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The September
Contrary Investor It's A Long Hard Road is an exceptional marriage of
debt-deflation concepts, long-wave K-Cycles, credit cycles, and Austrian
economic thinking. Here is a lengthy snip of several key points with
permission.
If
there has been one consistent theme since day one at CI, it has been our
perhaps near myopic focus and focal point highlight of importance that is the
macro credit cycle. Does this play into long wave and perhaps Kondratieff
cycle or Austrian economics type of thinking? Call it what you will, but
elements of all of these schools of thought very much overlap. Right to the
point, we believe THE key thematic construct to keep in mind as a macro cycle
decision making overlay and character point dead ahead is the now more than
apparent collision of the generational long wave credit cycle with the
current short term business cycle of the moment. Without trying to reach for
melodrama, this is the first time a multi-decade long wave credit cycle has
collided with the short-term business cycle since the late 1920’s/early
1930’s. Most decision makers and Street seers of the moment have
absolutely no experience with this type of a generational collision.
Moreover, our illustrious academician Fed Chairman has never even considered
long wave or credit cycle based Austrian economics thinking in his and the
broader Fed’s policy making – absolutely key and crucial mistake.
Although it’s just our perception, this will be Bernanke’s legacy
Waterloo. It also tells us directly that his only policy tool ahead will be
more money printing.
We suggest to you that macro credit cycle issues did not end in 2009.
Certainly Europe is a poster child example of this thinking, but it
absolutely also applies to what lies ahead for the domestic US economy.
We’ve only had a reprieve from long cycle reconciliation over the last
few years due to historically unprecedented Government and Federal Reserve
balance sheet levering, which itself is unsustainable longer term. Has the
election cycle played havoc with needed deleveraging reconciliation and
simple identification of the underlying causes of current circumstances?
Without question. Although it’s clearly a personal comment, we’ve
been disgusted with the short-term focus and actions of politicians at the
expense of longer cycle strategic domestic economic thinking and needed
financial reconciliation. These actions simply guarantee the deleveraging
process will play out over a longer period than may otherwise have been the
case. A very important construct with direct implications for the tone and
rhythm of the domestic economy over time.
The top clip of the following chart is probably the one graphic we’ve
published the most times over our short existence. Total US credit market
debt relative to GDP. As is more than clear, the process of total credit
cycle reconciliation has barely begun.
The bottom clip of the chart is one you’ve seen a number of times from
us and we believe quite important to what lies ahead. To the point, real final sales to domestic purchasers is GDP stripped of
the influence of inventories and exports. What we’re left with is as
good look at domestic only GDP and as you can see, the year over year change
in terms of growth in the current cycle is the weakest of any initial
economic recovery cycle over the time in which official numbers have been
kept. Message being? We are seeing very weak aggregate demand, exactly as one
would expect in a generational credit cycle reconciliation process.
We also need to remember that THE primary goal of the Fed and politicians has
been to thwart the generational credit cycle deleveraging process to the best
of their abilities while it is occurring, all in the interests of being
reelected. So as you look at the bottom clip of the chart above, remember
that this is the growth in domestic economic activity in the current cycle
that has occurred while the Government has borrowed $5 trillion and used the
proceeds for increased transfer payments, cash for clunkers, help for those
with mortgage problems, deals for appliances, etc. And yet still we’ve
experienced incredibly subdued domestic economic activity. Just what would
this have looked like in the absence of historic Government balance sheet
leveraging?
Monetary Policy Useless in Deleveraging Cycles
Although it appears obvious conceptually, we're not so sure the markets yet
fully appreciate the fact that in true generational deleveraging cycles,
monetary policy is powerless to influence credit expansion. Again, our near
myopic focus on credit is driven by the fact that credit is the cornerstone
of modern economic development and balance, and certainly not just in the US.
The character, availability and price of credit regulate the ongoing tone of
aggregate demand, so monitoring credit is simply crucial. If credit cannot
expand, then neither can aggregate demand. A simple yet key truism,
especially in our current circumstances. As you can see below, we've seen
literally unprecedented monetary expansion so far in the current cycle, yet
private sector credit creation (as is exemplified by the bank loans and
leases outstanding) remains wildly subdued at best. The whole pushing on a
string thesis? Exactly.
The bottom clip of the chart above has been adjusted for the $450 billion of
off balance sheet bank loans that were mandated to arrive back on bank
balance sheets as per FASB dictates in April of last year. As is clear, bank
loans and leases out since early 2009 have declined significantly. The bulls
have trumpeted the growth over the last three months. You can decide for
yourself whether this minor uptick is deserving of trumpeting, if you will.
