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Friday, September 16, 2011

The Inflation Storm (October 2011)

The Inflation Storm (October 2011)

The US has had the Great Depression (1930s) and the "Great Recession" (as some people like to call the period from 2008-2010). Some people have dubbed the moderately inflationary period between 1971-1981 the “Great Inflation”. However, others (like Peter Schiff, Warren Buffet, Jim Rodgers and Yours Truly) think real inflation is yet to come. And that it will be uncontrolled and manifest itself more rapidly than anything experienced since the latter days of the Weimar Republic. I have dubbed it “the Inflation Storm" (though maybe “Inflation Tsunami” would a better description of the dynamics of what is yet to come).

The Inflation Storm will manifest itself as the result of the policies which have been undertaken by the Federal Reserve. The Fed has since 2009 deliberately been trying to create inflation, with two objectives in mind:
  1. To prevent asset deflation in the housing market, which has the potential of destabilizing the entire banking system, as falling real estate prices are a threat to the solidity of banks and induce a significant risk to the entire financial system, and;
  2. To reduce the real burden of the debt held by the US Government and consumers, as inflation will increase their nominal incomes, while the nominal value of the debt stays the same.

Learnings from the Great Depression

One of the architects behind the coming Inflation Storm (but far from the only culprit, as events to come are a consequence of failed monetary policies since the abandonment of Bretton Woods in 1971) is Chairman of the Federal Reserve Bank, Ben Bernanke. Bernanke is known to have been a devoted student of the "Great Depression", a severe economic contraction that occurred between 1928-1931 following an extended economic boom financed by large increases in debt by US consumers and businesses (1923-1928).

The economic contraction and corresponding deflationary spiral that occurred during the Great Depression was particularly severe because the Fed did nothing to expand the money supply (by the way, similar deflationary dynamics are now observable in Greece, see my article "It's the end of the Euro"). On the contrary, the Fed was even forced to raise interest rates to preserve the USD against speculative attacks and maintain its pegged value to gold.

Furthermore, back then the Fed allowed bank collapses to happen on a massive scale, and the prospects of losing their deposits lead to large parts of the public “keeping their money in their mattresses” instead of in banks, were it could be lent on to healthy businesses. This pushed the cost of financing for individuals and businesses to extreme levels, choking the economy.

Helicopter Ben

Ben Bernanke has stated that he will "let money reign out of helicopters" before he allows the deflationary dynamics of the Great Depression to re-occur. For this statement, someone has nick-named him "Helicopter Ben". With this level of determination (also not forgetting the 2 trillion dollars that the Federal Reserve has injected into the US economy since 2009), it is highly likely that he will succeed. It will then not be the first time in modern history the US government is running high inflation to reduce the US public debt burden; in the 1960s and 1970s the Nixon administration borrowed heavily to finance the Vietnam war, in order not to lose elections and fuel public disapproval for the war by raising taxes. As the costs of the war increased beyond expectations, with US defense spending peaking at close to 10% of GDP (1968), the government took the USD off the gold standard (1971) enabling the unrestricted printing of money by the Federal Reserve. The resulting increase in the money supply brought inflation up to a peak of close to 15% year on year in March 1980, averaging around 8% between 1971 and 1981.

Take From the Rich and Give to the Poor

High inflation essentially implies a re-distribution of wealth (measured by its purchasing power) from savers to debtors. The dynamics of this are slightly technical and involves a basic understanding of the time value of money, so feel free to skip this section is you are looking for an easy read. If you are still reading, imagine that you are keeping your savings in 10-year US government bonds, which have an annual yield that equals inflation, initially about 2% p.a.. If inflation suddenly increases from 2% to 20% year on year, your bond holdings will have a required return (“discount rate”) of 20% instead of the initial 2%. Discounting the same cash flows from the bonds with the new discount rate implies they will lose more than 75% of their value. The government can then refinance the bonds (e.g. buy them back in the market with funds from newly issued bonds) at 25% of their initial value, immediately reducing the value of the debt on their books by 75%.

