Rehab, Euro Style

My June post (“Rehab Revistied”) continued the story I originally began in September 2010 (“Busting Out of Rehab”), where I compared our situation in the U.S. Economy to that of a drug addict forced into rehab against her will, only instead of being addicted to drugs the U.S. was addicted to debt. As we rejoin our story today, our U.S. addict is still struggling with her debt and deficit addictions, paying lip service to getting clean but so far still partying every night (at the Democratic Party that is), supplied by her Chinese pushers and some quiet little guy in the shadows named Ben. She would like to get back into serious rehab at the clinic, run by a bunch of supposedly reformed debt addicts from that Republican Party that ended a few years ago. (And what a party that was, by the way. Eight years long and more debt drugs than in all other parties before that combined!) But those guys are tee-totallers now, or at least they claim to be. They want our addict to not only go cold turkey on debt drugs, but to eat right and start exercising every day to get lean and fit and trim – and all at once and all right now! Of course, that kind of regiment might very well kill our addict in her fragile addicted state.

But as bad as things are for our American addict, her European party buddies are in even worse shape. That guy Greece is the worst of the bunch. He may live, but they’re going to have to amputate his legs if he’s to survive. That’s a shame, but he was never really a “player.” He just hung out on the periphery doing his best to party with the big boys. The real question is what will happen to the big core partyers of the group – Italy, Spain and Portugal. All three of them keep waking up in the gutter. Every time that happens, their big brothers, France and Germany, give them a good talking to. The addicts then promise to do better, and they pay lip service to that for a while. But it doesn’t last, and before long they are again waking up badly hung-over with some under-age Italian girl in a seedy condo owned by the head of some labor union.

Not long ago, the pushers started to think that maybe they will never get paid for all of the debt drugs they are supplying, so they started cutting back on the debt drugs they were willing to sell to Italy, Spain and Portugal. But without an organized, expensive and time-consuming rehab, these addicts are in no condition to suddenly cut back on their debt habits. To do so could quite literally kill them. Concerned for their survival, their big brothers (France and Germany) called in the family doctor, Dr. E. C. Bee. Like any good doctor, Dr. E. C. Bee’s first priority was to stabilize the patient. His only immediate option was to fill the gap left by the reluctant pushers, and to himself start supplying the addicts with the debt drugs that they so desperately need every day just to get out of bed in the morning.

This kept Italy, Spain and Portugal from going into fatal withdrawal, but France and Germany realized that it was not a good long term solution… although France really didn’t have a big problem with it. (After all, France is a casual debt partyer now and then – just a little debt “weed” on the weekends, not that crack debt stuff that the hard core partyers like.) But Germany… Germany HATED Dr. E. C. Bee supplying the addicts. After all, Germany never has more than one beer on a Saturday night, always staying WELL within the safe limit to drive home. (And don’t even get their little brother Slovakia started. Before they would even let him get his driver’s license they made him go completely stone-cold sober and join AA. Italy of all people had been part of the group that was so strict with him. Boy is he pissed!) Nevertheless, the truth was that old Doc E. C. Bee wasn’t really licensed to treat debt addicts anyways. In fact, the law specifically prohibited him from doing so. So France (and even little Slovakia) had to agree with Germany that they needed to bring in some new help.

They decided the answer was a new doctor just out of medical school. His full name is a European mouthful, so everyone just refers to him by his initials – Dr. EFSF. He’s a brand new doc, so he’s short on experience, but he has the best credentials and a brand new Euro440 billion medical center. Surely with that kind of dough behind him he could get Italy, Spain and Portugal clean and sober. Well, maybe not all the way, but at least better enough to hold down a job and be productive members of society again.

Only it turns out that there are two problems with that plan. First, the worst partyer of the bunch, Italy, seems a bit reluctant to check himself in to the new rehab clinic. He keeps promising to go, but so far he hasn’t actually made any concrete plans to do it. But the worse problem is that Dr. EFSF’s Euro440 billion won’t be enough. Getting the addicts through rehab is going to take more, a lot more, like maybe Euro2 TRILLION.

So once again France and Germany have to come up with a new plan. Officially everyone in the extended family is working on the plan “together,” but everyone knows that is just to keep up appearances for the American and Asian neighbors. France and Germany will decide, and (perhaps surprisingly or perhaps not) the latest plan that they are discussing would pull a page out of the old party playbook. Their new plan is for Dr. EFSF to start using massive amounts of the debt drugs for himself, probably from the Chinese pushers. In other words, if the doctor can’t cure the addicts, then the solution is to turn the doctor into an addict himself. What could go wrong?

***

If we are lucky, this story will continue for years, perhaps even a decade or more, as the addicts go through the long, slow, painful and costly process of getting clean. Not completely clean, of course, but clean enough to be productive and at least healthy enough to be sustainable. Our addicts will never be able think about living it up like the last two decades (not for a generation at least), but with luck can at least recover enough to live a happy, although poorer and less exciting, life. That is if we are lucky. The alternatives are either the addicts can’t cut back and sober up enough to live sustainably, or else they try (or are forced) to go cold turkey before they are strong enough, and either course could be fatal.

Rehab Revisited

In my September 2010 post “Busting Out of Rehab” I compared our situation in the U.S. Economy to that of a drug addict forced into rehab against her will, only instead of being addicted to drugs the U.S. was addicted to debt. In 2009, I was hopeful our addict would stay in rehab and get off the debt drugs. Individuals were reducing their debt (both through repayment and default) and state governments began drastic spending cuts. The historically low tax rates that were initially sold as being temporary were set to expire. Maybe we could get clean.

