by Dr. Kurt Richebächer
A study recently published by the Bank for International Settlements
(Monetary and Prudential Policies at a
Crossroad?) says:
"Financial liberalisation is undoubtedly critical for the better allocation
of resources and long-term growth.
The serious costs of financial repression around the world have been well
documented. But financial liberalisation has also greatly facilitated the
access to credit... more than just metaphorically. We have shifted from a
cash flow-constrained to an asset- backed economy."
Though we basically agree with the analysis and the conclusions of the
study, we radically disagree with the one sentence that "Financial
liberalisation is undoubtedly critical for the better allocation of
resources and long-term growth." The indispensable first condition for
proper resource allocation at a national as well as global scale is
avoidance of excessive money and credit creation. In many countries, and in
particular in the United States, they are excessive as never before.
If Mr. Bernanke complains about irregularities of M2, this is nothing in
comparison with the fact that credit and debt growth in the United States
has exploded for more than two decades. When Mr. Greenspan took over at the
helm of the Fed in 1987, outstanding debt in the United States totaled $10.5
billion. In less than 20 years, this sum has quadrupled to $41.9 billion. In
reality, this significantly understates the rise in debts because, for
example, highly leveraged hedge funds with trillions of outstanding debts
are not captured. In 1987, indebtedness was equivalent to 223% of GDP, which
was already pretty high. Lately, it is up to 317% of GDP.
In actual fact, there used to be a very stable relationship between money or
credit growth and GDP or income growth until the early 1980s. Growth of
aggregate outstanding indebtedness of all non-financial borrowers – private
households, businesses and government - had narrowly hovered around $1.40
for each $1 of the economy's gross national product. Debt growth of the
financial sector was minimal.
The breakdown of this relationship started in the early 1980s. Financial
liberalisation and innovation certainly played a role. But the most
important change definitely occurred in the link between money and credit
growth to asset markets. Money and credit began to pour into asset markets,
boosting their prices, while the traditional inflation rates of goods and
services declined.
The worst case of this kind at the time was, of course, Japan.
Do not be fooled by the sharp decline in consumer borrowing into the belief
that money and credit has been tightened in the United States. Instead,
borrowing for leveraged securities purchases (in particular, carry trade and
merger and acquisition financings) has been outright rocketing, with
security brokers and dealers playing a key role. Over the three quarters of
2006, their net acquisitions of financial assets have been running at an
annual rate of more than $600 billion, more than double their expansion in
the past.
Federal funds and repurchase agreements expanded in the third quarter at an
annual rate of $606.3 billion, or an annual 26%. The main borrowers were
brokers and dealers.
During the first three quarters of the year, their assets increased $427
billion, or 27% annualised, to
$2.57 billion. A large part of the money came from the highly liquid
corporations. There is no reason to wonder about low and falling long-term
interest rates.
All this confirms that financial conditions remain extraordinarily loose.
Even that is a gross understatement. Credit for financial speculation is
available at liberty. Expectations for weaker economic activity only foster
greater financial sector leverage.
Why such unusually aggressive speculative expansion in the face of a slowing
economy?
The apparent explanation is that the financial sector intends to make the
greatest possible profit from the coming decline of interest rates,
promising further rises in asset prices against falling interest rates.
While the real economy slows, the leveraged speculation by the financial
fraternity goes into overdrive.
Principally, there is nothing new about such speculation. New, however, is
its exorbitant scale.
Before leading his jumbo-sized delegation to Beijing, Henry Paulson, U.S.
Treasury secretary, cautioned against expecting any big breakthroughs from
the visit.
And so it has turned out. The meeting produced plenty of statements about
the desirability of improving relations, but nothing concrete to do so.
Of course, the Chinese are in a very strong position with the central bank
holding more than $1 trillion of bonds in its portfolio, mostly denominated
in dollars.
According to reports, the American visit was initiated by Mr. Paulson in an
effort to contain rising Sinophobia in the U.S. Congress, which increasingly
blames China for America's economic problems, from its huge current account
deficit to stagnating real incomes. In other words, those troublemakers, not
the trade deficit, are the problem.
One cannot say that U.S. policymakers and economists have been preoccupied
with worries about possible harmful effects of the exploding trade deficit.
They appear obsessed with the conventional wisdom that free trade is good
and must always be good under any and all circumstances, as postulated in
the early 19th century by David Ricardo.
Ricardo exemplified this by comparing trade in wine and cloth between
Portugal and England. Portugal was cheaper in both products, but its
comparative advantage was greater in wine. As a result, according to
Ricardo, Portugal boosted its production and exports of wine. In contrast,
England gave up its wine production and could produce more sophisticated
goods. In both countries, living standards rose.
For sure, it appears highly plausible that American policymakers feel they
are following Ricardo's logic.
Only they are disregarding some caveats of Ricardo's.
For equal benefit, first of all, balanced foreign trade is required.
"Exports pay for imports" was a dogma of classical economic theory. Ricardo,
furthermore, disapproved of foreign investment, with the argument that it
slows down the home economy.
With an annual current account deficit of more than $800 billion, the U.S.
economy is definitely a big loser in foreign trade. To offset this loss of
domestic spending and income, alternative additional demand creation is
needed. Essentially, all job losses are in high-wage manufacturing, and most
gains are in low-wage services.
In essence, the U.S. economy is restructuring downward, while the Chinese
economy is restructuring upward.
