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Why we should expect low growth amid debt

By Carmen Reinhart and Kenneth Rogoff

Published: January 27 2010 20:17 | Last updated: January 27 2010 20:17

As government debt levels explode in the aftermath of the financial crisis, there is  growing uncertainty about how quickly to exit from today’s extraordinary fiscal stimulus. Our research on the long history of financial crises suggests that choices are not easy, no matter how much one wants to believe the present illusion of normalcy in markets. Unless this time is different – which so far has not been the case – yesterday’s financial crisis could easily morph into tomorrow’s government debt crisis.

In previous cycles, international banking crises have often led to a wave of sovereign defaults a few years later. The dynamic is hardly surprising, since public debt
soars after a financial crisis, rising by an average of over 80 per cent within three years. Public debt burdens soar owing to bail-outs, fiscal stimulus and the collapse in tax revenues. Not every banking crisis ends in default, but whenever there is a huge international wave of crises as we have just seen, some governments choose this route.

We do not anticipate outright defaults in the largest crisis-hit countries, certainly nothing like the dramatic de facto defaults of the 1930s when the US and Britain abandoned the gold standard. Monetary institutions are more stable (assuming the US Congress leaves them that way). Fundamentally, the size of the shock is less. But debt burdens are racing to thresholds of (roughly) 90 per cent of gross domestic product and above. That level has historically been associated with notably lower growth.

While the exact mechanism is not certain, we presume that at some point, interest rate premia react to unchecked deficits, forcing governments to tighten fiscal policy. Higher taxes have an especially deleterious effect on growth. We suspect that growth also slows as governments turn to financial repression to place debts at sub-market interest rates.

Fortunately, many emerging markets are in better fiscal shape than advanced countries, particularly with regard to external debt. While many advanced countries took on massive increases in external debt during the run-up to the crisis, many emerging markets were busy deleveraging. Unfortunately, this is not the case in emerging Europe, where external debt burdens average over 100 per cent of GDP; external (again including public plus private) debt levels in troubled Greece and Ireland are even higher. Will the typical wave of post-financial crisis defaults follow in the next few years? That depends on many factors.

One factor that is different is the huge expansion of the International Monetary Fund initiated last April. IMF programmes can mitigate outright panics and will help those countries that genuinely make an effort to adjust. For some countries, however, debt burdens will prove politically intractable even after IMF loans. They will eventually require restructuring. Indeed, the IMF must ensure that it does not simply enable countries to dig deeper holes that lead to more destructive defaults, as occurred in Argentina in 2001. Having imposed very lax conditions in response to the financial crisis, the IMF now faces its own difficult exit strategy. How this unfolds will affect the timing of defaults, though debt downgrades and interest rate spikes have already started to unfold.

Another big unknown is the future path of world real interest rates, which have been trending downwards for many years. The lower these rates are, the higher the debt levels countries can sustain without facing market discipline. One common mistake is for governments to “play the yield curve” – as debts soar, shifting to cheaper short-term debt to economise on interest costs. Unfortunately, a government with massive short-term debts to roll over is ill-positioned to adjust if rates spike or market confidence fades.

Given these risks of higher government debt, how quickly should governments
exit from fiscal stimulus? This is not an easy task, especially given weak employment, which is again quite characteristic of the post-second world war financial crises suffered by the Nordic countries, Japan, Spain and many emerging markets. Given the likelihood of continued weak consumption growth in the US and Europe, rapid withdrawal of stimulus could easily tilt the economy back into recession. Yet, the sooner politicians reconcile themselves to accepting adjustment, the lower the risks of truly paralysing debt problems down the road. Although most governments still enjoy strong access to financial markets at very low interest rates, market discipline can come without warning. Countries that have not laid the groundwork for adjustment will regret it.

Markets are already adjusting to the financial regulation that must follow in the wake of unprecedented taxpayer largesse. Soon they will also wake up to the fiscal tsunami that is following. Governments who have convinced themselves that they have done things so much better than their predecessors had better wake up first. This time is not different.

Ms Reinhart is professor of economics, University of Maryland, and Mr Rogoff is professor of economics, Harvard University. They are co-authors of ‘This Time is Different: Eight Centuries of Financial Folly’ (Princeton)

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On The Watchlist At BNP Paribas

On The Watchlist At BNP Paribas: "This chart comes from the Number Cruncher of last week, click on chart to enlarge, courtesy of BNP Paribas.