But by September 2010 it had become plain that the addict would only stay in rehab as long as she was forced to stay against her will. The addict still liked being an addict. As I wrote then:

“But wait! There’s a tapping at the window. It’s the addicts’ old pushers – China and Japan. ‘Don’t worry,’ they say, ‘We are here for you. We will supply your habit no matter what! In fact, we have some new really good stuff for you – better stuff than we have ever given you before. Remember when all we had for you was ten year five percent stuff? Well now we’ll supply with you with ten year two percent stuff!’ Also outside the window are the addicts’ old friends from a place called ‘Congress.’ Some of them say, ‘Hey, come on out – I’ve got some more of that stimulus stuff for you.’ Others from Congress say, ‘Forget that nasty stimulus stuff. You know it leaves you with a nasty hangover. What you really need is some more of these tax cuts! That’s the good stuff!’ (Those Congress guys fight a lot with each other, but the one thing they have in common is they all just want the addicts to come out and party.) Then the addicts look outside and they can’t believe their eyes. It’s Dr. Bernanke and Dr. Obama. They’ve gone over to the dark side. ‘We’ve got even more good stuff for you,’ they say. ‘I’ve got some quantitative easing that you’re going to love’ says Dr. Bernanke, and Dr. Obama adds, ‘And I can help those Congress boys get you even more stimulus and tax cuts!’”

I wrapped up that post with the following:

“As a result, it suddenly appears that the party may start again… [but] the addicts are still far from healthy. They can’t party like they used to, and besides, they will claim they have all learned their lesson. In fact, if the addicts aren’t careful they may end up right back in rehab very quickly, or even worse (that Greece guy really doesn’t look healthy enough to be partying again!). And even if the addicts keep the party going for a long long time, they will still be addicts. Eventually the day of reckoning will come, and it will be all the worse for having been postponed this time around. But that could be years, maybe even decades, away. After all, pretty much everyone and every government on earth has a vested interest in keeping this party going. So for now, the addicts say, ‘Let’s eat, drink and be merry! And put it on our tab.’”

So how is our addict doing now, nine months later? While in rehab, the doctors (Dr. Bernanke and Dr. Obama) had prescribed some of their low interest rates and TARP to help wean our addict off the drugs, but the withdrawal was still too painful. So our addict busted out and started partying again, bingeing on more of the same debt drugs that put her in rehab in the first place. Unfortunately, as with all addicts, our addict needed bigger doses of stronger drugs just to get the same high. Low interest rates and low tax rates used to be enough to keep our addict flying, but no more. Our addict had to start taking ever bigger doses the deficit drugs, bigger than she had ever tried before. And still that was not enough, so she had to start main-lining the really hard stuff – quantitative easing (the “Q.E.”). Lucky for her, Dr. Feel Good (aka Bernanke) was more than happy to comply.

But our addict still doesn’t feel so good. That Q.E. is good stuff when added to all the other drugs, but our addict is paying the price for partying too hard for too long. Our addict seems to need more and harder drugs each time, but still her highs aren’t as good as they used to be. When you get right down to, even though she’s now taking more drugs than ever, she still feels pretty lousy. So what happens when our addict can’t get high from all the drugs she can get? When the drugs just don’t work anymore? What now?

If our addict was thinking clearly (she isn’t) she would realize she can’t just keep taking more and more of the same drugs. For starters, her suppliers are tenuous at best. First and foremost, that China guy has been pushing so much stuff, some wonder if he can keep up being the main supplier for just about everyone else. What if that guy gets sick for a while and can’t supply everyone? Plus that China guy doesn’t even like our addict! He keeps spying on her and breaking into her house and snooping around her room, hacking into her computer, and stealing her DVD’s and the plans for her new F-22 stealth fighter jet. Not really the kind of guy our addict should be depending on. And those Congress guys that used to be such reliable suppliers of the deficit and stimulus drugs (good stuff!) – now a bunch of those guys are going all teetotaler on our addict, lecturing her about the evils of using all this stuff and threatening to cut off her supply completely. Even Dr. Bernanke seems to be having some concerns about the side effects of any more of that Q.E. stuff.

So what is our addict to do? At least she’s not as bad as her friend Greece. That guy’s whole life was consumed by his addiction to the debt drugs. He can’t hold down a job or make any money, and he has spent everything he has, so he can’t afford rehab even though he is finally realizing maybe there is no other way. Lucky for that guy he has a bunch of rich brothers to bail him out. Even though some of them are griping about it, they seem to realize that the family had better stick together, for now at least. Even his family will abandon him and kick him out if he doesn’t get his act together soon.

Our addict doesn’t have any family members rich enough to bail her out and keep financing her habit, or her rehab. She doesn’t realize it yet but there are no good options left to her. She is trying to continue with the status quo, but she is getting sicker and sicker from too many drugs. Her former suppliers in Congress may realize this and cut her off for her own good, or that China pusher may get sick or hit by a bus, but either way if she is involuntarily cut off from her debt drugs without a good rehab program in place the withdrawal will be horrible, long lasting, and involve much pain and suffering. She might never fully recover. Even if China and her other foreign suppliers don’t cut her off, they will start worrying more and more about collecting payment for the drugs they supply, and so will start raising prices (also known as interest rates). As she has to spend more and more to keep the debt drugs coming, she will have less and less to spend on other things, like health care and education, all of which will impact her ability to pay for more drugs in the future, in a viscous cycle that can only lead back to being cut off completely.