To ourselves the message appears absolutely crystal
clear. In generational deleveraging cycles, Fed monetary policy is simply a
non-event. Rather monetary extravagence finds its
way into inflation hedge assets and can be used simply to speculate.
Remember, as per Fed monetary largesse, the banks are sitting on $1.5
trillion of excess reserves as we speak. Excess reserves can be used as
collateral for derivative and futures trading. You already know trading
profits have been a crucial piece of bank earnings since 2009. As of now,
monetary policy has been completely ineffective in the current cycle in
creating credit - the lifeblood of economic activity and growth - except in
one instance. And that instance lies below. Of course we are referring to
Government debt.
In typical recessionary periods past, the Fed has been able to lower interest
rates and stimulate demand for credit. Demand for credit ultimately stimulates
broad economic activity via an increase in aggregate demand. But in
deleveraging cycles as opposed to typical business cycles, interest rates can
fall to zero and still not positively influence demand for credit. This is
exactly what has occurred in the current cycle. You may remember from our
discussions over the years we asked one question again and again, "is
this a business cycle or a credit cycle?" The only borrower of substance
in the current cycle has been the Federal Government, yet we are currently
reaching the limits of Government balance sheet expansion tolerance, as
clearly witnessed by the debt ceiling melodrama. This has only served to
weaken the US as a credit. Again, the inability to generate demand for credit
by almost any means (and in our present circumstance historic means) is
simply a classic fingerprint of a generational deleveraging cycle.
Bernanke No Student of History
Never in modern history have we faced the type of domestic labor market
circumstances we face today. As we've tried to describe, monetary policy is
powerless to change this. If Mr. Bernanke was the true student of history he
would fully realize exactly the circumstances we've described. It's not that
we don't have precedent. The US in the 1930's and Japan over the last two
decades are the model. Looking at the Depression years and claiming the issue
was that the Fed was not loose enough misses the key fingerprint character
points of a generational deleveraging cycle completely. Again, the refusal of
Bernanke and friends to even acknowledge Austrian or Kondratieff economic
constructs has been and will continue to be their policy making downfall. Who
knows, maybe all of this will find its way into the economics textbooks of
tomorrow. Let's hope so anyway for future generations. But as the old market
saying goes, people don't repeat the mistakes of their parents, they repeat
the mistakes of their grandparents.
Government and Fed policy has been aimed at fostering credit creation up to
this point. Fed money printing and Government borrowing has been undertaken
in an attempt to stimulate credit creation and likewise spark broad
reacceleration in consumption. Certainly Government and Fed actions have also
been an offset to the contraction in private sector (think financial sector)
credit so far in the current cycle. As of now, unprecedented Fed actions have
acted to both devalue the dollar and suppress interest rates. But in a
generational deleveraging cycle, the Fed is ultimately impotent in terms of
being able to successfully spark private sector credit creation that would
lead to expansion in aggregate demand and macro GDP growth.
But what has occurred as a result of Fed and Government "solutions"
again is a classic macro deleveraging cycle response - a devalued currency
and negative real interest rates has driven investors into inflation hedge
assets such as gold, oil, ag assets, etc. at the
margin. As opposed to having achieved the stated goal of fostering employment
growth, credit creation and raising aggregate demand, etc., Fed QE has
essentially succeeded in raising the cost of living in a cycle characterized
by generational labor market and direct wage pressure among the middle and
lower class wealth demographic. From a broad perspective, has Fed and
Government policy actually done more harm than good? It simply depends where
one sits amidst the wealth demographic pyramid of life. Policy has been
fabulous for Wall Street and the banks, but not so fabulous for the average
household. The average household has faced vanishing interest income and
negative real wage growth amidst an environment of a meaningfully rising cost
of every day living (food and energy prices).
Policy has been counterproductive because policy makers continue to focus on
short term outcomes as opposed to longer term structural remedies. Remember,
people repeat the mistakes of their grandparents, not their parents. Mr.
Bernanke is apparently an "expert" on the actions of
"grandparents", yet he is very much repeating their same mistakes
by his implicit refusal to even consider Austrian/Kondratieff like economic
ideas. You already know, THE key character point of successful investors over
time is flexibility in outlook and behavior. It's just a shame we can't clone
that character point inside the Fed and Administration at present. But of
course that would be counterproductive to the interests of Wall Street and
the big banks.
Credit Cycle
Understanding is Key to Returns
There is much more in the Contrary Investor article. I excepted
the ideas pertaining to credit.
