At The Precipice: The Choices We Make vs. The Choices We’re Forced to Make

Author/Editor’s Note: You are about to embark on reading a post that is long, wonkish and meandering.  So while I admit it being this way, I will make no apologies for it.  This post is what it is.

This is a tough post for me to do.  Tough because so many discussions that seem disjointed and siloed, are in fact ones in which I see connections and I think the topics are interdependent: you can’t discuss X without discussing Y and Z.  So on that note, I’m going to talk about the inflation/deflation *and* the expansionist/austerian debates.  There’s a smattering of other things in here, too.  Like the unemployment conundrum.  Or Green technology.

Because while those topics are worthy of having separate discussions, you can’t come to any satisfying conclusions about any of them without looking at the first two debates, which are inextricably linked, and trying to tie them together with the other topics. It’s ambitious, I know, but I’m going to attempt it.  But with Jackson Pollack as a navigator and both Hunter S. Thompson and Jack Kerouac sitting in the back seat of this car, there’s no telling how this will come out.

I’ve read just about everything written over the past couple of weeks, discussed a lot of this stuff with folks on Twitter.  On blog comment forums.  And all I can say is I’m struggling to come to terms with this stuff, just like other folks I’ve discussed it with, and that has led me to come to some really profound – yet uneasy – conclusions which I’ll get to later on.

Inflation vs. Deflation

There’s been a lot of ink spilled on this.  Are we being confronted with one?  With both?  Let’s consider a few things in answering that.  First, a look at core CPI:

Not inflationary by any measure.  Prices are collapsing as a at least two effects I can think of are hitting the labor markets: persistence in long-term unemployment and under-employment: the folks who work part-time but are ready and willing to work full-time if a job is available.  Both of these effects are eventually reflected in GDP, personal income and last but not least, tax receipts.  Both of these effects are providing downward pressure to prices, plus they force people to choose products/retailers they wouldn’t choose before.  So the actual basket of stuff that’s getting sold now is different than the basket of stuff that was being sold before when people either had jobs or the jobs they had then paid them more.  Chalk that up as the choices we’re forced to make.

Another thing about inflation is the use of debt to fuel asset purchases and consumption.  Easy credit – and appetites that had been whetted by easy access to credit – had fueled a lot of purchases we had seen before the onset of the recession, and the levels of consumption we had seen conditioned others – such as auto manufacturers, strip mall developers, etc. – to expect those growth rates in consumption (and at that those nominal levels) going forward.  Well, this next chart shows that’s not happening:

About the only thing we can cheer about here is that the rate of decay is slower than it was the past year.  But it’s still declining as debt is shunned – a choice that can fall either in the camp of choices we can make or the camp of choices we’re forced to make.  A comment I saw on this struck me as being interesting, both right and wrong at the same time:

In one sense that’s true, and in another, it’s not.  I think in a macro, aggregate demand context, it’s very true.  Somehow we need to get back to the levels – think about the debate between growth rates and levels – we saw in that time frame.  But there has to be some product or some asset that would induce that kind of demand again.  Well, has that occurred?  Are securitized markets improving?  Well, you tell me.  Are they?

Did that make you choke on something?  If so, you don’t want to see this one:

Forget about securitized credit for a second.  This is bigger than that.  These two charts are about debt revulsion and market illiquidity.  This is not coming back. The king is dead.  Long live the king.

Lastly, a y-o-y chart on total bank credit.  Note that on a y-o-y basis, we’ve gotten to a point where credit is just not falling as fast; that’s not the same as growth:

As Kevin Depew observed in a spectacular piece at Minyanville:

Make no mistake, there are the same underlying economic problems here that exist all across America in cities both small and large: too much real estate development, too few home buyers; too many cars, too few cars buyers; in short, too much malinvestment, thanks to decades of artificially cheap credit.

via Five Things You Need to Know: The Modern Stealth Depression Revisited | Markets | Minyanville.com.

So there you have it.  Artificially cheap credit and malinvestment, and fewer financial intermediares to give credit to us.  You could easily make parallels to agribusiness, where our food supply is controlled by a small number of national players, juiced on artificially cheap corn.  But that’s a whole other discussion, that can only be done after watching Food, Inc.

