An Undercapitalized Fed

“We head west,” our new friends exclaimed, “like hippy people from America do.”

We encountered our fellow adventurers in Japan last week, while dining at one of Fukuoka’s famous Yatai (traditional street side food stalls). We were in Japan on a kind of reconnaissance mission. Deflation is on a global rampage and we wanted to see what it looks like up close, taken to a multi-decade extreme. If price collapse is on the rise in the west, we reasoned, it might be useful to see how those in the Land of the Setting Sun deal with it. And so, hoping to preview one possible economic future for the U.S., we caught a glimpse into an Orient-fused version of it’s cultural past.

“Jobs are not easy for us,” one of the travelers told us. A college graduate, the young lady has been “on the road” for almost two years, mostly in Japan but also in India and South America. Now she makes jewelry along her journey, living off the funds and friends’ couches while she figures out her next step.

“It’s not like when our parents got rich,” she says. “We don’t know where we will go from here.”

Indeed, Japan itself has been wandering in a desert of deflation for the better part of two decades now (incidentally, their horse may or may not have a name). After the now-infamous market implosion, which we touched on in last week’s notes, their meanderings have been painfully punctuated by many a mirage of recovery. Alas, their parched tongue met with nothing but sand and dry heat. The stock market finally “bottomed” last year…for now, that is.

Then, to rub salt in the wounds, Japan’s most faithfully consuming customers became victim to a crisis of overconfidence. Americans are tightening their belts. So while savings rates there marched toward a 14-year high, Japan’s exports dropped off a cliff. May recorded a year-over-year decline of above 40% (not a typo).

Unsurprisingly, government tax receipts are coming in well below expectations too. Overall tax revenues slid by record 13.2% for fiscal year 2008, The Japan Times reported last Friday. Even more worrying, corporate receipts sunk by almost a third (32.1%) as earnings deteriorated.

So is the United States doomed to repeat the mistakes they warned the Japanese about two decades ago? Are we headed toward terminal deflation, a negative feedback loop of earnings destruction and job layoffs? In many ways, we’re already there. You saw the jobs numbers last week – 365,000 more people worth of “slack” in demand ought to exert significant downward pressure of prices for a while yet. Home values are still falling, for example, while foreclosed inventory levels pile up each and every day.

America’s assets have only been hissing for two years, mind you; Japan’s have lost two decades worth of hot air. And, with such a delusional runnup in prices, who’s to say when enough air has been let out? As one blogger recently quipped, “What is the natural price when everyone wants to sell?”

The natural correction for low prices, of course, is low prices. But, in a world where prices must seek government approval to fall below a certain level, it is increasingly difficult to ascertain where that watermark is. That said, the longer prices refuse to obey the will of our elected and unelected officials, the farther they are likely to overshoot the mark in the opposite direction when they are “allowed” to snap back.

Meanwhile, the cries to “do something” were loud and desperate enough in the corridors of Capitol Hill that unprecedented intervention was not only allowed, but encouraged. The Federal Reserve balance sheet, for instance, has exploded like a Hiroshima mushroom cloud.

With $45 billion in capital and $2.1 trillion in assets, the central bank would not withstand the scrutiny normally afforded other institutions, James Grant, editor of Grant’s Interest Rate Observer said recently in a television interview.

“If the Fed examiners were set upon the Fed’s own documents— unlabeled documents—to pass judgment on the Fed’s capacity to survive the difficulties it faces in credit, it would shut this institution down,” he said. “The Fed is undercapitalized in a way that Citicorp is undercapitalized.”

So what happens now? We must rely on the people who got us into the most indebted position in the nation’s history to turn the hoses off at the precise time. If they fail, the deserts will flood and all the creatures in it (including horses with and without names) will drown. Guard against deflation for now, in other words, but prepare for the rains.

The Daily Reckoning