Showdown With the Bond Vigilantes

It’s time for summer vacation in France.

“You can forget about getting anything done in the month of August,” said colleague Simone Wapler. “The French are busy with serious things…real things…like painting shutters and picking green beans…fixing curtains and making strawberry jam. They don’t want to hear about economics or markets…”

France begins its summer vacation today. We’ve come to join them…

But we will keep an eye on the money anyways…because it’s just getting interesting…

Two interesting things are happening. First, the feds are facing a showdown with the vigilantes…you know, the people with money – $2 trillion worth of reserves, $1.5 trillion of it in U.S. Treasury paper. They’ve got to convince them that they’ll protect their investment. If they fail, the vigilantes sell their bonds…cause the dollar to collapse…and force up U.S. interest rates – which will come down like Round-Up on those green shoots of recovery.

Meanwhile, stocks are not only anticipating a recovery, they’re counting on it. And for that, they depend on stimulus from the feds. But what Bernanke gives in stimulus, the vigilantes are likely to take away…

More on that in a minute…

The other big thing that is going on is the rally in the worlds’ stock markets. On Wall Street, for example, the Dow rose 96 points yesterday. How far will this rally go? Should you try to take advantage of it?

As a rough rule of thumb, a bounce can be expected to recover half of the losses from the crash. The Dow went down 7600 points below its pre-crash high. So, we can expect a rebound of about 3800 points – which would put the index back around 10,300. By that measure, this rally could still have a lot of life in it – enough to convince practically everyone that the depression will soon be over. Don’t believe it. This depression is going to last at least a few years…and the bear market isn’t over. The Dow will eventually close below 5,000. At least…that’s our story and we’re sticking with it.

But let’s go back to poor Ben Bernanke. And poor Tim Geithner. The poor fellows don’t seem to know what they are doing. But why should they? Ben Bernanke spent his career as a professor of economics. Modern economics is fundamentally an intelligence-destroying trade. The longer you spend in economics, the less you know about how the economic world functions. Many years ago, the profession got the wrong idea of what it was up to. Ever since, it’s been barking up the wrong tree. (More below…)

As for Geithner, he is a smart young man…destined for hackdom almost from the day he was born. Ivy league university…consulting firms…government – a protégée of Robert “Nobody Saw the Crisis Coming” Rubin – you can’t blame Geithner either; he hasn’t had time to think about how an economy really works.

But at least their mission is clear: to convince the world of two things at the same time…both impossible and mutually exclusive! The Chinese vigilantes must believe that the feds won’t undermine the dollar…and the rest of the world must believe that they will! Inflation is necessary for recovery and growth in the United States…or so everyone believes.

It was French economist Jacques Rueff who revealed the scam more than half a century ago. The whole idea of Keynesian stimulus, he explained, was to cause inflation…which would reduce the real price of labor. In a modern democracy, politics prevents wages from falling. But in a correction, if wages don’t fall people don’t get jobs. Keynes’ didn’t mention it, but the only reason his stimulus works is because it pulls the wool over the eyes of the working classes – reducing their wages by inflation so employers can afford to hire them again. Ergo, no inflation…no recovery in the job market. No recovery in the job market…no recovery in the economy.

But inflation will cost the Chinese plenty. And they’ve let it be known they won’t sit still for it.

“China seeks assurances that US will cut its deficit,” says a New York Times report:

“China sought and received assurances from the Obama administration that the United States would reduce its budget deficit once an economic recovery was under way, a senior Chinese official said Tuesday at the end of two days of high-level talks between the countries.

“Attention should be given to the fiscal deficit,” said Xie Xuren, the Chinese finance minister. He said Treasury Secretary Timothy F. Geithner had assured the Chinese that once the economy rebounded, the deficit would gradually come down from its current record levels.

“Mr. Geithner confirmed that, saying, ‘As we put in place conditions for a durable recovery led by private demand, we will bring our fiscal position down to a more sustainable level over time.’”

Did you notice, dear reader? Geithner promised a “durable recovery led by private demand.” In other words, it won’t be government spending that pulls the United States out of its slump, he told the Chinese.

He must have had his fingers crossed behind his back. At this stage, what other kind of demand is there? Are factories being built? Are they hiring? Are consumers borrowing and spending more? As we pointed out yesterday, private demand has collapsed …and it’s likely to collapse even more.

But let’s stick with our vigilantes for a while. Inflation would cause them to lose money. More importantly, it would cause them to lose face. American officials have told them not to worry; the Chinese seem satisfied. But woe to the debtor who lies to his creditor; he gets cut off.

Meanwhile, a report from the IMF names Britain and the United States as the world’s two biggest spendthrifts…and sees no end coming soon.

A global recovery is “not yet under way” and likely to occur at different times around the world, so pulling back public spending and investment may be “premature,” the IMF staff said.

Additional discretionary spending may be needed in 2010, the report said.

The staff report also said inflation expectations are picking up, posing a risk to a rebound in economic growth.

“Preserving investor confidence in government solvency is key to avoiding an increase in interest rates, thereby not only preventing snowballing debt dynamics, but also ensuring that the fiscal stimulus is effective,” the report said.

The IMF noticed the fix U.S. officials are in.

“On the one hand, a too hasty withdrawal of fiscal stimulus would risk nipping a recovery in the bud,” the report said. “On the other hand, with a delayed withdrawal investor concerns about sustainability may increase, leading to higher interest rates on government paper, undermining the recovery and increasing risks of a snowballing of debt.”

The IMF staff urged countries to develop medium-term strategies to rein in rising debt levels. Some countries already have begun to do so, the report said.

The economists at the IMF see this as a problem of “balancing risks.” Here at The Daily Reckoning, we see it differently. To us, it is lies colliding with each other. Stimulus will not produce genuine prosperity. You can’t cure a credit-caused crisis by offering more credit; it just won’t work. But rather than let the system correct itself, the feds are determined to ‘do something!’ What can they do? They can only destroy the dollar – or try to – thereby destroying the value of China’s $1.5 trillion treasure.

Now, more on why private demand is going to weaken, not increase.

As the boom of the post-war period continued, consumer spending played a larger and larger role in the economy. It averaged 64% of the GDP during most of the period, but increased to 70% in 2007. Likewise, debt service as a percentage of disposable personal income rose too – from less than 5% in the ’50s and ’60s to over 14% now.

If, as we suspect, the trend towards more and more consumer debt has finally peaked out; consumption should have peaked out too. We should now see the percentage of the economy devoted to consumption go down…year after year…until it reaches the ‘normal’ level. Private debt too should go down, until it is at a more ‘normal’ level.

We calculated that during the last 7 years of the Bubble Epoque consumers added $1.4 trillion in debt per year. That was the spending that made the old mare go. But now what? They are now adding no debt – zero. In fact, they are paying off debt. This alone removed $1.4 trillion in private demand from the economy.

The savings rate is up dramatically too – from zero to 7%. This is another way of measuring the same phenomenon: the decline in consumer spending.

The only thing that would cause consumer spending to go would be a substantial increase in real wages. This would allow Americans to buy more – while simultaneously paying down debt. But with 16% unemployment (Rosenberg’s estimate) it will be a long time before real wages increase at all…let alone substantially.