"Arx tarpeia Capitoli proxima" or the recent US Downgrade threat and the Fed dual mandate issue

"Arx tarpeia Capitoli proxima"

The price of continued US lax fiscal policies has seriously risen with S&P putting the US economy under negative watch.

The Fed has now kept the benchmark at zero to 0.25 percent since December 2008 while proceeding to two rounds of Quantitative Easing.

Whereas in Europe, the ECB has started tightening. It is the first time ever the ECB has acted before the FED preemptively in relation to inflation concerns.

This is an important point, as it clearly shows the divide in policies between the US and Europe.

While Trichet and the ECB seems to be sitting in a more classical camp, Bernanke and the Fed, seems to believe in a Keynesian approach in resolving the difficulties faced by the US economy.

It is important to remind at that point the clear differences in mandates between the ECB and the FED. While the ECB's core mandate is of price stability, the FED has a dual mandate, price stability and maximum employment. Hence the current difficulties faced by the Fed. Targeting both unemployment levels and inflation levels is a near impossible task for the Fed currently. It has to promote both “maximum employment” and “stable prices. The Fed’s mandate was extended to "maximum employment" in 1978 as a way of forcing the central bank to "print money". This extension of the mandate made sure the Fed would always be under continuous pressure from the politicians. But, Paul Volcker initially in the early 80s did not play it that way. He clearly understood the risk in not taming the inflation beast. He knew he could not fight on two fronts and initially targeted inflation versus maximum employment. His policy of taming inflation with a rapid surge in interest rates led to a very severe recession but put back the US economy on track. The recession was short but indeed very painful which led Mr Volcker to be hated by both Republican politicians as well as Democrat politician.

One of the main reason of QE2, can be sourced to this ill-fated dual mandate.

The Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, as well as lifting stock prices, playing on the wealth effect game. I criticised the wealth effect policy in February 2011 (Ben Bernanke - The illusionist and the year of the rabbit - The illusion of wealth).

It is important at this stage to link this post to a previous one I have written: "The Hurt Locker". In this previous post I published in September last year, I discussed the fundamental flaws in Washington’s stimulus policies, linked to the flawed dual mandate imposed on the Fed.

Also, I quoted Jacques Rueff and his analysis of the failings of Keynesian stimulus policies:

"Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for 'things' meant that salaries - in real terms - would go down. That was the greasy scam behind Keynes' General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them."

What we are seeing right now is a Fed creating price inflation during the current slump ensuring the "poor schmucks" real terms wages are going down.

This is what happened during the big Stagflation period of the 70s:

"Between 1974 and 1984, real wages fell as much as 30%."

In Homage to Jacques Rueff, Bill Bonner added the following:

"But Rueff’s insight comes with a warning. The faith-based, dollar-dependent monetary system is like a loaded pistol in front of a depressed man. It is too easy for the US to end its financial troubles, Rueff pointed out, just by printing more dollars. Eventually, this “exorbitant privilege” will be “suicidal” for Western economies, he predicted."

Bill Bonner concluded:

"Paul Volcker put the pistol in the drawer. Ben Bernanke has found it. And Jacques Rueff must look on in amusement to see what happens next."

In May 2010, I wrote: Anterograde Amnesia or Retrograde Amnesia? Or both?:

"Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past in unaltered." This seems to be the position of the classical ECB while the Fed seems to be suffering from Retrograde Amnesia. "Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible."

It is very important to understand the game played by politicians in relation to creation of the additional mandate of the Fed, namely maximum employment and its fallacy.

Joseph Schumpeter, one the greatest economist we ever had, clearly understood's the role politicians played; He presented in the quote below as "The Intellectual in reality our politicians. I initially referred to Schumpeter in December 2009 in the following post: "Blue pill or Red Pill?"

"Capitalism’s Greatest Enemy: The Intellectual

"The proper role of a healthily functioning economy is to destroy jobs and put labor to better use elsewhere. Despite this simple truth, layoffs and firings will still always sting, as if the invisible hand of free enterprise has slapped workers in the face. Unsettling by nature, capitalism’s churn gives rise to a labor movement designed to protect workers from job loss. That movement is fed emotionally by displaced workers and others who blame the capitalist system for their troubles, but it is led psychologically by a whole other type of person—the intellectual. Intellectuals—with little to do owing to the success of the capitalist economic system but with an intense desire to be seen as caretakers of society’s general well-being—anoint themselves as leaders of the labor movement. They object to capitalism on moralistic grounds and seek its destruction and replacement by another system—socialism—which places them center stage."

"You could replace "intellectuals" in the quote in today's economy by politicians and you would not be far from what is currently happening in many countries today" I argued back in 2009.

Creative Destruction as defined by Schumpeter, is at the core of Capitalism. Politicians for the sake of getting elected or re-elected cannot accept this core feature of capitalism. One could argue that Schumpeter's view of the evolution of Capitalism towards Socialism, is in fact quite accurate in the description of the process.

But I digress, let's go back to the Fed's dual mandate issue and the current situation.

The Fed is trapped in its dual mandate enforced by US politicians. QE2 will make it extremely much tougher for the Fed to eventually reduce its gigantic balance sheet, therefore risking higher inflation.

While the ECB's mandate make it more easier to react to inflationary pressures, regardless of unemployment levels:

Fed officials not attached to dual mandate - Reuters

"In a clean discussion of what the appropriate role for a central bank is, I can see some merit in looking at a narrower objective," Chicago Federal Reserve Bank President Charles Evans.