It is very refreshing to see someone else writing about debt deflation and
how powerless the Fed is to stop it. Instead, we see article after article by
people touting high inflation, even hyperinflation.
Hyperinflation is complete silliness at this point. Were it to come, it would
be an act of Congress that would create it, not an act of the Fed, and the
Fed would probably have to play along. I doubt the Fed would. For all its
many faults, the Fed does not want to destroy banks. Hyperinflation would do
just that.
The Republican dominated House wants little or nothing to do with more stimulus. Certainly US government debt is going to mount,
but it is going to mount in Japan, the Eurozone, and the UK as well.
Moreover, Eurozone structural issues matter now, while US government debt
will matter more in the years to come.
Midst of Deflationary Collapse or Brink of Inflationary Disaster?
Although the Keynesian and Monetarist economists have missed the boat on what
is happening and why, Austrian minded folks who fail to understand the
importance of credit and how little the Fed can do to revive it have blown
the call as well.
It pains me to see articles like On the
Brink of Inflationary Disaster by Austrian
economist Robert Murphy.
We are clearly in the midst of a deflationary collapse as noted in Yes Virginia, U.S. Back in Deflation; Inflation Scare
Ends; Hyperinflationists Wrong Twice Over
Focus on Money Supply Alone is Fatally Flawed
Deflation is about credit, it is also about attitudes that govern the demand
for credit.
As I have stated many times over the years, and as stated above in the Contrary
Investor, there is nothing the Fed can do to force businesses to expand or
banks to lend.
That point explains why Austrian economists who focus on money supply alone
have failed and will continue to fail.
Until consumer demand returns, businesses would be foolish to expand.
Unfortunately, the Fed's misguided easing policies have stimulated commodity
speculation thereby increasing manufacturing costs, while simultaneously
clobbering those on fixed income and reducing final consumer demand.
I wrote about the plight of those on fixed income in Hello Ben Bernanke, Meet "Stephanie" back in January.
Please give it a read if you have not yet done so.
The Deflationary Hurricane of Deteriorating Social Mood
One of the best posts recently on social mood and deflation is by Minyanville professor Peter Atwater.
Please consider The Deflationary Hurricane of Deteriorating Social Mood
This
morning, in the aftermath of Fed Chairman Ben Bernanke’s speech on
Friday, the editorial page of the Wall Street Journal noted, “Mr.
Bernanke also lectured that ‘U.S. fiscal policy must be placed on a
sustainable path,’ though not by cutting spending in the short-term. So
the Fed chief joins the Keynesian queue of spending St. Augustines
– Lord, make us fiscally chaste, but not yet.”
Everything we need to do for long-term economic, if not societal success and
stability comes with very severe short-term consequences. And so the response
of most policymakers (and not just those responsible for fiscal policy but
also regulatory policemen like Mr. Bernanke himself) has been to advocate for
short-term expansionary programs and rules, while postponing the real teeth
of necessary change until some later date in the future. Basel III, for
example, has a phased-in capital-strengthening requirement for the banking
system that does not finish until 2019 – again, "chaste, but not
yet."
I am sure that what is behind the thinking of policymakers is the notion that
if we can just get through this tough “transitory” period, the
economy will turn up; and at that point, whether it is fiscal or regulatory
policy, our ability to handle constraints will be much, much easier to bear.
After 11 years of declining social mood, the notion that further monetary
stimulus has limited use is hardly a surprise. As I have cautioned so many
times, when it comes to the consumer it is not the depth of a recession that
matters, but rather its length. And while for policymakers and financiers
this may feel like a three-year-old recession (and for some even just a
three-week-old recession!), for the American consumer this is a decade-old
recession that has deteriorated well into a depression. The average American
is now financially and emotionally exhausted. And given the news reports out
of Washington over the past month, they are also now afraid that they are at
risk of losing some or all of their government safety net, too. Like the children
of fighting, divorcing parents, they are now fearful of what an increasingly
uncertain future holds.
While further fiscal stimulus – particularly job-related initiatives
– may slow the pace of deterioration, I am increasingly afraid that
further fiscal and monetary policy actions are now impotent agents against
our current social mood. Where in 2000, the future was so bright that
we’d need shades, in 2011, the future for many
Americans is so dark that they can’t see their way forward.
The consequence will be price deflation -- and not just further price
deflation across those debt-dependent purchases like homes and automobiles,
but across all categories of consumer goods. And for the first time since the
1930s, American businesses will see that lower prices are not always met with
greater demand.