Considering that Chinese wages are just a fraction of U.S. or European
wages, it appears absurd that the Chinese authorities deem it necessary to
additionally subsidise their booming exports by a grossly undervalued
currency, held down by pegging the yuan to the dollar.
In the U.S. financial sphere, the year 2006 has set new records everywhere:
records in stock prices, records in mergers and acquisitions, records in
private equity deals, record-low spreads, record-low volatility.
Manifestly, there is not the slightest check on borrowing for financial
speculation. There is epic inflation in Wall Street profits.
One wonders what can stop this unprecedented speculative binge. Pondering
this question, we note in the first place that the gains in asset prices -
look at equities, commodities and bonds - have been rather moderate. To make
super-sized profits, immense leverage is needed. We think the speculation is
unmatched for its scope, intensity and peril. Plainly, it assumes absence of
any serious risk in the financial system and the economy.
The surest thing to predict is that the next interest move by the Fed will
be downward.
In our view, the obvious major risk for speculation is in the economy - that
is, in the impending bust of the gigantic housing bubble. Home ownership is
broadly spread among the population, in contrast to owning stocks. So the
breaking of the housing bubble will hurt the American people far more than
did the collapse in stock prices in 2000-02.
For sure, the U.S. economy is incomparably more vulnerable than in 2001.
Another big risk is in the dollar.
Regards,
Dr. Kurt Richebächer
for The Daily Reckoning
Market Notes
Adrian Ash, shouting at the traffic in 'Ammersmith:
- So fat tongue in fat cheek, the great Gordondo pulled off his greatest
feat of magic in 10 years of trickery at Westminster.
- "Abracadabra...ala-ka-zam" he shouted for 54 minutes.
And poof! Nothing had changed except the detail – and the press coverage. He
got the headlines alright. Even the London press knows to watch his sleight
of hand these days.
- Now that's magic!
- The detail's so dull, in fact, that only London's army of financial hacks
could spin it out to 20 pages packed with "analysis". Gordon Brown's
swag-bag was £1 billion lighter in 2005/6 than he had projected. Now he
reckons he'll nab £1 billion more in 2006/7 than he forecast 12 months ago.
- A billion here...a billion there...who cares?
- The Cabinet Office alone will spend £2.4 billion this year. On what, you
might wonder – new mugs and biros?
Only inflation looks certain after yesterday's palaver.
Keeping the New Labour executive in tea and biscuits will cost 9% more in
2007/8 than it did during the last fiscal year.
- But hey – you gotta keep the troops' strength up! War never came cheap.
And now they're waging war on terror...poverty...light bulbs...and what's
left of British manufacturing.
- So what if Gordon Brown knocked 2p off the basic rate of income tax? He
more than doubled the tax rate on your first £2,000 of taxable income.
- He cut 2% off corporation tax, but excluded anyone investing in plant. R&D
firms got a £100m tax cut, but the punitive charges on North Sea oil & gas
firms remain. Better to trade "carbon credits" than squeeze the last few
drops out of Britain's domestic resources.
Offshore hedge funds trading these 21st century indulgences will now enjoy
zero tax.
- He also gave fresh tax breaks to "sukuk" investors looking for financial
products to comply with Koranic law. But he raised the tax-rate paid by very
small businesses. A smart way to encourage risk-taking outside the financial
markets, eh?
- He gifted free money to property speculators too, sharing the tax
advantages of REITs with unit trusts invested in real estate. Their number
has swollen from four to 15 over the last two years.
- You might wonder where the value-added lies here, but so what? That kind
of growth at M&G and New Star deserves recognition – as do second-home
owners buying property overseas. Cutting income tax charges on holiday homes
will reward around 2-3% of British adults, the FT says today. Failing to cut
the 70% charge on pension assets passed onto your family, on the other hand,
hurts everyone wanting to save for the future.
- "Mr Deputy Speaker," said Prudence, "I want to send a signal about the
importance we attach to encouraging saving." Raising interest rates would
make a start. For basic-rate payers, cash in the bank now pays minus 0.4%
after tax and inflation.
- He also recalled his "ambition for this Parliament...of two million new
owner occupiers." Yet again, higher interest rates would actually help here.
Even Mervyn King knows that cheap money has failed!
Meddling with shared-ownership schemes only pushes inflation in house prices
still higher.
- But simple economics was never going to be Gordon Brown's game.
- Oh, and in a move of brilliance he cut the new issuance of index-linked
gilts, too. The pensions industry, as regular readers well know, is forced
by government to hunt down these rare beasts...matching liabilities to
assets as judged by the price of inflation-proof bonds.
- Just last week, Ed Balls – our dear Chancellor-in- waiting – told pension
fund managers in Edinburgh that New Labour would skew new gilt issues
towards index- linked and long-dated bonds. Did he really not see a draft of
yesterday's Budget? In 2007/8, the government will issue £4 billion less in
these bonds than in 2006/7.
- "This is not particularly helpful to pension funds,"
says Nick Horsfall, a senior consultant at Woodrow Wyatt. "We are already
struggling to get pension funds long-dated, high-quality assets."
- Not that it matters, of course. No budget from Culpability Brown, Ed
'Chocolate' Balls, George Osborne or any other buffoon will ever halt the
megatrend towards big government stealing your money just to give you a
little of it back...and all at the policy wonks'
discretion and a time of the bureaucrats' choosing.
- Better look after yourself and get what wealth you can to safety. The
ballot box will only pay dividends if you sneak into Westminster and grab a
few non-exec directorships alongside your state-paid expenses.
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