Failed Experiments in Fiscal Stimuli
The outlook for the U.S. economy is not so good right now. In the essay below, Marc Faber explains the problem of interest rates, which are artificially low and below the rate of inflation.
If a shift from low volatility to high volatility signals a change for the worse in the macroeconomic outlook, then the collapse in the yield of short term US Treasury securities is a symptom of the current credit crisis, which has infected all the sectors of the credit market save the highest quality credits.
At the same time, the sharp decline in the yield of ten- and 30-year Treasury bonds and the collapse of lower-quality bond prices seem to indicate that a bad deterioration in US and world economic conditions is about to occur. Since, according to Philip Isherwood, equities tend to perform poorly when volatility is high, cash and bonds would seem to be a good alternative. But, stating his case in favour of US equities on CNBC, a US money manager made the comment that "money in cash is also at risk". This is certainly true for bank deposits, CDs all structured products, and even money market funds, because the return of capital is uncertain. In the case of Treasury securities, "money is also at risk" but for different reasons.
In the case of Treasuries, the return of capital won’t be a problem for now, but I suppose that with a yield of less than 2% on two-year, 3.7% on ten year, and 4.5% on 30-year Treasury securities, the risk is that inflation (not that published by the government, but the cost of living increase for the median household), which is already higher than these yields, will over time completely eat away the purchasing power of the principal, including the interest.
I hope my readers understand the problem of interest rates, which are artificially low and below the rate of inflation. This forces investors, including individuals, institutional investors, and state and private pension funds, into risky investments, which as we have now seen can also lead to widespread losses. In fact, the losses are now so large that they threaten the entire financial system. I estimate that, when all is said and done, the losses experienced by the financial sector and investors brought about by Mr. Greenspan’s and Mr. Bernanke’s irresponsible monetary policies will exceed several trillion US dollars if we add up the combined capital losses on homes, nongovernment bonds, and equities.
Expressed in Euros or gold, the total wealth of the US has already shrunk by at least 40-50% since 2000. I don’t have a high regard for any government (except, possibly, that of Singapore), but the most destructive course a society can embark upon is to appoint academics to positions of responsibility. A problem of artificially low interest rates that is seldom discussed is that many individuals depend on interest income in order to meet their living expenses. Equally, pension funds depend on a certain annual income to meet their present and future liabilities. Moreover, high interest rates provide investors with a cash flow, which can cushion downturns in asset values. Say, an individual or a pension fund owns a balanced portfoli 50% in equities and 50% in fixed income securities of various maturities. Let’s assume that, in a given year, the stock portfolio declines by 20%. If interest rates average 10% on the fixed income portfolio, the total loss on the portfolio will "only" be around 10%.
Moreover, the cash flow from the fixed income portfolio can be reinvested in equities. But what if the yield on the fixed income portfolio averages only 3%? Obviously, the opportunity to make up for the losses on the stock portfolio by investing the cash flow and averaging down diminishes. And what if the annual cost-of-living increases average 5% or more? In this case, the purchasing power of money will rapidly vanish. Moreover, because of negative real interest rates, consumer price inflation will accelerate, as was the case in the 1970s. At the same time, the "real" spending power of households whose income depends on fixed interest securities will be cut and their standards of living will decline.
My friend David R. Kotok, chairman and chief investment officer of Cumberland Advisors, writes regular insightful comments on the US financial market. Recently he stated: "We still have to deal with dysfunctional credit markets. The Fed must persist in their work of creating liquidity. Only time and transparency will relieve the problem of insolvency. That process is working, too. It takes time and it does and will succeed. Remember, there are no examples of Depression in economic history where stimulus was applied and where the inflation-adjusted interest rate was brought to zero by the central bank. That is the condition in the US today. In sum, stimulus works."
Well, David, on this one I must disagree with you. I know many economies where monetary and fiscal stimulus was applied and yet they still went into depression. In all these economies, the inflation-adjusted interest rates were not only brought down to zero but, in fact, significantly below zero. The failed experiment by John Law with paper money in France at the beginning of the 18th century ended with a depression, and money printing in Germany between 1918 and 1923 brought about total impoverishment of the German working and middle class. Latin America went through extremely poor economic conditions in the 1980s. (In Argentina, car sales declined by more than 50% between 1980 and 1988.)
However, in all these instances, the depression wasn’t accompanied by nominal price declines but by hyperinflation and collapsing asset prices, GDP, and standards of living in real terms. In fact, I know of two little empires that, as a result of excessive monetary and fiscal stimulus, went bankrupt and ceased to exist: the Roman and Spanish empires.