Unprecedented ...

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A story of deleveraging in Japan

PIMCO - Investment Outlook February 2010 Bill Gross The Ring of Fire

PIMCO:

Investment management is a privileged profession – not just for being paid by X-times what you’re really worth to society, but from the standpoint of longevity. If you’re good, and you at least give the impression that you still have most of your faculties, you can literally hang around forever. James Carville, the well-meaning but evil-lookin’ guy from the Clinton Administration once remarked that in his next life he’d like to come back as a bond manager. He had part of it right – the influence, the wealth, and even fame – but there was no need to imagine himself as some cryogenically preserved Wall Street version of Ted Williams – he was young enough at the time to make the leap and still have a 20-year career ahead of him. Other professions do not afford such opportunities – the gold watch at 65 is not only symbolic, but a statement in most professions that says you are more or less washed up. Athletes have at most 20 years and musicians seem to have that brief window of creation as well. The Beatles, for instance, were done after a decade’s time. Paul is still writing songs, but the magic clearly disappeared in the 70s and now his concerts are “garden parties” of remembrances as opposed to creation.
What I think is close to unique about investment management is that it’s really about the stewardship of capital markets, and that time weeds out the impostors, leaving the aging survivors to appear as wise and capable of guiding clients through the next crisis – whatever and whenever it might appear. That assumption has some logic behind it, but critically depends on the investor truly enjoying the game and – of course – holding on to at least a few billion brain cells that keeps him from being obviously senile or at least being accused of having “lost it.” An investment manager at 65 fears both. I remember having met John Templeton on the set of Wall Street Week nearly 20 years ago. I was a young buck and he was – well – on the downside of his career. About the only thing he could tell Rukeyser, it seemed to me, was to cite the rule of 72 and proclaim that stocks and the Dow would be at 100,000 by 2030 or something like that. Now, approaching that same age, I’m a little more understanding and a little less young-buckish. If that was his only lesson, then it was a pretty good one I suppose – Dow 5,000 and the New Normal notwithstanding. And despite the strikingly premature departure of Peter Lynch and the transition of George Soros to philanthropic pursuits, there are some great examples of longevity in this business. Warren Buffett, of course, comes immediately to mind, as does Dan Fuss of Loomis Sayles, who may wind up as the Bear Bryant or Adolph Rupp of the bond business. Peter Bernstein, who passed away but a few months ago, was a brilliant writer and commentator on the investment scene well into his 80s. So there’s hope for you still, James Carville, and, I suppose, for me as well. It’s quite a privilege to be a “steward of the capital markets,” to have done it well for so long and to still be able to walk up to the plate and face a 95-mile-an-hour fastball. Or, is it a curve? Time will tell.
There have been numerous changeups and curveballs in the financial markets over the past 15 months or so. Liquidation, reliquification, and the substituting of the government wallet for the invisible hand of the private sector describe the events from 30,000 feet. Now that a semblance of stability has been imparted to the economy and its markets, the attempted detoxification and deleveraging of the private sector is underway. Having survived due to a steady two-trillion-dollar-plus dose of government “Red Bull,” Adderall, or simply strong black coffee, the global private sector is now expected by some to detox and resume a normal cyclical schedule where animal spirits and the willingness to take risk move front and centre. But there is a problem. While corporations may be heading in that direction due to steep yield curves and government check writing that have partially repaired their balance sheets, their consumer customers remain fully levered and undercapitalised with little hope of escaping rehab as long as unemployment and underemployment remain at 10-20% levels worldwide. “Build it and they will come” is an old saw more applicable to Kevin Costner’sField of Dreams than to today’s economy. “Say’s Law” proclaiming that supply creates its own demand is hardly applicable to a modern day credit-oriented society where credit cards are maxed out, 25% of homeowners are underwater, and job and income creation are nearly invisible.
In this New Normal environment it is instructive to observe that the operative word is “new” and that the use of historical models and econometric forecasting based on the experience of the past several decades may not only be useless, but counterproductive. When leveraging and deregulating not only slow down, but move into reverse gear encompassing deleveraging and reregulating, then it pays to look at historical examples wherethose conditions have prevailed. Two excellent studies provide assistance in that regard – the first, a study of eight centuries of financial crisis by Carmen Reinhart and Kenneth Rogoff titled This Time is Different, and the second, a study by the McKinsey Global Institute speaking to “Debt and deleveraging: The global credit bubble and its economic consequences.”
The Reinhart/Rogoff book speaks primarily to public debt that balloons in response to financial crises. It is a voluminous, somewhat academic production but it has numerous critical conclusions gleaned from an analysis of centuries of creditor/sovereign debt cycles. It states:

1. The true legacy of banking crises is greater public indebtedness, far beyond the direct headline costs of bailout packages. On average a country’s outstanding debt nearly doubles within three years following the crisis.
   