"It's interesting," he said in November. "The ECB (European Central Bank) has a price stability mandate ... The only thing a central bank can do in the long run is control the long run rate of inflation, so from that point of view it makes sense to have single mandate"

according to St. Louis Fed President James Bullard.

"With no explicit plan for when or how this quantitative easing will be withdrawn, the Federal Reserve could do more for the American economy by focusing singularly on maintaining the value of the dollar and protecting the purchasing power of Americans,"

Mike Pence, No. 3 Republican in the House.

It looks like Mike Pence care about the "poor schmucks" Jacques Rueff mentioned, who are seeing their real terms wages are going down with the US dollar...

Former U.S. Treasury Department undersecretary John Taylor indicated as well is wish for an end to the dual mandate of the Fed in January 2011:

John Taylor Advocates Narrowing Fed Mandate - WSJ

“It would be better for economic growth and job creation if the Fed focused on the goal of “long run price stability within a clear framework of economic stability,’”

Taylor told the House Financial Services Committee.

An excellent post from November 2007 on the blog published by Macro Man can be find below, relating to the subject of the dual mandate:

Does the Fed's dual mandate spell doom for the dollar? - Macro Man

"Simply put, the Federal Reserve, as a matter of policy, is less interested in protecting the international purchasing power of its currency than other central banks are. Such a policy focus is really quite remarkable for the central bank of THE hegemonic reserve currency, and no doubt explains why the FX reserve managers are, broadly speaking, trying to reduce (or at the very least not increase) their dollar holdings as a percentage of their reserve baskets.

It is also a damned good reason why the dollar pegs of current account surplus countries, particularly those with high inflation, are wildly inappropriate. The Fed's implicit promise to sacrifice the international purchasing power of the dollar (and by extension under current policies, the renminbi, riyal, dirham, etc.) to support domestic employment as a matter of course is wrong, wrong, wrong for China, Saudi Arabia, the UAE, etc."

Recently Dr Hussman, wrote an excellent article related to the trap the Fed has put itself in with QE2:

Charles Plosser and the 50% Contraction in the Fed's Balance Sheet (Hussman)

"A week ago, Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should increase short-term interest rates to 2.5% "starting in the not-too-distant-future," preferably during the coming year. Given the robust historical relationship between short-term yields and the amount base money per dollar of nominal GDP, we can make a fairly tight estimate of how much the Fed would have to contract the monetary base in order to achieve a 2.5% yield without provoking inflationary pressures. While the monetary base will be over $2.5 trillion by the end of this month, a 2.5% interest rate would require a contraction of about $1.3 trillion in the Fed's balance sheet, to a smaller monetary base of just under $1.2 trillion.

In his comments, Plosser discussed a plan to sell about $125 billion in Fed holdings for every 0.25% increase in the Fed Funds rate. That overall estimate is just about right (ten increments of 0.25 each, with an overall contraction approaching $1.3 trillion in the Fed's balance sheet). So Plosser's estimates correctly imply that a 2.5% non-inflationary interest rate target would require the Fed's balance sheet to contract by more than 50%.

The problem, however, is that the required shift in the monetary base is not linear. It's heavily front-loaded. Based on the historical liquidity preference relationship (which explains about 96% of the variation in historical data), and assuming nominal GDP of $15 trillion, the following are levels of the monetary base consistent with a non-inflationary increase in short-term interest rates up to 2.5%. The non-inflationary provision is important. You can't just allow interest rates to rise without contracting the monetary base. Otherwise, as noted earlier, non-interest bearing money would quickly become a hot potato and inflation would predictably follow.

The upshot is that Plosser's estimate of about $125 billion in asset sales for every 0.25% increase in yields is an accurate overall average, but the profile of required asset sales is enormously front-loaded. The first hike will be, by far, the most difficult. In order to achieve a non-inflationary increase in yields even to 0.25%, the Fed will have to reverse the entire amount of asset purchases it has engaged in under QE2. Indeed, the last time we observed Treasury bill yields at 0.25%, the monetary base was well under $2 trillion.

In my view, this is a major problem for the Fed, but is the inevitable result of pushing monetary policy to what I've called its "unstable limits." High levels of monetary base, per dollar of nominal GDP, require extremely low interest rates in order to avoid inflation. Conversely, raising interest rates anywhere above zero requires a massive contraction in the monetary base in order to avoid inflation. Ben Bernanke has left the Fed with no graceful way to exit the situation."

Dr Hussman also added in this must read article:

"The first 25 basis points will require an enormous contraction of the Fed's balance sheet. Risky assets have already been pushed to price levels that now provide very weak prospective returns."

In relation to today's market environment, the outcome is likely to be a very significant risk of unstability and sharp volatility increase. Given the potential for the economy to come to a stalling point in the upcoming quarters due to external inflation pressures (oil prices high prices) already creating serious headwinds on corporate profit margins as well as consumption, it is extremely important to be well aware of the consequences of unbalances which has been generated by a reckless Fed in launching QE2.

Another surge in Gold was clearly expected, I agreed with Martin Sibileau's view when he posted in his blog A View from the Trenches, on April 4th, 2011: "Gold, the Fed, Ron Paul and Napoléon Bonaparte"

"The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold."

The release of information related to the access to the discount window of the Fed, thanks to Bloomberg's tenacity in their lawsuit also underlines a very important point between the current relationship between the Fed and the ECB. Martin Sibileau in his post,goes further in the analysis of the access to the Discount Window of the Fed: loans to overseas banks including cross-currency swaps, and their implication in magnifying global leverage worldwide.

