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The
Economist Magazine posed this question on the cover of this week's magazine
with an illustration of the various pieces of Wall Street machinery being
sucked into the vortex of a tornado. The market appears to have stabilized which
was the intent of Secretary Paulson in the unprecedented actions he took last
week. What comes next for the bailout plan are more goodies from Congress. Why
stop at $1 trillion? What comes next for the real economy is going to be the
aftermath of this Pyrrhic victory the Fed, SEC, and Treasury jointly scored
last week in preventing financial Armageddon.
The economy was
already rolling over before this fiasco started. If the US Government could
agree to a 700 billion dollar bailout for Wall Street in two days just think
what they will come up for Main Street over the next two years . Steve
Rattner, the highly-respected managing principal of the Quadrangle Group
wrote in The Wall Street Journal last week, "And make no mistake, the
crisis on Wall Street will spill over to Main Street. With the economy
already continuing to soften, the inevitable further contraction of credit -
as well as the ripple effect of so many lost financial-services jobs - may
well tip us into a modest recession." Kenneth Rogoff, the former chief
economist at the IMF, wrote an editorial in the Financial Times
("America will need a $1,000bn bail-out") just a day before the
rescue package was announced where he ominously warns: "...at this
juncture, there is every possibility that the credit crisis will radiate out
into corporate, consumer and municipal debt. Regardless of the Fed and
Treasury's most determined efforts, the political pressures for a much larger
bail-out, and pressures from continued volatility in financial markets is going
to be irresistible."
And what comes after
that is monetization. We aren't going to dig our way out of this one any
other way. Citigroup analysts, John Hill and Graham Wark are calling the
period we are entering "muddle-through and monetization." This is
the best case and most likely scenario. The alternative is "gloom and
doom." They write: "A more likely macro outcome involves
slow-growth accompanied by monetization and socialization of derivative
losses. Actions such as the US takeover of GSE/mortgage and insurance
entities and lending/guarantees to derivatives-laden banks, replicated
globally, are likely to act to the detriment of paper currencies relative to
hard assets and gold." And they wrote this before the comprehensive
bailout package was announced.
Influential investor
and institutional advisor, Dennis Gartman, seconded the sentiment, quoted in
a Bloomberg article ("Dennis Gartman 'Joining Gold Bugs on Outlook for
Inflation") saying, "Gold tends to rally during inflationary
cycles, and we see the Fed as embarking in precisely that sort of thing. The
Fed shall have to buy Treasury securities from the dealers to make certain
that very high-powered money is made available to them, and in the process,
it shall reflate the economy.' Rogoff also envisions inflation on the
horizon: "The shrinking financial system will also undermine another
central foundation of the strength of the US economy. And it is hard to see
how the central bank will be able to resist a period of allowing elevated
levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts."
Felix Zulauf,
founder of Zulauf Asset Management and long-time contributor to the
"Barron's Roundtable" in this week's interview section of Barron's
notes that "the level of Treasury paper on the Fed's balance sheet has
now reached such a low point that it cannot expand more without really
monetizing debt." He goes on, "You can't stop this [downturn] or
turn it around without going to monetization, a step the central bank
hesitates to make. But eventually the developments will force the Fed to do
it."
Zulauf has an
outstanding track record -- probably the best of the ten or so who
participate in the roundtable. Most of the others tend to represent more
'mainstream' thought. The coming debate among the pundits set to dominate the
airwaves of financial TV over the next year or so will be whether or not the
Fed will be forced to monetize. The same congenital optimists who have been
incorrectly calling market bottoms, telling us that the worst for the
financial firms is behind us, and that the 'economy' is merely stumbling,
will passionately make the argument that talk of monetization is crazy.
After the last three
years, these guys (and much of the mainstream) should have very little
credibility. Yet many of them are still selected to host the financial TV
shows with the largest audiences. That is scary. Why would you listen to
them? They have been mostly wrong for the last decade. In addition to the credit
crunch and the collapse of our financial institutions, most of them missed
the housing bubble, and almost all of them missed the bull market in
commodities. They have been on the wrong side of almost every secular trend
this decade. Do yourself a favor -- listen to strategists and managers who
were on the right side of these movements. They are out there, and are
occasionally featured on the programs.
And as far as our
government officials go, you know that they are going to emphatically try to
suppress any talk of monetization, decrying it as "silly." Of
course, they are the ones who have been errantly reassuring us that housing
prices had stabilized, the economy is strong, the credit markets would not
freeze up, there would be no need to save other financial institutions, and
the list goes on. Even if they are correct this time, you would be foolish to
place any trust in a group with a track record like that. To the contrary, it
would be more reasonable to think that they will not succeed in preventing monetization.
It looks like the market may now be looking to discount the prospects for
monetization and higher inflation.
It appears that
another pivot point might have been reached on September 15. The "long
deflation, long dollar, long US Stocks/short commodities and hard
assets" trade that began on July 15 seems to have reversed. The pivots
in the oscillations between inflation and deflation tend to be swift and
vicious. The deflationists might be lining up to go the investment guillotine
this time around. The US dollar failed to poke through the
"80-level" where it encountered massive resistance. It will be
difficult for gold not to stage an impressive rally from where we are today. A
little over a week ago, it felt like we were caught in the vice grips of
inescapable deflation. In one fell swoop, the "Paulson Plan",
certain to only grow in size and scope from here, has completely reversed the
landscape to an inflationary/stagflationary one. Prices go up and growth goes
down.
The bottom line is
that as the relief we have survived another crisis and the threat of
annihilation wears off, the reality of negative impact all of this is going
to have on an already weakening world economy is going to sink in. Psychology
is going to turn sharply negative quickly. Here, I don't mean the monthly
indicators which measure sentiment and are prone to bounce all over the
place. Rather, I am referring to the long-tem psychology and the recognition
that deleveraging is not an event, but rather a painful process that is going
to be with us for years. Hope will turn to despair and this will have the
effect of exacerbating the negative feedback loops which are now ramping up
to work full throttle. This is what comes next.
Kurt Kasun
www.greenfaucet.com
A contributing writer to GreenFaucet.com, Kurt Kasun writes a
high-end investment timing service, GlobalMacro, which is focused on identifying
opportunities that produce returns in excess of market with reasonable risk.
He is strategically located in Washington, D.C., a key to maintaining
contacts and relationships which help Kurt understand global policy and
economic factors as they emerge. His investment approach has always been
macro in nature largely due to his undergraduate studies at the U.S. Military Academy at West Point (B. S. National Security, Public Affairs, 1989) and his
graduate studies at George Mason University (M.A. International Commerce and
Policy, 2006).
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