As I said last September, our addict can still party for the time being, and maybe for quite a while still. Her foreign pushers don’t want to lose their best customer – even that China guy seems to understand that. Her best friend (England) is still in rehab and still kind of shaky, so she’s no fun anymore, but her friends the BRIC brothers still want to party all the time. They are healthy and feeling good, and seem willing to drag her out with them each night. She even has a designated driver (that guy Germany – he’s not much fun, but always helps Greece and the other addicts get home safe, at least he always has so far). But our addict may have blown her last chance for a nice orderly rehab. She is living on borrowed time.

***

Like the addict in our story that is still trying to party like the good old days, we have way too much debt in the US, but our federal government continues to spend far more than its revenues. Amazingly, this year our federal government is spending the MOST money as a percent of GDP for any year in the last 50 years, while simultaneously collecting the LEAST in tax revenues as a percent of GDP for any year in the last 50 years. But also like our addict, we may shortly be in for the extremely unpleasant experience of going cold turkey quickly, or in that direction at least. Witness these (seemingly obvious) facts:

1. Individuals continue to reduce debt (through both repayment and defaults), reducing consumption, which is bad for the economy in the short run.

2. Both democrats and republicans now agree we must cut federal government deficits – republicans say cut spending (a lot!) and democrats say cut spending (not as much) and raise taxes – either way fiscal policy is becoming more restrictive.

3. State governments continue to cut their budgets (they can not deficit spend), also contributing to restrictive fiscal policy.

4. QE2 is ending this month – i.e. monetary policy is becoming more restrictive.

5. All of this while the economy is still far from strong, with low growth, high unemployment and low capacity utilization.

So in the face of a struggling economy, fiscal policy is tightening, monetary policy is tightening, and consumers are trying to pay down debt. Unfortunately, like the addict, we have binged on debt to the point where we may not be healthy enough to survive such harsh remedies. Add to this the risk of a serious disruption, such as a Greek debt default, or the bursting of the Chinese real estate bubble, or a major earthquake in California (don’t laugh – in the past year or two there have been major quakes on the other three corners of the pacific plate – Japan, New Zealand, and South America – and these things tend to occur in cycles as movement on one side of the plate affects the other sides as well) and the short term outlook for the U.S. economy looks bleak.

Of course, many emerging markets are still a bright spot for the world economy. Germany is doing quite well. China, with a control economy and a huge incentive to preserve the status quo, may be able to continue driving global growth for many years to come. Uncle Ben could serve up QE3, and maybe that will drive the markets up again, just as with QE1 and QE2. So the market could do quite well for months, maybe even years. I am just saying that the risks are skewed to the downside in the near term.

But all of that misses the more important point, because even if we survive the next few years relatively unscathed, the piper will still have to be paid. Unless our economy starts consistently growing at around 4% real GDP growth (not likely), we will not be able to grow ourselves out of this mess (showing this requires a rather extensive analysis – too much for this short piece but available in the article linked at the end of this blog entry). Unemployment will stay high, and the economy will still have excess capacity, and eventually we will have another recession. Only this time the starting point will be an already weak and over-leveraged economy. Tax receipts will decline and demands for social programs will increase. Our deficit will widen further. We will start to look even more like Greece.

When any country, such as Greece, gets to the point that its debt and deficits are unsustainable – i.e. the country can not grow its way out of the problem (the addict is beyond rehab) – its options become severely limited. In fact, the only good option is to find some richer bigger countries to bail you out. That may work for Greece, but it won’t work for the United States. No country is big enough or rich enough to bail us out. For the USA, we are left with five options (or some combination thereof):

1. The first option, and until recently the only option we had pursued, is to pretend that we are NOT at the point where our debt and deficits are unsustainable – i.e. we CAN grow our way out of this problem. The addict’s first line of defense is to deny she has a problem. She will cut back, and everything will be fine. This option is not a permanent solution. It only works as long as the addict’s suppliers (in our case, the foreign countries that lend to us to finance our debt and deficits) believe it, and eventually they wise up. When they do, this option is no longer available, and if we try to stick with this option we will be involuntarily kicked to option #2. But this option has worked and can continue to work for a surprisingly long time, because everyone on all sides has a vested interest in maintaining the status quo.

2. Option 2 is to continue to run deficits, and continue to borrow from foreigners to do so, even as these lenders become more and more concerned over our ability to repay our debts. As a result, the price we must pay for debt (the interest rate) will rise. This will have two impacts. First, rising interest rates equates to restrictive monetary policy, choking off the productive lending of our economy, causing recessions and reducing tax revenues. Second, more and more of the government’s revenues must be devoted to interest payments, leaving less for education, health care, roads, infrastructure, etc., which also will hurt the economy, leading to lower tax revenues and higher need for social programs. All of this will widen the deficit further and harm economic growth further, putting us right back to where we started with too much debt and too little growth, only even worse. In other words, Option 2 not only doesn’t solve the problem, it makes it worse.