Simultaneously, in this scenario one will expect nominal GDP and government tax income to grow at minimally the rate of inflation. In our example above, with 20% annual inflation, the nominal value of GDP will therefore growth to 250% of its initial value over five years. A debt burden which then initially equalled 100% of GDP when inflation and interest rate were 2% will therefore amount to less than 10% of GDP five years later (remember that the debt will have a nominal value which is only 25% of what it was initially, whilst GDP now will be at 250% of its initial value). And "puff" - it’s like magic; government indebtedness is (almost) no more!

The losers in this game are those who are holding large amounts of USD denominated t-bonds, t-bills and cash. They include pension funds, foreign central banks, sovereign wealth funds and similar. In the simplified example above, the purchasing power of their holdings will be reduced with 90%.

What creates inflation

The dynamics of inflation can be observed in a game of Monopoly. When players start playing, the amount of monopoly money in circulation is low, leaving little cash for the players to buy property (“invest”). As the game progresses, each player receives monopoly money when passing “Start”, adding to the supply of currency circulating in the game. As the monopoly money stock increases, so does the players’ ability to pay for properties, leading to price increases on properties traded between players during the game (if you haven’t seen it, order the game and try it for yourself :-)).  

As illustrated in the above example, price inflation is essentially determined by how much money is chasing how many goods and services.

It can therefore be triggered by either one of two events: 1) A reduction in the supply of a good or service (“supply shock”) or 2) a dramatic increase in the spending on goods and services. Simply put; if Apple reduces the production of computers (e.g. a supply shock), the price of an apple computer will increase. And if Apple should suddenly decide to buy apples instead of keeping its massive cash pile in the bank (God forbid), it will inflate the prices of apples (also considering that a newly planted apple tree needs about four years before it can bear fruit and add to supply).

It is meaningful to classify the players in the global inflation monopoly game into two groups, based on their objectives and how they collectively may behave.
  1. Domestic players. These include everything from pensioners and other individuals, to pension funds, to corporates (for example, Apple’s cash holdings were recently reported to be about USD 76 billion)
  2. Foreign entities, reflecting that the US have been running a negative trade balance against the rest of the world for several decades (e.g. the US economy has borrowed from the rest of the world to keep consuming)

When the Federal reserve is supplying new money to the economy (the increase in M1 money stock since November 2010 has been close to an astonishing 50%), it only means increased inflation if this money results in increased demand for goods and services (and does not just end up in savings accounts). In today’s global Monopoly game, most players have been saving rather than spending the extra currency the Fed has issued. The key questions are why, and how long one can expect this to continue. To understand how they will behave, one needs to examine them in greater detail.

Domestic players will start spending when the US real estate market has hit the bottom

Domestic players (e.g. the general public in the US) are motivated by maintaining the purchasing power of their savings. They face the choice between spending their money now (consume/invest) or saving their money in order to be able to spend them later. Excluding the share of the population which is saving for retirement (which is low in the US compared to for example Japan) the public will only chose to spend now, if it thinks that its savings will allow it to buy less things later (e.g. price increases are expected).

Currently, the expectation/ consensus view of the US general public is that spending later will buy them more things than spending now. Real estate prices have been declining since 2006, and are expected to decline further in 2012 by “everyone”. Just like a series of rapidly increasing prices in the beginning of 2000 lead to continued expectations of price increases, a series of decreasing prices since 2006 are now leading the public to expect continued price decreases.

It is noticeable that the Fed’s attempts to drive inflation with money supply increases are futile, as long as consumers and corporates expect decreasing prices. When consumer expectations change, all the cash that has been piled up will come into the economy as demand very fast and in great quantities (because it will become clear to “everyone” that one dollar spent today will buy more than one dollar spent tomorrow, and the public will rush to spend their money not to be left out). US inflation increases will be driven by a bottoming-out of the US housing market, likely to occur some time during 2012 (at current price decline rates, real estate values vs. rents and disposable income should then become about 10% undervalued compared to its long term average, which has signaled the turning point in previous real estate price declines).

Foreign players will start spending when...???