"These loans and cross currency swaps are the “leverage of the leverage”, so to speak. With them, other central banks give up their sovereignty and the Fed effectively becomes the world’s lender of last resort. For instance, when the Fed loans US dollars to a German bank, as it did, the European Central Bank can no longer act as lender of last resort, should the German bank default on its obligations with the Fed. But, would this in reality occur? Of course not! If the German bank was not able to repay its US dollar denominated loans, the Fed would simply roll over the liquidity line. This is a very troubling scenario because the Fed in fact expands the supply of US dollars worldwide (global leverage), without any counterbalancing reduction of credit in the US currency zone.

In our view, these “global” discount window operations are the necessary (but not sufficient) step towards the collapse of fiat money. If we are ever going to see the end of fiat money, it will be thanks to global loans from the Fed. Without them, other central banks will always retain their sovereignty and become alternatives to the US dollar. But with them, once the loans are out and a wave of defaults is triggered, the Fed becomes the easy prey for the collective gold longs."

Like Martin Sibileau, I sit in the same camp, outcome will be stagflation.  We both believe in strong stagflationary forces being at play in the current environment.

What will happen when Asian countries as well as Oil rich countries, gorged with USD reserves and facing the rising threat of inflation, will decide it is not wise anymore to invest these reserves in US Treasuries, but to invest in gold, tangible assets and more yielding assets?

As I wrote previously you cannot expect China to bow to American pressure and start revaluating the Yuan versus the dollar. China has learnt the lessons from Japan: Revaluation of Japanese Yen, a historical lesson to draw: analysis - This is an article on the seventh page of People's Daily, September 23, by Pro. Jiang Ruiping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

Chinese government officials have stepped up the rhetoric game with the USD stating they might have to diversify their USD 3 trillion of currency reserves away from U.S. dollars. Who would blame them, given the sinking value of the USD, therefore the sinking value of their chips in the game of marbles?

The dollar is 5% away from its all-time low, touched in March 2008, as tracked by the dollar index, which dates back to 1971.

The recent action led by S&P relating to its concern on the US economy, is a stark message sent to the US politicians, they need to put the US house in order and begin to show some long term fiscal discipline.

On the subject:

From Theory to Praxis - Sean Corrigan, Diapason Securities

"Only under the rules of what Jacques Rueff scathingly termed the 'childish game of marbles' by which the winners (the Chinese) return their spoils (the excess dollars) back to the American losers at the end of each round - by buying US Treasury and Agency bonds, in the main - and as a result of what the great Frenchman also dubbed the 'monetary sin of the West' - the fact that the dollar hegemony allows the US to go on mindlessly inflating and blaming others for its own lack of financial virtue - can the Chinese be held culpable for what is at work here."

Sean Corrigan also adds in his article:

"Emphatically, the only 'risks associated with deflation' are those which come from clinging too long in the naive faith that the value of one's money will be preserved by a central bank which can still talk about such an eventuality while the malign effects of its inflationary policies are everywhere increasingly undeniable."

"In a West already displaying symptoms of the extirpation of the middle class, in favour of the governing military-political elite and at the cost of buying off its feckless urban proletariat with a higher dole and more spectacular circuses, the more the state expands in this way, the more success it will enjoy in the only one of its wars on abstract nouns which it wages unremittingly and a outrance - its War on Capital."

The Dollar Standard which succeeded Bretton Woods in 1971, following its collapse, has allowed the deficit countries like US, to consume more than they produce. Whereas surplus countries, such as China, Singapore and others, have been able under the new system to produce more than they consume, therefore accumulating vast USD reserves accordingly.

Between January 2004 and the beginning of 2008, worldwide international reserve assets more than doubled. Asian countries have boosted their reserves by acquiring export dollars. These dollars then moved back to the US, where they funded most of the excesses: subprime mortgages, leveraged buy-out, structured credit markets and so on.

QE2's wealth effect, it can be argued, cannot be branded as a success. The surge of US stock prices has been a mere reflection of the decline of the US dollar, hence the rise in Gold in the process.

The excellent David Goldman clearly illustrates the point:

If the economy is weak, why are stocks up?

"The last two weekly unemployment claims prints above 400,000 show how weak the labor market is. I’ve been saying for two years (pardon the broken record) that an entrepreneurial economy can’t do that well as long as there are no entrepreneurs in the picture. If that’s the case, why are stocks doing so well?

Part of the answer is that stock prices reflect the declining dollar: overseas profits increase when translated back into dollars, and American cash flows look cheaper to foreign investors."

Trade Weighted Dollar vs. S&P 500, April 20, 2008 to April 20, 2011

In relation to the current situation, the recent warning shot fired towards the USA by S&P, is an important inflection point as we moved towards what I have previously called relating to Chess, "The Endgame - Fin de partie":

An endgame is when there are only a few pieces left. We are close to the point.

"Artistic endgames (studies) – contrived positions which contain a theoretical endgame hidden by problematic complications".

This is the situation the Fed is currently in.

"You have a choice between the natural stability of gold and the honesty and intelligence of the members of government. And with all due respect for those gentlemen, I advise you, as long as the capitalist system lasts, vote for gold."

George Bernard Shaw

 

The Great Pretender - the Bluff Call of 1971 - the Nixon shock.

In 1971, one of the greatest poker game ever played came to halt. It marked the end of the Gold Standard and the convertibility of the US dollar in Gold.