   
2. The aftermath of banking crises is associated with an average increase of seven percentage points in the unemployment rate, which remains elevated for five years.
   
   
3. Once a country’s public debt exceeds 90% of GDP, its economic growth rate slows by 1%.

Their conclusions are eerily parallel to events of the past 12 months and suggest that PIMCO’s New Normal may as well be described as the “time-tested historical reliable.” These examples tend to confirm that banking crises are followed by a deleveraging of the private sector accompanied by a substitution and escalation of government debt, which in turn slows economic growth and (PIMCO’s thesis) lowers returns on investment and financial assets. The most vulnerable countries in 2010 are shown in PIMCO’s chart “The Ring of Fire.” These red zone countries are ones with the potential for public debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yellow and green areas are considered to be the most conservative and potentially most solvent, with the potential for higher growth.

A different study by the McKinsey Group analyses current leverage in the total economy (household, corporate and government debt) and looks to history, finding 32 examples of sustained deleveraging in the aftermath of a financial crisis. It concludes:

1. Typically deleveraging begins two years after the beginning of the crisis (2008 in this case) and lasts for six to seven years.
   
   
2. In about 50% of the cases the deleveraging results in a prolonged period of belt-tightening exerting a significant drag on GDP growth. In the remainder, deleveraging results in a base case of outright corporate and sovereign defaults or accelerating inflation, all of which are anathema to an investor.
   
   
3. Initial conditions are important. Currently the gross level of public and private debt is shown in Chart 2.

Initial conditions are important because the ability of a country to respond to a financial crisis is related to the size of its existing debt burden and because it points to future financing potential. Is it any wonder that in this New Normal, China, India, Brazil and other developing economies have fared far better than G-7 stalwarts? PIMCO’s New Normal distinguishes between emerging and developed economic growth, forecasting a much better future for the former as opposed to the latter. Chart 3 displays a startling recent historical and IMF future forecast for government debt levels of developed and developing countries. “Escalating” might be a conservative future description for advanced countries. “Stable” might now be more applicable to many emerging sovereigns.

What then is an investor to do? If, instead of econometric models founded on the past 30–40 years, an analysis must depend on centuries-old examples of deleveraging economies in the aftermath of a financial crisis, how does one select and then time an investment theme that can be expected to generate outperformance, or what professionals label “alpha?” Carefully and cautiously with regard to timing, I suppose, but rather aggressively in the selection process under the assumption that it’s never “different this time” and that history repeats as well as rhymes. Reinhart and Rogoff’s book, if anything, points to the inescapable conclusion that human nature is the one defining constant in history and that the cycles of greed, fear and their economic consequences paint an indelible landscape for investors to observe. If so, then investors should focus on the following 30,000-foot observations in the selection of global assets:

1. Risk/growth-oriented assets (as well as currencies) should be directed towards Asian/developing countries less levered and less easily prone to bubbling and therefore the negative deleveraging aspects of bubble popping. When the price is right, go where the growth is, where the consumer sector is still in its infancy, where national debt levels are low, where reserves are high, and where trade surpluses promise to generate additional reserves for years to come. Look, in other words, for a savings-oriented economy which should gradually evolve into a consumer-focused economy. China, India, Brazil and more miniature-sized examples of each would be excellent examples. The old established G-7 and their lookalikes as they delever have lost their position as drivers of the global economy.
   
   
2. Invest less risky, fixed income assets in many of these same countries if possible. Because of their reduced liquidity and less developed financial markets, however, most bond money must still look to the “old” as opposed to the new world for returns. It is true as well, that the “old” offer a more favourable environment from the standpoint of property rights and “willingness” to make interest payments under duress. Therefore, see #3 below.
   