But with respect to the deflation in credit that is happening after seeing those two charts, frankly it doesn’t scare me.  Because as I had heard and read about in understanding addiction “the mind that brought you here will not be the mind that leads you out of here.”  We’ve got to find something else that can lead us out of this morass of corroding debt and overindulgent consumption.  That means giving up the ghost that more of the same will get us out of here.  It won’t.

But that won’t stop people from trying to go back to what was done before and try to make it work.  Charles Mackay’s classic is filled with such behavior, where people thought the road back to recovery was paved by the habits and assets that brought them to the brink the in the first place, only to see those efforts fail. Yet we try it over and over again.  In short, not only does this sort of behavior exemplify Albert Einstein’s definition of insanity, we want to repeat the definition to ourselves to make sure we get it right.

So that’s in favor of the case for deflation.  But what about inflation?  Also, what are to make of the run-up in the price of gold – the classic inflationary hedge?

This came up at Street Meet, which I had the privilege of attending.  Is this move an inflationary hedge?  Sure, by many it is.  But with all due respect, I offered that there was a second motivation, which is a real psychological shift: the move has nothing to do with inflation or deflation, but a move to store value in gold as a hedge against poor decisions made by central banks.  The fact of the matter is, central banks have lost the modicum of trust they had. Over the past three years, how many times have you read about something *good* a central banker has done?  Outside of the droning of some economists, not much.  The move to physical commodities as a store of value away from paper/fiat currency is a revolt against central banks.  Taken to its ultimate end, we won’t need an “End the Fed” bill to render them obsolete; just settle transactions in anything but paper money.  No potency cocktail of ginseng, Viagra or Cialis would help them at that point.

And meanwhile, yields head lower for Treasuries:

That’s a 20 year chart.  Here’s a 5 year:

Which is also having an unintended consequence, which factors into the austerity/expansionary debate.  Risky assets are also yielding less as well:

This is on a 20yr chart.  They want to head lower, and they will head lower.  One other thing to note: look at the sweeping parabolic nature of Baa rates from the last downturn in ’00 to the current one.  I bet if I found a parabola to fit that trend, the coefficients this time around would be bigger than the coefficients on the mini parabolas you see in the ’90s.  Why?  The convexity of yields.  Also, looking at the time periods between the cycles, I am starting to think that we’ve compressed economic cycles now with all of the cheap liquidity and stimulus.  That subject is probably more open for debate than the compression of market cycles, which is another topic we touched on at Street Meet and one where folks could easily agree that cycles in markets have compressed.

At any rate, here’s a 2 year chart:

The channel that had formed is breaking down, as 10yr yields head lower.  Another way to look at this?  Spreads between Baa bonds and 30yr Treasuries.  The Baa yields published daily are yields for bonds with more than 20 yrs left to maturity, so the spread to 30yr Treasuries can serve as a risk-free proxy:

As I, as well as others pointed out, defaults on high yield and leveraged loans/bonds are much lower than everyone has expected.  I’ve said it before, but I’ll say it again: we may be watching a new feedback loop form between rates and defaults.  Central banks pushed liquidity into the market, suppressing rates on, well,  everything.  High yield assets benefit as default rates head lower, thereby making them less risky compared to higher quality assets.  Risk compression is in play, and it may not end anytime soon.

But this is an important facet to the next debate.  A debate where the discussion of interest rates almost never gets discussed.

Austerity vs. Expansionism

This discussion and the inflation/deflation one are linked.  If inflation is the issue, austerity is will correct it.  Deflation on the other hand, is different.  In a deflationary environment, consumption and/or investment is encouraged as the capital inflows kick-start economic activity.  But when there are charts like this…

and this…

It’s bothersome.  The debt keeps increasing and to listen to the expansionists, it needs to keep expanding.  Because governments are the only ones that can fill the void and consume while the private sector repairs their balance sheets, for which there’s no guessing how long that can take.  Indeed, this is one of the basic tenets to Richard Koo’s framework for dealing with balance sheet recessions.  Plus, looking at Japanese bond yields, they’ve only gone lower as inflation has become a distant memory.  And that was 20 years ago.  Indeed, the biggest takeaway in my mind from Koo is that instead of bemoaning the Japanese experience, we should be embracing it.  Sure there are some things that they did wrong (lack of structural reform, banks not charging off losses, big banks that got bigger – gee why does this all sound so familiar), but by and large,  the policy of governments taking on ever larger deficits to stop deflation is something to be accepted, not fought.  I can see in one sense that is true.  As I read and re-read posts and comments on this debate, there are a couple of things I see as true: there is no magic debt/GDP percentage where everything goes bust and as interest rates head lower, the interest burden is lessened, which allows more debt to be taken on.  Indeed, it’s like a feedback loop sprouts up out of nowhere as a result.  Like a weed staring at you in your driveway which forces you to ask “how did this get here?”