3. Option 3 is the seemingly direct approach that many in Congress now favor, and that is to reduce deficit spending in a big way – either cut spending or raise taxes or both. Unfortunately, no matter how you do it (spend less or tax more), that is like a kick in the gut to our weak economy. It will kill what little growth we have, causing a recession which will raise unemployment, decrease tax revenues and increase the need for social programs. As with option 2, this will widen the deficit and harm economic growth further, again putting us right back to where we are now with too much debt and too little growth, only even worse. In other words, Option 3 is not a solution either. It makes the problem worse, just like Option 2. The addict is far too weak to take this tough medicine. (As an aside, if we had tried this option sooner, when our debt and deficits were smaller, we could have done it gradually over time so that it would not kill our economy, but at this point our debt and deficit are so big that the gradual approach to deficit cutting is unlikely to work in time, and you end up back at Option 2.)

4. Option 4 is to just refuse to repay our debts. After all, if you take the interest expense off the ledger it makes it much easier to balance the federal budget, and once the budget is balanced we won’t need to borrow anymore anyways. And for a small peripheral country like Greece they might even be able to get away with it, but not us. The entire world economy is built on the dollar (specifically in the form of Treasuries) as the world’s reserve currency. If all those Treasuries become worthless then that will literally mean the destruction of the foundation of the entire world economy. Think Lehman Brothers’ collapse was bad in 2008? Try multiplying that by about a thousand. The turmoil would quite literally threaten civilization as we have come to know it. Think Mad Max movies.

5. Option 5 is less extreme, and it is the other option that we have been toying with lately. Unlike Greece and most of the other debt addicts, we have been able to issue all of our debt in our own currency. The Greeks have to repay in Euros. Third world countries have typically had to borrow and repay in U.S. Dollars. When these countries’ economies go down, repaying in Euro’s or Dollars becomes impossible. With their economy floundering they have no way to earn enough foreign currency to repay their debts. They are forced to default. But here in the U.S., where all of our debts are in dollars, we can quite easily get the money to repay all our debts and be debt free. Because we can print our own dollars! The Federal Reserve can literally print dollars and then use them to buy Treasuries, and voila! No more debt owed to foreign countries. The government just owes the money to itself! Does this sound familiar? It is because it is EXACTLY what we have been doing for the last nine months. It is called Quantitative Easing, or Q.E. No wonder the addict in our story loved the Q.E. – it seems like the easy solution to all of her problems.

Option 5 has been tried many times by many countries in past decades and centuries, from the Romans putting base metals in their gold coins so they could mint more, to Germany after World War Two, to several Latin American countries since then. Unfortunately, Option 5’s track record is pretty bad. The result has almost always been that once governments start manufacturing money, they can’t seem to stop themselves from going too far. If a little inflation helps a little, then surely a lot of inflation must help a lot! But the Germans who had to use a wheel barrow to cart cash to the grocery after World War 2, or the Argentinians who saw their life savings inflated away to nothing, would disagree.

So our politicians will ride Option 1 for as long as they can, slowly drifting toward Option 2, while also pursuing Option 3 as much as the voters will tolerate the pain, to buy time and credibility. But Uncle Ben knows, and eventually others will realize, that Option 5 is in fact the only solution that doesn’t automatically make our existing problems of too much debt and too little growth even worse. And in theory at least, if done to a limited extent, Option 5 could help things improve. It will cause inflation, but it will also spur economic growth (in nominal terms at the very least). This will increase tax revenues and help the deficit. Since the Fed will be the biggest buyer of Treasuries they can keep interest rates low, again helping both the economy and the government’s interest expense. All of this is an unfair wealth transfer from savers and lenders to debtors, since inflation and artificially low interest rates hurt savers and lenders, but that is the price of fixing the problem. And it is a risky course, as past history indicates, that if done poorly it could end in financial ruin for the U.S. (which would result in worldwide economic calamity). But what other choice is there?

That is why Dr. Bernanke has already been dabbling in Option 5, and why I believe when his first choice to date (Option 1 – pretend we can grow our way out) fails, and when Congress’s new first choice (Option3 – cut deficits) fails, he will fully embrace adding Option 5 back into the mix. And if he maintains discipline on Option 5, not printing too much money, but just enough, he might be able to get us to the point where a gradual use of Option 3 could work. This plan has its problems… SERIOUS problems… but when one’s choices consist of certain death vs. probable severe injuries that might not be fatal, one is wise to choose the latter.

***

As with everything in life and investing, timing is everything. As I mentioned above, everyone has a vested interest in keeping the train from careening off the tracks, so the status quo could be preserved for quite some time, perhaps longer than anyone expects. Perhaps, if our leaders are wise and disciplined, we can gradually inflate our way out of our predicament while gradually reducing our deficits, until we eventually are back to a sustainable situation. So in that sense, the longer this takes to fix the better, as long as we are actually spending that time fixing it and not making it worse. At the price of another “lost decade” or two we can, maybe, eventually dig our way out - lousy for investors, but not catastrophic for the world as a whole. Of course the longer this takes to fix, the greater the risk that the train will uncontrollably go off the tracks. Maybe there is some external shock (e.g. China’s real estate bubble bursts, or unrest in the Middle East sends oil up over $150/barrel), or maybe our lenders just lose patience and start demanding much higher interest rates, or maybe Greece defaults in an uncontrolled manner much like Lehman Brothers in 2008. The U.S. is in no position to pay for another round of rescues and bailouts. It could get ugly.

