In-depth analysis on Credit Writedowns Pro.

A few brief comments on America’s fiscal choices

  1. The private sector (particularly the household sector) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector (although asset price appreciation can attenuate this through the Wealth Effect). That necessarily means the public sector must run a deficit or the import-export sector must run a surplus.
  2. Most countries are in a state of economic weakness. That means consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar. That leaves the government as the sole way to pick up the slack.
  3. Since state and local governments are constrained by falling tax revenue and the inability to print money, only the Federal Government can run large deficits.
  4. Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
  5. Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver.  However, when the prop of government spending is taken away, the global economy will relapse into recession.
  6. As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
  7. Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
  8. From an investing standpoint, consider this a secular bear market for stocks then.  Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.

-The recession is over but the depression has just begun, October 2009

I don’t see the need to change any of these bullet points because the logic of that post is still operative. We are now at bullet points number 4-7 in this time series.  Look at the budgetary debate in Washington as proof of point 4. Look at QE and the liquidity provided by the ECB and the BoJ and the increase in commodity prices as proof of point 5.  Look at the imminent increase in rates in Europe as proof of point 6. Look at the unrest in the Middle East as proof of point 7.

Note that the commodities complex is still moving higher. Gold is trading near a record high of $1459. Silver is trading at a 31-year high near $40 an ounce. Brent crude is above $122 a barrel while WTI is above $108.

commodities futures

For readers like Ralph who object to the use of the phrase "print as much money", I must add that quantitative easing is an asset swap. Looking at the Federal Reserve as part of the U.S. government’s consolidated balance sheet, the Fed is creating electronic credits that it swaps for interest bearing bonds. No net financial assets are added to the system. In reality, money is created when government spends since there is no corresponding financial asset that it buys in doing so.

In my view, the ongoing fiscal debate in the U.S. will lead to a contractionary outcome – at least in the short-to-medium term. Longer term issues regarding malinvestment are less clear. With household balance sheets highly leveraged and the financial sector still fragile, the potential for economic and market tail risk is large.

As an aside, I should also note that the situation in the Ivory Coast is spinning out of control. If one listens to BBC World Service radio, one can hear much of the news is on this and the situation in Libya. According to the BBC, there is a food and water crisis developing as we speak as refugees enter neighbouring countries. Yet, no one is talking about a no-fly zone or humanitarian intervention. The reason should be clear: there is no oil in the Ivory Coast.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

3 Comments

  1. Anonymous says:

    I would say that the wealth effect from the QE was a lot less than everyone thinks. The extra QE flowed straight into stocks and commodities, bypassing Main Street completely. Now that the commodities bubble is coming back as inflation on imports, which is deflationary and I suspect is a lot more effiecient at working its magic than the “wealth effect” from the QE. It affects a lot more people and so is going to result in more pain than what boost QE will have helped them.

    • David,

      Did you see Claus’ last post on wealth effects? I thought it was interesting. It definitely showed that an alleged wealth effect may really not be that strong. I also thought his discussion on Ricardian equivalence was interesting even though I think Ricardian equivalence in its strong form is bogus much as the efficient markets hypothesis is.

      In any event, there are enough variables at play here that defenders of QE will still claim that there is no connection between commodities speculation and QE. People with an ideological agenda will always proffer some sort of intellectual justification for their viewpoint. And Economics is just not rigorous enough of a subject to make definitive statements on the issue and this allows ideologically motivated arguments to dominate the discussion.

      • Anonymous says:

        I had not read the article from Claus yet. My observations were simply that, personal observations.

        I never felt that the wealth effect was at all credible. In effect it would have to be the sum of all peoples reactions to news that they were wealthier. Some might spend more in line with the theory. Some will not change at all because it will all be paper profits and until they have crystallised those profits they keep things as they are. Some will get a loan or mortgage based on the fact that they are wealthier but this must be minimal as many will have ploughed much of that apparent wealth into buy-to-let investments. Now with the real estate markets crashing this wealth has just evaporated and take much of their other wealth with it. This is why many central banks are doing everything to stabilise the property markets. Masses of buy-to-let investors getting burned will send the markets into another tailspin.

        Also consider the wealth effect from a renters perspective. A property bubble might have pushed up rental expectations considerably from landlords. This will mean that rents have risen and these will reduce the disposable incomes of renters in fact reducing the wealth effect. Making it almost a zero sum game. With the property bubbles more of the rentals have gone in higher mortgage payments to the banks. This means that people have speculated with leverage on a housing bubble continuing. Ultimately this all ends up transferring income and wealth from tenants and landlords to banks.

        As for the Ricardian equivalence, I have to concur that it is a bogus hypothesis. People simply do not plan that far ahead. A year at most unless saving for a specific event like a child attending college or a house purchase. If the government plans to issue bonds to fund a war they do not cut spending in advance to prepare for the eventual taxation to pay it. Once the government announces its plans then they cut their spending, just like now in the UK as people prepare for the austerity. People do not spend money because governments say that they may get a tax cut next year. Once they have the tax cut in their bank account then it becomes a different matter.