But is that how we want our government to operate?  Taking on debt so we don’t have to?  I realize the comparison to Japan is not a perfect one, for at least two reasons: the difference in savings rates and the composition of their debt market: practically all domestic investors.  Indeed the sovereign default question is puzzling when one looks at Japan, because while their debt/GDP keeps rising, the only talk of default comes from outside of their borders – not within.  This chart is as of end of last year, but it still gets the point across:

But GDP growth has not resumed in a robust manner, it has languished and continues to do so.  Personally, in Japan I see an economy that has spent a lot of public bucks and gotten very little bang for it all.  It just seems to me there has to be a better use of all of that money.

And then I read this (emphasis, mine):

What we haven’t yet experienced—at least in a sustained manner—is deflation. That, combined with the enormous fiscal stimulus, may explain why unemployment has stabilized to some degree now despite sustained private sector deleveraging, whereas it rose consistently in the 1930s….

Whether this success can continue is now a moot point: the most recent inflation data suggests that the success of “the logic of the printing press” may be short-lived. The stubborn failure of the “V-shaped recovery” to display itself also reiterates the message of Figure 7: there has not been a sustained recovery in economic growth and unemployment since 1970 without an increase in private debt relative to GDP. For that unlikely revival to occur today, the economy would need to take a productive turn for the better at a time that its debt burden is the greatest it has ever been..

via Steve Keen’s Scary Minsky Model « naked capitalism.

Here’s the figure:

Keynesians and MMTers beware.  This speaks to secular deflation: a large, demographic and psychological shift away from the use of debt. Debt-induced growth won’t work if there’s no appetite to take it on and there’s no productive use for it that has a greater benefit than the costs of servicing it.  Maybe Keynes got it wrong.  Perhaps it should be the Paradox of Debt instead of the Paradox of Thrift: societies resist taking on debt just as they should take it on, because they already took on so much beforehand.  I’ve heard the argument before that that shouldn’t matter because a government can always print more money to cover the interest.  And risk inducing hyperinflation as a result?  Because governments don’t know what the optimal quantity of money is better than any one of us do.  Plus, taken to its extreme, that kind of outcome can be viewed as a technical default.  The political risk of being the next Zimbabwe or Wiemar Republic is very real, currency standards (fiat vs. gold) notwithstanding.

And it might actually be worse.  If you can’t trust a government to act prudently with respect to fiscal matters, how can you trust that rules that are made by that body are fair?  That they are enforced fairly?  Or interpreted reasonably? Again, these are conversations that are thought of in isolation, but can only be treated in a satisfying way when discussed concurrently.  Chalk this up as a choice we can make – for now.

But the austerity argument has its own warts.  Cutting safety nets is largely out of the question, because as Andy Grove wrote in Bloomberg Businessweek:

I fled Hungary as a young man in 1956 to come to the U.S. Growing up in the Soviet bloc, I witnessed first-hand the perils of both government overreach and a stratified population. Most Americans probably aren’t aware that there was a time in this country when tanks and cavalry were massed on Pennsylvania Avenue to chase away the unemployed. It was 1932; thousands of jobless veterans were demonstrating outside the White House. Soldiers with fixed bayonets and live ammunition moved in on them, and herded them away from the White House. In America! Unemployment is corrosive.

via Andy Grove: How America Can Create Jobs – BusinessWeek.

I very much value what others who have fled oppression in such countries as Hungary in the 1950s have to say because they’ve seen what oppressive, overreaching governments are capable of.  Are we there yet?  No, but when you see things like this – on Independence Day no less – it makes me wonder how close we are.

But back to the safety net issue and what to cut.  There’s obviously little wiggle room on one side of the equation – the safety nets.  They’ve become interwoven into the fabric of our society and the best thing we can do is strive to ensure fraud, waste and abuse are minimized.  Eliminating it is a joke so when politicians talk in such absolute terms, I just laugh.  Or holding up unemployment extensions for the sake of the deficit?  Please.  Nevermind the fact we’ve got whole departments of the Federal government where  nobody knows what they do, how effectively they do it or what it costs to keep all those folks in their “jobs.”  Talk is the most inflated currency out there.