So the pain appears inevitable. If we are unlucky, or our leaders make bad decisions, we will take it all at once, in the form of uncontrolled economic catastrophe. But hopefully, with good leadership and a little luck, we could spread the pain out over another lost decade (hopefully just one), so that it isn’t so catastrophic at any one time, just a long slow dull pain.

There are also two “fat tails” to this risk curve, one at the positive end, and one at the negative end. For a description of the negative extreme, the brave of heart can read a recent piece (http://www.itulip.com/forums/showthread.php/19599-The-Next-Ten-Years-%C2%96-Part-I-There-will-be-blood-Eric-Janszen?p=200282#post200282)by economics uber-geek Eric Janszen, who predicted (among other things) the tech bubble burst (in a 1999 newsletter), the housing bubble burst (in multiple mid 2000’s newsletters) and the decade-long rise in gold (in 2001). Janszen does a great job of showing why it is now too late to grow ourselves out of our current predicament. Unfortunately, he goes on to conclude that like the great depression of the 1930’s, the only way out this time is World War. I hope he is wrong. But even though he is not a polished writer (he is too busy making points to fix all the typos, mislabels on charts, and the like), I regret to say he makes a pretty convincing case.

But I will end with the positive fat tail. The obvious (although by no means easy) way out of our predicament would be a technological breakthrough on the energy front. If we suddenly figure out, for example, how to make solar energy for the equivalent of $30 per barrel of oil. The resulting growth and benefit to the U.S. economy would be so huge that our problems would be over (economically at least – the resulting chaos in the Middle East could result in all sorts of problems for U.S. security, but at least would be able to afford to protect ourselves).

Reverse Psychology

I just saw Dennis Gartman (aka the world’s most pompous commodity trader and author of a commodities trading newsletter) on CNBC. He expressed his shock and disbelief that the Euro has stayed strong against the dollar. This probably means Gartman is short the Euro, and therefore losing money, which is why he can’t believe it, but on the surface I would have to agree with him. If there is one place in the world with bigger financial problems than the U.S. it has to be the EU. The market for Greek debt is clearly pricing in a default, and the logical solution for Greece is to leave the Euro and devalue a new Drachma. The ECB keeps reiterating that any default (technical or otherwise) on Greek debt will make it no longer eligible as collateral for European banks at the ECB. Irish voters seem to slowly be awakening to the fact that letting their banks default on their debt to the rest of the EU would probably work out pretty well for Ireland (although likely not for the rest of Europe). Spain and Portugal aren’t far behind. Voters in Finland and Germany are already revolting over the potential cost of bailing out these spendthrift nations. Etc. Etc. How can the Euro be going up?!?!?

Well, what is likely to happen to resolve all this? At the macro level, either Germany and the other strong Euro nations bail out Greece and the weak Euro nations, or else they don’t. Clearly the rates on Greek debt indicate that the market is betting they won’t, so let’s look at that scenario first. If Greece defaults, the government will not be able to borrow any more money. Since they can’t balance their budget, and they can’t print Euros. They will have to reinstitute the drachma and set an artificially low official initial exchange rate at which to convert Greek debts from Euros into drachmas. If you own a 1,000 Euro Greek bond, you will get drachmas in repayment that are worth 600 Euros on the open market. If you have 1,000 Euros in a Greek bank, you will be given drachmas in their place that quickly become worth 600 Euros. There will be riots in streets. Tourism to Greece will plummet. It will be ugly for Greece. Spain and Portugal will see this and either get their act together, or else decide to leave the Euro on their own terms before it is forced on them in the same disastrous way it was forced on Greece.

If this occurs, the ECB will have to bail out many banks in the rest of Europe that hold Greek, Spanish, and Portuguese debt, but it would be more palatable to Germans to be bailing out German banks rather than the Greek government.

In this scenario the market disruptions and dislocations would be huge. It is not hard to imagine the Euro getting hit by 10% or 20% against the dollar in a single day. But maybe not, because the market might realize that once the smoke clears you will be left with the core of the EU in much better shape than today’s EU, with just the healthier economies and government balance sheets remaining. All of that would seem to argue for a stronger Euro.
What about the alternative scenario, where the EU does bail out Greece et al? This would equate to printing Euros, which will stimulate demand and the money supply. To avoid inflation in Germany and the other healthy growing economies, the ECB might have to raise interest rates at least a bit. Rising interest rates vs. the near-zero rates in the U.S. would again argue for a stronger Euro against the dollar, not a weaker one.

So while the EU is indeed a mess, the short-Euro trade is not such a no-brainer… as Dennis Gartman has apparently learned as well.

The Answer is Yes

I remember many years ago, when people first started having their cholesterol checked, the result was just one number, the total cholesterol number. People talked about their “cholesterol” (the total) as if it were just one monolithic reading. But as time went on people realized that this was misleading. They learned that to really understand what was going on they needed to look deeper to the “HDL” and “LDL” components of total cholesterol, because those are two very different things that function in very different ways with very different effects.

We learned our lesson on cholesterol, but not inflation. The financial press is full of debates on inflation vs. deflation. Are QE, ZIRP (zero interest rate policy) and deficit spending sowing the seeds of future inflation? Or will excess capacity and unemployment drive deflation? Is core inflation near zero the correct measure? Or should we fret over record price rises for food, oil, gold and other commodities? The entire debate treats inflation like one monolithic reading that is either “high” or “low”, “good” or “bad”. But like total cholesterol, it is not that simple. The proper way to look at inflation is by looking at its main components.

