Saturday, August 23, 2008

Pimco vs the ECB

some of the comments coming out of the Fed's annual symposium at jackson hole highlight big tensions on the global monetary scene:


"it's beyond me people in our business consider the fed is thinking about raising interest rates. part of it's because you have the inflation hawk/nutters who are talking all the time. [ the majority of fed governors ] has no intention of opening up more downside risk to the economy, financial system, by tightening interest rates now."
-- Paul McCulley, Pimco managing director and de facto spokesman for Fed Chairman Ben Bernanke.


"The medium term outlook for inflation is still crowded by inflation risk we simply need to take care of.
We get, of course, complaints from European enterprises that in terms of competitiveness it has eroded due to the exchange rate.
[ European companies ] ... have become more competitive out of their own strengths. Competitiveness is won conducting business. It's not won in the foreign exchange market.
We have to consider the economic impact the interest rate has but it's not a major target for our monetary policy conduct. There we focus on medium-term price stability." (bold added)

- Axel Weber, Member, Governing council of the
European Central Bank & President of
Deutsche Bundesbank (Germany's Central Bank)
both quotes were made on CNBC in response to questions from reporter Steve Liesman. (link to McCulley.. link to Weber. )
normally I would not include such long quotes, but these highlight strongly the bigger long-term trend happening in the global money system: quite simply, the US dollar is in a long-term process of decline. this will hamper the wealth of americans over the next 20 years and reduce our economic power, which will have significant political and even military consequences. comparing these two quotes emphasize more than ever that 20th century, the "american century", is over. we have entered a new era.
[ as a proviso, I should add that the US dollar will probably do pretty well over the next 4-8 months. over the longer term, it has major problems. ]
some quick background: WWII elevated the US to a dominant position in the global economy that no country had seen before or since. we supplied most of the war effort, and then proceeded to rebuild europe. under the bretton woods system, most global currencies were essentially pegged to the dollar. this caused the greenback to serve the same purpose as gold under the 19th century British system.
this system grew strained over the years as the european and asian economies developed. this caused the dollar to be devalued in in 1971. it continued to decline for the rest of the 1970s and inflation accelerated. at one point it got so bad the U.S. had to borrow in german marks.
this ignominy ended when Paul Volcker raised interest rates above 10%, which broke the back of inflation and restored confidence in the greenback. no one realized it at the time, but Volcker had unleashed perhaps the biggest, and most important bull market, of the 20th century. from december 1980 to december 1986, it surged 52% against the currencies of our main trading partners:



(click here for the source of the data)

the dollar then weakened throughout the 1990s, only to come roaring back in the late 1990s as the asian financial crisis caused people to seek safety in our currency.

importantly, whenever the dollar has gained in value, americans went deeper into debt. this was because foreigners don't just fill up their mattresses with cash -- they lend to the U.S., normally by buying our bonds. this makes money cheap to Americans and causes us to borrow.

this is essentially what caused the subprime mortgage crisis: excessive foreign money in our economy caused banks to use it recklessly. for instance, when gasoline is cheap, GM and Ford churn out gas-guzzling SUVs. if caviar was $2 a pound, you'd see it on sandwiches at subway.

getting back to the ECB and the Fed. over the past year, the Federal Reserve has cut interest rates more than half ( from 5.25% to 2% now) because of the subprime mortgage crisis. on paper, this allows banks to borrow at cheaper rates. the plunge in home prices has seriously reduced the value of mortgage loans backed by the those houses. this has triggered hundreds of billions of dollars in losses by the banks. when they lose money, they have to stop lending for a while until they rebuild their so-called capital cushion. one easy way to let them rebuild their capital cushion is to lower their borrowing rate. if they can get money from poor schmucks like me at you for 1-2% in our savings accounts, and buy safe treasuries yielding 3-4%, the resulting profit helps them rebuild their capital.

(this is what alan greenspan did in the early 1990s after the savings and loan crisis, when banks also faced huge losses. as noted above, the Fed's easy-money policy also caused the dollar to depreciate at the same time.)

the problems with cut interest rates is that it makes a currency worth less and stokes inflation -- which is what's been happening over the last 6 years, and is why oil prices have skyrocketed. that's why some members of the Federal Reserve (along with Paul Volcker himself) have expressed serious reservations about our rapid interest-rate cuts.

Paul McCulley mocks these "inflation hawk/nutters." he thinks it's more important to let the banks recover and to keep the U.S. economy out of recession.
this makes sense to a limited degree. inflation tends to slow during a recession because weaker demand pushes prices lower. also, when banks stop lending, assets such as houses collapse in value, which is also deflationary. this is why the textbook says to cut interest rates during a recession. (many academics have rightly observed that tight interest rates, which made it harder for banks to lend money, prolonged the Great Depression.)
I am not sure if McCulley fears "deflation" per se, but some observers, like former CNBC contributor Ron Insana have expressed concern about a spiraling effect of price declines. to me, there is one major problem with the deflation thesis: exchange rates. every instance I can find in economic history of "deflation" came after a country's currency appreciated in value:

1- the UK had deflation in the 1920s because it tried to return to the gold standard, which made the currency too strong

2- the USA had deflation in the 1920s because it had amassed great gold reserves during WWI, which made the dollar stronger. the great economic slowdown of the Great Depression then made deflation much worse, but it cannot be ignored that currency appreciation, not depreciation, preceded the crisis.