But then you read things like this:

President Barack Obama Friday signed a law giving consumers already in the process of buying a home three extra months to close the deal and still get a popular tax credit from the government.

Homebuyers that signed the contract by April 30 but failed to go to closing by the original June 30 deadline have until September 30 to finish their purchases.

Homebuyers with contracts signed by April 30 who failed to go to closing by the original June 30 deadline will now have until September 30 to complete their purchases.

via Housing Fix: Obama Signs 3-Month Extension of Homebuyer Credit – CNBC.

You just can’t help but feel, well, deflated.  The old saying of “good money chasing after bad” applies.  Just as it did with TARP.  With Bear Stearns.  With AIG.  Pork-barreled projects stuffed into legislation at the 11th hour, 59th minute.  Need I pile on?  So when folks tell me it doesn’t matter how it gets spent, just as long as it does get spent, I have to disagree.  Throwing money at the things that got us into this situation will not be the things that get us out of it.  Nor will wasteful pork-barrel spending.

Also to the austerians’ credit, there is a valid case to be made for government and entitlement restructuring.  The current way healthcare benefits like Medicare are collected and distributed is one area ripe for restructuring.  Social Security is another.

True market reforms are what’s needed, not just debating about levels and amounts of stuff to increase or decrease.  I like the way Joe Wiesenthal expressed it:

Lost in this debate is any discussion of what actually goes into a competitive or dynamic economy. There are so many factors that go into this. Let’s just rattle off a few that could have an effect:

• Immigration
• Education
• Tax fairness
• Labor mobility
• Labor flexibility
• Environmental policy
• Demographics
• Family planning policy
• Health policy
• Agricultural policy
• The weather
• Corruption

We could probably go on forever, listing factors that would help determine whether a given economy was competitive or not. And yet this stimulus vs. austerity debate ignores all these things, as both sides pretend that these are secondary, as opposed to foundational, aspects of what makes the economy hum.

via Why It’s Time To End The Whole “Stimulus Vs. Austerity” Debate.

And I couldn’t agree more.  Rather than take this time to really sit down and think what it’s going to take to move us forward, we’re mired in squabbling and posturing.  It’s easy to do because it’s lazy.  Most people would rather argue about throwing money – or not throwing money – at a problem because these topics make most people’s heads hurt.  But in reality it just sets the table for the last two things I’m going to look at.

Jobs and Green Tech

By now, we all know that unemployment has basically held steady, at 9.5%.  And the participation rate continues to be a negative on the economy.  So I took a look at both of them, together in this chart:

Looking at this chart, we can see that unemployment – when compared to labor force participation – hasn’t been this bad since the recessions of the ’80s.  The ’80s marked another transformational period in this country as we saw the decline of manufacturing and the rise of the service-based and information-based economies.  This becomes very clear when you see capacity utilization:

The lower lows are a sign of technological innovation taking root in each phase of the economy.  Automated manufacturing uprooted people from working in manufacturing several decades ago and we’re seeing something similar in our current economy as we’re able to produce more with less.  This presents us with a couple of problems.  First, as we get more efficient, we have to find better uses for capital that give us returns we want.  This is a huge issue as Keen pointed out earlier: we need better returns on capital to fund our debt.  We’re not finding it now and we need something – an innovation – a radical breakthrough in something from somewhere, anywhere – to get us there.  Second, there’s this issue :

Over the past couple of weeks I have been fascinated with the topic of overpopulation as I explained in my last post that “overpopulation was the greatest threat to sustainability in my book.”

…

Long story short he believed that the two classes capitalists and landlords (where Labor was considered equipment of the land) a typical feudalistic setup, population unchecked would grow at an exponential rate or geometric ratio.

via BankrChick (Tonight I do).

So overpopulation while we get more efficient and yet at the same time, we need to conserve more of our resources.  Not an easy task.

This is where Green tech could fill the void.  The theory being that Green tech would allow us to make something again and put people back to work while at the same time, if we export our products (not the technology and there’s a big difference between the two in terms of exporting), we can solve it all.  Mr. Birds 1 & 2, you’ve just been killed by one green, eco-friendly stone.