Prices are driven by the cost of their labor, material, and capital inputs. To make something in a factory you have to have investors and lenders provide the money (capital input) to build the factory, and you need the material and labor inputs to run the factory and make the products. Looking at each of these components separately, it is easy to see that labor costs will remain constrained by unemployment in the developed world and by huge pools of cheap labor in emerging markets. Capital costs will remain constrained because industrial utilization is low and emerging markets have overbuilt industrial capacity in their export industries, particularly in China (just like Japan in the 80’s). Prices for materials, on the other hand, will continue to be supported by physical capacity limitations (there is only so much oil, copper, molybdenum, etc. in the ground), emerging market populations moving to cities (where, for example, they eat more meat, which requires a lot of grain to produce, and use more plastics, oil and gas), and by lousy yields on most investments (which makes gold, copper, etc. more attractive as alternative investments).

So in the debate over inflation vs. deflation… the answer is yes. Labor and capital deflation. Materials inflation. Until… material inflation forms a bubble that gets bad enough that it chokes off all economic growth, at which point the bubble collapses and then everything is deflationary. When this happens it will be a very difficult time for the world economy. When will it happen? Maybe this year, maybe next, maybe even the year after (but I really doubt it). My best guess is that it happens before the end of this year. Oil at $100, Chinese real estate priced like Japan in the 80’s, Facebook worth $50 billion – these are all signs of a developing bubble. The end of QE2 and impending (I hope!) reductions in government deficits (fiscal tightening) could be the pins that prick the bubble. Or maybe not. Maybe the economy is strong enough to continue growing into next year without stimulus, but this will simply drive up materials prices more, making the inevitable bust that much more painful.

Recognizing a developing bubble is easy. Predicting it will end badly is easy. Predicting when it will end, or how high it will go before it ends, is very hard. Caveat emptor.

Japan Redux

Anyone around my age (46 – ugh!) can still recall one of the dominant themes in every aspect of American life as we were transitioning from adolescents to adults in the early and mid-1980’s. In the news, in entertainment, in pop culture – we heard it everywhere: Japan was taking over the world. From the daily economic reports of Japan’s record exports, Treasury bond holdings and New York City real estate purchases, to Congress’ threats of trade penalties, to popular movies such as “Rising Sun” and bestselling books including “Japan as Number One” – Japan’s world dominance was considered an imminent fait accompli.

Sound familiar? Substitute 2010 for 1985 and China for Japan and it is just a new verse of the same old song. So before we all get too far down the road planning our investment strategies around China and Asia’s new world dominance, perhaps we should ask ourselves: How did that work out for Japan back in the 1980’s? And how did that work out for everyone who invested in the Nikkei in 1985? The answer, of course, is not so good, as Japan’s lost decade now stretches out towards two decades. If China is not careful, they will suffer the same fate.

The details of what happened in Japan, and of how it could happen again in China are complex, but the basics of the problem are relatively simple. After World War II Japan embarked on a managed-economy program to grow from a destitute and devastated wasteland to the world’s second largest economy. Simply put, they exported everything they could to the U.S. and Europe, and then used the proceeds in dollars, pounds, marks, etc. to buy badly needed capital equipment and commodities to further build and fuel their export industries. As they perpetuated and grew this cycle they moved up the value chain to more advanced export goods, generating more foreign currency proceeds to further grow their export industries to move even further up the food chain – a virtuous cycle.

But in the 90’s this virtuous cycle turned vicious. Japan continued to suppress domestic demand and consumption in order to build production capacity well beyond what the world could use. Further excess dollars and euros (earned from exports) that could not be invested in more production capacity were left in bank accounts in the US and Europe, or were used to buy US and European sovereign debt or other assets. Most of the dollars and euros earned from exports had to be either used to buy imports or left abroad, for exchanging those dollars and euros back into yen would have driven the yen way up, destroying Japan’s export competitiveness. But inevitably some of the export wealth did manage to trickle down to Japanese citizens, so to absorb it and suppress demand for goods the government engineered asset price bubbles in real estate and the stock markets.

Eventually these asset price bubbles had to collapse (at one point the land under the royal palace in Tokyo was theoretically worth more than the entire country of Canada). In addition, Japanese exporters had built so much production capacity that they could never find customers for it all overseas (or domestically, where tax and other mechanisms worked to suppress demand). Japanese banks, that had financed the purchase of overpriced assets in Japan and around the world had huge losses and began to fail in massive numbers. Furthermore, since export currency was not converted into yen along the way, Japan now found itself with a significant portion of its wealth, and in effect its money supply, tied up in dollars and euros in foreign bank accounts.

All of the pieces fell into place: Excess production capacity, collapsing asset price bubbles, failing banks, contracting credit, and a constrained money supply formed the perfect deflationary storm. Japan still has not recovered, and their entrenched government shows no signs of making the painful changes needed anytime soon.

Now China is Japan in the early 80’s. Their export industries in technology and complex manufacturing (e.g. cars) have not reached global preeminence, but they are getting there and they have now become the world’s second largest economy. They may soon choose to begin to encourage domestic consumption along with production focused on meeting domestic demand, to import more consumer goods and focus less on exports, and to let the Chinese people innovate and found companies to serve domestic markets, especially in the service sector. But if instead China continues to focus all of its energy and resources on building export capacity while controlling and limiting domestic demand, and continues to use the excess foreign currency proceeds that result from massive trade imbalances to fund the debt of their customers (the U.S. and Europe), then Japan’s fate awaits China as well.

