ECONOMIC SCHIZOPHRENIA -- You do not have to be a medical doctor to diagnose a certain level of schizophrenia in the market. Detroit files for bankruptcy with other cities lined up in the same queue and yet the stock market reaches record levels. The FED's actions have put us back "on course" but food stamp usage is at record levels and Bernanke admits that if he tightened monetary policy (i.e. raised interest rates) the economy would tank. Housing stages a recovery and yet we are greeted with headlines in recent days announcing that "Housing Starts Miss Most Since January 2007, Permits Have Biggest Miss In History." The world economy is on the mend but our political and monetary masters are preparing for a new system of bail-ins.
WHAT ARE WE AIMING FOR?
Everyone is aiming for a recovery and yet in our saner moments we acknowledge that yesterday's debt fuelled and leveraged orgy of spending and speculation laced with questionable banking practices, was not only damaging but also unsustainable. So whatever "recovery" means it certainly cannot mean a return to the excesses leading up to the GFC.
So we are left with three problems. The high level of debt which is hampering economic activity , secondly no real consensus as to what kind of a sustainable recovery we should be aiming for and thirdly the problem of how to engineer any sort of recovery without the constant need for infusions of cash through debt.
I CALLED FOR BAIL-INS FIRST
Both in September 2009 and September 2010, I warned that bank deposits would have to be subjected to haircuts as a means of cleansing the system of dead and non-performing debt rather than "lumping bank losses and failures onto the public purse." No one else seemed to be making these calls and it was only in October 2011 that the Financial Stability Board ( a unit of BIS) produced a report which in part stated the following:
"The objective of an effective resolution regime is to make feasible the resolution of financial institutions without severe systemic disruption and without exposing taxpayers to loss, while protecting vital economic functions through mechanisms which make it possible for shareholders and unsecured and uninsured creditors to absorb losses in a manner that respects the hierarchy of claims in liquidation."
Then there was silence until the people of Cyprus woke up in March of 2013 to find that their savings were effectively burnt toast. In my mind the Cyprus bail-in was an abject failure both practically and intellectually because of the manner in which it was carried out. Since then, and despite initial refutations to the contrary, bail-in procedures and plans are being prepared for use on a bank by bank basis across the globe.
WILL THIS NEW APPROACH WORK?
The answer in a nutshell is "no".
There are three basic reasons:
- The proposed manner of the bail-in on a bank by bank basis will cause people to shift their accounts first between banks and then between nations as they realise that the axe has possibly been raised over their current bank. This will cause a great deal of mayhem.
- The second reason is that this kind of solution is the equivalent of throwing passengers overboard in order to keep the ship afloat. In other words, any procedure that is simply designed to keep the banks operating but which does not give mortgage relief to existing and severely stressed borrowers, is simply a stop gap measure and will require ongoing bail-ins over time.
- The final reason is that the proposed approach of the bail-in does not achieve the normalisation of interest rates and a reversion to a sustainable mean of asset values. The FED and the BOJ amongst others are trying to sustain an illusory level of asset values through QE and ZIRP. This approach only acknowledges the current owners of various asset classes. In my books it is far more important to consider both current and future owners.
To put this last proposition in simple terms, there is no point in trying to keep an inflated level of asset values in place through artificial means when the younger generation is weathering high unemployment, part time employment, poorly paid employment and a humungous level of student debt which makes asset acquisition extremely difficult. Under such circumstances inflated asset prices cannot persist nor can they be met by an economically disadvantaged younger generation.
There is at present a clear disconnect between the generations and try as he might, Ben Bernanke and his colleagues across the globe will ultimately fail.
IS THERE A PAINLESS SOLUTION?
There is no painless solution. To use another analogy, the FED and others, are confronted with a series of sink holes, but rather than fill them, they are simply building bridges over them. One pylon rests on the ZIRP and the other on QE.
The debt levels of the world across all levels is beyond calculation, servicing and repayment. With time, compounding and further downturns, this will simply push us into a vortex of chaos, war and extreme solutions.
Central to the problem, we must all recognise that banks do not hold cash (other than a small cash float). What they hold is predominantly a bunch of mortgages and it is in those mortgages that depositors are effectively investing in when they deposit their savings.