   
3. Interest rate trends in developed markets may not follow the same historical conditions observed during the recent Great Moderation. The downward path of yields for many G-7 economies was remarkably similar over the past several decades with exception for the West German/East German amalgamation and the Japanese experience which still places their yields in relative isolation. Should an investor expect a similarly correlated upward wave in future years? Not as much. Not only have credit default expectations begun to widen sovereign spreads, but initial condition debt levels as mentioned in the McKinsey study will be important as they influence inflation and real interest rates in respective countries in future years. Each of several distinct developed economy bond markets presents interesting aspects that bear watching: 1) Japan with its aging demographics and need for external financing, 2) the US with its large deficits and exploding entitlements, 3) Euroland with its disparate members – Germany the extreme saver and productive producer, Spain and Greece with their excessive reliance on debt and 4) the UK, with the highest debt levels and a finance-oriented economy – exposed like London to the cold dark winter nights of deleveraging.

Of all of the developed countries, three broad fixed-income observations stand out: 1) given enough liquidity and current yields I would prefer to invest money in Canada. Its conservative banks never did participate in the housing crisis and it moved toward and stayed closer to fiscal balance than any other country, 2) Germany is the safest, most liquid sovereign alternative, although its leadership and the EU’s potential stance toward bailouts of Greece and Ireland must be watched. Think AIG and GMAC and you have a similar comparative predicament, and 3) the UK is a must to avoid. Its Gilts are resting on a bed of nitroglycerine. High debt with the potential to devalue its currency present high risks for bond investors. In addition, its interest rates are already artificially influenced by accounting standards that at one point last year produced long-term real interest rates of 1/2 % and lower.
The last decade – the “aughts” – were remarkable in a number of areas: jobless recoveries in major economies, negative equity returns in US and other developed markets, and of course the financial crisis and its aftermath. If an investment manager and an investment management firm proved to be good stewards of capital markets during the turbulent but vapid “aughts,” they may be granted a license to navigate the rapids of the “teens,” a decade likely to be fed by the melting snows of debt deleveraging, offering life for unlevered emerging and developed economies, but risk and uncertainty for those overfed on a diet of financed-based consumption. Beware the ring of fire!
William H. Gross
Managing Director

Morgan Stanley's Teun Draaisma Joins Goldman's O'Neill On Bear Train

Morgan Stanley's Teun Draaisma Joins Goldman's O'Neill On Bear Train: "

Yesterday we disclosed the latest thoughts from Goldman's traditionally cheerful Jim O'Neill, indicating that the strategist was shifting to a notably bearish exposure. The most notable sell-side development over the past 24 hours is that Morgan Stanley's head of European Strategy, Teun Draaisma, has now joined the bearish team, with his January 25 report titled 'Sell into strength as the tightening phase has started' - the title is pretty self-explanatory.

Summarizing Teun's concerns:

Sell into strength, as authorities have switched from 'all out stimulus' to 'let's start some stimulus withdrawal'. Tightening measures are coming in thick and fast around the world. We always thought that the start of tightening was not the first Fed rate hike, but could be many other things including higher taxes, less spending, more regulation, Chinese/Asian tightening, or Fed language change. Recent initiatives include Obama's banking initiatives, and several Asian tightening measures. In the next few months this theme is set to intensify, and we expect positive payrolls, a Fed language change, and the start of QE withdrawal. This willingness of authorities to move away from crisis mode is an important change and means that the tightening phase in the broad sense of the word has now started. Thus, indeed, 2010 is shaping up to be like 1994 and 2004, as we expected. The start of tightening is hardly ever the end of the growth cycle, and normally the accompanying dip needs to be bought, but it typically is a serious double-digit dip lasting 2 quarters or more. The sector rotation has of course already started in October-2009 and is set to continue. As a result we move 2% from equities to bonds in our asset allocation, going to +5% cash, -2% UW equities, -3% UW bonds. We think short-term strength is quite possible, and we have not quite gotten an outright sell signal on our MTIs either, but the 6 month risk-reward of being long is worsening, and we recommend to sell into strength. Our 12 month MSCI Europe target of 1030 implies 6% downside.

Zero Hedge is hardly as sanguine about economic propsects to believe that the Fed is indeed willing to tighten any time soon - in fact our belief for a while has been that Q.E. will likely be extended in some official form, which is the antithesis of tightening. However, assuming tightening is indeed on Bernanke's agenda, and further pursuing Teun's idea, yields the following interesting observations on the correlation between rates and markets- in short, the upside/downside risk, as determined by the liquidity pump, at this point has shifted materially into bears' territory.