The article linked here (http://www.foreignpolicy.com/articles/2010/09/30/the_japan_syndrome?page=full) explores some aspects of this in greater detail. As the article says, “Japan as Number One now languishes as the 400,000th most popular book on Amazon.com while When China Rules the World is a bestseller.” We’ll see.

Busting Out of Rehab

A female drug addict entered rehab. She didn’t want to do it – it was forced upon her. She could not bring herself to quit on her own. Far too many people surrounding her (her suppliers, her addict “friends”, her pimp) all had a vested interest in keeping her addicted. But she could no longer afford her growing habit, she was repeatedly in trouble with the law, and it was taking an increasingly heavy toll on her health, so external factors (a courtroom judge, her family physician and loved ones) forced her into rehab to save her life. Deep down she knew it was her only hope. She knew if she didn’t enter rehab now it would be twice as difficult to quit later. But she still had to be dragged there, kicking and screaming.

Once in rehab it was not pleasant for our addict. The withdrawal symptoms were horrific. In fact, it was so bad that our addict needed a doctor to administer a few more drugs just to keep her from entering a death spiral from which she would never recover. Even with this limited amount of new drugs, withdrawal was awful. Some experts said giving her the drugs to help her through was a mistake – the sooner she went cold turkey on everything the better. Others said she needed more drugs or she wouldn’t make it through the night. The truth was that nobody really knew for sure either way. And either way, quitting would still be a long and painful process. She had been an addict for a long time.

But the addict made it through the night. She started to feel a little bit better each day. So the doctors started to eliminate the drugs they had been giving her in rehab. They had served their function; they had saved the patient’s life. The patient would have to make it the rest of the way through recovery on her own. She wasn’t clean yet.

That night in rehab was a rough night for our recovering addict. As she lay suffering in a nightmarish half-sleep half-waking state, there was a tap on the window. It was her old pusher, her old pimp, and some of her old wasted “friends.” “Come on out,” they beckoned. “Don’t stay in here suffering. We have plenty of good stuff. You can feel great again. Ditch this rehab place and party with us.”

***

The United States, or more accurately our economy and financial system, is also an addict, only in this case the drug of choice is debt, and its close cousin, excess consumption. Known on “the street” as leverage, it comes in many forms, ranging from home equity loans to credit cards to government bonds to commercial paper to asset-backed finance. But it is really all the same thing – debt. And like the addict in our story above, the US has many enablers surrounding it that want to keep the addict addicted. The Chinese and Japanese need to fund the US debt habit so that the US will keep buying their exports. In addition, those debt pushers both have huge inventories of the drug (US Treasuries) and they don’t want to devalue their own inventory. The other addicts out there (all of the other developed debtor nations – the UK, France, the rest of Europe) want to keep the party going as well. They can’t admit the US has a problem, because that would mean they themselves have a problem.

But our addicts got in a little trouble here recently. They want on a bender of historic proportions. They loaded up on the debt drug every which way they could get it. When the party ended they too found themselves involuntarily committed to rehab. Economists have a name for this rehab – it is called a recession, or for really bad addicts a depression. It is painful, but it breaks the addict of their drug (debt and excess consumption) habit.

Immediately our addicts began feeling the painful symptoms of withdrawal – plunging stock market values, corporate bankruptcies and unemployment just to name a few. In fact, like the addict in our prior story, it looked like these patients could also spin out of control in a death spiral if something wasn’t done. The resident doctors at the rehab clinic (doctors Bernanke and Obama) decided that to save the patient they needed to administer controlled doses of the drug (TARP, the stimulus package, Federal Reserve lending, etc.) to wean the addicts off of their dependency. Again, some said it was a mistake to give addicts in withdrawal any drugs at all, while others said it was not enough, but no one really knew for sure. But either because of it or in spite of it, these addicts also made it through that first dark night without spiraling downward out of control. Even the worst addict of the bunch (some guy named “Greece”) made it through, although for him it really was touch-and-go for a while.

So now our group of addicts is facing the tough task of making it the rest of the way through a long and difficult rehab without any more help from any drugs at all – no more TARP, no more stimulus, expiring tax cuts, etc. It will be painful. It will require our addicts to suffer much pain and sacrifice, which unfortunately has not been their strong suit in the past. They are used to having a good time partying. They are not sure they can do it.

But wait! There’s a tapping at the window. It’s the addicts’ old pushers – China and Japan. “Don’t worry,” they say, “We are here for you. We will supply your habit no matter what! In fact, we have some new really good stuff for you – better stuff than we have ever given you before. Remember when all we had for you was ten year five percent stuff? Well now we’ll supply with you with ten year two percent stuff!” Also outside the window are the addicts’ old friends from a place called “Congress.” Some of them say, “Hey, come on out – I’ve got some more of that stimulus stuff for you.” Others from Congress say, “Forget that nasty stimulus stuff. You know it leaves you with a nasty hangover. What you really need is some more of these tax cuts! That’s the good stuff!” (Those Congress guys fight a lot with each other, but the one thing they have in common is they all just want the addicts to come out and party.) Then the addicts look outside and they can’t believe their eyes. It’s Dr. Bernanke and Dr. Obama. They’ve gone over to the dark side. “We’ve got even more good stuff for you,” they say. “I’ve got some quantitative easing that you’re going to love” says Dr. Bernanke, and Dr. Obama adds, “And I can help those Congress boys get you even more stimulus and tax cuts!”