The foreign players are much more interesting, in the sense that it is very hard to predict how they will behave. Contrary to domestic players, the primary objective of foreign central banks of holding USD denominated asset is not to save money for future consumption. The holders of US currency are for a large part institutional players in economies that have pegged their currencies to the USD, have been running massive trade surpluses vs. the US over several years, and are reliant on a export oriented manufacturing strategy to drive domestic growth and maintain social stability. 

China is leading the pack, with the Chinese central bank alone holding around USD 3.2 trillion in currency reserves (e.g. 3,200 billions!). Most of this is invested into USD denominated t-bills and bonds. China has been de-facto pegging its currency to the USD since the 1970s, (though after 2005 officially to a “basket of currencies”). The overarching priority of the Chinese policy is domestic stability and economic growth for their largely export based economy, achieved by keeping their currency low in spite of running a massive trade surplus against the US. China is struggling with increasing inflation.

Gulf Council states (Saudi Arabia, the UAE, Kuwait, Qatar, Oman and Bahrain) together hold around 2 trillion in foreign assets, of which roughly half are central bank holdings (the number is difficult to judge as sovereign wealth fund holdings are intransparent). Their currencies are without exception pegged to the USD. These countries have mixed economic states. The UAE is struggling with de-flation in the aftermath of a recent real estate bubble, whilst Qatar and Saudi Arabia are experiencing too high inflation.

Bank of Japan has foreign currency reserves of USD 1.1 trillion, most of it in USD. Their main objective is to keep their currency low against the USD not to hurt their largely export oriented economy. Japan has been trying to create inflation for almost two decades, but its population is dominated by old individuals that are saving for retirement - they simply will not spend more even if they have more money.

The central bank of Russia has foreign exchange reserves of around USD 530 billion. Their objective is to manage currency fluctuations of the Rubel as their banks are largely financed in USD. 

Interestingly, relatively small currency areas like Taiwan and Hong-Kong (population of 23 and 7 million, respectively) have currency reserves of USD 400 and 280 billion, respectively. They have been keeping their currencies low in export oriented economic growth strategies, similar to those undertaken by China and Japan, but started much earlier. Hong-Kong is struggling with high inflation (close to 8% y/y), whilst Taiwan seems to have inflation under control.

These are some of the main examples, though there are many more. It is notable that a minor part of the currency reserves mentioned above is not USD denominated (they also hold EUR, JPY, GBP and other currencies), however the bottom line is that foreign savers (conservatively estimated) hold between 10-15 trillion in USD denominated financial assets! If these should choose to liquidate their holdings (by for example not rolling over t-bills and not re-investing bond principal repayments) and exchange their cash for durable physical assets (e.g. real estate, gold, stocks, farmland, whatever there is) the resulting demand will have a massive inflationary impact, completely dwarfing that of the US general public!

Additionally, not counted in the above are dollars used in the European interbank market (the bulk of bank funding is in USD, as the EUR interbank market is smaller and less liquid), USD on the books of foreign corporates (as a trading currency) as well as cash in circulation among the general public in developing countries (for example, one can pay with USD is most African and Latin American countries, also many individuals have USD accounts). Though the US only has a 27% share of global GDP, the dollar is the global exchange and savings currency and probably the basis for 70-80% of global money stock (including currencies that are pegged to the USD, such as the Chinese Yuan, or that are sought kept low against the USD, such as the Japanese Yen).

The status of the USD as the World’s currency following the end of World War 2 has given the US economy substantial benefits, as it has enabled the US general public to receive foreign goods and services without having to exchange US produced goods and services in return (e.g. a USD in circulation in Zimbabwe was once received by a Zimbabwean as payment for something with originated in a supply of a good or service to the US public - as long as that USD stays in Zimbabwe and is preferred as a mean of payment, it will not result in demand for a US produced service - it's an IOU that will never be called!). Collectively as a Nation, paying with IOUs that will never be called, has contributed to increased standards of living for Americans, and enabled them to consume more goods per capita than most other nations on the planet.

So, being the object of a currency peg has enabled America to consume much more than it produces. And US national debt has been increasing with 0.5 trillion USD a year.