Therefore, the assurances of governments that they are guaranteeing deposits up to certain levels is nothing but a lie. When governments already owe billions and trillions in debt and when governments cannot bring their deficits under control despite record low bond rates, one has to ask the question "where is the money coming from to cover depositors?" There is of course no money. Cypriots found that out the hard way. So be warned.
MY THOUGHTS
Debt levels and the cost of servicing them is breaking the back of governments and other borrowers. Simultaneously, savers are being raped by ZIRP and are forced to consume capital to meet living expenses. To make matters worse, the middle class is giving up its share of the "market" to big corporations which endeavour to grow by squeezing the middle class out of the market through outsourcing and margin compression.
Matters have been exacerbated over the years with huge trade imbalances being smoothed over by huge borrowings recycled in the opposite direction with which to continue the trade imbalances. This has led to the gutting of industries at one end and excess capacity at the other end.
The complex web of measures adopted by governments and central banks have turned into a Gordion Knot that defies untying with Bernanke unsure as to how reverse out of QE.
When Alexander the Great arrived at the town of Gordium he was confronted with a knot on a cart and a prophecy which said that the man who was able to untie it would become master of the world. By one account, Alexander drew his sword and cut through it rather than try to unpick it.
TIME TO CUT THE KNOT
At this point I am going to fly a kite in the hope that sharper minds might be able to see some merit in it and take it to a higher level.
In summary I propose the following to take place simultaneously throughout the world:
- A haircut of 50% on all bank deposits and bonds over a certain amount.
- A haircut of all debts between businesses to the tune of 50%.
- A haircut of 50% on all government debt.
- A haircut of 50% on all credit card and student debt.
- The possible issue of shares or bonds to bank depositors and bondholders with a face value equalling the haircut.
- All banknotes in circulation to be similarly "cut" in half and replaced with new notes for half the previous value. The purpose of this is to flush out hoards of undeclared cash as well as to not give an unfair advantage to those who put their money under a mattress instead of a bank.
- Trade imbalances between nations to be either eliminated or to be met with the payment of gold/silver or other assets of value.
- Government deficits to cease unless they are met by asset sales.
- Banks not to increase their nominal margin on existing loan rates.
- Allowing home loan and commercial borrowing to be determined by the market - which for the purposes of this proposal I assume will double.
SO WHAT IS THE BENEFIT?
Now if loan amounts fall by half but interest rates double where is the merit in the process?
At present a home loan is at around 4% while a bank depositor makes somewhere between 0% and 1% on their savings (or let's say 0.5%). Also let us assume that banks are making a margin of 2% as a minimum before write-offs and non-performing loans.
If rates were to go to 8% on home loans and depositors were to get 6% on a $200,000 deposit, the math would be as follows:
BEFORE WRITE-OFF AFTER WRITE-OFF $400,000 @ 0.5% $200,000 @ 6%
DEPOSITOR $ 2,000 $ 12,000
BORROWER $16,000 $ 16,000
BANK MARGIN-2% $ 8,000 $ 4,000
The depositor is better off but how is the borrower better off?
The answer lies in the repayment period:
- A person paying off $400,000 over 25 years at 4% would pay $2,111.35 per month and a total of $233,404.21 in interest.
- A person paying off $200,000 at an 8% rate with repayments still at $2,111.35 per month, would repay the loan in under 14 years. That is a saving of 11 years x 12 months x $2,111 = $278,000.
- Alternatively the cash strapped borrower may still opt for a longer repayment period which will noticeably reduce his monthly loan repayment. This will allow consumers to spend more and save more for other things as well.
The one downside of course is that with interest rates doubling to 8%, the value of homes would suffer. My answer is, so be it. Our baby boomer generation has come to expect their ever increasing home value to be a source of perpetual wealth that would fund their lifestyle and their retirement as well. This was without regard to the next generation's earnings that did not and could not keep pace with the increases in asset values.
In any case the exorbitant capital appreciation of the pre-GFC period was not the result of booming population growth, real wealth creation and unmet demand. In was a contrived growth predicated on debt and fast-forwarded consumption.
IT'S ALL ABOUT THE NEXT GENERATION
Asset prices must keep some relativity with regard to the earnings of the next generation of buyers rather than just the expectations of the current generation of owners and the endeavours of the FED.
The trick which was perpetuated until it failed was to lower rates and provide teaser rates. Even the current low rates present a clear and sudden danger if the market panics and rates start to spike. If that happens the smoke and mirror progress of the last few years will soon vanish and a series of cascading collapses will ensue. Even Bernanke recently admitted that tightening monetary policy would tank the economy.