In this post I will revisit this great moment and highlight some of the contributions of one of the great adversary of Keynes to this moment, Jacques Rueff.

The context of the Nixon Shock of 1971:

http://en.wikipedia.org/wiki/Nixon_shock

"By the early 1970s, as the costs of the Vietnam War and increased domestic spending accelerated inflation, the U.S. was running a balance of payments deficit and a trade deficit, the first in the 20th century. The year 1970 was the crucial turning point, which, because of foreign arbitrage of the U.S. dollar, caused governmental gold coverage of the paper dollar to decline from 55% to 22%. That, in the view of Neoclassical Economists and the Austrian School, represented the point where holders of the U.S. dollar lost faith in the U.S. government’s ability to cut its budget and trade deficits.

In 1971, the U.S. government again printed more dollars (a 10% increase) and then sent them overseas, to pay for the nation's military spending and private investments. In the first six months of 1971, $22 billion dollars in assets left the U.S.[citation needed] In May 1971, inflation-wary West Germany was the first member country to leave the Bretton Woods system — unwilling to deflate the Deutsche Mark to prop up the dollar. In order to prevent the dumping of the Deutsche Mark on the open market, West Germany did not consult with the international monetary community before making the change. In the next three months, West Germany’s move strengthened their economy; simultaneously, the dollar dropped 7.5% against the Deutsche Mark.

Because of the excess printed dollars, and the negative U.S. trade balance, other nations began demanding fulfillment of America’s “promise to pay” - that is, the redemption of their dollars for gold. Switzerland redeemed $50 million of paper for gold in July. France, in particular, repeatedly made aggressive demands, and acquired $191 million in gold, further depleting the gold reserves of the U.S. On 5 August 1971, Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against foreign price-gougers. Still, on 9 August 1971, as the dollar dropped in value against European currencies, Switzerland withdrew the Swiss franc from the Bretton Woods system."

The great imbalances we have witnessed in the last couple of decades come from this defining moment of the summer of 1971, when the great poker game played by the US came to halt as more and more countries called their bluff, worried by the US deficits. The agressive demands coming from France had been initiated by the advisor of General de Gaulle, Jacques Rueff, Keynes greatest opponent.

"The conditions which formerly were able to give rise to the ‘gold exchange standard’ have changed. The currencies of the Western European States are restored, to the extent that gold reserves of the Six today equal those of the Americans … This means that the custom of ascribing a superior value to the dollar as an international currency no longer rests on its initial foundation – I mean America’s possession of the largest share of the world's gold. This unilateral facility which is granted to America is serving to cloud the idea that the dollar is an impartial and international medium of exchange, when it is a means of credit belonging to one State … Gold has real value."

- Charles de Gaulle, February 4, 1965.

With great power comes great responsibility.
Stan Lee - Spiderman

The abuses of Bretton Woods.

The US have behaved irresponsibly for too long, putting us all at risk.

The privileged status of the US which was granted under the Bretton Woods arrangements, made it possible for the US to run a deficit that would never disappear while the dollar standard prevailed. Jacques Rueff concluded that this privileged status would inevitably lead(dollar standard and associated deficits) to a global economic crisis that would end in tears, an event akin with the Great depression. This is the situation we are currently going through.

Jacques Rueff has proven to be right and the Keynesians dangerously wrong.

A recently published biography on Jacques Rueff by Christopher Chivvis, The Monetary Conservative, is reviewed using the below link. It gives you a brief insight on Rueff's belief and contributions to economic policies:

http://www.realclearmarkets.com/articles/2010/09/14/book_review_the_monetary_conservative_by_christopher_s_chivvis_98667.html
http://74.217.243.103/publications/pubID.2261/pub_detail.asp

The clear abuse from the Dollar domination was very clear with the 1985 Plaza Accord of the 22nd of September 1985. I went through the consequences for Japan in a recent post relating to the bogus currency wars and the attitude of the USA towards China. Japan's never fully recovered from the economic suicide they committed by allowing the Yen to rise very fast again the US dollar.

The US survived the Saving and Loans Crisis by pushing Japan to the floor, and ruining in the process their largest creditor at the time. The US are attempting the same game with China today, this time around let's all hope they will fail. China is trying to curb hot money pouring in as well as taming inflation. They recently raised one year lending rate to 2.5%. It is becoming extremely difficult for China to slow hot money flows. Some countries have already implemented capital controls.

For Jacques Rueff, the only solution to remove the great current imbalances, would have been to reform the system and avoid a currency like the US Dollar to play the role of the world's leading currency or any other currency. Would a return to a Gold Standard work? Or a Bancor currency as advocated by Keynes? Bancor was indeed proposed before Bretton Woods led to the US Dollar assuming the role of the World's currency. Both Rueff and Keynes did not want the US Dollar to be the prevailing currency. They both understood the risks.

Tim Geithner's latest proposal targeting trade deficits and surpluses is basically an attempt to go back to Keynes Bancor proposal.

Felix Salmon recently wrote a post on Geithner's proposal in Seeking Alpha:

http://seekingalpha.com/article/231671-tim-geithner-s-poor-imitation-of-john-maynard-keynes

"Tim Geithner has proposed to his fellow G-20 finance ministers that trade surpluses and deficits be capped at 4% of GDP. The idea is already running into criticism from countries that run big trade surpluses."

QE2 is the nuclear option the US are currently playing with. They are willing to export inflation to the emerging markets to force their hands.