Price Deflation on
the Way?
My definition of deflation is "a decrease of money supply and credit
with credit marked-to-market". Judging by symptoms of deflation and
Fed's efforts at fighting it, the US is back in deflation now by my measure.
In my model, falling prices are not a requirement for deflation.
The important point is not definition, but rather
the expected conditions. Yet, the conditions I expect and indeed the
conditions in the US right now (in aggregate) match deflationary scenarios,
not inflationary ones.
Murphy calls for an "inflationary disaster" while Atwater
calls for "price deflation across all categories of consumer goods".
I do not know if we see across the board price deflation Atwater calls for
given peak oil constraints and an inept US energy policy that also affects
food prices.
However, I do expect to see falling education costs and falling medical costs
as well as falling prices in a broad array of consumer goods and services,
especially if Republicans can get a few sensible deficit measures passed.
Whether that scenario happens or not, the idea "brink of inflationary
disaster" is complete silliness unless and until the Fed can revive
credit, yet the Fed is powerless to do so.
So, unless Congress goes really haywire, attitudes will change and
deleveraging will play out before the US experiences serious inflation.
Unfortunately, Fed and Congressional policies have only served to lengthen
the deleveraging timeline.
Those looking for hyperinflation or even strong inflation have missed the
boat again, and again, and again, and will continue to do so, interrupted by
periodic inflation scares until debt-deflation plays out.
Understanding the Deflationary Cycle
To understand what is happening, why businesses are not hiring, why housing
is stagnant, and where the economy is headed, one needs a model that takes
into consideration five key factors ...
1.
Mark-to-Market Measures of Bank Credit and
Capitalization Ratios
2.
Credit
Cycle Theory
3.
Attitudes of Banks, Businesses, and Consumers
4.
Futility and Limits of Keynesian Stimulus
5.
Futility of
Monetary Stimulus
1 -Mark-to-Market Measures of Bank Credit and Capitalization Ratios
Banks cannot and will not lend unless they are not capital impaired and
unless they have credit-worthy customers. Atwater noted Basel III was delayed
until 2019. I noted on many occasions banks are still hiding investments off
the balance sheets in SIVs and mark-to-market rules have been suspended
several times.
As happened in Europe, delay tactics can only work for so long before the
market questions if loans on the balance sheets of banks will ever be repaid.
That time is now, not 2019. Thus banks are too capital
impaired to take excessive risks, even if they wanted to. Moreover, too few
credit-worthy businesses want to expand in the first place.
2 - Credit Cycle Theory
In accordance with long-wave, Kondratieff Cycle (K-Cycle) theory credit
expansion and contraction cycles play out over decades. At least 75% of the
time, continuously (not on and off), the economy grows in an inflationary
manner. When deflation hits, few expect it because all many have known for
their entire lives is inflation.
As long as consumers have ability and willingness to add debt an leverage, the Fed seems to have power to revive the
economy via various stimulus efforts. Once a consumer deleveraging cycle starts, the Fed's power ends.
3 - Attitudes of Banks, Businesses, and Consumers
The willingness and ability of banks to lend and consumers to borrow and
increase leverage is shot. Banks don't want to lend (or are to capital
impaired to lend), and boomers are heading into retirement overleveraged in
housing, without enough savings.
Consumers first thought tech stocks would be their retirement, then housing.
Both dreams have been shattered. Consumers are now determined to pay down
debt (saving), even if by outright default or walking away. Default and
walking-away impacts banks willingness and ability to lend.
Think of attitudes like a pendulum. Attitudes can only go so far before they
reverse. Housing reversed in 2007 as did the Nasdaq
in 2000. Both reversed when the pool of greater fools ran out.
The Nasdaq is still nowhere close to old highs.
These cycles last longer than most think. I expect housing will be weak for a
decade once it bottoms, and it has not yet bottomed.
Finally, it's not just boomer attitudes that affect credit. Kids see their
parents and grandparents arguing over debt, worried about bills, worried
about jobs and vow not to repeat their mistakes. This point ties in with
K-Cycle theory above.
4 - Futility and Limits of Keynesian Stimulus
Keynesian economists always want more, then more, then still more stimulus
until the economy heals. Japan with debt-to-GDP ratio over 200% has proven
such policies cannot ever work.
Keynesian economists always refuse to discuss the endgame, how the debt can
be paid back, and what happens when stimulus stops.