Admittedly, these empires’ rulers weren’t as smart as our present-day leaders of Western democracies….
Also, I was pleased to hear that Robert Mugabe (another academic with several degrees from Oxford and an honorary degree bestowed on him by China’s Hu Jintao "for his brilliant contribution to international diplomacy and peace") has offered Mr. Bernanke a teaching job at the University of Harare. This will provide him with a first-hand opportunity to study the devastating impact of excessive monetary and fiscal stimulus on a society.
So, to a large extent, I agree that "money in cash is also at risk", because there is the risk either of default or that money’s purchasing power will decline. Also, I am beginning to wonder for how much longer buyers of ten- and 20-year Treasury bonds will accept their low yields, which are now below the cost-of-living increases and below nominal GDP. The poorly delivered, contradictory, and incoherent statements made by Mr. Paulson and Mr. Bernanke at a recent Senate hearing didn’t provide much comfort to holders of US fixed interest securities. Not surprisingly, gold has more than doubled since Bernanke was appointed Fed chairman, while the yield on 30-year US government bonds is higher now than before the January 125 basis points Fed fund rate cuts.
Surely, the Fed can cut the Fed fund rate to zero. But this doesn’t mean that longer-dated bonds will rally. If inflation were to accelerate further, rate cuts would inevitably lead to higher long-term rates and capital losses on long-term bonds – particularly if the dollar weakens further! In other words, the Fed can bring down short-term interest rates, but it has little power over the longterm bond market. I may add that one of the problems of hyperinflating economies is that the long-term fixed rate bond market ceases to exist.
I should like to introduce one more thought. Throughout most of the 1970s interest rates were below the rate of nominal GDP growth and negative in real terms. So, what happened? Inflation accelerated, bond yields soared from 6% in 1970 to above 15% in 1981, and the US dollar tanked. After 1981, we had for most of the following 20 years bond yields that were above both nominal GDP growth and the rate of inflation (positive real interest rates).
What happened? We had a lengthy period of disinflation. Also, because real interest rates were particularly high in the early 1980s, we had a huge US dollar rally between 1980 and 1985. After 2001, we again had interest rates that were below both nominal GDP growth and cost-of-living increases, which led to the unprecedented credit inflation we experienced between 2001 and 2007 and the subsequent historic bust.
Now, let us assume that market participants begin to believe in the nonsense Mr. Bernanke has been coming out with concerning "money printing" and "dropping dollar bills from helicopters" in order to stabilize asset markets and avoid economic downturns. They will begin to realize that he is the messiah of the gold bulls and the arch-enemy of sound money.
What will investors do? They will dump bonds and the US dollar en masse. In this context, it is interesting to note that recently, on very poor economic statistics, bonds didn’t rally but sold off. The Institute for Supply Management’s non-manufacturing index, which is representative of almost 90% of the US economy, fell in January from 54.4% to 41.9%. (A reading of 50 is the dividing line between growth and contraction, and the index has averaged 57.6% since its inception in 1997.) January retail sales – closely scrutinised – were a disaster and confirmed my view that US economic statistics published by the government misinform the public about the true state of the economy.
How can January auto retail sales increase by 0.6% when volume sales were down 6% month-on-month? According to David Rosenberg, in addition to declining sales at department stores (down in three of the last four months), sporting goods and book stores, furniture and building materials stores, sales at electronic stores were down 1% in January on top of a 2.5% slide in December, which represents the worst back-to-back performance since the 1990 recession. According to Rosenberg, the "bottom line is that the cyclical components of retail sales – autos + clothing + furniture + electronics + sporting goods + building materials + department stores – were down 0.1% in January.
By way of comparison, spending on gasoline, food and health care rose 1.1% collectively for the month."
The poor state of the economy is reflected by the collapse of the ABC News/ Washington Post Consumer Comfort Index and its various components. The personal finance component is now lower than it was in 2002. Also, the University of Michigan index of consumer sentiment collapsed in January to its lowest level since 1992. According to Rosenberg, "consumer sentiment is now at a level that is telling us that we are not on the eve of a recession but are rather already several months into the downturn".
As I have noted in earlier reports, the US economy is already in recession in real terms, but this fact is obscured by the government’s grossly understating price increases throughout the economy. Despite, in my opinion, horrible economic statistics (in real terms), the Fed needs to be very careful not to disturb bond holders by "printing too much money" (electronically), which – aside from the collapse in lowerquality bonds that had already occurred – would also lead to a rout in long-term government bond prices. At the same time, the US must be increasingly careful about its budget deficits and about bailing out the entire financial sector, which is loaded with crappy paper.