Ambrose Evans Pritchard in an article published in the Telegraph on the 10th of October discuss what is currently happening, paving a road to a potential new Bretton Woods, and the removal of the US Dollar as world reserve currency.

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/8054066/Currency-wars-are-necessary-if-all-else-fails.html

"The atomic bomb, of course, is quantitative easing by the Federal Reserve. America has in effect issued an ultimatum to China and G20: either you stop this predatory behaviour and agree to some formula for global rebalancing, or we will deploy QE2 `a l’outrance’ to flood your economies with excess liquidity. We will cause you to overheat and drive up your wage costs. We will impose a de facto currency revaluation by more brutal and disruptive means, and there is little you can do to stop it. Pick your poison."

The US are playing the Great Pretender game.

The United States has had the luxury of being in a position to avoid economic adjustment in spite of its deficits for too long. It is time to adjust to the reality and stop pretending.

The Great Pretender
The Platters/Freddie Mercury:

Oh yes I'm the great pretender (ooh ooh)
Pretending I'm doing well (ooh ooh)
My need is such I pretend too much
I'm lonely but no one can tell

Oh yes I'm the great pretender (ooh ooh)
Adrift in a world of my own (ooh ooh)
I play the game but to my real shame
You've left me to dream all alone
...

The Hurt Locker

Definition: noun. a period of immense, inescapable physical or emotional pain.



The Hurt Locker and the problem of the liquidity trap.

Paul Krugman's definition of the liquidity trap, the Keynesian view:

[a] liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. By this definition, a liquidity trap could occur in a flexible price, full-employment economy; and although any reasonable model of the United States in the 1930s or Japan in the 1990s must invoke some form of price stickiness, one can think of the unemployment and output slump that occurs under such circumstances as what happens when an economy is trying to have deflation — a deflationary tendency that monetary expansion is powerless to prevent.[29]


Excellent comment this week by R. Glenn Hubbard, dean of the Columbia Business School and former Chairman of the Council of Economic Advisers under President George W. Bush, and Peter Navarro, a professor of economics at the Merage School of Business at the University of California-Irvine:

http://blogs.reuters.com/great-debate/2010/09/10/desperate-times-do-not-always-call-for-desperate-measures/

"The fundamental flaw in Washington’s stimulus logic is the incorrect assumption that America’s current economic woes began with the 2007 recession. In fact, the roots of our slow-growth problem date back at least a full decade.

From 1946 to 1999, GDP grew annually at 3.2 percent, but since then, we’ve only averaged about 2.5%. On a cumulative basis, this seemingly small difference adds up to about 10 million jobs we failed to create.

What these statistics add up to is not a short term cyclical downturn, but rather longer-term trouble driven by four major structural imbalances in America’s GDP “growth driver equation.”


Overconsumption:

From 1946 to 1999, consumption averaged 64 percent of GDP but over the last decade, that share jumped to 70 percent. This increase was fueled not by rising wages, but rather by a housing bubble and a mortgage refinancing wave that turned American homes into ATM machines. This overconsumption has been mirrored in a low saving rate and a second major structural imbalance – underinvestment.

Underinvestment:

Business investment in research and development, technological innovation, and the new productive capacity required for the job creation process has been the single most important missing ingredient in our economic recovery – and for renewed long-term prosperity. Yet the current administration seeks only to raise the regulatory and tax burdens of business.

Chronic trade deficits:

These have been equally destructive. During the 2000s, our current account deficit more than doubled and likely reduced our annual GDP growth rate by a half a percent or more.

Excessive government spending:

This spending has provided some short-term stimulus. However, an overfed Uncle Sam represents the ultimate seed of destruction through upward pressure on taxes and interest rates and a stark future of sharp cuts in defense, education, and infrastructure spending."

"Over the long — and short — term, in implementing any stimulus, we should favor tax cuts to stimulate business investment as the best way to stimulate job creation. Reducing the fiscal burden of entitlement programs is also essential to restoring prosperity."

Federal Government Debt: Total Public Debt



In relation to the raging inflation/deflation debate, Bill Gross at PIMCO has decided to put a wager on it. A 8.1 billion USD wager...quite meaningful (notional value of derivatives position tied to the Consumer Price Index).
They bought inflation floors in size...

"Inflation floors, structured as options on the consumer price index for all urban consumers, are similar to insurance. The buyer of the contract pays a premium at the outset in return for the right to receive a payment after 10 years should the CPI decline during this period."

The bet is that the USA will not be like Japan and are not on a verge of entering a similar lost decade as Japan did.

As I previously discussed in relation to the heated deflation/inflation debate, we are going through a deleveraging period, which meant deflation in some asset prices (real estate, etc.) but inflation in other items, such as food items (up 16% since 2009). In a previous post I argued you could have both deflation and inflation at the same time as currency values are being debased. The latest new record of Gold is of no suprise and the trend is up and up, given we can expect a second round of QE in November in the US.

The rise in food prices are strong inflationary forces at play which is probably creating a lot of headaches for the Bank of England given its inflation target of 2%. You can therefore expect the UK to rise interest rates sooner than expected which will coud increase the risk for a double-dip recession due to the current constraints in household balance sheets. I hope Mervyn King still has plenty of ink in his pen, as he will definitely have more letters to write to the chancellor in the coming months...


http://noir.bloomberg.com/apps/news?pid=20601087&sid=aqqEDrWMDO3w&pos=3

“We think the possibility that the U.S. goes 10 years with stagnant or falling prices is remote,” Mihir Worah, the head of Pimco’s real return portfolio management team, said in an e- mailed response to questions. “The options were priced at rich levels to the underlying” risk, added Worah, whose funds invest in Treasury inflation protected securities."