        As for QE not inflating the commodities bubble then how else would they describe the causes? Yes the Chinese have been stockpiling metals but the volumes moving since the worst of the crisis are low and the Baltic Dry Index is only a fraction above its worst so freight traffic is very low. It also looks like the Chinese have completed their stockpiling. It cannot be for contango trades. Last year there were dozens of ships literally mothballed off Singapore waiting for rates to improve. So it has to be speculation. What else have the banks been doing with the hundreds of billions of QE funds? Not lending to customers, that is clear. The daily market for oil is well within the range of the extra funds from QE. Though it will not have been spread evenly, hence why all the commodities have risen. I suspect that once QE is ended that much of the upward pressure on commodities will evaporate.

        I am concerned that economics has become far too mathematical without good cause. There are way too many variables to account for, which explains why so many models are wrong, needing that little tweak to account for the global financial crisis. So many avoid the fact that they missed the crisis because their models did not account for it. Though I suspect that they will not account for the next one either or the one after that.

  2. DavidLazarusUK says:

    I would say that the wealth effect from the QE was a lot less than everyone thinks. The extra QE flowed straight into stocks and commodities, bypassing Main Street completely. Now that the commodities bubble is coming back as inflation on imports, which is deflationary and I suspect is a lot more effiecient at working its magic than the “wealth effect” from the QE. It affects a lot more people and so is going to result in more pain than what boost QE will have helped them.

    • David,

      Did you see Claus’ last post on wealth effects? I thought it was interesting. It definitely showed that an alleged wealth effect may really not be that strong. I also thought his discussion on Ricardian equivalence was interesting even though I think Ricardian equivalence in its strong form is bogus much as the efficient markets hypothesis is.

      In any event, there are enough variables at play here that defenders of QE will still claim that there is no connection between commodities speculation and QE. People with an ideological agenda will always proffer some sort of intellectual justification for their viewpoint. And Economics is just not rigorous enough of a subject to make definitive statements on the issue and this allows ideologically motivated arguments to dominate the discussion.

      • DavidLazarusUK says:

        I had not read the article from Claus yet. My observations were simply that, personal observations.

        I never felt that the wealth effect was at all credible. In effect it would have to be the sum of all peoples reactions to news that they were wealthier. Some might spend more in line with the theory. Some will not change at all because it will all be paper profits and until they have crystallised those profits they keep things as they are. Some will get a loan or mortgage based on the fact that they are wealthier but this must be minimal as many will have ploughed much of that apparent wealth into buy-to-let investments. Now with the real estate markets crashing this wealth has just evaporated and take much of their other wealth with it. This is why many central banks are doing everything to stabilise the property markets. Masses of buy-to-let investors getting burned will send the markets into another tailspin.

        Also consider the wealth effect from a renters perspective. A property bubble might have pushed up rental expectations considerably from landlords. This will mean that rents have risen and these will reduce the disposable incomes of renters in fact reducing the wealth effect. Making it almost a zero sum game. With the property bubbles more of the rentals have gone in higher mortgage payments to the banks. This means that people have speculated with leverage on a housing bubble continuing. Ultimately this all ends up transferring income and wealth from tenants and landlords to banks.

        As for the Ricardian equivalence, I have to concur that it is a bogus hypothesis. People simply do not plan that far ahead. A year at most unless saving for a specific event like a child attending college or a house purchase. If the government plans to issue bonds to fund a war they do not cut spending in advance to prepare for the eventual taxation to pay it. Once the government announces its plans then they cut their spending, just like now in the UK as people prepare for the austerity. People do not spend money because governments say that they may get a tax cut next year. Once they have the tax cut in their bank account then it becomes a different matter.

        As for QE not inflating the commodities bubble then how else would they describe the causes? Yes the Chinese have been stockpiling metals but the volumes moving since the worst of the crisis are low and the Baltic Dry Index is only a fraction above its worst so freight traffic is very low. It also looks like the Chinese have completed their stockpiling. It cannot be for contango trades. Last year there were dozens of ships literally mothballed off Singapore waiting for rates to improve. So it has to be speculation. What else have the banks been doing with the hundreds of billions of QE funds? Not lending to customers, that is clear. The daily market for oil is well within the range of the extra funds from QE. Though it will not have been spread evenly, hence why all the commodities have risen. I suspect that once QE is ended that much of the upward pressure on commodities will evaporate.

        I am concerned that economics has become far too mathematical without good cause. There are way too many variables to account for, which explains why so many models are wrong, needing that little tweak to account for the global financial crisis. So many avoid the fact that they missed the crisis because their models did not account for it. Though I suspect that they will not account for the next one either or the one after that.