the 18 holes drilled in 2010 is 1.36 grams per ton (g/t) gold and 5.95 g/t silver, a silver to gold ratio of 4.4:1.
Another one we like is African Gold Group, Inc. (TSX.V:AGG), a minerals exploration firm focused in West Africa, which has significant gold concessions in both Ghana and Mali. Its most advanced asset is the Kobada gold project in Mali, which has an NI 43-101-compliant inferred mineral resource of 740 Koz. of gold at 0.3 g/t Au emanating from 10% of strike potential. Recent news (1/13/11) from the company included analytical results for 19 near-surface oxide drill holes. At the Foroko North Discovery Zone, which is contiguous with AGG’s Kobada concession on the eastern boundary and projects north into the northeastern section of the Kobada concession, step-out hole KBRC10-059 extends gold mineralization to 1.2km (expanded from 600m). That same hole intercepted 48 mat 1.28 g/t Au, including 1m at 12.72 g/t Au. Of great significance is the fact that this discovery hole is located 600m south of hole KBRC10-048. This was a significant extension of the gold mineralization area.
In addition, another company on our list is Colossus Minerals Inc. (TSX:CSI), which is now at the resource delineation stage with a gold-platinum-palladium project in Serra Pelada in Brazil. It is advancing towards production. They have had a great run with high grades.
Finally, Continental Gold Ltd. (TSX:CNL) is an advanced-stage gold exploration company with an aggressive development timeline for its flagship Buritica project in Colombia. They have an extensive portfolio of gold projects, more than 200,000 hectares of highly prospective ground in areas of historical gold production. The company’s priorities include advanced exploration and definition drilling programs at its high-grade Buriticá gold project and phase-one drilling at the Berlin project, which produced over 413,000 oz. at 16g/t gold, historically.
TGR: Do you have some closing remarks?
MA: Well, I think we’re building the conditions for a new bubble in a series of asset classes. I say that because we’ve got decent, but not booming, aggregate demand. We’ve still got high rates of unemployment, so pricing pressures are still fairly minimal. Corporate balance sheets are cashed up to a degree they haven’t been in years and corporate profitability as a percentage of GDP is the highest it’s been in years. But because the external environment is still relatively uncertain and companies are not inclined to invest substantially in their businesses, they will probably take a lot of that cash and buy back their shares. That’s not a superb environment if the ultimate goal is see the unemployment rate go from, say, 10% down to 6%, but it’s a very good environment for financial assets, so we could see a 25%– 30% move higher in the markets this year.
The other point I want to highlight is that so many CEOs and managers, with compensation packages that are largely predicated on stock market performance, are getting this “casino capitalism” behavior. By that, I mean the stock market is not used as a way to help finance productive assets; the market is just there to help improve a company’s share price.
In many instances, accounting approaches are there to flatter short-term earnings. It’s what my friend, Professor Bill Black of the University of Missouri at Kansas City (UMKC), who gave testimony re the Lehman failure, calls “control fraud.” I’m not saying all these companies are frauds, but that sort of thing often takes place near the end of a cycle. My guess is that it could be a fairly benign year for financial assets. I think we are setting the stage for a new bubble because, basically, we used the last crisis to re-establish the status quo rather than making structural changes that would make our economy more productive in the long term.
TGR: Thanks very much for your time.
By Claus Vistesen, on December 15th, 2010
I did have some plans to do a series of post to give a brief overview of my main macro and trade themes for 2011, but time has, not surprisingly, caught up with me. As such, you will have to make due with a special version of random shots.
Risky Assets to fly in 2011? – This one is a bit too general to answer in full of course, but one interesting discourse that has emerged lately is that as bond vigilantes are feasting on the Eurozone (and even going for an altogether larger prey in the US), investors are being pushed into equities.
Following a well worn cliché in the world of finance, equities is the least ugly alternative.
Now, this may only be a working explanation on the surface since the underlying move into equities is also part of a more structural consequence of QE2 since the Fed is not only trying to move investors around on the yield curve, they are also trying to move them out of the curve altogether and into more risky alternatives. In this sense, what appears to be a melt up in equities might just be a slow but steady excess liquidity driven grind. Surely, Bernanke is in no rush to raise interest rates in 2011 and if the US economy continues to slowly heal, there will be only speed bumps ahead of a general trend upwards. One interesting thing here will be how the market reacts to event the slightest hawkish tone from the Fed or perhaps even a downtoning of the dovish stance. I think; not all too well but precisely because of this assumption (which I think many share with me), the Fed will remain uber dovish as far ahead as the eye can see.
