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Felix Zulauf says the die is cast. Is it?

I was just looking at Barry Ritholtz’s synopsis of Felix Zulauf’s observations from an in-office interview Barry had with him and I have to say I agree with the man 100%.

But is the die cast? Are we headed into something much worse? I was thinking about just this question earlier today. So let me say a few words and send you off to Barry’s site to read the bullet points from that discussion with Felix Zulauf. I’ll put up a chronology of the posts I think represent the best framing of my ideas at the end of the post.

When it comes to global macro, I think Felix Zulauf and Ray Dalio are the analysts most aligned with my world view. As some of you may know, I come at the macro causes of this debt crisis from an Austrian perspective. I set out the framework when I started the blog in my third post called “The US Economy 2008”.

The gist of it is that we have had a secular run up in credit creation due in large part to the inflationary policies of the Federal Reserve. The Fed would intervene in the economy during downturns to prop up asset markets upon which US households depended due to stagnant incomes. This allowed the financial sector to grow ever larger as the assets collateralising debts increased. Eventually, this form of policy intervention hit the wall when rates dropped to zero percent. The Fed has tried desperately to intervene and prop up asset prices artificially through unconventional monetary policy. But it has been largely unsuccessful.

In late 2008, I wrote a trilogy of posts about economic depression and government intervention that formally marked the beginning of my support for preventing a second Great Depression. Here they are: “Confessions of an Austrian economist”, “What does Mises say about trying to stimulate the economy out of recession”, and "A brief philosophical argument about the role of government, stimulus and recession”. The posts were an argument in favour of not avoiding recession but of avoiding depression. As Felix Zulauf says according to Barry’s piece:

There was a window for an Austrian economics solution, but that opportunity has passed. Worse still, imposing Austrian economics on weak countries here and now will only make the situation worse, causing a recession or making any contraction worse.

As I very recently explained about avoiding recession:

The Austrian in me says avoiding recessions eventually leads to crisis through the build-up of macro disequilibria. Back in 2008, I did a few charts which showed how distorted the US economy had become. New home sales were way over the top as was the real increase in house prices. US debt, was through the rough along with the current account deficit. And the savings rate absolutely plummeted while household debt climbed.  There were some serious macro disequilibria

[…]

Avoiding recession and avoiding depression are two different things. In a panic, the economy is in disequilibrium. Market crashes, property crashes, bankruptcies, and bank runs can lead to some serious knock-on effects and dead-weight economic loss, especially when the downturn is global. The Keynesian in me says debt deflation and depression are the result of this disequilibrium. Obviously you want to prevent moral hazard by letting truly bankrupt enterprises fail. To me, it’s all about the credit writedowns. My view is that until these failures occur and until creditors write down unpayable debts, debtors can only be sustained through gambling on greater income from more debt as an out. You are just papering over the situation and storing up more problems for later.  The point of Keynes is to have government work counter cyclically as it should since the sector balances mirror each other (non-government surplus equals government deficit). You only exaggerate business cycles through pro-cyclicality otherwise. As Felix Zulauf recently pointed out, cutting government into the teeth of recession makes a debt deflation and crisis more likely.

Moreover, I believe that, in the absence of stimulus, the present global crisis would be much more severe. In fact, it could threaten systemic collapse and a Great Depression — if allowed to continue without some measure of countervailing monetary and fiscal stimulus. Not everyone agrees with this view. Some believe that the economy is self-equilibrating, meaning that the ship will eventually right itself once you “purge the rottenness out of the system”, as Andrew Mellon is reputed to have said.

I wrote a lengthy post dedicated to this theme. My prediction was that a “collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios”. I said trying to cut government and private sector debt at the same time would be the origins of the next crisis.

I have to be honest, sometime in 2009 after The Fake Recovery was engineered, I came to the view that Felix Zulauf has about the inevitability of this crisis. This is what I was thinking about earlier today. The question I was asking myself had a lot to do with the tension between hope and expectations, and between policy advocacy and prognostication. I like to be optimistic without losing view of reality. My tack has been to hope for the best, prepare for the worst and expect something in between. This creates a tension for me in my writing because, depending upon whether I am expressing my hope and advocating a policy or expressing my expectations and making a prediction, you can get two different views. The aspirational advocacy pieces are fewer these days (since I wrote that they would be last year). Today, I write in more in terms of crisis policy paths and potential outcomes based on those.