Further quantifying the various tiers of future market performance, Draaisma presents the following three scenarios:

• Bull Case 'Goldilocks': MSCI Europe 1,400 (27%) upside - Bond yields of 3.75%, short rates at 1.25%, CPI remains low at 1.5% and EPS growth is 50%. Using a CVI value of 0, this implies a MSCI Europe target of 1400, and an implied PE of 15.
• Base Case 'Strong Growth, Rising Rates': MSCI Europe 1,030 (6% downside) - Bond yields of 4.5%, short rates at 2%, CPI is well behaved at 1.8%, and EPS growth is 35%. Using a CVI value of -0.5, this implies a MSCI Europe target of 1030 and an implied PE of 12.5.
• Bear Case 'Inflation, FX and Bond Trouble': MSCI Europe 750 (32% downside) - Bond yields reach 5%, and 3M rates as well as headline CPI to reach 2.5%. EPS growth is less than expected at 20% as input costs bite. Using a CVI value of -1, this implies a MSCI Europe target of 750 and an implied PE of 10.

And as the core variable behind Draaisma's projections is interest rates, the strategist provides the following observations on embedded risks.

Two risks to betting on repeat of bullish historical pattern.

While the past does not repeat itself, we think it rhymes, and our analysis of the past paints a positive outlook for equities and cyclicals if real rates were to rise appreciably. However, we see two risks and would caution betting on such bullish outcomes:

Risk #1 – correction associated with ‘start of tightening’. We continue to believe strong growth will lead to the start of tightening, which is tactically bearish for equities. We found that there always is some sort of equity correction around the first Fed hike coming out of a US recession – averaging 13% over 6 months, typically starting just before the first hike. To be sure, we always thought the start of tightening could be many things other than the first Fed hike in this cycle. Start of tightening in Asia, more onerous financial regulations and the general willingness of authorities to move away from crisis mode in recent weeks all means that the tightening phase, in a broad sense, has started, we believe.

In the next few months, we expect positive payroll, a change in Fed language, and the withdrawal of excess liquidity as the tightening phase intensifies. We see 6% downside to MSCI Europe in the next 12 months and recommend selling into strength (see 'Sell into Strength as the tightening phase has started', 25 January 2010).

We also found that rising real yields are not always bullish. For instance, real yields bottomed in Sept 1993 after the early 90s recession, rising from 2.0% to 5.3% by end-1994, reflecting the economic recovery. Equities reacted positively to the initial move up in real yield until the start of the Fed tightening cycle, and higher rates started to bite early in 1994. Equities then corrected 17% between February 1994 and March 1995 as real rates continued to rise (Exhibit 6). Similar patterns were seen post US recessions ended in 1970, 1975, 1980 and 1982.

The defensive sector rotation associated with this phase started in October 2009, and will continue, in our view. We think our portfolio is well positioned already with Staples, Energy and Healthcare as our biggest overweights. Financials and Utilities remain our biggest underweights (see Exhibits 7 and 8).

Risk #2 – Back-up in yields driven by an inflation scare and/or fiscal concerns. While not our current expectations, the risks are worth monitoring, as equities stand to suffer much more than our historical analysis would suggest. While we are not worried about problematic inflation in 2010, we do believe inflation will start an upward trend that could eventually become problematic. Authorities’ higher tolerance for inflation, record amounts of excess reserves that could be lent out and push up money supply, rising commodity prices and a narrowing output gap on the back of sustainable recovery all suggest that inflation risks are on the upside. Inflation expectations have already rebounded strongly to pre-crisis levels, and we continue to monitor inflation risks by watching both the 10-year and 5-year, 5-year forward break-even rates in the US bond markets (USGGBE10 and SGG5Y5Y Index <GO> on BBG), money supply growth and copper prices.

Markets are also likely to become increasingly worried about longer-term fiscal sustainability, given the poor state of government finances in many advanced economies. Because outright defaults are extremely unlikely, as most debt is denominated in domestic currency and governments could instruct their central banks to print whatever is needed, we believe fiscal concerns would be translated into higher borrowing costs and inflation premia in bond markets.

Academic studies have also found that global banking crises are historically associated with a high incidence of sovereign defaults on external debt (see Exhibit 12; and ‘This Time is Different – Eight Centuries of Financial Folly’, Carmen M. Reinhart & Kenneth S. Rogoff). If heightened fiscal concerns, rather than growth, become the main driver of higher rates, we believe the headwind for equities would be more severe than historical analysis would suggest.