Technically, I think the melt up towards the end year is in for a rude stop in the beginning of the year and I have the SP500 declining to about 1180-1190 in January. This would then provide a potentially tasty entry point for a 2011 rally. Other than a veritable cataclysm in the Eurozone (which appears the main source of systemic risk at the moment) and China suddenly slamming on the breaks in an unduly harsh manner, I see little resistance for risky assets in 2011. This is especially the case as the BOJ and the ECB will likely add their interpretation of “QE2″ to the table to respond to the ongoing sluggishness of their respective economies.
We have already gotten a barrage of 2011 predictions and outlooks from research houses, banks and other financial sages and quite frankly it is quite difficult to get a bearing on it all. I did find the Barclay Macro survey quite interesting though as it shows that about 70% of all investors see risky assets in the form of commodities and equities to outperform in 2011 while US treasuries will underperform. The underlying rationale is again quite simple I think. Given the severity of the crisis, monetary policy will tend to apply the brakes with a considerable lag and if 2010 saw the first signs of the effect of such a lag, 2011 could give us the full force. Again, this is especially important to note as the ECB and the BOJ might just be about to join the party.
On the other hand, “underperforming treasuries” will also present Bernanke with a dilemma in the sense that the extent to which the infamous bond vigilantes fancy more than a pot shot on US bonds he may be forced to apply even more pressure to keep yields low.
Low Growth in the OECD – This one is hardly news and hardly one exclusively for 2011 either. However, I still think there is a lack of recognition of just how low growth in the OECD is likely to come in for the coming years. In this way and just as investors have their focus set on outperformance in Asia and Latin America, I think that the ultimate growth outcome in the OECD will be worse than the market currently expects.
The point I am basically getting at is that we need to think about the fact that the Eurozone periphery essentially are going to be hampered by negative trend growth rates and that the rest of the OECD will be dependent on exports to grow (think mainly Germany, Japan and now also the US). Apart from any productivity miracle or some other exogenous source of growth, the growth engines in the OECD are simply tapped out. Indeed, this is probably the most important structural macro theme for me at the moment.
Now as for 2011, a lot of this will also depend on whether economies really intend to walk the walk in terms of fiscal tightening or whether they are simply talking. Clearly, countries under the spotlight in the form of the Eurozone periphery will see their growth rates severely dented by the need to consolidate public finances. In the US on the other hand, I think the latest estimate for the 2011 budget deficit is 10% of GDP which is hardly tight.
According to the IMF’s latest forecasts “Advanced Economies” will be running a deficit on the structural balance to the tune of 5% in 2011 and the G7 as a whole one of 5.88%.
But all this only goes to accentuate the issue since if there is one thing we have learned by now it is that one cannot borrow ad infinitum and especially not as you are essentially borrowing against a depreciating asset in the form of future growth held down by population ageing. So the big (as in biig!) question is; if you substract the 5% government spending induced deficit from the equation what kind of trend growth rate is left in the OECD as a whole?
Clearly, we know that some economies are now basically saddled with negative trend growth rates, but I think that even the aggregate number in advanced economies would be scary reading. We could call this decoupling in reverse and thus how vulnerable we now are to the continuing growth spurt of Asia and other so called emerging economies. But in the end, it is a basic question of not having any more components of the national identity to lever up as it is obviously clear that governments are only going to find it increasingly difficult to borrow (even in the case of very generous central banks).
Indeed, as we move forward I see this low growth environment for the OECD (and actual negative trend growth in some economies) as one of the main components in my call that we are going to see some spectacular and costly sovereign defaults in the OECD edifice going forward. On this, I think the current mess in the Eurozone is only the beginning.
The Euro and the Eurozone - Actually, I have not followed FX a lot lately so I am a bit of out form here, but I still use my Old Maid metaphor when thinking about big global currency movements and intra G3 movements especially. Interestingly, 2010 saw the JPY as a looser and thus holder of Old Maid in the sense that it appreciated significantly against the USD and Euro. In essence, the USD was being held down by the Fed’s policies and the Euro actually acted as a nice buffer against the crisis in the Eurozone as it fell strongly throughout the spurts of Eurozone tension in turn providing a much needed boost to external competitiveness when it was needed the most.