When Helikopter Ben is increasing the US monetary supply, he is also increasing the monetary supply in currencies that are pegged to the USD.

The problem with this policy is that it can only be sustained for longer periods if the currency is undervalued against the USD, e.g. if the economy is running a current account surplus (is exporting more than it is importing). The central bank can then sell its local currency in infinite supply, in the case of China being the Yuan, to counter the demand for Yuan coming from the exports. This essentially implies that the central bank is issuing new money it is changing into USD. It has the effect of creating domestic inflation (as its efforts are increasing the domestic money supply), but also acts to decrease US inflation, as money that otherwise would be circulating in the US are taken "off the market" and placed into t-bills and bonds. This has helped keeping US interest rates close to 0 for long periods of time in spite of excessive borrowing, and without any dramatic domestic inflation observed so far, by some dubbed an "economic miracle".

When the Federal Reserve prints more money domestically in an effort to drive up US inflation, it also means that China and the other nations in the pack of peggers need to buy more USD in order to maintain their currency pegs. Which for China means an increase in Chinese money supply, which means more fuel added to the fire on Chinese inflation. Current measures undertaken in China to contain inflation are related to price controls and control of the lending requirements of banks, however it is without a doubt that these measures have failed to contain inflation, especially when prices of real estate are taken into account. The Chinese have allowed for a re-valuation of the Yuan (it has increased 7% since June 2010), however it has not been enough to counter the currency flows and the continued increase in Chinese money supply. Offcially, China is experiencing a 6.5% year on year inflation, nevertheless if adjusting for increases in the prices of real estate, as well as considering the extensiveness of Chinese measures to curb inflation (even letting their currency appreciate!) true Chinese inflation is likely in the double digit range.

Sunday, September 11, 2011

It’s the end of the Euro (as we know it)

Several investment banks and think-tanks have stated that the Eurozone is at a “cross-roads”. Either there is more fiscal integration they say (e.g. common coordination of government spending), or the zone will be facing monetary dis-integration (e.g. countries going out of the Euro). Some are even claiming that the “end-game” is nearing, e.g. that we are going to see in which direction this is heading soon.
These are correctly pointing to the fact that monetary integration (with low inflation targets) without fiscal coordination is unsustainable. Nevertheless, the idea of a sufficiently potent European fiscal coordination is utopia (will Greeks allow the German’s to dictate their public pension schemes and tax-levels? It’s like returning to being ruled by the Roman Empire overnight…). 

The likely end-game is that countries like Portugal, Spain and Greece will continue suffering until they chose to abandon the Euro. And when they leave, they will briefly suffer substantially more, before things eventually will get better.

A brief recap of history

To fully understand what is happening, one needs to recap a little bit of history. The entire concept of the Euro and the European Union is built on that of economic convergence. With no restrictions on the flow of labour, capital, goods and services between countries, labour costs, capital returns and prices will converge to a common average. In other words, if labour is cheaper in Greece, then the return on real capital invested in Greece (such as a car assembly plant) is higher. 

The higher prospective capital returns will continue attracting more capital, fueling demand for local labour (increasing local wages) until capital returns and labour costs are more or less the same everywhere. Similarly, if wages are higher outside of Greece, Greek workers will go working abroad, reducing domestic labour supply and adding to the labour supply where the cost of labour is the highest. The free flow of labour and capital in the Eurozone should lead to greater prosperity and economic growth for all, as labour and capital will flow to where it is most efficiently utilized.

Before 2007, when the most recent economic contraction was initiated (by some investment analysts barely out of their diapers referred to as “The Great Recession“), there were in fact many signs that convergence had taken place. Borrowing costs went down substantially in the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain), the cost of labour increased markedly, and the cost of a shopping basket (adjusted for differences in VAT) became more or less the same in Spain as in Ireland. Spain experienced higher GDP growth than most of Europe, and in Ireland the growth was so high the country was dubbed “the Celtic Tiger“. The Euro appeared to be a success; overall GDP growth in the Eurozone was showing levels not experienced in decades.  

So, from this magnificent state of economic euphoria, what went wrong?