But in my mind, it won’t in its current state, for two reasons.  First, let’s start with the job creation issue.  I went back to Andy Grove on this:

Such is the case with advanced batteries. It has taken years and many false starts, but finally we are about to witness mass-produced electric cars and trucks. They all rely on lithium-ion batteries. What microprocessors are to computing, batteries are to electric vehicles. Unlike with microprocessors, the U.S. share of lithium-ion battery production is tiny (figure-E).

That’s a problem. A new industry needs an effective ecosystem in which technology knowhow accumulates, experience builds on experience, and close relationships develop between supplier and customer. The U.S. lost its lead in batteries 30 years ago when it stopped making consumer electronics devices. Whoever made batteries then gained the exposure and relationships needed to learn to supply batteries for the more demanding laptop PC market, and after that, for the even more demanding automobile market. U.S. companies did not participate in the first phase and consequently were not in the running for all that followed. I doubt they will ever catch up.

via Andy Grove: How America Can Create Jobs – BusinessWeek.

He’s saying we’ve been out of the game for so long we may not be able to compete in this new area.  I don’t necessarily agree.  We’re at a disadvantage yes.  But in my mind, Green tech isn’t good enough yet.  Ethanol cars?  Please, you’re harvesting an ag crop to turn it into fuel, plus you have to burn billions of BTUs to turn it from starchy sugary food into something you can use in a car.  Yes, cellulosic ethanol may be better because there’s less refining that has to be done, but you’re still faced with the fact that you’re using a fuel that will 1) not be as efficient as gasoline (your vehicle’s range is diminished) and 2) is actually corrosive to the engine since ethanol is a form of alcohol and it burns quickly and dryly.  Electric cars?  After watching this review by the guys at Top Gear and reading this rebuttal from Tesla (note the charging time and compare that to the time it takes to fill up a petrol car), it’s clear to me that electrics aren’t ready for primetime, Tesla’s IPO be damned.

There are other cars that might be though, and in comparing the two, it raises a point I want to make: green tech, to be palatable,  needs to raise the bar.  Planting a solar farm 20 football fields wide and 20 football fields long of solar panels out in the middle of nowhere isn’t going to help us if there’s a better use for the land and we tear up miles more of land to get the power from the solar farm to a generation station that can put that power on the grid.  There has to be a better way to do this that fits the lives we live today or offers us something better than we already have.  Otherwise it will fail.

Which leads me back to the austerity/expansionist debate: why isn’t the government investing more in this?  High speed rail could substitute air travel as it’s cleaner and can be more efficient (and possibly more convenient), but nobody is talking about setting up an incubator to research it.  Government can step in there.  What about other alternative energy sources and investing in more R&D in the other issues like making power transmission more efficient – so things like wind and solar power make more sense?  Instead we’re bailing out car manufacturers that are slaves to fossil fuel technology, but our economy as a whole has moved past volume production in this manner for at least 3 decades.  The things that got us to this precipice will not be the things that will lead us away from it.  The government has the opportunity to be the biggest angel investor ever and they’re not taking the chance to do it.  That’s disappointing.

So What Do We Do Now?

But I’m hopeful.  Maybe we should realize, as Kevin Depew says “the time for preparations and battening down the hatches has passed. It’s here.”

Which echoes Joe Wiesenthal’s sentiment.  We need to focus on the bigger picture issues.  Education for our children is still going to be an issue that will still be there.  Care for an aging population is still going to be with us, as well as figuring out what our economy can produce as those of us who follow the Baby Boom have to keep things moving somehow.  These are all things we can still choose to do something about, even as other things we can’t do anything about (the trajectory of real estate prices, for example) head along their own paths.  We don’t have to let our actions or even our lives be governed by that stuff.

I don’t know about you, but I’m glad that we don’t have to let those things dictate outcomes.  Because on this Independence Day weekend, I’ll take the power of choice – the freedom to choose, in fact – any day of the week over the alternative.

A Crash Course in Deflation. Seriously…

Seems there’s a lot of data that seems to be pointing to one outcome.  The outcome which shall not be named.  First, there was a piece by Ambrose Evans-Pritchard discussing the decline in M3:

Paul Ashworth at Capital Economics said the decline in M3 is worrying and points to a growing risk of deflation. “Core inflation is already the lowest since 1966, so we don’t have much margin for error here. Deflation becomes a threat if it goes on long enough to become entrenched,” he said.

via US money supply plunges at 1930s pace as Obama eyes fresh stimulus – Telegraph.