In principal, these trends do not stop at year end and will continue to dominate at least part of the intra G3 movements in 2011. The main question is what kind of bazooka, if any, the BOJ will pull out to revive the ailing Japanese economy. If it becomes the kind of shock and awe many are expecting we could be into a nasty long squeeze in the JPY. This also goes for the Euro in the context of the ECB being forced, kicking and screaming, into supporting Eurozone bond markets. I hold this to be almost given since the current setup simply does not work.
Today, Trichet called for more bold action on the fiscal front and in terms of capitalising the stability front (didn’t he just tell them to tighten their belts?). This is no doubt part of a futile attempt to preempt any defacto query, to the ECB, by part of the EU on taking an active and open role in the bailout. Trichet and his compadres are not going to like it, but the alternative asking Italy and Greece to pay for the bailout of Spain who in turn helped finance Greece and Ireland is simply hogwash.
As I have noted on several occasions; should the issue turn out to be contained with Greece, Ireland and Portugal the fiscal solution/stability fund would suffice, but evidently we are looking at a much more structurally problematic issue and Spain is surely next in line and even yields on German and Belgium bonds have begun to break loose. As such, it is becoming increasingly clear that the ECB will have to take a more active part beyond “simply” supplying liquidity to the banking system and buying bonds on the drip (or covertly).
I tend to have little opinion on the EUR/USD in general, but I will timidly forward the idea that we can expect the ECB to surprise with some of open support to the periphery, it should provide some pressure on the single currency. Yet, it is also fair to assume that the extent to which risky assets fly in a bath of excess liquidity the USD will depreciate and the Eurozone will gain on carry flows as interest rates are still higher in the Eurozone (especially, if things get so calm that the ECB starts turning hawkish again, but this may be selfdefeating in itself of course).
Emerging Markets – Well, the EM story is important enough to merit its own section even if it is intimately tied to the risky asset story. Yet, there is no need to re-invent the wheel and in this sense I think that Morgan Stanley’s Manoj Pradhan’s recent note on the 2011 EM outlook is pretty much accurate in all the important areas.
Especially his first point is important on structural outperformance by the EM relative to the developed world whereas 2011 should see EM growth cooling and, hopefully, growth in the developed world nudging up. As such, 2011 will see relative outperformance by developed markets. This is a bold, but also astute, call. It is bold because I think the link between the EM and DM is still too strong to see DM growth decouple entirely for a relative slowdown in emerging markets. In this sense, how far and how fast monetary policy in emerging markets are tightened in response to fears of overheating will be key. It is astute because, all things point in the direction of a slowdown in the emerging world after a breakneck 2009 and 2010 and in this sense, on the margin, perhaps the developed world is the place to be in 2011 on a tactical basis.
I also like that he spends some time on the inevitable, but important, process of rebalancing away from a reliance of an overlevered Anglo-Saxon consumer in the OECD (and of course, a now cracked Eurozone periphery). Reverse decoupling and rebalancing towards the emerging markets are two of the main global discourses and real economic drivers at the moment.
Finally, I think it is also important to re-emphazise the basic problems emerging markets face as they try to cool their economies through higher interest rates only to allow more hot money flowing in. The policy mixture is obviously being developed as we move along with some form of capital controls being implemented across the board. In a world of structural excess liquidity this policy dilemma becomes an additional issue on top of the more traditionally discussed trilemma.
As such, I am large cautious on the emerging markets going into 2011 as I think they are overloved, but the long term bull call stands uncontested. In addition, there appears to be general acceptance and expectation that key emerging economies (China most notably) will react strongly to any lingering signs of overheating and just as Bernanke might not care that his low interest rates will fuel asset bubbles far from the shores of the US, so may Chinese policy makers care very little if they have to slam on the brakes to the detriment of global growth and OECD’s recovery.
By Claus Vistesen, on October 27th, 2010
Popular wisdom has it that markets are always right or, more appropriately; that if you find your self on the wrong side of the market consensus the best cause of action is to join the ranks less you want to be rolled over by a steamroller. However, it may take some time before the market corrects to the underlying fundamentals or so, at least, I will argue.