As borrowing costs decreased, borrowing increased. Real interest rates in Spain, Ireland and Greece were de-facto strongly negative, so investors and consumers were incentivized to borrow as much as they could and place funds in assets whose prices are a direct function of domestic inflation, such as real estate. This was also fueled by significant European Union development grants (e.g. payments from richer to poorer member states to pay mostly for infrastructure investments, such as roads), a form of fiscal stimuli given completely without regard to where the economies were in the business cycle, further adding to economic imbalances

Constantly increasing real wages (and declining unemployment) lead to optimism about the future, GDP “trend growth” estimates where revised upward to account for the economic boost that had been experienced by convergence, prompting governments to believe there would be more tax income in the future that could be used for current spending and investment.

Though the underlying changes in the economic conditions were supported by the fundamentally sound principles of economic convergence (and the noble ambition of European economic equality and development), the growth momentum created lead to the economies experiencing the same dynamics that have created every economic bubble known to mankind, from the Dutch Tulipmania in the 1640s to the dot-com bubble in the early 2000s, to the real estate bubble that popped in Dubai in 2009; an irrational public belief that the trends experienced in prices and incomes over a limited recent historic time-frame are likely to continue far into the future.

In fact, among the Eurozone countries with the lowest initial real-wages (e.g. those that were the furthest away from other countries in terms of economic conditions and thus experienced the strongest momentum in the convergence process) expectations of prices and growth rates took on a dynamic of its own, decoupling from the initial economic fundamentals which had triggered the trend. For example in Spain, lower financing costs initially lead to increased demand for real estate, which lead to price increases, which lead to more investment, employing more people in the construction sector, decreasing unemployment, increasing GDP growth momentum and income levels, leading to more demand for real estate and further expectations on price increases, etc.

These dynamics has taken us to where we are today; the economies of Portugal, Ireland, Italy, Greece and Spain are deep in debt, and they are unsuccessful in attracting the capital necessary to generate growth, as real wages are higher than what is economically justifiable by the productivity of labour (the consequence of running high past inflation, and also a consequence of the Czech Republic, Poland, Hungary, Slovakia, Bulgaria, Romania having joined the European Union). 

Worse yet, a considerable chunk of the debt is held by governments, much subscribed to recent fiscal over-spending aimed at stimulating the economies back to a misguided perception of what is the true “trend growth” of the economy. The government fiscal spending has actually made things worse, as the bulk of funds have been deployed unproductively (such as government grants given to consumers to make new car purchases, prepping up the balance sheets of failed banks, preventing necessary restructuring).

The most likely end-game

As the fundamental problem of the economies is that they currently have labour costs that are too high, growth will not return until labour cost have come down sufficiently to provide competitive capital returns again (e.g. the same economic mechanism which had initiated the growth is now hindering it). 

This can happen in two ways:
  1. Through labour market mechanisms (e.g. price adjustments through shifts in the supply and demand of labour)
  2. By a de-valuation of the currency vs other currencies

Decreasing the cost of labour through labour market mechanisms essentially means that the economies will run with high unemployment, and that the unemployed will be required to compete for the jobs on offer by requiring less pay. As the labour force on average eventually will earn less, their ability to pay for housing and other capital goods will decrease, essentially implying that the entire economy will undergo a process of deflation. 

Falling real-estate prices will then continue to threaten the value of collateral for loans held on banks’ balance sheets and restrict their ability to keep lending. This will hamper new investment in the industry and service sector, restricting demand for labour (initially creating even more unemployment).

Furthermore, the high taxes these governments need to collect to pay back the high public debt implies lower capital returns, which means that labour cost must come down even more in order to compensate. Considering that these economies additionally have good unemployment benefits, public pension schemes, inefficient government bureaucracy, high level of corruption, a high share of labour in the public sector, strong unions and high minimum wages, wages will take a very very long time to adjust

The deflationary spiral that will follow will resemble that of the Great Depression of the 1930s, when the gold standard restricted the possibility of reducing real wages trough quantitative easing (e.g. by printing money so that prices increase more than nominal wages). What has been dubbed as “the Great Recession” is very far from showing its full impact; the imbalances (public and private indebtedness) seen today are far worse than those of the 1930s.