3- japan had deflation in the 1990s after the yen roughly doubled in value.

4- hong kong had deflation from about 1998-2004 after the asia crisis. while neighboring countries devalued their currencies after the asian financial crisis, the hong kong dollar remained pegged to the U.S. dollar. that was a de facto form of currency appreciation.


the U.S dollar is now in a totally different position than any of these cases above. it has lost about 18% of its value versus major trading partners since 2003. while this isn't a massive devaluation, it's still a devaluation. furthermore, our external trade has accelerated recently. all of these forces oppose the deflationary process.

in an earlier posting, I argued that the ECB's next action would be to raise, not lower interest rates. at the time, this ran counter to every expert and strategist on Wall Street. sure enough, on july 3, the ECB boosted its rate by 25bp.
it didn't take any stroke of genius to predict this. all I did was listen to the words of the central bankers themselves who adamently maintained they were going to keep raising rates.
this time, weber is still giving us the same message: inflation is too high and we need to make it go down. we want it at 2% and it's currently 4%. furthermore, he says the recent negative GDP readings were caused by seasonal factors. but most importantly, he stresses that europe is not experiencing a general credit crunch.

this is the key difference between the USA and the eurozone. the USA is now facing up to a 50-year process of leveraging by the consumer: mortgages, credit cards, home equity loans, autos and student debt. it's spread throughout the economy like termites on the frame of a wood house. millions of people have huge debt coming due over the next few years. it's either coming due in the form of mortgage resets or things like auto leases expiring. they're all slightly different in how they work, but they will all have a similar effect: pushing down the price of assets.

after all, if you choose not to keep your SUV after a 3-year lease, you as a consumer isn't hurt, but the leasing company is. now that big SUV's are worth less, it has a smaller asset against the debt it owes. that means it has less capital to buy more cars going forward.

now, things like credit cards and student loans are not tied to any single asset. but every dollar people spend to pay these off takes money out of the economy -- it's one more bill to pay. the easiest solution is to simply reduce the value of money. in other words: inflation and depreciation.

this is the dirty little secret people like McCulley don't want to emphasize. in fact, he has spoken of the need to "manage" the dollar's decline. and if you listen to his boss, mohamed el-arian (one of my financial heroes), the dollar will continue to lose value.

when you contrast this with major euro economies like germany and france, you find they have much less debt at the consumer level. yes, they have long-term government liabilities tied to social security, etc, but they aren't hamstrung by a debt-riddled consumer. if anything, they have been experiencing a wage-price spiral much more similar to the US in the late 1970s. if you look back to the 1970s, the Fed responded by hiking rates, which triggered a dollar rally. now the ECB is refusing to cut rates... my question is: what if they pull a volcker? what if they decide they can tolerate a slowdown to kill inflation? what if they keep interest rates high or lift them again? what happens to the US dollar?

one final thing to worry about on the inflation front: deficit spending in the USA. the deficit will probably exceed $500bln in 2009 and could continue to expand in coming years because of falling asset prices (which mean less capital-gains tax revenue) and weak income growth. then the democrats are already talking about the need for a second stimulus package, and I would also add the minimum wage will also be increased. this would also be inflationary.

this is my fundamental worry with the current situation. inflation is often caused by complacency and a desire to protect the economy from contagion. it's easy to do because inflation only becomes a real problem over time. it discourages people from investing in the economy or putting money into financial assets. it drives money from bank accounts, where it can be lent out to help businesses, and into perverse things like gold or foreign currencies.

while I think the dollar will probably do pretty well over the remainder of the year, its underlying problems will last for years. I still think we face a situation similar to latin america in the 1980s. their economies had enjoyed massive inflows of capital, which resulted in large, unsustainable debt loads. their ultimate response was to print money and devalue their currencies, resulting in triple-digit inflation rates. it probably won't get that bad here, but the paralells are numerous. I was in latin america in the late 1990s and saw the result of this long process -- it was decay, capital flight, a lack of investment and stagnate incomes.

one more thing worth looking at on the inflation front is commodity prices. they fallen a ton since the middle of july. it's hard to predict the duration of this correction, but global demographic factors should keep commodities in tight demand. let's look at the ages of the USA, India and China:





the last time the dollar fell significantly was the early 1990s. that helped reduce imports and trigger one of the best economic booms in history. also lending a hand then were falling global commodity prices and a perfect demagraphic situation in the US as the babyboomers hit their prime earnings years.
this time things are different. we have an older population, less slack in food and energy, and much nearer-term debts coming due (mortgages plus social security). and, we're a less attractive country to invest than most others (there's a reason jobs and capital have been leaving.) add to that the likelihood of a worsening political crisis in washington (I'll get to that in another blog entry) and the US faces some major headwinds. going forward, we're going to see more and more of the world's economic growth simply bypass the USA.
comparing the comments of the pimco vs ECB help to see what's really going on.

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