“It is frequently thought that relieving an alleged shortage of money will solve all social problems. Even today, with an economic crisis raging, the response of our government and the Federal Reserve has been characteristic. Interest rates are driven to zero and trillions of dollars are pushed into the economy with no evidence that any problem will be solved. The authorities remain oblivious to the fact that they are only making our problems worse in the long run.
Ron Paul, End the Fed, p.3
Timing Is Everything
Ron Paul is a disciple of the Austrian School which is strongly opposed to central bank money creation and bailing out losers in a recession. Just about every Austrian economist since the collapse of the Bretton Woods neo-gold standard in 1971 has predicted the collapse of the dollar. So far, they’ve been wrong.
Timing is everything in the investment world. Most people “knew” that the Soviet Union would collapse sooner or later, or that one day Fannie and Freddie would succumb to political pressures and lower their credit standards to the point of no return. But for investors those were useless insights. For investors, the long run is too long. What good is a prediction today of the collapse of the dollar if it happens in the year 2015?
At the risk of joining the ranks of the fallen Austrians who have gone before, I will forecast that a major change/crisis in the international monetary system will occur sometime in the next two years. This change/crisis won’t be seen as a plus for the United States.
This Time Is Different
In a book with the above title, Carmen M. Reinhart and Kenneth S. Rogoff review banking crises in 66 countries. This book is the most comprehensive of its kind ever written on this subject and is required reading for anyone who wants to know what’s really going on in the national and global monetary and banking scenes.
Although they don’t label it as such and no two banking crises are exactly alike, R&R outline what I have distilled into an eight step model or pattern which to a greater or lesser extent describes the lead-up and aftermath of full scale banking crises as they occurred in the 66 countries. I will reproduce this below-it’s sort of a “Banking Crises for Dummies” – with my own comments on how United States in the current crisis fits this pattern.
Note that R&R have concluded that a recession coupled with a banking crisis is a very serious affair and much more dangerous than an inventory driven recession. If a banking crisis/recession – such as the current one – occurs on a global scale, worse still. In the last century only the Great Depression qualified a truly global.
Stages of a Financial Crisis
01. Financial Liberalization – Historically, financial liberalization has preceded banking crises. In the case of the US, the years prior to 2007 brought a massive expansion of the financial sector combined with all kinds of financial innovations ranging from SIVs, to CDOs to subprime mortgages. The assumption was that the (essentially efficient) markets knew best and that the new computer technologies allowed greater financial innovation and leverage. Totally ignored was the huge moral hazard that permeated the system and the lust for leverage that typified so many past bubbles. Profits were private, losses it turned out would be socialized. The argument made now that the US financial sector needs more supervision and regulation seems hollow if you look at the history. For example, it was the SEC in 2004 that permitted major increases in leverage for the investment banks including Lehman Brothers and Bear Stearns. The SEC had the power, it could have said no. It was the Congress that egged Fannie and Freddie on to make more loans to low income groups and it was the Congress which did nothing about Fannie and Freddie’s undercapitalization.
02. Significant Capital Inflows and Exchange Rate Overvaluation – R&R label this the “capital flow bonanza” syndrome. With its massive post-2000 current account deficits, the US was the “lucky” bonanza recipient huge capital inflows, notably from China. An undervalued renminbi was a major factor. Ex-Japan against Asian currencies in general, the US dollar was overvalued.
03. Real Estate Bubble Followed by Collapse – Real estate prices have historically experienced a bubble prior to a banking crisis and then have collapsed. The key collateral of banks and lenders everywhere is real estate. In many countries banks are little more than pawn shops with real estate as the collateral. The US as is now well known experienced an unprecedented run up in residential real estate prices with real US residential real estate prices peaking at the end of 2005. The decline in house prices preceded and largely caused the financial crisis. According to R&R, peak to trough real estate price declines historically have averaged four to six years. The widely followed Case-Shiller Index shows existing US house prices bottoming in May, 2009. That puts the US slightly ahead of schedule, a surprising outcome given the extent of the U S bubble. Massive government interventions, including the new owner’s house credit and the nationalization of the mortgage finance industry, may be distorting the picture. Time will tell. Increases in non-performers continue to soar and ominous significant upward adjustments in outstanding Alt-A mortgage payments lie ahead.
04. Stock Price Bubble Followed by Collapse – Typically in response to capital inflows and rising levels of credit, stock prices along with real estate prices experience a bubble then collapse. Many stocks of course are directly linked to real estate. The US equity market peaked in 2007, then crashed in 2008 only to recover in 2009. This is somewhat atypical performance historically. But then again historically there has never been such a globally coordinated program of fiscal and monetary stimulus thrown at a banking crisis. We shall see if this effort has created more problems than it solved. But congratulations to investors who concluded getting long stocks was the only way to go in the face of these stimuli.
05. The Actual Banking/Financial Crisis – The popping of the US real estate bubble brought about an intense contraction of bank and nonbank lending and massive distress to the banking and non-bank financial sector in 2007-8. The sordid details of this crisis do not need repeating here.
06. Recession and Rise in Unemployment – According to R&R, the aftermath of banking crises is associated with profound declines in output and employment. The US is right on schedule there with the unemployment rate now at 10.0% or 17.2% if you prefer the broader U6 definition.