*Gasp!!*  Ashworth said it: deflation.  But M3 isn’t kept track of by the Fed anymore.  What is kept track of by the Fed, though, is MZM – money of zero maturity.  And, um, it’s well, deflating:

This was a monthly chart.  But when you take a look at it on a quarterly basis, which is how you need to align the MZM data with GDP data to perform a calculation of velocity, the change looks even more compelling:

Which, given the downward revision in GDP…

Is not that encouraging…

So I recalculated the velocity of money based on the revised GDP data.  The supposed rebound in velocity is looking more and more distant.  This is really a flat-lining.  An absence of decline.

We’re not cheering rebounds or snapbacks.  We’re just happy to not be falling.  If you want to see the data I used, it’s here:

View this document on Scribd

Then Zero Hedge comes out with this whopper:

SocGen’s Albert Edwards chimes in with an observation from a slightly different angle, namely that the collapse of global FX reserves, whose explosion until 2007 “fuelled both global GDP growth and the credit bubble,” which are simply indicative of global imbalances and are a very useful measure of total liquidity, are now plunging. This merely reinforces the deflationary pressures of the plunge in money supply, and forces the Fed into a corner from which there is no escape except by activating another multi-trillion QE program.

via Is The Collapse In FX Reserves Even More Dangerous Than The Plunge In Money Supply? | zero hedge.

There’s also this chart in the post, which I find to be quite interesting:

The thing to note is the amplitude/size of movements in the time series.  Earlier parts of the series have less jumpiness but now we’re clearly in a period with more volatility.  I’ve commented on rising volatility in an earlier post, that fittingly enough, featured some more of Albert Edwards’ charts:

What will the Fed do the next time an easing is needed? Whatever it is, the response will have to be stronger and possibly more unorthodox – more unconventional – than it was before. People in Austin, TX like to say “Keep Austin Weird” and that’s fine. They can keep their weirdness. I sure as hell don’t like seeing my central bank engage in it, however…

…

But what I wonder is this: are we in for more volatility in economic indicators as Fed monetary policy response looks more and more like a” Twilight Zone” episode and less like central banking?  And with what effect?  What if all this stimulus, all this unorthodoxy in central banking does is – as a best case scenario – get us back to our last cyclical peaks in 2007?  We would’ve replicated Japan.  Richard Koo would be trying to convince us that was a good thing while I look at him like he is a three-headed cyclops.  The image of a three-headed person just wouldn’t capture my level of bizarreness well enough.

via How We Can Be V-Shaped, Yet Japanese At The Same Time « Deep Thoughts by Professor Pinch.

And with interest rates near zero, well, I had this observation:

The credit market is not just priced to perfection: it’s priced to the hilt. At these funding costs, credit creation could be almost unlimited. Yet what are we seeing? The charts I presented above. Illiquidity. Possible bank runs. Carry-traders getting the gas-chamber treatment as Euro-Yen trades blow up. Then there’s the stimulus to stave off bank failures, which gets recycled through abnormally high levels of risk-taking (i.e. moral hazard). The bailout machinery will be running 24/7. Kind of like the Shit Sandwich Deli was 3 years ago.

via Like The Movie “Syriana,” It’s All Connected « Deep Thoughts by Professor Pinch.

In short, this can only lead to one thing, and it ain’t pretty.  Zero Hedge put it pretty succinctly:

The bottom line is that in attempting to fix one problem in a suddenly broken system, another one develops, as everything is interrelated and interconnected in the global economic system, linked up through channels of liquidity, or lack thereof. M3, global imbalances, declining wages, all these are indications that the Fed is certain to lose the war. But not the the next battle, which will be fierce: expect a massive, unprecedented, and record reflation attempt yet by the Fed and the global central banks, that will make all stimulus to date pale in contrast.

Which means that the quantity of money can only go up if the central banks are going to try and foist “stability” on us.  I think there’s plenty of folks that would agree with us.  Where I diverge from Tyler is the ultimate result: a run on gold versus bigger drawdowns on currency.  The dollar funding pressures we’ve seen recently tell me there’s still widespread (and possibly growing) fear that there’s still a lack of liquidity out there.  Frankly, I don’t think the central banks can shovel it out there fast enough in enough channels.