"Pimco Chief Executive Officer Mohamed El-Erian said last month the chance of deflation in the U.S. is around 25 percent."

Deflation then inflation is still the ongoing theme, which might lead us to Stagflation 70s style.

The latest inflation figure in the UK is of no surprise: August's consumer price inflation came in at 3.1 %. QE is working just fine...I kept saying the results of QE would be more inflation down the line, in April, in March...



http://www.telegraph.co.uk/finance/economics/8003750/UK-inflation-is-uncomfortably-high-says-Bank-of-England-rate-setter-David-Miles.html

"Inflation has been above the central bank's 2pc target since December 2009 although policymakers have argued that it is largely down to one-off factors and should subside over time."

Can the policymakers please specify the time frame? They won't...

High UK inflation no conspiracy:
By James Mackintosh

http://www.ft.com/cms/s/0/81dacaae-c038-11df-b77d-00144feab49a.html?ftcamp=rss



Jacques Rueff, a great French economist clearly saw the strategy behind Keynes General Theory of Employment which is currently being used in the UK with QE:

http://www.moneyweek.com/news-and-charts/economics/homage-to-jacques-rueff-88380.aspx

"Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for 'things' meant that salaries - in real terms - would go down. That was the greasy scam behind Keynes' General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them."

Bill Bonner also adds in his hommage to Jacques Rueff the following:

"Rueff died in 1978. Had he lived, he probably would have been as surprised as we have been by the stamina of the monetary horses. Except for a brief rest while Paul Volcker was managing the stables, they have run from bubble to bubble... delivering more liquidity wherever it would do the most damage. All the while, inflation continued to cut the price of labour. Between 1974 and 1984, real wages fell as much as 30%. Then, more moderate levels of inflation held them down for the next 24 years.

But Rueff’s insight comes with a warning. The faith-based, dollar-dependent monetary system is like a loaded pistol in front of a depressed man. It is too easy for the US to end its financial troubles, Rueff pointed out, just by printing more dollars. Eventually, this “exorbitant privilege” will be “suicidal” for Western economies, he predicted."

Bill Bonner concludes:
"Paul Volcker put the pistol in the drawer. Ben Bernanke has found it. And Jacques Rueff must look on in amusement to see what happens next."

http://www.thedailybell.com/1114/Britain-to-See-Inflation-Risk.html

"Until the 1970s, classic Keynesian economists seem to have believed that it was impossible to have a stagnant economy along with an aggressive monetary stimulus program. In slumps, central banks should print money, and more money, to stimulate via government spending and bank lending. Of course, while such Keynesian solutions may not stimulate the economy much (not with real jobs anyway), they do lead to inflation, and then price inflation, especially in severe slumps. Hence, stagflation..."

http://www.marketoracle.co.uk/Article21501.html

"Krugman's monetary solution to a liquidity trap is sustained inflation, where the central bank reverses fears of future deflation by instead causing an increase in the price level through massive monetary pumping (Krugman estimates this to be in the area of $10 trillion, borrowing the figure from a prior study conducted by Goldman Sachs)."

Housing in the US is still in the hurt locker:

More pain to come unfortunately. There is a huge shadow inventory that needs to be worked through. Banks reposession runs unabated. Housing starts at rock bottom still.

http://www.cnbc.com/id/39175282

"RealtyTrac, an online foreclosure sale site, will release its monthly numbers on Thursday, but sources there confirm the number of repossessions will come in just shy of 100,000 for the month.
That is the highest since the site began tracking in 2005. July's repossession number was the second highest on record. The last highest was 93,777 in May of 2010."

U.S. Home Prices Face Three-Year Drop as Supply Gains:

http://noir.bloomberg.com/apps/news?pid=20601109&sid=aPjDFWbLAdd8&pos=10

“Whether it’s the sidelined, shadow or current inventory, the issue is there’s more supply than demand,” said Oliver Chang, a U.S. housing strategist with Morgan Stanley in San Francisco. “Once you reach a bottom, it will take three or four years for prices to begin to rise 1 or 2 percent a year.”

Gains Versus Inflation

"If the market doesn’t fall to its natural bottom, price gains in the next five to 10 years won’t keep pace with inflation as the difference is made up “on the backend,” said Barry Ritholtz, chief executive officer of FusionIQ, a New York research company. Price increases that fail to at least match inflation are the same as reductions in value, Ritholtz said."

"The Obama administration’s effort to help mortgage holders, the Home Affordable Modification Program, or HAMP, is another source of future inventory as owners with new loan terms re- default, Ritholtz said. About half of the modifications done in 2009 were behind in payments by the first quarter of 2010, according to the Treasury Department."

‘Day of Reckoning’

“The belief has been: if we stimulate sales with a tax credit and delay foreclosures with modifications, the market would stabilize,” said Ritholtz, author of “Bailout Nation.” “We’re just putting off the day of reckoning and drawing out the pain by not letting the housing market hit its bottom.”

Insanity: doing the same thing over and over again and expecting different results. Albert Einstein.

Just the facts on housing in the US:

"Owners of about 11 million homes, or 23 percent of households with a mortgage, owed more than their property was worth as of June 30, according to CoreLogic. Another 2.4 million borrowers had less than 5 percent equity in their houses and probably would lose money on a sale after paying broker fees and closing costs, CoreLogic said Aug 25."