Last time I wrote on Ireland I noted how the country’s latest move to emphasize its strong cash position (as well as the fact that it announced the intention not to go to market to seek financing) was a wink to EU policy makers that either the current plan works or Ireland will need funding help. Private market funding at current and future expected rates is not an option and the really important question is whether the interest rates charge by some form of European SPV would also be consistent with a recovery or simply another debt spiral. I have my doubts here.
Indeed; with a the running deficit to GDP of 32% in 2010 it is absolutely necessary that Ireland addresses this as a first priority. No matter how much cash you have lying around or how much you expect to be able to get from a coordinated relief program (essentially borrowing with low rates and long maturity), the failure to react now would mean that the time path of public debt would prove instantly unsustainable as we moved into 2011 and 2012
However, markets don’t seem to be very comfortable with the prospects of very strong austerity measures in Ireland.
Quote Bloomberg
Bond investors are losing faith in Ireland’s plan to lower the deficit as spending cuts threaten to undermine economic growth, reducing government revenue. Irish 10-year bond yields climbed within 50 basis points of the 454 basis-point record spread, set Sept. 29, relative to similar-maturity German bunds. Portugal’s spread fell about 1 percentage point against the German benchmark in the past month, the Greek-German yield gap narrowed 102 basis points and the Spanish spread was close to the lowest level since Aug. 10.
It is important to understand the underlying message here. What drives the worry is not so much the debt and deficit itself, but more so that the severe austerity measures needed to restore the evolution of debt will derail the economy and thus become counterproductive. Indeed, this is the main issue which most OECD economies grapple with at the moment.
But surely, it is not easy being Ireland at the moment. On one day, spreads climb because you are trying to plug the hole in the budget as you try to salvage a broken financial sector and the next spreads climb on growth fears as you introduce austerity measures in an attempt to correct the deficit incured in the first place.Look up the old proverb of being stuck between a rock and a hard place and you will find the European Periphery as a chief example.
What is interesting in particular are the comments extracted by Bloomberg from various fixed income portfolio managers across Europe. They seem to me to be getting closer to a does not compute moment of their own (all quotes are gathered by Bloomberg). Firstly, Dermot O’Leary, chief economist at Goodbody Stockbrokers simply turns the focus upside down and argues that now, surely, growth is the most important goal for Ireland.
“With the scale of consolidation now known, the department’s strategy for returning the economy to growth” could “now be described as more important than the consolidation measures,”
I wonder whether he would change his mind if the black hole of Anglo Irish takes the 2010 deficit/GDP figure to 40% (or perhaps 50%?). But there are other much more fundamental issues being raised; for example by John Fitzgerald a member of the central bank board.
The risk is “the medicine is too severe so that, like chemotherapy, it puts the patient into decline,”
Indeed, this is a risk and one which I (and others) have been banging on about the last 2 years, but the one I really liked was the comment by Ralf Ahrens from Frankfurt Trust and the simple yet crucial question;
“There is this central question of where does growth come from.”
Well, well. Aren’t we coming full circle here?
Allow me to repeat three questions I posed recently in relation to the ongoing efforts to solve the the crisis in many European economies.
- How do you correct external competitiveness deficiency from within a currency union at the same time as implementing fiscal austerity without risking debt levels to spin out of control?
- How long should Southern Europe and Ireland endure deflation relative to the core to restore external competitiveness (will Germany accept a lower external surplus as result)?
- How might a sovereign restructuring in a Eurozone economy play out?
The first question is really the main issue at hand. In the absence of nominal currency devaluation you need to impose wage restraint and deflation in order to correct a large external balance. As this large external imbalance is reflected in a large domestic debt level there is a real risk that if the entire correction must come from the domestic price level, the level of debt in itself will spin out of control which then manifests itself in either large scale private sector defaults or default on the sovereign level.
The main message here is simple macroeconomics. If you combine deflation and negative nominal growth rates over a prolonged period of time and given an already elevated debt level; your overall level of debt relative to the value of your activities (GDP) quickly become unsustainable.
So how do correct then? Well, not without a little help from your friends which brings us to the second question.