No doubt, anyone with income producing property who has a substantial portion of their debt wiped out will see an increase in their taxable income which will help fill government coffers but will also experience a drop in the value of the property owing to higher interest rates. A drop in debt might also enable them to drop their rentals in an effort to give their lessees some traction.
There are of course some problem areas and in particular for corporations such as insurance companies and pension funds if half of their bonds and cash disappeared overnight. But let us be honest and admit that too many pension funds are doomed to failure under any scenario as the mess in Detroit quite clearly shows.
There is also a view that governments should take a long hard look at the approximately $21 to $32 trillion dollars stashed away in tax havens as a means of smoothing out any losses which might cause more grief than relief. Perhaps some of that money could also be used to recapitalize banks, reduce government debt and prop up some pension funds.
The proposition I have set out above is by no means a cure all. However the system has so much deleveraging to do and so little time to do it in, that anything is worth considering. But it is essential to note that a haircut on savings, bonds etc must be accompanied by debt relief to existing borrowers otherwise any haircut will lead to more haircuts as the system falters even further.
We must act now otherwise we will see the continuing destruction of capital and any remaining capital becoming concentrated in fewer and fewer hands.
The one group that will suffer is the banking sector, which will find itself with half the loans it previously had while still making the same margin. The banking sector and the value of its stock will shrink dramatically and possibly return to a time when it accounted for a far smaller percentage of the economy.
The rise in interest rates will curb speculation and malinvestment. Together with higher equity requirements being made of borrowers, tighter lending standards, as well as a drop in credit card limits, the need to haircut (bail-in) in future will be much diminished as will the probability of bubbles forming.
The role of government will have to be curbed and re-thought as the present practices and trajectories are nothing short of suicidal. Needless to say, wars, the cost of medical care and other issues are in addition to the problem of debt.
AND GOLD?
At the end of the day there is no such thing as a safe asset although gold and silver stand tall in the pages of history. India and Vietnam may be seeking to curb the popularity of gold and this may dampen the demand for gold. However, beating down the fiat price of gold does not secure the success of the fiat system. It simply masks its cancer until the day of reckoning.
You can be sure the elite are not stacking their vaults with dollar notes but with gold and silver. Everything else is not worth the paper it is written, printed or scribbled on when it comes to the crunch. The day will come when the metal exchanges will not only return your gold in cash, but you can also be sure that they might not even give you cash for the gold you own.
A much saner economic system may well see the price of gold and silver stagnate and possibly fall, but it goes without saying that the price of these metals is inevitably secured to a large degree by the cost of extraction. On the other hand the cost of producing fiat is and always will be just a few cents per banknote.
Life is full of choices, some of which are clearer than others. The Indian woman working the fields with gold bangles on her arm while the sophisticated US housewife selling her jewellery at a gold party for cash is an example of such a choice.
The contrast is already stark and the outcome will be even starker when the system implodes.
If your savings mean anything to you, then this is the time to take action.
Inevitably what is of paramount importance is a sustainable economic system that gives opportunity to the next generation. If we fail them, then we have failed as well. The bottom 90% have to be recapitalized and even though my proposal would represent a large asset redistribution from the super rich to the rest of the population, the fact nevertheless remains that the vastly improved cash flow and debt situation of the bulk of consumers (albeit with higher interest rates) would also see the effect of trickle up economics benefit the top 1% over time. Moreover, that great fulcrum called the middle class (however you define it) needs to be nurtured otherwise an inevitable clash between the haves and the have nots is bound to ensue.
Crazy idea?
Possibly. But then again no crazier than Ben Bernanke who has painted himself into a corner with no way out.
Crazy idea?
Perhaps. But then again Warren Buffet has talked about giving away his wealth anyway, so let's just speed up the process without waiting for our death and the death of the system. With the issue of debt being dealt with through a massive bail-in, the world can then focus on its remaining issues of demographic decline, derivatives, trade imbalances, political tensions etc.etc. etc.
Ultimately, we must keep in mind that much of the debt that will be destroyed is odious debt that cannot be ever repaid or even serviced and which came into existence using questionable practices. It is now just a gangrene that threatens the rest of the system.
Crazy idea?
You bet!!! But what have the alternatives as displayed in the USA and Cyprus achieved so far?
Sydney Australia