Otherwise, Treasury securities will reach "junk status" sooner than I had expected. But I can very confidently predict that, in the long term, US debt will become "junk"!
So, whereas under a sound monetary regime high-quality bonds would be – like utilities – a candidate to outperform, under a central bank that lacks any monetary discipline they are a rather dangerous investment. But this isn’t to say that, at some point in the current downturn, distressed lower-quality bonds won’t provide a great buying opportunity.
Dr. Marc Faber
for The Daily Reckoning
March 05, 2008
Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.
Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.
The banks face "challenging conditions," says Fed governor Donald Kohn. Many are watching their revenues decline as debtors fail to pay up, while the value of their collateral goes down.
Bankruptcy filings are going up, reports the LA Times, which it regards as a "grim omen." Delinquencies in Alt-A debt, a step above subprime, are rising. Car and truck sales were down 10% in February; both Ford (NYSE:F) and GM (NYSE:GM) say they’re cutting back on production.
Is the United States in recession already? Yes, says Warren Buffett. Whether it is technically in a recession or not, we don’t know. But it hardly matters. Across the board, indicators are signaling a slumpy economy. We’re just waiting for the details – how slumpy? And for how long?
The Fed’s remedy is to lend the banks more cash on better terms. The smart money is betting that Bernanke will cut rates again – a sixth time – this month. Not only that, but traders are looking for a big cut – 75 basis points.
Bernanke insists the economy is not well and needs the kind of medicine the Fed usually dispenses. But remember, the Fed is not exactly a U.S. government agency – as if that would be any comfort. It is a cartel of big banks, which regularly conspires to set the price of credit at a level that is agreeable to its members.
Of course, the Fed has a duty to the U.S. government…and to the American people…too. It is a duty that has evolved over time, from supposedly protecting the value of the U.S. dollar to supposedly maintaining full employment. The prevailing economic theory is that you need a steady rate of inflation to keep the factories humming and the shops full, so these two goals were never compatible. Now, faced with real and present danger on both fronts – rising unemployment on one side…rising prices on the other – Ben Bernanke has left no doubt as to which direction he will go. He’s fighting the slump.
Damn the inflation torpedoes! If his actions also help the big banks, by moving their losses onto the public (in the form of higher consumer prices), well, so much the better.
Yesterday, we felt a little sorry for Ben Bernanke. He’s getting blamed for everything…while his predecessor, Alan "Bubbles" Greenspan collects huge fees for kibitzing. Yesterday’s reports from Wall Street said it was Bernanke’s fault that stocks fell. Apparently, his recent remarks have not been upbeat enough. The former professor of economics at Princeton is not as good at obfuscation as the man who preceded him; but he’ll get the hang of it. Then, Ambrose Evans-Pritchard, writing in the Telegraph, branded him a failure. The Fed’s rescue attempt isn’t working, he says.
Today, it gets worse. Not only are the Fed’s rate cuts not working – they’re actually ‘doing more harm than good,’ says a report on MarketWatch. While this is undoubtedly true, we don’t like to see the press gang up on poor Ben.
Here at The Daily Reckoning, we always rise in defense of the poor…the downtrodden…the inebriated and the incompetent. Are the Fed’s efforts really futile, we ask? Are they worse than nothing? Well, the answer depends on who you are. If you have been holding euros, instead of dollars, you might want to send the Fed a ‘thank you’ note. The euro has been going up steadily, ever since Ben Bernanke began fighting recession with more cash and credit. Yesterday, it took $1.52 to buy a euro. Eight years ago, you could have bought one for only 88 cents.
Gold holders, too, should be happy with the Fed’s anti-recession program. Yesterday, the yellow metal dropped $17. But it has already added a third more value since the first rate cut last September.
And what of all the wheat farmers…and rice planters? Rice just hit a 20-year high. And the wheat growers are all buying shiny new tractors. Surely, they should be grateful. Of course, there’s the oil industry, too. Oil didn’t get to $100 a barrel on its own; it had the Fed behind it every step of the way. And don’t forget the platinum miners. Platinum has gone up 46% since the beginning of this year.
Last, but not least, there are the bankers themselves.
Among the Fed’s efforts to relieve the bankers’ pain has been a new line of credit – the Term Auction Facility. What a handy tool! It allows the banks to borrow against the same infected collateral that caused them problems in the first place. Private lenders wouldn’t touch it; but the Fed…as chump of last resort, with the taxpayers’ credit card in hand …accepts it as if it were lost Rembrandts and uncirculated gold coins.