The US has virtually nothing to show for all the make-shift, ready-to-go
projects that temporarily put people back to work in 2009 and 2010. Not only
did we repave roads that did not need paving, those hired still have
debt-overhang and are still underwater on their houses.
All that happened was a delay in the day-of-reckoning. More Keynesian
stimulus will only further delay the day-of-reckoning while adding to the
national debt and interest on the national debt.
Priming-the-pump Keynesian theory will fail every time in a debt-deleveraging
cycle. Indeed, it never works, it only appears to
work until debt leverage is maxed out.
5 - Futility of Monetary Stimulus
As discussed above, monetary stimulus negatively affects the real economy for
the temporary benefit of the financial economy and Wall Street. The tradeoff
was not worth it except through the perverted-eyes of Wall Street.
Telling action in bank stocks says the limits of helping Wall Street may have
even run out.
Many point to excess reserves as a sign of future inflation. I point to
excess reserves as a sign of failed Fed policy. Commentary from Austrian
economists shows they fail to understand how credit even works.
The idea those excess reserves are going to pour into the economy in a 10-1
leveraged fashion is simply wrong. Banks do not lend when they have excess
reserves. Banks lend when they have credit-worthy borrowers, provided they
are not capital impaired.
It is time Austrian economists finally wake up to this simple economic truth.
Academic Theory vs. Reality
Economists of all sorts stick to failed models.
·
The Monetarist currency cranks want more monetary
stimulus even though it is counterproductive
·
The Keynesian clowns simply will not admit end-game
constraints
·
The Austrians for the most part either ignore credit
or incorporate failed models of credit expansion into their theories.
Each camp points the finger at the others as to why the others are wrong.
Ironically, none of the camps seems to understand the combined mechanics of
debt-deflation, deleveraging, and attitudes.
That said, I side with the Austrians about what to
do (essentially let things play out, while implementing much needed
structural reforms).
Twelve Specific Recommendations
1.
Banks and bondholders should take a hit. Banks are
not going to lend anyway so bailing them out at the expense of taxpayers is
both morally and economically stupid. End the bailouts, all of them, and
prosecute fraud, the higher up the better.
2.
Implement serious bank reform now, not 9 years from
now. Banks should be banks, not hedge funds. This proposal will necessitate
breaking up banks. So be it.
3.
Scrap Davis-Bacon and all prevailing wage laws. Such
laws drive up costs and have wreaked havoc on many cities and municipalities,
now bankrupt or on the verge of bankruptcy.
4.
Pass national right-to-work laws. Once again, we
need to reduce costs on businesses and local governments to spur more hiring
and reduce costs.
5.
End collective bargaining rights of all public
unions. The goal of unions is to provide the least service for the most
money. The goal of government should be to provide the most services for the
least money.
6.
Scrap ethanol policy and end all tariffs.
7.
Legalize hemp and tax it. Prison costs will go down,
tax revenue will grow, and biofuel and fiber research will expand as hemp
produces very soft fibers.
8.
Corporate income tax rates should be lower in the US
than abroad. Current policy encourages capital flight and jobs flight via
lower tax rates on profits overseas than in the united
states. This penalizes businesses that work only in the US, especially
small businesses that do not have an army of lawyers and lobbyists.
9.
Stop the wars and set a plan to bring home all US
troops from Iraq, Iran, and 140 or so other countries.The
US can no longer afford to be the world's policeman.
10. Implement Paul Ryan's
Medicare voucher proposal. It is the only way so far that anyone has proposed
that puts much needed consumer "skin-in-the-game" that will reduce
medical costs.
11.
Legalize drug imports from Canada
12. End the Fed and
fractional reserve lending. Both have led to boom-bust cycles of
ever-increasing amplitude.
Those are the kinds
of things we need to do, not throw more money at problems. The latter does
nothing but drive up national debt and interest on the national debt for
short-term gratification.
Notice how counterproductive Fed policy is and how counterproductive Obama's
policies are.
The Fed wants positive inflation but businesses have not been able to pass
the costs on. Instead, companies outsource to China. Those on fixed income
get hammered.
Fool's Mission
Obama wants to create jobs via stimulus measures. It's a fool's mission.
Prevailing wages drive up the costs, few are hired, and the cost-per-job
(created or saved) is staggering. Money never goes very far because the US
overpays every step of the way.
Stimulus plans that do not fix the structural problems are as productive as
pissing in the wind. Then when the stimulus dies, which it is guaranteed to
do, a mountain of debt remains.
Instead, my 12-point recommendation list will fix numerous structural
problems, create lasting jobs, and reduce the deficit. What more can you ask?
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