THE BEAR'S LAIR Possible October surprises
By Martin Hutchinson
Economists' crystal balls are clouded right now. They see signs of a burgeoning
global recovery, but retail sales and other key data surprise with their
weakness. There is no sign of inflation, yet commodity prices are extraordinary
strong, given we are in the depths of a major recession. The reality is that
fiscal and monetary experiments have been tried that have never been tried
before, and their combined effect is only beginning to be felt.
Conventional wisdom, based on the experience of the 1970s, holds that
over-expansionary monetary policies should lead to inflation, while large
budget deficits should lead to higher interest rates. Yet there is little sign
of accelerating consumer price inflation at present (although Federal Reserve
Chairman Ben Bernanke's 3am fear of deflation has also not appeared), while
interest rates have trended down in the last few weeks, contrary to
expectations of "crowding out" from the US Treasury's unprecedentedly large
budget deficit.
Were the adverse effects of excessive money creation and huge budget deficits
not to appear at all, much of economic theory would have to be rewritten. It
would mean that excess money creation could magically disappear, leading to no
real world effects. It would also mean that budget deficits ad infinitum could
be financed, as the global pool of capital simply expanded to accommodate them.
Economically, the world would have invented a perpetual motion machine, in
which government could create resources at will without adverse side effects.
Perpetual motion machines being impossible in the physical world, one's natural
skepticism supposes them to be impossible in the economic world. Hence the
adverse effects of excessive money creation and budget deficits must either be
delayed or be appearing in some novel form, so that observers looking for a
repetition of the 1970s do not spot them.
As soon as the problem is posed in this way, the evidence becomes obvious.
Commodities prices are far higher in real terms than they were at the top of
the 2000 boom, while gold is on the verge of breaking through its record high
and soaring into unknown territory. In itself, that makes no economic sense; in
a deep recession such as the current one, where markets are allegedly fearful
of deflation, commodities and gold prices should be extremely weak.
Commodities and gold therefore are the destination of this year's hot money and
are forming the new bubble. They are a hedge against inflation, obviously, but
they are also a hedge against prolonged recession, since the authorities have
made it very clear that in such a case they would continue ad infinitum their
current loose money policies.
That makes sense. Stocks, the most likely bubble suspect, are held back by
recessionary earnings and prospects. It becomes impossible for even the most
enthusiastic Wall Street analyst to push up stocks beyond a certain level if
the raw material of "stories" is not there, and in this economy the stories are
decidedly absent.
China of course sees its stock market soaring to ever greater heights, since
its domestic funding sources have lots of money and very few alternatives, but
that market is still largely independent of the world as a whole. As for
housing, in most national markets there is a huge inventory overhang, together
with a backlog of borrowers heading slowly for foreclosure, so that too is
unlikely to see much of a takeoff.
Bonds are an interesting case. From December to June, 10-year Treasury bond
yields backed up from 2.07% to 4%. That's what one would expect with the
ludicrous levels of deficit, more than 10% of US gross domestic product in both
2009 and 2010, that the United States is currently running. However, yields
then backed off; the 10-year Treasury bond is currently yielding about 3.4% and
the Treasury is able to fund hundreds of billions of new confetti-like
financing with the utmost ease.
That suggests a fair-sized bubble has developed in the T-bond market. With the
world in recession, yet with Asian central banks and other institutions
generating massive cash flows because of easy money, the most obvious place to
put those flows remains T-bonds. If this is a bubble, however, it is an
extraordinarily vulnerable one. At any moment, a modest resurgence in US
inflation or difficulty in a long dated T-bond auction could cause confidence
to flee the Treasury bond market and yields to leap uncontrollably upwards.
The current situation is unstable. The problems caused by excessively lax
fiscal and monetary policies are indeed appearing, but not yet in a form that
forces policymakers and economic participants in general to take action. The
rise in commodity prices will remove purchasing power from Western economies
and push up their consumer price indices, but it has not yet done so since it
has been offset by the natural deflationary effects of recession.
The recent modest decline in Treasury bond yields conceals an increasingly
unstable bubble, and it is only a question of time before that bubble bursts.
Given the current predilections of the world's central bankers, it is likely
that when the T-bond bubble bursts, they will rush to the printing presses, the
Fed buying Treasuries in a frantic attempt to stabilize the bond market. In all
but the shortest term, that is unlikely to work; it will cause a spiraling
increase in gold, oil and other commodities prices that will make it clear to
the doziest Federal Open Market Committee member that the punchbowl has been
drained dry and the party of monetary profligacy must end.
October 2009 is unlikely to produce another banking crisis. It may very well,
however, produce a crisis of confidence in the Treasury bond market, followed
by an economic relapse as interest rates are forced upwards and high commodity
prices reduce purchasing power in those Western countries that are heavy net
consumers of commodities.
If October 2009 fails to produce a full-scale T-bond rout, it will not be long
delayed thereafter; the resurgence in consumer price inflation caused by
continually rising commodity prices will eventually cause even central bankers
to demand higher yields.
Either way, the flood of money that has poured into commodities, bonds and the
stock market cannot prop them up for much longer. Like previous such floods, it
must eventually reverse, and its reversal will cause yet another round of
bankruptcies and unexpected disasters. The "Great Moderation" of which Federal
Reserve chairman Ben Bernanke spoke so lovingly before the present
unpleasantness was always a myth. In reality, the flood of easy money from 1995
caused a succession of bubbles, each one more devastating than the last once it
burst. Monetary policy since 1995 has been wholly immoderate, expanding the St
Louis Fed's broad measure of money, MZM, by 8.7% annually since spring 1995,
82% faster than the 4.7% annual rise in nominal GDP. Its long-term results have
been and will continue to be equally immoderate.
The laws of economics have not been repealed. It is indeed not possible to run
a huge fiscal deficit without destabilizing the bond market; attempting to
finesse the problem by creating excessive money simply causes spiraling
commodities prices and subsequent inflation. Equally, an over-stimulative
monetary policy will find an outlet either in consumer prices or in asset
prices, though it may take a considerable time to do so.
Apart from instability, the long-term costs of excessively cheap money are
beginning to be seen in the US economy itself. By allowing money to remain so
cheap for so long, and by running incessant payments deficits, the United
States has surrendered the advantage of its superior long-established capital
base, narrowing its capital cost advantage over emerging markets and exporting
that capital to countries with less profligate approaches.
Huge budget deficits, themselves worsening the trade deficit, merely export yet
more US capital to the surplus nations. That makes it inevitable that the years
ahead, in which the United States will no longer enjoy a capital advantage over
its lower-wage competitors, will see highly unpleasant declines in US living
standards.
Job losses within the US in the current downturn are steeper than in any
previous recession, even though the output decline is only equivalent to those
of 1973-75 and 1981-82. Income differentials have widened unpleasantly, as the
working class jobs in manufacturing are outsourced to Asia while the cheap
money has created a parasitic and unpleasant class of financial manipulators at
the top of the distribution. Only a decade of sound money and sound budgets
will rectify these problems, and halt the decline in US living standards.
Needless to say, we are a very long way from even the start of such a decade.
There really are no free lunches in this world. Of all the attempts to create a
free lunch, or a perpetual motion machine, the delusion by government that it
can create wealth is the most dangerous.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)
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