The current modus operandi of decreasing the cost of labour through market mechanisms will eventually lead to so much social unrest that any government following this policy sooner or later will be replaced. It is a recipe for social and economic disaster; the deflationary spiral that will follow will add tremendous systematic risk to the entire European banking system, not to mention the political risk that will be created by the social unrest that will accompany such a policy.

The inevitable will eventually happen; these economies will exit the Euro, de-facto devaluing their currencies. This will imply the governments defaulting on their debt, making it impossible for them to borrow more, nevertheless it has the benefit of immediate restoring domestic wages to competitive levels, as prices of imported goods will increase so much that it becomes economical to produce many of these domestically again. 

This will attract capital and external demand for domestically produced products and services (for example, agriculture in Greece is about 4% of GDP, whilst tourism directly accounts for about 15% (2009), both will increase substantially as Greece becomes more attractive as tourist destination and improves its terms of trade). And growth will be restored, although from a much lower base (as measured in Euros).

So what does this mean for the Euro?

It means that the “bad news” for the Eurozone are to continue and that the “end-game” is no-where near. Weaker economies still have some way to go before realizing that exiting the currency is the only way forward. Early indicators to watch out for is public opinion towards the Euro in the troubled countries, financing problems triggered by flight of deposits from PIIGS domiciled banks, as well as irregular changes of government. It may take 12-36 months to unfold in its completeness; it will continue to be strongly resisted by Germany, who is benefiting from a low Euro in its exports, and whose banks will be heavily penalized by a PIIGS default.

However, unless fiscal integration becomes more than just an idea, the structural problems created by a common currency will likely not stop just with the PIIGS countries. For illustrations sake, let’s say the PIIGS countries all exit the Euro and the Euro essentially consists of France and Germany. It is reasonable to expect the Euro to appreciate against other currencies in such a scenario, as it will only consist of remaining stronger economies. 

Though Germany may find a stronger Euro compatible with its national inflation targets, France may not, and suddenly the remaining Eurozone is facing the same issues, even just with two economies remaining (e.g. the real exchange rate is suitable for Germany but not for France, and France may exit to avoid deflation. Already now France is pushing for a more inflationary ECB monetary policy, whilst Germany – whose population consists of net savers- is resisting).

Once the “shake-up” has been complete, the Euro will be synonymous with the Deutschmark. It will continue strengthening against other currencies until the German current account is balanced. Meanwhile, funds will continue to flow to Gold, Swiss Francs, Norwegian Kroner and other currencies with strong underlying fundamentals, as the US will be running high inflation, potentially having more resemblance to Zimbabwe than the global reserve currency it used to be (more on this to follow later, in a separate article).

The last straw of hope

The last straw of hope for the Euro is through the aggressive printing of new money by the ECB and the creation of inflation. Inflation may create differences in real wages between countries without having them to go through dangerous deflationary spirals, however such a policy would require that stronger economies (such as Germany) are willing to run with higher inflation than weaker ones for longer periods of time to consciously deteriorate their own terms of trade

As this in practice would mean a transfer of wealth from net savers (e.g. Germans) to net debtors (e.g. Greeks), it is highly questionable what level of support such a policy might have among the general public in the stronger economies. The social and economic cost of a “soft” default, which this implies, would in any case be preferable to the cost of a “hard” default from Greece and a full exit from the Euro, arguably also for the German public (if they understood the full consequences, however national pride and PIIGS bashing seems to be getting in the way of judgement). 

This will in any case require a radical change in ECB policy, which needs to happen fast, where monetary policy at all times will be adjusted to accommodate for the weakest membership states and where the ECB inflation target is adjusted significantly upwards (a firm requirement to ensure stability in the Eurozone in the absence of fiscal integration, as it gives countries greater flexibility in adjusting their terms of trade). If this change in policy manifests itself (it is most likely far too late for that now anyway, as the deflationary spiral is gaining momentum in all of the PIIGS), the next bubble to be created will be in German real estate.