This all looks pretty appealing to our addicts. After all, who wants to suffer through months or even years of more rehab?

***

A few months ago I actually thought there was a decent chance the US was going to stay in rehab and get better. Not intentionally perhaps, but since the Republicans and Democrats can’t seem to agree on anything, it seemed possible, perhaps even likely, that the stimulus would run out, the Bush tax cuts would end, and the Fed balance sheet would start to shrink back down. This would likely cause a double-dip recession, unemployment would rise a bit more, the stock market would fall or tread water, and it would last for years. It would be a long sluggish deflationary time period for markets and the economy while everyone (and the government) cut back on consumption and paid down their debts. It would be painful, but in the long run it would be for the best, and it would be easy for investors as well. All one needed to do was buy high quality corporate and government bonds, and indeed that was what we saw in the markets.

The past week or so has changed all of that. It has become clear that the US is intent on busting out of rehab, long-term consequences be damned. The fed voted not to let their balance sheet start to wind down as securities they hold mature, and “Helicopter Ben” made it clear that he is more than ready to expand the Fed’s balance sheet without bounds through quantitative easing (i.e. buying more securities, or lending more money, in the debt markets). Furthermore, it seems that this fall the democrats are about to get a painful lesson in how much the American public appreciates being in rehab, so now it looks like they are getting religion on extending the Bush tax cuts. And once the Republicans win a bunch of seats in Congress they won’t like rehab any better than the democrats, so if the quid-pro-quo for extending the tax cuts is a bit more stimulus spending then they will probably go along with that.

As a result, it suddenly appears that the party may start again. Clearly the markets realized that as well this week as stocks jumped and high-grade corporate debt retrenched. The party will likely be subdued, for a while at least. The addicts are still far from healthy. They can’t party like they used to, and besides, they will claim they have all learned their lesson. In fact, if the addicts aren’t careful they may end up right back in rehab very quickly, or even worse (that Greece guy really doesn’t look healthy enough to be partying again!). And even if the addicts keep the party going for a long long time, they will still be addicts. Eventually the day of reckoning will come, and it will be all the worse for having been postponed this time around. But that could be years, maybe even decades, away. After all, pretty much everyone and every government on earth has a vested interest in keeping this party going. So for now, the addicts say, “Let’s eat, drink and be merry! And put it on our tab.”

Depressing

An overleveraged, overpriced market brutally declines by about half, only to be followed by a rebound of about 50% that is almost as swift as the decline. A description of 2008 to 2010, or of 1929 to 1930? The answer is both. So what happens next? From mid-1930 to 1932 the market declined an additional 86%. Could we see a repeat of this, and the Great Depression that accompanied it?

The short answer is yes, but only if governments around the world repeat the mistakes of the 1930’s. And that would not be easy for governments to do. First of all, several of the missteps of the early 1930’s have already been avoided. With no FDIC or emergency Fed funding, millions lost their savings as over 5,000 banks closed in 1929-1932. This also resulted in a massive contraction in the money supply, contributing to deflation. There was no unemployment insurance to support the spending of millions of unemployed workers as the unemployment rate climbed to almost 25% in 1933, further driving down demand and fueling deflation. Likewise, farmers had no assistance as drought and the dust bowl ravaged the plains beginning in 1930. So in all of these ways, this time truly is different. Programs already in place (the FDIC, unemployment insurance) and actions taken since the current crisis began (emergency Fed funding, Fed securities purchases, TARP, stimulus spending) have supported both demand and the money supply and prevented (thus far) the devastating deflationary spiral that defined the Great Depression of the 1930’s.

That is not to say that we are out of the woods. Governments around the world could still take ill-advised actions that could at a minimum drive us back into a severe recession. By 1937 there had been a substantial recovery in the economy and the stock market that was driven (at least in part) by the 1930’s version of the stimulus package (the multitude of New Deal programs). But in that year a conservative coalition in Congress that decried the resulting government spending and deficits as ruinously large and threatening inflation successfully pushed through a roll-back of much of the New Deal spending in an effort to balance the budget. Sound familiar? The result was another plunge in both the markets and the economy that lasted until World War 2.

As in the United States of the late 1920’s and Japan of the early 1990’s, the U.S. today is still over-leveraged. Sooner or later all of that excess leverage has to unwind. It may happen gradually (as it did over more than a decade in Japan) or quickly and severely (as it did in the early 1930’s). At this point in our nascent economic recovery, the more governments here and abroad try to raise taxes, reduce spending and balance budgets, the more likely we are to de-lever quickly and painfully, and with some risk of a deflationary spiral like that of the 1930’s. This seems to be our present course, with the fiscal stimulus money, TARP, and the Bush tax cuts all about to come to an end (and worse yet, many pushing to cut spending even further). On the other hand, an extension of the Bush tax cuts and/or stimulus spending would help the economy, and likely give the stock market a huge boost in the short run. But even in that case we will still need to de-lever, leaving Japan’s “lost decade” (which really lasted even longer), during which banks, individuals and companies slowly paid down their debts while the economy more-or-less flat-lined, as an example of the best we can hope for.