07. Significant Fiscal Deterioration – Thanks to bank bailout costs, declining recession driven government revenues and increased counter cyclical expenditures, serious deterioration in a nation’s fiscal situation generally occurs for years post the financial crisis. Historically according to R&R on average the real government debt post-crisis nearly doubles. In my opinion there are a host of factors that will make the US fiscal deterioration worse than the historical average. The US is fighting two wars, the US has adopted an extreme Keynesian stimulus/ quantitative easing approach, the US has nationalized the mortgage industry with Fannie and Freddie now in an economic sense part of the government and the Obama Administration is pushing for health and alternative energy programs that will likely significantly add to the deficit. Moreover, the moral hazard associated with these programs and the stimulus is huge and is for all to see as Wall Street, the auto industry and the profligate unionized federal and state public sectors get bailed out for their bad behavior. The nation and the world can witness the misallocation of US economic resources that is occurring before their eyes just by turning on the TV. Simple Keynesianism holds it doesn’t matter how a stimulus is spent. Common sense concludes that can’t be true. Wasted trillions do not enhance productivity and long term growth. Rewarding losers sparks public anger and populism. In an earlier Dismal Optimist I referred to work done by economists Gonzalo Fernandez de Cordoba and Timothy Kehoe which examined a number of twentieth century recessions. They concluded “massive public interventions in the economy to maintain employment and investment during a financial crisis can, if they distort incentives enough, lead (italics mine) to a great depression.”
08. Currency Collapse, Outright Default and/or Default by Inflation – So far for the US this is the shoe that hasn’t dropped. I think it will in one form or another. Frequently in the past, banking crises frequently ended with a spurt in inflation and a collapse of the currency. So far so good with the US – neither has happened. But consider. One and a half trillion dollar plus deficits, endless quantitative easing and mega doses of moral hazard and resource misallocation do not inspire respect for a currency, especially one that is supposed to be the world’s reserve currency. Investors have to absorb the huge supply of Treasury securities that are coming, all the while wondering if US quantitative easing is going to eventually bring high inflation. True enough the US borrows in its own currency and a legal default is not likely. And some of the world’s other major countries, notably the UK, are in equally dubious shape. Is it possible that a currency crisis and inflation lie in the future for the US? It certainly is. There are many who believe that the US government will never be able to service the debt that it is piling up. Inflation is one way to default. A currency collapse is another. By the way. The US has defaulted in the past. In the 1840s a handful of state governments defaulted. And in the 1930s the Roosevelt Administration unilaterally abrogated the obligation of gold based government (and private) bonds to pay off in gold. And the Supreme Court rolled over and legalized this breach of contract. Query: If US inflation jumped to 20%, what would the government do about TIPS?
What Should the Investor Do?
I see a multistep scenario unfolding.
First, longer term US Treasury yields will continue to rise. Not as the result of current inflation but as the result of ever increasing supply and increasing unwillingness of anyone – foreign or domestic – to buy them. Unfortunately, the private sector is going to get crowded out in this process. This has to be an adverse event for all private sector longer term fixed rate assets. Current dividend yields will become less attractive as competing Treasuries rise and favorable dividend tax treatment is anticipated to end in 2011.
Second, the backup in Treasury yields will slow down the already tepid US economic recovery.
Third, near term the dollar may continue to strengthen against other currencies as long term US interest rates rise. But this may be a short lived rally. Higher long term interest rates are the bribe the US will have to pay to convince foreigners to buy US Treasuries. To a large extent the dollar’s near term direction will also depend on how bad things get in the Euro zone, notably with Greece, Italy and Spain. But this stronger dollar is a trade. Long term, things don’t look good for the dollar.
Fourth, with fits and starts gold and silver will continue their long term rise in price. Will the gold standard ever return? Not if any government can help it. The gold standard implies total loss of control of monetary policy by government central banks and an inability to impose disguised taxes through money printing. No government will give that up voluntarily. Of course, if a major international monetary crisis is coming then who knows what governments may be forced to do. A reestablishment of a genuine gold standard would imply a huge increase in the price of gold because at current prices and existing tonnages, there is nowhere near enough gold in the world for gold to serve as the world’s primary monetary reserve.
Fifth, Bernanke will never pull off his promised Houdini trick and extricate the Fed from its quantitative easing. He has provided the US with a permanent upward ratchet in the US monetary base that he cannot and will not remove. Inflation will return one day like a tsunami but not in 2010. The deleveraging US consumer and still rising defaults on residential and commercial real estate are too much of a near term deflationary force. Short term rates will stay down until a dollar crash forces Bernanke to do something.
Sixth, China will begin to reap as it has sown with its cheap renminbi. The real value of the renminbi has to rise through revaluation or domestic inflation. The Chinese have chosen the latter. Inflation and asset bubbles will be a 2010 story in China. Very near term the Chinese equity markets will likely continue to rise. We will see if this continues later in 2010 if the nay sayers on China are right. The nay sayers have argued that China has overinvested in capital, real estate and infrastructure and that this cannot continue. They could be right but bubbles can take a long time to get popped and until they do you don’t want to stand in their way.
Seventh, with short term interest rates artificially held down to near zero, investors will continue to want to own US stocks. The KISS principal has been at work in the US equity markets—keep it simple, stupid. Short rates near zero, an economic recovery of some sort ahead and valuations moderate – so buy stocks. So the US market is likely to rise further near term. Technology and export oriented stocks may continue to run. But watch out for that big monetary event if US long rates ratchet upward and the dollar collapses.
Finally, I have to put in a plug for India. India has avoided manipulating its currency and its government is too broke to have overindulged in a huge wasteful stimulus program like the US and China. I believe the Indian equity market will outperform the Chinese in the long run. Unfortunately, at least at the retail level foreign investors are somewhat limited as to what Indian equities they can buy.