Overall, my sense is that policy makers are too wedded to the status quo until the system collapses. For example, Franklin Roosevelt was not prepared to deliver a radical agenda in 1932. He campaigned to be more Hooveresque than Herbert Hoover had been, meaning putting teeth into the words of fiscal probity that Hoover preached but did not practice. That was standard orthodoxy at the time. Events caught up with Roosevelt and he changed tack.

This is why I have written an increasing number of posts referencing Herbert Hoover. I think it’s important to remember what Hoover was saying and doing. I see Barack Obama as a similar character. He is someone who stepped into a serious economic problem, unaware of how serious it was at the time. Both Hoover and Obama have been prepared to do some unpopular things to right the ship. However, neither was prepared to deliver the kind of radical agenda that Roosevelt did. It is seeing Obama in action which has most convinced me of the Zulauf view that the die may be cast. I am ever hopeful, so I say the die may be cast. I am hoping that it is not.

Source: Felix Zulauf: The Die is Cast – Barry Ritholtz

Here’s a partial list of the posts that show the evolution of my ideas at Credit Writedowns (I will add to this list in the next few hours as I think of posts that best reflect what I have been saying on this site. Feel free to make suggestions. That would be appreciated.)

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.

10 Comments

  1. David Lazarus says:

    Like you I have thought that the policy was to maintain the status quo. If the fiscal stimulus enabled people to clear debts then it could have been similar to the Japanese decades where the government pumps enough money into the economy to allow the debts of the private sector to be paid down as asset prices slowly fall. The stimulus was very badly designed, possibly deliberately so. It is now inevitable that the US and Europe will now slowly implode on the debt deflation.

    As this crisis broke I looked back at the Depression and saw that the austrian attitude during 1929 to 1932 actually cleared out a lot of malinvestment and cleared the economy for new opportunities after the New Deal. What we have now is extend and pretend on the economy till the system breaks. We still have substantial asset write downs to come. While real estate has fallen it has not been followed by the commensurate write downs at the banks. That means we still have years of problems trying to avoid banks taking losses. What Bernanke thought was the solution, saving the banks, might actually be the cause of the next crisis. We now have many governments who are in serious trouble because they saved the banks. If they had cleaned up the mess afterwards then we would still have moral hazard and debt write-downs.

    So my expectations are that things will get very messy soon. Debt burdens in Greece will force the nation to default and even the current talk of 50% or even 60% write-downs will probably be insufficient. I am looking at near 90% write-offs. If Germany wants to punish the Greeks then expect the Greeks to fight back. The banks are clearly trying to pass the buck onto the sovereigns. Though in which case the sovereigns should nationalise the banks booting out the boards.

  2. Randy Pickard says:

    Time will tell how badly the European contagion hits the U.S. Seems to me the best case is that it puts the U.S. economy back into a mild recession while a much worse result can not be discounted. I fear the Apple and 3M earnings misses are just the tip of the iceburg. The European’s are making things so much worse by kicking the can down the road. Greece is in a downward cycle and the austerity measures and the strikes in reaction to them will turn a nasty recession into a depression. It’s mind boggling to me that the obvious step of freeing Greece from the Euro is anathema to European leaders.

    • David Lazarus says:

      Apple exceeded the same period the year before, the expectations were for even higher figures. Analysts are regularly wrong about Apple figures. 3M is a better warning sign. I do agree about the kicking the can down the road. Though the US cannot say it is in the clear. With the severely downgraded Dodd-Frank act meaning little change for the banks the scope for another US financial crisis needing spectacular levels of bailout are very high. A credit event in Europe will trigger a wave of losses in US banks.

  3. SH says:

    How about redeploying the army and the army corp of engineers to rebuilding bridges? The servicemen are already on the payroll so no loss there. There is an established bureaucracy that has skills not only in contracting but engineering and we can experiment with this allocation of resources idea for free. Is money better spent building up other nations or our own? This idea seems like a win win.