We believe gold remains an essential hedge for higher inflation, but sectors that are either the sources of inflation such as commodity-related sectors or have inflation linked pricing including utilities, motorways, airports, bus & rail and satellite should do well (see ‘Hedging Inflation Risks’, 10 March 2008). Exhibit 13 shows that Energy, Staples tend to be the two best sectors in past periods when inflation is high and rising.

Our key takeaway from this analysis. Equities tend to do well when real rates are rising, but there are risks that it could be different this time if higher yields are driven by an inflation scare and/or heightened fiscal concerns. 'Start of tightening' remains our dominant theme of the year, and we continue to expect a consolidation in equities associated with the start of tightening. Market volatility around the start of Asian tightening and announcement of more onerous financial regulations confirms our long held view that the start of tightening could be many things other than the first Fed hike. With the general willingness of authorities to move away from crisis mode in recent weeks, we believe the tightening phase has now started and will intensify, and we expect positive payrolls will lead to a change in Fed language and the start of excess liquidity withdrawal in the next few months. We see 6% downside to MSCI Europe in the next 12 months and recommend selling into strength. Defensive sector rotation associated with the tightening phase has already started in Oct-09, and will continue. Our portfolio is well-positioned with Staples, Energy and Healthcare as our biggest OWs. Financials and Utilities remain our biggest UWs.

And for those who agree with Teun that tightening is in the cards, he provides the following useful checklist to track if indeed the Fed is doing as Morgan Stanley expects:

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"Fear the Boom and Bust" a Hayek vs. Keynes Rap Anthem

Economicz does not get any more simplified than this:

Drinking poison to quench thirst

Drinking poison to quench thirst | China International Business

Financial markets didn't wait for the smoke to clear from the Dubai debt crisis before jumping back into the happy days of shorting the dollar and piling into everything else. After the massive government bailouts in the last crisis, the markets don't have any doubt that there would be bailouts the next time. This no-downside psychology is making each market correction shorter and shallower.

The zero-interest rate environment and rapid monetary growth are scaring conservative savers into becoming budding speculators. By threatening to destroy the value of cash and by subsidizing speculation with low interest rates and bailouts, good guys really finish last. It may be better surfing the speculative waves than staying put. One may die in a speculative crash, but holding onto cash when governments are hell-bent on printing money to solve every problem seems like certain death.

The Dubai crisis wasn't even the most important event last month. The confirmation of Ben Bernanke and Obama's announcement of the surge-and-withdraw decision for the Afghan War were both more important. Both indicate that the most important decisions in the world are focused on sustaining existing trends despite catastrophic consequences in the long term.

Senators expressed huge frustration during Bernanke's confirmation hearing. They all sense the existing system is wrong. After all, the last crisis happened for a reason. Throwing around so much money to stabilize the financial system didn't cure anything. For the first time since the 1930s a global speculative boom is taking place amidst fragile economies and high unemployment rates. Of course there is something wrong with this world. On the other hand all the senators felt that Bernanke did a good job under the circumstances and there isn't another person available now to do a better job. Despite their misgivings they don't have the courage to start anew.

If you listen to how Bernanke is justifying what he has done and is doing, it sounds just like Greenspan. It is about decisions made on marginal considerations, not on the soundness of the system. The most powerful consideration is put on how the decisions impact GDP and employment in the short term. There is a Chinese saying that one could quench ones thirst by drinking poison. Bernanke seems to be prescribing exactly this to the US economy. He talks about interest rates being kept low because the unemployment rate is high, but he doesn't talk about how low it should be. He is confusing people between levels and marginal changes.

During his campaign last year Obama insisted that Iraq was the wrong war and Afghan the right one. Both were wrong. It seems that Obama didn't have the courage to go against the system and go back on his words to stop the war. Afghanistan is an infinitely tougher nut to crack than Iraq, and the chances are very slim that the US can win this war. Obama was elected on a platform of ‘change,' but so far the system has changed him more than the other way around.

If you try to search through the minutia of economic data to gain insight into the future, you are probably looking in the wrong place. The crisis threw the world out of balance. Governments throwing around trillions of dollars restore stability temporarily, but this strategy is too expensive to last. Only massive structural changes can bring the global economy into self-sustaining balance and lay the foundation for another growth cycle. The problem is that structural reforms would bring pain first and gain later. Politicians, wherever they are and whatever parties they belong to, seem incapable of talking about accepting pain. The policy consensus to prop up the global economy with stimulus will continue until inflation takes off or governments are broke.