Deep sea fishing: Housing starts still at rock bottom



From the excellent Calculated Risk blog:

http://www.calculatedriskblog.com/2010/09/two-key-housing-problems.html

"The excess supply is keeping pressure on residential investment, and therefore on employment and economic growth. As new households are formed, the excess supply will be absorbed - but this is happening very slowly."

"It takes jobs to create households, and usually housing is the key driver for employment growth in the early stages of a recovery. So this is a trap: the excess supply means weak employment growth, leading to few new households, so the excess supply is absorbed slowly - putting off more robust employment growth.







The excess supply is also pushing down house prices (prices are just starting to fall again). Lower prices will eventually help clear the market, however lower prices will push more homeowners into negative equity."

"Negative equity frequently leads to distressed sales (short sales or foreclosures), and losses for lenders."

It will take a long time to clear the mess in US housing. A long, painful process to clear the excesses of the housing bubble.

The inflation debate or why you can have inflation in a deflationary environment

From one article to the next, one site to another, the inflation debate is raging.

On the website Pragmatic Capitalist, the author of the blog TPC is arguing that the "inflationistas" are wrong in relation to the risk of inflation down the line due to the massive money printing exercise we have been witnessing.

It is indeed a very complex debate and in this post, I will try to add my contribution on the subject. The discussions surrounding the inflation debate will lead us to question the definition of inflation and inherently the definition of sound money.

To summarise the ongoing debate, is the massive liquidity injections we have witnessed in the world inflationary or not?

For TPC on its blog, it is not inflationary at least in the US do to the ability of the US to print money at will, same apply to the UK.

http://pragcap.com/talking-ourselves-off-the-edge-of-the-cliff

"First, the government doesn’t actually print money (at least not in terms of money creation). They simply press a button on a computer that changes accounts up and down. It’s not like they find a gold miner and print up a note and “monetize” anything. Most importantly though the government never actually has nor doesn’t have dollars. They simply change accounts up and down as they tax and spend. So what does the Fed do? They target the Fed Funds Rate via monetary operations with the belief that they are the grand wizard behind the whole operation. The Fed’s interest rate mandate or target of “price stability” actually means they can’t monetize the debt."

"Now, this is generally the point in the conversation where the inflationistas begin talking about the “effective default” of the USA via dollar devaluation. The problem is, each time the crisis flares up the price action in markets makes it abundantly clear that there is no inflation, but rather continuing deflationary fears. Einhorn’s comments regarding inflation are no different than the other inflationistas who continue to scream “fire” in a crowded theater despite no signs of fire. Of course, there has been no inflation because there is none. The inflationistas have made the same error that Mr. Bernanke made when he supposedly “saved the world” in 2008. Mr. Bernanke assumed that banks were reserve constrained while Mr. Einhorn assumes that adding to reserves is inherently inflationary. But as we see very low levels of borrowing (due to the private sector’s lack of debt demand – caused by the continuing balance sheet recession and de-leveraging) we see zero signs of inflation."

In this lenghty article TPC replies to the comments made by David Einhorn from Greenlight Capital.

TPC also add the following comment:

"In terms of government spending (or blanket Keynesianism as most doubters prefer to call it) it’s largely an accounting identity. Private sector deficit is public sector surplus. If government never spends private sector funds are slowly drained. Just imagine a one time 100% asset tax. What would happen to the economy? It would die of course. Contrary to popular opinion, government must spend before it can tax. Not vice versa. Therefore, a certain level of government spending is necessary. The recent CBO findings show that government spending was the primary reason why the economy didn’t sink into a black hole over the last year. We also know from borrowing data and bank conditions that monetary policy has failed entirely. Of course, I have argued that the government spending has been very poorly targeted and resulted in more malinvestment and ineffective output than should have been the case, but that shouldn’t surprise anyone when you allow the bank lobbyists to control legislation. Spending is not the answer, but we must understand that spending at the government level also isn’t the enemy. Regardless, these blanket statements that government spending is always bad is flat out wrong."

The issue and I agree with TPC in relation to Government spending is the quality of the spending. Government spending can be necessary provided it is acting as an investment such as infrastructure spending. In many countries, UK, France, Greece, the US, there is a lot of waste in goverment spending which have to be addressed.

We previously looked at what Canada did in the 90's in a previous post which lead to a decrease in the debt levels to GDP and boosted the economy. Of course there were short term massive pains but it generated long term gains.

The debate about inflation as highlighted by the response of TPC to David Einhorn's comments, is as well a debate between the Austrian School of Economy versus Keynesians believers.

I was recently given to read an article relating to the monetary situation of Europe following the First World War up to the Second World War and beyond. This article was written by Jacques Rueff, French Economist, Memories and Reflections on the age of inflation, 1956.

Jacques Rueff was very conscious about the risk the dollar faith economy would lead to.

In this article of the Daily Reckoning, published by Bill Bonner, Bill Bonner highlights the insight Jacques Rueff had in 1976, warning of the risk of a "faith dollar based economy".

http://www.dailyreckoning.com.au/jacques-rueff/2008/08/11/

"Since 1911, there existed in England a system of unemployment insurance that gave an indemnity to jobless workers, known as the "dole." The consequence of this regime was to establish a minimum salary level, at which workers would prefer to ask for the dole rather than work for less. It appears that in the beginning of 1923 salaries, which had been declining with other prices in England, suddenly hit this new minimum. There, they stopped falling, and since then, they practically ceased to move."

