Saturday, March 1, 2008

it could happen here

as we continue to march into the financial abyss, it's worth addressing one of the key questions that has been in the media lately: are we headed towards a stagflationary period like the 1970s...

my immediate answer is: no. in fact, a far better precedent stands for the situation we're now facing.. the Latin American debt crisis of the 1980s.

I've been aware of the parallel for many months now ... after articulating it in conversations and emails, it's time to make it official.

let's consider how it started ...

Latin American countries displayed years of steady growth after WWII as modern capitalist/corporate principles were adopted. the simple introduction of better transport, the spread of electricity and the concept of the modern integrated business all permitted 2-3 decades of relatively consistent economic progress ...

most international capital flows were confined to the likes of multilateral lenders like the IMF and World Bank. for years, Latin countries showed themselves to be safe credits.
that's parallel #1 with the present situation ... what credit is safer than the USA? and, in the USA, what was previously the safest thing other than treasuries? mortgages... "houses never decline in value." people had seen companies like Enron, WorldCom and RJR blow up, plus commercial real estate in the previous credit crunch. but residential was never considered very risky because it was tied to "good collateral."

now, what happens when something has the precedent of being safe, and then you add a wave of liquidity? money rushes into the ultra-safe investments, causing a massive credit bubble.

how does this unfold? "official lenders" like the IMF and governments established Latin America as credits in the 1950s and 1960s, commercial banks stepped up to the plate in the 1970s. swimming in petro-dollars, they started lending and accounted for the vast majority of latin america's external debt by the early 1980s.

essentially, it went from a government-sanctioned, quasi-socialist form of lending to an aggressively capitalist and profiteering model. banks are far more prone to compete with each other by easing terms and offering larger amounts of leverage. just as automakers try to win business with unnecessary bells and whistles, wall street inevitably cooks up every form of financial novelty to win business when the bubble is forming. as a result, they continued lending to latin america long after it made sense.. after all, when something works for a long time, no one wants to stop. how can a CEO look shareholders in the eye when he walks away from a business that's still going good?

instead of the IMF, the US has Fannie Mae and Freddie Mac. they trace their origins to the 1930s, when the New Deal promoted home ownership and car-based exurban sprawl as a way to stimulate demand for everything from carpentry to crude oil. much like the IMF, they were originally government owned ... and for their first 30 years, they more or less controlled the secondary mortgage market -- just like the IMF and world bank owned the market for developing-country finance for decades before the banks get involved.

in our current situation, what Fannie and Freddie created, Mssrs. Mozilo, CDO, ABS and SIV made into a bubble.

the stamp of official/government sponsorship on a cerain asset class over a period of decades preceded both the Latin American debt crisis and our current housing meltdown. parallel #2

so far, we have only the seem that both the US and Latin America shared the same ground work. but mere than just creditworthiness are needed to make a bubble.

the key determining factor: a liquidity boom. ... parallel #3 the first time, it was petrodollars. this time, it started with asian export earnings and was beefed up with a surge of arab oil money filtered through london banks in the last 3-4 years.

and ever since the reagan years: an ever-widening trade deficit... parallel #4 ... our country's trade imbalance lasted a lot longer than latin america's because of its relevance in the world -- the biggest economy and anchor of the global financial system. but it still must reverse (and is starting to do so... but is a very painful process measured by in per capita income and standard of living.)

if that weren't enough, we're also following the Latin precedent with parallel #5: capital flight

between 1981 and 1982, mexico's private sector moved more than $20bln of assets outside their country. at the same time, the peso lost 80% of its value. (source: p 8-9 )

fast forward 25 years and go one country to the north: last year out americans bought a net $223bln of foreign stocks and bonds -- approximately a threefold increase from 2004.

the dollar has fallen through the floor and is headed for new lows ... with ben bernanke taking up residence on easy street there's no reason to buy dollar assets now. money globally will avoid it like the plauge -- exactly the same way the world scoffed at latin paper 25 years ago.

a closely related item, parallel 6: were institutional shifts allowing capital to move more freely from "official standard assets" to other stores of value. countries like chile and argentina loosened restrictions on actions like repratriating profits in the 1970s, making it easier for money to leave the countries. in countries like venezuela, people opened US banking accounts and shifted their savings offshore.

this sort of thing was only a garden hose compared to the river of money that could flow from the ETF movement. capital is pouring into things like coal (KOL), gold (GLD), silver (SLV), agricultural commodities (DBA), euros (FXE), yen (FXY). people will come to realize we're not just suffering a downturn, but a genuine economic dislocation. that will cause a rush for these assets and ruin the dollar. (after all, when people buy commodities, they are selling dollars)
just as latin americans shifted from their accepted standards of value (their own currencies) in into dollars in the 1980s, wisdom tree and iShares are now shifting retirement savings into the new standard of value: hard assets. ETFs may uncork a completely new and unknown genie ... it was credited with the rally in gold starting in 2004

the next question then becomes whether the government will do anything about it? I suspect that if they do get involved, it would only come after years of impoverishment and runaway inflation.

when they write the history books, they will say it was subprime that brought down the american giant and ushered in the new global era. subprime will have its own chapter, standing alongside the panic of 1907, both world wars, the abandonment of bretton woods and volcker's triumph over inflation.

that brings us to to the most unduring similarity of of all.. parallel #7: devaluation.. the dollar index is down 10-15% in the last 12 months and looks ready to make another move lower...

Latin America circa 1982 vs the USA right now:

1- a government-sponsored benefactor makes a certain kind of risk safe ...
2- allowing a market to form around it....
3- separately, an exogenous wave of liquidity forms and seeks a home in this new, safe asset ...
4- a trade deficit develops (the inverse of the old capital account surpluses)
5- as the bubble bursts, interest rate differentials and capital flight occur...
6- an industry facilitates the capital flight, accelerating the trend ...
7- devaluation...

so, can it happen here?

a $10 slice of pizza, a $12 gallon of gas? at first inflation seems like a small thing..

$50 slice of pizza, $60 gas ... then it becomes scary

$200 pizza ... and eventually comical.

... I started as a journalist in Venezuela in 1999, and learned economics from men whose country was ravaged by financial mismanagement... while we're unlikely to repeat the stupidity of policies like multiple exchange rates, gentle ben is now playing much the same role as central bankers in latin america 25 years ago... yes, the differences between bolivia then and the USA now are obviously great. yes, we have the institutions and the reputation. it's easy to say "it will never happen here."

that makes me think of a parable I heard from several people in latin america. it seems to have been a common perception of the period: if you throw a frog into a pot of boiling water, it will immediately jump out and survive. but if you put the frog in the water first and THEN turn on the heat, it never becomes aware of the danger and winds up cooked solid....

the similarities are ever more glaring ...


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