Consequently, this is not only about the European periphery suffering, it is about them suffering more than everyone else. Indeed, the recent ascent of the Euro is no good for them in so far as goes competitiveness outside the Eurozone and even inside Europe, it is starting to look like everybody’s race to the bottom in terms of on whose back intra-Eurozone imbalances are supposed to correct. Naturally, a steady depreciation of the Euro would, strictu sensu, be welcome news for Greece, Ireland et al. Yet, this seems far off at the moment with the Fed doing the printing and the ECB reluctant to add further stimulus. On the concrete question of time, you just need to slice up the effects of say, a 30 % nominal devaluation (e.g. against the Euro or USD) which is the likely alternative scenario, I think, if any of the most troubled Eurozone economy had their own currencies. It then means that we would need to see a prolonged period of relative deflation to Core Europe.
This however would in itself be problematic since 5-10 years of slow pain would almost certainly result in a Japan type lost decade, but also be almost impossible from within the Eurozone (i.e. politically). So by proof of elimination we reach question three. Indeed, PIMCO’s El-Erian recently argued that Greece is likely to default within 3 years and that this need not be cataclysmic. I fully agree.
It is impossible to do any form of calculation here since we don’t have any numbers that are coherent, but surely I would think that something along the lines of a 30% haircut on the principal and a notable extension of maturity is a likely result (but really, I have no idea!). The alternative would be that the rest of the periphery follows Ireland’s example and simply leave the private market (although China et al. have indeed been fishing lately) and thus, they would have to be capitalised slowly from within an intra Eurozone structural fund (or through outrigth monetization by the ECB, but this is not going to happen I think).
In the event of restructuring, big the question of the hole left on the balance sheet of Eurozone debt holders of peripheral bonds (let us think about foreign holders later). A couple of potential solutions have already been put forward.
Leaving aside the Structural Fund which is not supposed to recapitalise private entities (at least not yet) it would mean that those banks either would have to enter the market to recapitalise, be recapitalised by their domestic governments (a deal which could form part of the default), or simply transfers bonds at par to the ECB which tend would have to take the hair cut on its balance sheet.
At the end of the day, this kind of rhetoric is still seen as fearmongering and disruptive in the Eurozone collective since there is still a strong sense of resolve around the fact that no sovereign in the Eurozone may be allowed to default/restructure on its debt. As such, you could argue that one glaring omission in my analysis is that I don’t consider the costs of default. Well, they would naturally be substantial not only for the individual economies but for the Eurozone itself. However, when you run even a rudimentary simulation of the likely numbers it is pretty easy to see how this cannot go on. There is no exogenous source of economic growth that will help the periphery move in to a virtuous circle, there is only one big vicious one in which more austerity brings lower growth and deflation which in turn affects the level of debt to GDP.
I admire resolve and I even believe that it is merited, but this is only to the extent that Germany (and France) are willing to assume their part of the bill (which will be very big) or to the extent that the ECB decides to employ wholly new and Fed-like policy tools.
Absent this and leaving aside the question of whether Germany and France realistically would be able to foot the bill at all, the only question is if the markets are starting to get it, when will the shoe drop on the level of macroeconomic policy making?
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By Ajay Shah, on October 15th, 2010
From the mid 1990s onwards, the US trade balance has steadily become bigger. This is a centrepiece of the problem of `global imbalances’. Starting from values of roughly zero, this got all the way to values like $70 billion a month, where the US was importing over $2 billion a day of capital to pay for the trade deficit. Here’s the picture:
 |
| The US trade balance (goods+services, per month, seasonally adjusted) |
This was termed as the `Bretton Woods II’ configuration, where exporting countries like China gave loans to the US, in a form of suppliers’ credit, and the US bought Chinese goods. This magnitude of capital import was unsustainable for the US. Something had to give.
Warning for Indian readers: In India, the term `trade balance’ pertains only to merchandise trade. In the US, the monthly trade data covers both goods and services. So it is a meaningful measure of what is going on in international trade, unlike the corresponding Indian data.
Bretton Woods II first broke down in the financial crisis. In the downturn, the mighty American consumer purchased fewer 50″ television sets. The US trade deficit dropped nicely all the way to $25 billion per month. Alongside a rise in the US savings rate, this looked like a world which was rebalancing. In recent months, this movement reversed itself and the US trade deficit once again started getting worse. A deterioration of $20 billion per month is visible; i.e. a deterioration of $240 billion a year. Suddenly, the story of global imbalances righting themselves came under question. The present US run rate is around $40 billion a month or $0.5 trillion a year.