Some of the bright spots, like bank earnings and GDP growth, that governments are touting as results of the trillions of dollars they have spent are misleading. Banks are making high profits in a fragile global economy, but the global pie is not expanding quickly. How could banks make such huge profits? The usual explanation is that banks have traded well, like borrowing short-term funds from the Fed at a zero percent interest rate and investing in treasuries at 3.5% interest rate. The US' financial sector has USD 16.5 trillions of debt. Just 2% spread from such trades could yield over USD 300 billions in profits. That seems like a miracle: nobody is hurt, and banks make billions.

The pain is actually postponed in two ways. First, the low funding cost for banks' trading will turn into inflation that dilutes everyone's cash holdings: The Fed is just redistributing money from savers to banks, only the savers don't know it yet. Second, the banks' low funding cost has a government-guarantee component. Even though the Fed keeps its funds rate at zero, without the government bailout expectation even the best run banks would pay at least 2 percentage points more for debt, i.e., their profits would be wiped out if the debt market doesn't believe in a government bailout. All the excitement about the banks repaying the TARP money is an illusion. Could these banks exist at all, let alone make huge profits, without the implicit government guarantee on their debts? The cost associated with the guarantee is effectively a free insurance policy from the taxpayers. When the next crisis hits, the cost will materialize. The financial recovery that governments are touting is really a sham; it is just another robbery.

Inventory recovery, fiscal stimulus and asset inflation have been the three factors behind the recent economic recovery. The global economy probably grew at a 4% year-on-year rate in the fourth quarter. Inventory recovery is contributing to most of the current growth. When credit conditions tightened after Lehman's collapse, businesses were forced to shed inventory to raise liquidity. The subsequent demand collapse further reinforced the inventory destocking dynamic. Fiscal stimulus is mostly in the form of a stabilizer, i.e., governments don't cut spending when revenues fall during recession. It doesn't boost growth per se, but it stops the recession's multiplier effect through the government's budget constraints.

Asset inflation is making a significant contribution to global growth, mainly in emerging economies and in the housing, auto and commodity sectors. The perceived robust growth in emerging economies is mainly an asset inflation story, which is fed by the weak dollar-driven hot money. What's occurring is similar to what happened in 1995. Then the emerging economies had robust growth amidst asset inflation while the dollar was making a historical low.

Inflation will likely drive the next crisis. The normal lag between money creation and inflation is one year and a half – though it is probably longer now due to globalization. Massive money creation took place one year ago, so inflation will likely become apparent in 2011. A vicious wage-price spiral could take place in 2012, similar to that which occurred in the late 1970s. Inflation would scare central banks into tightening dramatically in 2012, which will pop the current asset bubble. By then the global problem would be more serious than now: in addition to the leverage problem in the household and financial sectors, the government sector would also be hugely leveraged. The global economy would experience something similar to what the US experienced in early 1980s, in fact probably worse.

The next crisis will be Bernanke's. While he is justified to keep interest rates low after a financial crisis, the issue is how low? Bernanke is keeping the short term rate at zero and the long term rate at 3.5% through the Fed's purchase program. The manipulation along the whole yield curve is creating massive distortion in capital allocation, essentially in favor of speculation. The slower Bernanke raises interest rates, the bigger the next crisis.

The next crisis will essentially be a continuation of the last one. Out of political concerns governments and central banks have thrown trillions of dollars towards preventing necessary economic adjustments, believing that stimulus will bring back growth. The money is buying some time, but the costs are (1) that the governments won't have enough money to cushion the pain during the coming economic restructuring and (2) that inflation will increase misery in an economic downturn.

The whole world is drinking poison to quench its thirst. It may feel like relief now, but the sickness will strike in 2012.

By Andy Xie.

Economic Black Hole: 20 Reasons Why The U.S. Economy Is Dying And Is Simply Not Going To Recover: "

Economic Black Hole: 20 Reasons Why The U.S. Economy Is Dying And Is Simply Not Going To Recover

Even though the U.S. financial system nearly experienced a total meltdown in late 2008, the truth is that most Americans simply have no idea what is happening to the U.S. economy. Most people seem to think that the nasty little recession that we have just been through is almost over and that we will be experiencing another time of economic growth and prosperity very shortly. But this time around that is not the case. The reality is that we are being sucked into an economic black hole from which the U.S. economy will never fully recover.