That's why France runs such high unemployment rates today; its dole is bountiful. When you add up the costs of "charges sociales," paperwork, and the minimum wage, more than one in ten potential workers is not worth the money. But no right thinking politician is about to suggest the obvious solution: get rid of the dole. So, Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for 'things' meant that salaries - in real terms - would go down. That was the greasy scam behind Keynes' General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them.

"Full employment" was soon no longer a wish, but an obligation.

"No religion spread as fast as the belief in full employment," wrote Rueff. "...and in this roundabout way, allowed governments that had exhausted their tax and borrowing resources to ressort to the phony delights of monetary inflation. "

At the moment, TPC is right in relation to the deflation environmnent we are experiencing.

Jacques Rueff commented previously that the additional increase in money generates inflation when people receiving additional receipts, prefer to keep these receipts in their till or wallet, which means that these additional receipts of money, which are not desired, creates an excess demand, which then affect price levels.

"Au contraire, l'émission de suppléments de monnaie engendre un phénomène inflationniste si elle a lieu sans que les personnes qui reçoivent les encaisses supplémentaires désirent les garder dans leurs tiroirs-caisses ou dans leurs portefeuilles, c'est-à-dire lorsque ces suppléments de monnaie, n'étant pas désirés, suscitent une demande excédentaire, qui alors agit sur les prix."

This explains why excess credit in the US, which lead to an increase in house prices, was inflationary on many assets prices.
I strongly believe that the Austrian School Business cycle theory is the best explaination of the financial crisis which started in 2007.
Both Ludwig von Mises and Friedrich Hayek correctly warned of a major economic crisis before the Great Depression.
Hayek made his prediction of a coming business crisis in February 1929. He warned that a financial crisis was an unavoidable consequence of reckless monetary expansion.

http://en.wikipedia.org/wiki/Austrian_business_cycle_theory

"Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.

According to the Austrian School business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "credit-fuelled boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. Economist Steve H. Hanke identifies the financial crisis of 2007–2010 as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by Austrian school economic theory."

In addition to the Autrian Business Cycle Theory, it is important to take into account Irving Fisher's contribution with his debt-deflation theory:

http://en.wikipedia.org/wiki/Debt-deflation

"In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:

1.Debt liquidation leads to distress selling and to
2.Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3.A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4.A still greater fall in the net worths of business, precipitating bankruptcies and
5.A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
6.A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
7.pessimism and loss of confidence, which in turn lead to
8.Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause
9.Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest."

Therefore a perceived inflation can happen in a deflationary environment, it can co-exist. We are witnessing it, in fact in the UK where recently inflation rose to 3.7% on an annualised basis while the UK is still entrenched in a very difficult deleveraging process.

The definition of inflation is as well a matter of intense discussion.

For the Austrian School and Ludwig Von Mises in particular, inflation is measured by the true growth of money supply.

http://en.wikipedia.org/wiki/Austrian_School#Inflation

This is what Ludwig Von Mises defined as inflation:

"Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. . . . As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation."

A lot of people argue around the current level of gold prices as a sign of incoming inflation, the truth is that we are still deeply in a deflationary environment, but inflation will be increasing at some point, when and only when the deleveraging process will be over.
The issue at hand is can the liquidity be withdrawn from the system at the moment? Probably not. The fear of deflation is very real and clear, hence the requirement of quantitative easing to avoid a deflation trap.

Inflation might have receded but cannot disappear given the current fractional banking system we are living in.

Alan Greenspan, former chairman of the Federal Reserve said the following at the start of his career:

"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."


The discussion around inflation is central as it leads to the understanding of sound money.

Ludwig Von Mises said the following in relation to money:

"It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and for bills of rights was a reaction against arbitrary rule and the nonobservance of old customs by kings."

In addition to the above and to open the discussion on the solution to the current environment, I would like to highlight Irving Fisher's proposed solution to the issue of deflation and his critics:

"Fisher viewed the solution to debt deflation as reflation – returning the price level to the level it was prior to deflation – followed by price stability, which would break the "vicious spiral" of debt deflation. In the absence of reflation, he predicted an end only after "needless and cruel bankruptcy, unemployment, and starvation", followed by "an new boom-depression sequence":

Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebted-ness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called "natural" way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.
On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged."

Reflation is currently what our governments are trying to achieve via massive liquidity injection and quantitative easing, and mind-blowing money supply increase as well as.

Remember Fisher's equation:
MV = PT where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place

QE in the UK, as I said in March is not working:

http://macronomy.blogspot.com/2010_03_01_archive.html

MV=PT as per Irving Fisher's equation. The Bank of England bought 200 Billions worth of long dated Gilts with QE. The BOE by pumping M (M4) is expecting T to rise and it is not really happening...
As a reminder: MV = PT. M is the stock of money in the economy,V is the velocity of circulation or the speed at which money flows around the economy. P is the price level and T the value of transactions, or gross domestic product (GDP). Hence by
increasing ‘M’, QE aims to increase ‘T’.

The initial MV = PT equation means that a rise in ‘M’ leads in reality to a fall in ‘V’ leaving no net benefit.

The solution of reflation is not working unfortunately. Debt-deflation, which is currently what is being tested, will fail.

To conclude on this post, relating to the deflation-inflation debate is that we are currently in a deflationary environment which poses no short term threat of massive inflation, but creates a risk of high inflation, if there is no debt restructuring at some point, as well as some profound structural reforms in public finances in the very near future, which will push us towards a double dip recession. It is unavoidable.