Credit Writedowns

Last year, we saw a sea change in official German policy regarding the euro crisis and inflation. The German government came out in favour of accepting higher inflation domestically in Germany as a sacrifice for eurozone wage and price adjustments to help alleviate crisis. The question is whether this matters. I believe it does, but only in part.

Now, you may well deduct from all of this that I am as bearish as I have ever been, but nothing could be further from the truth. The issues I have discussed in this month’s letter are clouds on the horizon which are likely to take years to play out and, in the meantime, investors will continue to be preoccupied with far more mundane issues. All I know is that financial markets cannot stay disconnected from economic fundamentals forever so, ultimately, the Tony Dyes of the world will be proven right. Unless they lost their jobs beforehand, that is.

I see that Paul Krugman has shifted his rhetoric in a recent post on British government economic policy. Let me explain how in this post so that I can make a point as to how bond market vigilantes actually work.

Japan is stuck in a shrinking population trap, and neither monetary nor fiscal policy will adequately solve the problem. Continuing to run fiscal deficits in a deflationary environment will only means that government debt is pushed onward and upwards leading to a variety of possible scenarios as to what the end game will finally be. Reining in the deficit, by raising consumption tax, for example, will probably only make deflation worse with a one year time lag, as happened in 1997, and will almost certainly force the economy into more economic shrinkage which in any event makes the debt issue worse.

Gold is breaking down in a big way right now. We are well into bear market territory here. Marc Faber thinks it could fall to $1300… before rebounding. A number of noted goldbugs are talking about a Fed conspiracy. So what is going on here? Personally, I like the way Pawel Morski puts it. Gold – unlike bank deposits, equity [...]

Finally, a prominent “mainstreamer” Keynesian gets MMT. Over the past couple of years, Paul Krugman has got close, but he keeps claiming that MMT believes “deficits don’t matter”. He refuses to cite any MMTer who has ever said such a silly thing. One doubts he’s actually read any serious piece by any proponent of MMT. I suspect he is just reacting to comments made on his blog—likely by anonymous supporters of MMT who might not have got it quite right.

I mentioned Fed Vice Chair Janet Yellen’s speech in the last post. I tend to like the way she phrases things because her statements are the clearest of all of the major FOMC policy makers. This speech is in that vein. If I could summarize her speech, I would say: “The Fed will focus on employment over inflation as far as its dual mandate is concerned until inflation is over 2.5% or unemployment is below 6.5%.”

I’ll be watching a number of things in 2013 in order to get a better sense of what the future will bring. On January 22 Princeton University Press will be publishing my book, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead, and in the last chapter of the book I argue that the great trade, capital flow and debt imbalances the were built up over the preceding two decades must reverse themselves. Imbalances can continue for many years, I argue, but at some point they become unsustainable and the world must adjust by reversing those imbalances.

As the winter storm pounded the north eastern United States on Friday, gasoline futures hit another high. The March delivery contract broke $3.06, indicating that retail prices for fuel will be going up.

Brazilian central bank’s highly accommodative policy in the past year and the recent weakness in the Brazilian real has helped boost growth.

“Who is afraid of currency wars?” asks Gavyn Davies in the FT. I have known Gavyn for 25 years and have to confess that he is way out of my league intellectually. He is one of the smartest people I have ever met and, thankfully, also one of the humblest. He rarely gets things wrong so, when I occasionally disagree with him, it always makes me slightly uneasy. In his latest post in the FT, he makes the valid point that the currency war debate has flared up yet again following newly elected Japanese Prime Minister Abe’s decision to change tact and openly bully his own central bank into action.

Yet Gavyn – and he is certainly not alone in that regard – ignores one important aspect in his argumentation and that has to do with what actually drives exchange rates. Just because a currency is depreciating doesn’t mean it is subject to manipulation. A quick look at chart 1 makes it pretty clear that the recent weakening of the yen is just a tiny blip on the curve. It all begins with the outlook for bond yields which, if you believe various commentators, is extremely bleak.

The talk in 2013 has been of the great rotation from bonds to the U.S. stock market. This accompanies a new world record for the Russell 2000 Index (small-cap stocks). The S&P 500 has topped 1,500. It did so twice before, in 2000 and 2007. Here we are, again.