The question is why.  Simply put, repos, reverse repos, currency swaps, etc. are just credit instruments.  Credit is deflationary.  You have to pay back more than you borrow.  That only makes sense if you can make more than what you’ll owe.  But if you can’t, it leads to a restructuring or austerity.  Take your pick.  Real Bureau of Engraving and Printing madness is all that’s left, where M1 would essentially swallow up MZM and M3 levels of money creation.  But the minute that occurs, the run on hard commodities will be on in full force.  Everyone will know the whole gig is up.

Which is why the central banks won’t do it.

On Debt and Deflation

I read a very thoughtful post over at Bondsquawk, so I want to build on what Rom wrote over there with some thoughts of my own I’ve cobbled together over the past few months.  Hopefully it will make sense to at least one person that isn’t me having an inner dialogue with myself.  No, I don’t fancy myself as an econometric Raymond Babbitt.  His social skills are far better than mine.

But let me pick up on Rom’s post.  Here’s a juicy tidbit I particularly liked:

In order to have inflation and to drive prices higher, resources need to be relatively scarce in the face of rising demand. Capacity Utilization, which measures the actual output produced as a percentage of potential output given current resources, continues to hover in the low 70’s, citing idle and slack resources in the manufacturing sector. Typically, during periods of growth, the Capacity Utilization percentage should exceed 80 percent.

via Deflation Risk is the Bigger Issue « BondSquawk

Rom started it, I’m going to finish it.  Let’s look at the chart:

You should notice two things: first, the chart has tended to see lower highs and lower lows with each cycle.  A deflationary force for sure.  But let’s look at why this is the case.  The peaks and valleys I highlighted in purple are from the 60s & 70s.  Vietnam-era stuff.  Also a stagflationary period, if you recall.  What would’ve set that off?  Massive increases in government spending that were a reaction to Eisenhower’s drive for balanced budgets and the maintenance of an adequate military.  Ike was Ron Paul before Ron Paul was even Ron Paul.  The Cold War loomed large, but LBJ also signed into law the Great Society that saw the biggest expansion of government since the New Deal.

But this was also the same point in time when we started seeing the decline of American manufacturing.  Sure it was only in dribs and drabs, but it was there.  You could see it.  Feel it.  Kiss it.  Well, maybe not kiss it.  But you get the idea.

So why the huge spike upward in capacity utilization in the 80s?  Two reasons.  One, we started seeing the benefits of Volcker’s policy to manage money supply versus interest rates.  Second, personal computing and the transition of the American economy.  Little did people know it, but by then we made our transition to an information/knowledge-based economy.  Manufacturing wasn’t going to lead the country anymore, it was going to be services and information.  So anything that helped expand the amount of information/services available in the economy were going to expand.  At least up until now.  I pointed this out in a nuanced manner in an earlier post:

We haven’t had a truly Earth-shattering breakthrough since some students at the NCSA started using something called HTML to design these things called web pages and Marc Andreessen ran with the idea and developed this company called Netscape. Yes, we have Twitter. Yes, we have Facebook and yes, dear God, we even have MySpace. But we still point and click our way around a two-dimensional GUI, most likely running on a 32-bit (although 64 bit is gaining) Intel-based chipset that has been essentially unchanged for decades. Yes folks, I’m saying we have plateaued in terms of innovation.

via How We Can Be V-Shaped, Yet Japanese At The Same Time « Deep Thoughts by Professor Pinch.

Capacity Utilization is headed downward again because our information-based economy has matured.  Also, there’s this factor called demographics.  So while there’s more slack, there’s also fewer able-bodied people to power the economy.  Indeed, as I pointed out:

A flat-lining labor force will happen in most of the developed world given its demographic characteristics, it’s just a matter of time. The question is do we measure it in years or decades. My guess is years. Eventually the confluence of declining birth rates, rising average median ages and declining population growth rates (in total, including immigration) will take its toll.

via The OECD’s Demographic Problem (i.e. We’re Turning Japanese) « Deep Thoughts by Professor Pinch.

But I also want to touch on debt for a second.  I don’t see debt as the same driving force of  inflation as many others do – far from it.  And there’s one very simple reason: debt has to be serviced.  Interest is owed.  So if you can’t pay the interest and get the principal rolled, you either default or restructure it.  Either way, you’ll need to change your spending patterns.  Money printing – i.e. boosting the amount of currency in circulation is definitely inflationary in the long run.  I realize many people will see debt expansion as inflationary, and I’ll buy into the idea that over the short-run it can be.  But over the long run, debt is deflationary in my mind.