Alongside this, we have news that the Chinese reserves rose by $194 billion in Q3 2010. The Chinese seem to have also passed on some of their problems of exchange rate pegging upon their neighbours by purchasing Japanese, South Korean and Indonesian assets. I am not aware of such behaviour having been observed prior to this in human history. Japan, South Korea and Indonesia have taken unkindly to this behaviour. Given the opacity of the Chinese regime, one can’t help wonder if similar things are going on through less visible channels – e.g. a Chinese sovereign wealth fund buys $10 billion of OTC derivatives on Nifty.
So we seem to be headed for quite some escalation of conflict over the Chinese exchange rate regime. Here are some interesting readings on the subject:
By Richard Daughty, on October 14th, 2010
Now that the federal government’s fiscal year ended on September 30 and they had to “square up” their accounting, we find some very interesting things, if you will forgive the use of the phrase “very interesting” when I should have used the more descriptive Poop In Your Pants Scary (PIYPS).
One of these PIYPS things is that the one-year increase in the national debt, thanks to the unbelievable fiscal insanity of the deficit-spending Obama administration and the corrupt and moronic Congress, which is not to mention the monstrous monetary insanity of the loathsome Federal Reserve creating so much new money for them to borrow that inflation in prices will destroy us all. It is now revealed that in FY 2010, the national debt rose $1.72 trillion! In one year!
The government, of course, only counts $1.3 trillion of this as “deficit spending,” but nevertheless, $420 billion more debt somehow appeared from somewhere to equal the $1.72 trillion increase in the national debt in one year.
The sheer staggering size of this incredibly enormous $1.72 trillion in borrowed money spent by the federal government is more than all the $1.3 trillion the government collected in personal and corporate taxes!
And remember that this $1.72 trillion is just the deficit-spending, and we are not even including the gigantic $3.5 trillion federal budget for 2010! Gaaaahhhh! We’re Freaking Doomed (WFD)!
If you are thinking that we are NOT doomed by astonishing long-term Congressional fiscal irresponsibility and Federal Reserve monetary treachery, then perhaps you will change your mind if I came over there, hauled you up out of that seat and slapped your face repeatedly until you got some smarts, which usually happens to most people pretty fast, usually about the time I reach out and grab them by the throat so that I can keep their heads from moving around while I am administering a therapeutic dose of Mister Slappy.
There are, of course, a lot of logistical problems associated with my kind, generous Mr. Slappy offer, not the least of which is that, after awhile, my hands would get really sore from the slap, slap, slapping. Ow!
This is why I am going to try to achieve the same “get smart” effect by using my new Mogambo Pedantic Method (MPM) of using real, “it’s going to happen to you” horror to terrorize and shock you into a huge fight-or-flight response, flooding your system with enough adrenaline and other save-your-butt biological hormones and doodads to make your central nervous system more receptive to threatening stimuli.
What threatening stimuli? Well, just the federal budget deficit – alone! – means that each, each, EACH of the 90 million American private-sector workers in the Whole Freaking Country (WFC) must produce enough profit by their labors (as they are the only workers who can actually make a profit from their labors) to pay down another $18,889 in federal debt accumulated over the last year!
And this crushing new debt burden comes on top of these sad, selfsame, sorry 90 million private-economy workers making enough to pay the painful principal-and-interest payments to support their $150,000 share of the $13.5 trillion national debt already in existence!
And this staggering load of debt is, with only some exaggeration, barely enough to even Scratch The Surface (STS) of all the debt that is owed, where $60 trillion is the total of all private debts on top of the national debt, and (staggeringly) all of it relying totally on these same few 90 million people being so immensely productive and profitable that everyone, literally, benefits.
The kicker is that they are supposed to do this on an average household income of $54,000 a year! Hahahaha!
If you are, like me, already raging from an overload of adrenaline in your system generated by the sheer, mortal horror of all of this, then leave it to the Mighty, Mighty Mogambo (MMM) to administer a sedative that will make you smile: Buy gold, silver and oil!
With them you will protect yourself from the federal government’s apparent plan to destroy you by turning the dollar into worthless crap, and it’s so easy to do that you, too, will rejoice as do I, shouting loud huzzahs to the beautiful, blue sky, specifically, “Whee! This investing stuff is easy!”
The Mogambo Guru
US Debt on the Shoulders of 90 Million People originally appeared in the Daily Reckoning.
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