  4. Dave Holden says:

    The powers that be need to start recognising this is largely a private sector debt problem and until they find a way and a will to writedown that debt and stop bailing out insolvent banks there will be no solution. Is there a “smooth glide-path scenario” to do this? Well as a lay person I wouldn’t pretend to know but it does seem to me that the powers that be have spent much more intellectual capital on preserving a broken status quo rather than addressing the fundamental problem – private sector debt.

    • Agree, Dave. All we can do is hope that we have leaders wise enough to realise that delaying the inevitable has made things considerably worse. It does seem that Europe is finally moving to a more fundamental take on the sovereign debt crisis with Greek debt writedowns and recapitalisation. So there is hope.

  5. Stevie b. says:

    Well, not only do I have to laugh, but surely Felix is having a laugh too.

    When he says the bear market wont end til 2017, none of us really knows what’s going to happen next month, never mind 2017 (and I speak as someone who used to lecture Merrill brokers worldwide on technical analysis which I assume is somehow involved in arriving at this date). When you read something like this, obviously written in witch-doctor mode, it should make you suspicious about all the other stuff.

    And what does he think a currency race to the bottom means? As long as the debt must be devalued and interest rates kept artificially low, what it doesn’t mean is a stock market going nowhere. Yes, savers in money get screwed, but you can see already that despite all the horrendous news, stock markets are adjusting upwards in anticipation of higher profits. Yes, like the debt the profits may become devalued, but that still means higher markets even if P.E.s stay constant. And if Europe splits up, at least it will be the lancing of that particular boil and we’ll cope with the aftermath, even if it means some bank shareholders and bondholders get their just desserts.

    As one of Barry’s commentators implies – move on, there’s nothing new to see here. As with anyone who says a lot, Felix is bound to get something right – and that may be that gold will continue to maintain real value and act as a hedge against possible chaos.

  6. Stevietheb. says:

    Well, not only do I have to laugh, but surely Felix is having a laugh too.

    When he says the bear market wont end til 2017, none of us really knows what’s going to happen next month, never mind 2017 (and I speak as someone who used to lecture Merrill brokers worldwide on technical analysis which I assume is somehow involved in arriving at this date). When you read something like this, obviously written in witch-doctor mode, it should make you suspicious about all the other stuff.

    And what does he think a currency race to the bottom means? As long as the debt must be devalued and interest rates kept artificially low, what it doesn’t mean is a stock market going nowhere. Yes, savers in money get screwed, but you can see already that despite all the horrendous news, stock markets are adjusting upwards in anticipation of higher profits. Yes, like the debt the profits may become devalued, but that still means higher markets even if P.E.s stay constant. And if Europe splits up, at least it will be the lancing of that particular boil and we’ll cope with the aftermath, even if it means some bank shareholders and bondholders get their just desserts.

    As one of Barry’s commentators implies – move on, there’s nothing new to see here. As with anyone who says a lot, Felix is bound to get something right – and that may be that gold will continue to maintain real value and act as a hedge against possible chaos.

    • David Lazarus says:

      I actually expect a bear market lasting longer than 2017. The reason is that we have not had a proper rebalancing of the economy for many years. We have had a bubble economy for decades and these will need to unwind. This will not be easy or quick. An early end might simply be a restoration of the past bubbles, not a new growth market.

      As for a currency race to the bottom, that is simply another way of competitive devaluation. All want the weakest currency so that their exports are competitive. That is why interest rates are so low. The last thing that any major nation wants is to have an influx of hot money.

      I do not see profits increasing easily. Most companies have boosted profits by cutting overheads, but their markets are still struggling. Consumers are struggling to maintain spending so how can profits increase? Overall PE ratios are grossly overvalued. That means if profits cannot increase will PE ratios climb even higher?

  7. fresno dan says:

    Nice analysis.
    However, you said, “Overall, my sense is that policy makers are too wedded to the status quo until the system collapses”
    so I changed it to:
    Overall, my sense is that policy makers are too corrupted by the status quo until the system collapses

    There, now its perfect….