We weren’t born yesterday. We know bakers don’t bake us bread merely because they want to see our fat, rosy cheeks. And we know bankers don’t bank merely because they want to see us with money in our pockets. So, we take it for granted that the bankers look out for Numero Uno just like everyone else.
Which is why we’re also suspicious of the latest initiatives to save homes from foreclosures. Ben Bernanke himself urged "banks to forgive portion[s] of mortgages," says a Bloomberg report. And there is another strange beast afoot…a proposed act of Congress, whereby the government would step in and buy the distressed mortgages itself. However much these measures might benefit humanity, we’re sure that the final wording would have them tossing a small bone to the bankers too.
*** "Price of wheat is soaring. So buying a loaf of bread is going to cost a lot more dough. What is happening?" our intrepid correspondent, Byron King wonders.
"Sure, we have lots of hungry mouths in this world. And more and more dollars are chasing those bushels of wheat, to feed those mouths. And couple it with the worldwide episodes of drought, and cropland destruction, and decline in soil fertility, and rising costs for seed and fertilizer and equipment. So just for reasons of limits on factors of production, it is harder and harder to increase supplies to match the growth in demand.
"But look at what else is helping drive the price of wheat upwards: Export tariffs.
"Whoops. The traditional use for tariffs was to limit imports into a nation, and protect domestic markets against ‘cheaper’ foreign competition. The idea was to protect domestic industry, and permit it to grow over time in a sheltered domestic market.
"But now the use of tariffs is shifting to control exports. The intent of these export tariffs is to protect internal national supplies of a critical commodity.
"But export tariffs are a two-edge sword. Tariffs may limit exports, of course. Export tariffs will limit sales into international markets. In doing so, they will support higher world market prices, because of limits to supplies in trade. And back home, export tariffs deny the benefits of higher world process to the domestic producers. That is, the farmer receives a ‘lower’ price signal. The taxing government is capturing the difference between internal and international prices, via the tariff. So there is less of a market incentive for the farmer to increase output, if that is otherwise possible.
"It gets back to the classical economic argument that tariffs distort markets. In the case of export tariffs on food, they limit production at home while supporting artificially high prices on international markets.
"Long term, tariffs are probably self-defeating. But that’s another discussion."
For more from Byron, check out his latest report. In it, he details a little known source of energy that he calls "China Lake Energy" that has enough reserves to significantly reduce our dependence on foreign oil. He’ll tell you what five penny stock companies — whose stocks are all priced less than $3 per share — that are set to take this energy public in a very aggressive and profitable way.
*** "This is war," said Damien yesterday.
Yesterday, we heard the shooting. Like the muffled sounds of handguns fired in liquor stores, it went on all morning. We thought for a moment that we were back in Baltimore.
Pow…pow…pow…at intervals of an hour or more each time.
"How’s the campaign going?" we asked at lunchtime.
Damien stood at the door of the library, with a large smile on his face. He wore his green overalls. And since the weather was so bad, he had on his cap with the large earflaps hanging down. The overall effect was of a big, friendly dog waiting for a pat on the head.
But this puppy was packing heat. Damien held in his hand a loaded, skeletal gun that looked like it may have been made in a prison shop, out of a license plate, when the guards weren’t looking.
"Not bad. You heard the shots. Each shot; one more dead mole.
"I think I’ve got them all from the front yard. Now, I’m going to attack on the left flank."
We wondered about his strategy and his artillery.
"Won’t they just come back into the front yard?"
"Yes, but not for awhile. This war never ends. It’s like your war on terror. You can never get rid of the moles entirely, because you can’t kill them all. But if you kill enough of them in the early spring, you’ll be fairly free of them all summer."
Damien’s war to exterminate the world’s moles goes back years.
"I’ve tried everything. Poison …traps…and just shooting them. Sometimes, I just take my rifle and wait. When I see a pile of dirt welling up, I just go over and shoot right down into it. Not very sporting. That stops them. But this is the best thing….
"This is an anti-mole gun," he explained, showing off the latest military hardware – an AMD, anti-mole device, as it is likely known in the trade. "You just put the cartridge in like this…and then you cock the trigger…like this…and then you put it in the mole hole. As soon as the mole touches it, he gets it right in the face."
"Nah…there’s no bullet. It’s just a charge of gas. Very humane."
The Daily Reckoning