Of course, there’s these charts to go with the whole debt servicing argument: the collapse in the velocity of money, collapse in commercial paper borrowings and consumer credit.  All courtesy of the St. Louis Fed publication “Monetary Trends:”

So let’s put things together: an economy that needs to transition into a new type of economy to better utilize the resources it has, meanwhile that same economy borrows money – which will require repayment; plus interest – at the same time the country is undergoing a demographic shift which will leave it with a smaller labor force than before?  So debt-per-capita expands?

Someone is going to have to explain how we get inflation or hyperinflation from this because I frankly don’t see it.

Commented on “The Reformed Broker”

The Reformed Broker has a good post out today on investing and essentially, where do we go from here.  I left him a comment there but I also wanted to post it here as well.

Josh,

First, a good article. And I think for the consensus point of view, it strikes a chord. That frame of reference you’re using is one that presupposes an inflationary environment. It’s natural for us to presume it because inflation is all most of us have ever seen or experienced.

But allow me to offer a different one. In a deflationary environment, your focus isn’t on increasing asset valuation, but preventing decreases in their values. Here, cash is the best defense not because it will gain the most, but because it will lose the least.

Originally posted as a comment
by professorpinch
on The Reformed Broker using DISQUS.

Swap Spreads Go Negative as Carry Traders Continue Running In Front of Buses to Pick Up Pennies

A lot of thoughtful commentary and analysis has been put out there this past week on swap spreads going negative this past week.  Good examples can be found here and here.  Well I’m going to throw in my two cents on the subject as well.

In trying to analyze the issue, I pulled data from the Federal Reserve to look at spreads at various points along the yield curve and compared the average swap rate each day to its equivalent constant maturity Treasury.  The following two graphs show this in two ways.  First, I looked at swap spreads for the 2, 3, 5, 10, and 30yr swaps to Treasuries through time.  While all the talk this past week was about 10yr swap rates going negative to Treasuries, they have been negative for at least 6 months at the 30yr:

Since I also wanted to view swap spreads as a yield curve in their own right, I wanted to see what the term structure of swap spreads looked like.  This was even more telling in some ways.  Not only is it negative sloping, note the degradation and shift in this term structure in the past month:

The only things I can think of that would have had such a profound effect on this curve was the Fed’s “extended period” phrase being left in after the last FOMC meeting and we had a bad Treasury auction.

But as I look at these charts and data, I can’t help but think both of the dominant theories about this phenomenon are at work.  In the near term in the 2s,3s, and 5s we have swap spreads that seem to be moving together both in direction and in the size of the spreads.  The fact we’re seeing all of them move lower in unison speaks of extreme market complacency in the near term – confidence that adjustable rates will remain super low and fixed keeps grinding lower in the process.  Again, the image of kids carry traders picking up pennies in front of oncoming buses comes to mind.

But at the 10 & 30 yr, things seem to be different.  There, I think David Merkel of the Aleph Blog may be on to something:

And this:

Which is what I also tend to believe.  I think this is more about a Treasury glut than it is a credit risk issue.  Because governments can tax and they can print more currency.  Debt issuance is not the same as issuing currency because debt is borrowed.  Currency isn’t.  Defaults in a sovereign context really have to do with the tendency of a government to do a strategic default on its debt.  Think of strategic defaults on mortgages except bigger.  Other events can serve as a proxy for default like IMF/World Bank assistance, or currency devaluation.

So given those are the default definitions we have to work with, can we really say the US is going to do one of those things?  It’s hard to imagine them doing so, but there is no such thing as a zero probability event.  Over a long enough timeframe, anything can occur.

But as great as it is to imagine all of this, the big question is what will the rate curve look like going forward?  I don’t know, but Dr. Donald van Deventer from Kamakura Corp. illustrated their 10yr forward forecast of the Treasury yield curve:

The thing I note? The compression of the curve.  At the left (i.e. present day) you can see a nice upward sloping curve.  But as you move right, you see the curve is being forecasted to get tighter and tighter, with most of the increase coming in the short maturities/front-end.  Call this another “tell” that the market is being too complacent.  If they were more focused on the idea that the curve’s shape can change, they wouldn’t be looking to gain extra basis points off the present shape, but would consider what else could happen.

Oh well.  Just don’t come crying to me if it all goes wrong…

Wordless Wednesday 01-06-10

Wordless Wednesday 12-16-09 – pt. 1

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