The problem is debt. Collectively, the U.S. government, the state governments, corporate America and American consumers have accumulated the biggest mountain of debt in the history of the world. Our massive debt binge has financed our tremendous growth and prosperity over the last couple of decades, but now the day of reckoning is here.

And it is going to be painful.

The following are 20 reasons why the U.S. economy is dying and is simply not going to recover....

#1) Do you remember that massive wave of subprime mortgages that defaulted in 2007 and 2008 and caused the biggest financial crisis since the Great Depression? Well, the "second wave" of mortgage defaults in on the way and there is simply no way that we are going to be able to avoid it. A huge mountain of mortgages is going to reset starting in 2010, and once those mortgage payments go up there are once again going to be millons of people who simply cannot pay their mortgages. The chart below reveals just how bad the second wave of adjustable rate mortgages is likely to be over the next several years....

#2) The Federal Housing Administration has announced plans to increase the amount of up-front cash paid by new borrowers and to require higher down payments from those with the poorest credit. The Federal Housing Administration currently backs about 30 percent of all new home loans and about 20 percent of all new home refinancing loans. Tighter standards are going to mean that less people will qualify for loans. Less qualifiers means that there will be less buyers for homes. Less buyers means that home prices are going to drop even more.

#3) It is getting really hard to find a job in the United States. A total of 6,130,000 U.S. workers had been unemployed for 27 weeks or more in December 2009. That was the most ever since the U.S. government started keeping track of this statistic in 1948. In fact, it is more than double the 2,612,000 U.S. workers who were unemployed for a similar length of time in December 2008. The reality is that once Americans lose their jobs they are increasingly finding it difficult to find new ones. Just check out the chart below....

#4) In December, there were also 929,000 'discouraged' workers who are not counted as part of the labor force because they have "given up" looking for work. That is the most since the U.S. government first started keeping track of discouraged workers in 1949. Many Americans have simply given up and are now chronically unemployed.

#5) Some areas of the U.S. are already virtually in a state of depression. The mayor of Detroit estimates that the real unemployment rate in his city is now somewhere around 50 percent.

#6) For decades, our leaders in Washington pushed us towards "a global economy" and told us it would be so good for us. But there is a flip side. Now workers in the U.S. must compete with workers all over the world, and our greedy corporations are free to pursue the cheapest labor available anywhere on the globe. Millions of jobs have already been shipped out of the United States, and Princeton University economist Alan S. Blinder estimates that 22% to 29% of all current U.S. jobs will be offshorable within two decades. The days when blue collar workers could live the American Dream are gone and they are not going to come back.

#7) During the 2001 recession, the U.S. economy lost 2% of its jobs and it took four years to get them back. This time around the U.S. economy has lost more than 5% of its jobs and there is no sign that the bleeding of jobs is going to stop any time soon.

#8) All of this unemployment is putting severe stress on state unemployment funds. At this point, 25 state unemployment insurance funds have gone broke and the Department of Labor estimates that 15 more state unemployment funds will likely go broke within two years and will need massive loans from the federal government just to keep going.

#9) 37 million Americans now receive food stamps, and the program is expanding at a pace of about 20,000 people a day. The United States of America is very quickly becoming a socialist welfare state.

#10) The number of Americans who are going broke is staggering. 1.41 million Americans filed for personal bankruptcy in 2009 - a 32 percent increase over 2008.

#11) For decades, the fact that the U.S. dollar was the reserve currency of the world gave the U.S. financial system an unusual degree of stability. But all of that is changing. Foreign countries are increasingly turning away from the dollar to other currencies. For example, Russia’s central bank announced on Wednesday that it had started buying Canadian dollars in a bid to diversify its foreign exchange reserves.

#12) The recent economic downturn has left some localities totally bankrupt. For instance, Jefferson County, Alabama is on the brink of what would be the largest government bankruptcy in the history of the United States - surpassing the 1994 filing by Southern California's Orange County.

#13) The U.S. is facing a pension crisis of unprecedented magnitude. Virtually all pension funds in the United States, both private and public, are massively underfunded. With millions of Baby Boomers getting ready to retire, there is simply no way on earth that all of these obligations can be met. Robert Novy-Marx of the University of Chicago and Joshua D. Rauh of Northwestern's Kellogg School of Management recently calculated the collective unfunded pension liability for all 50 U.S. states for Forbes magazine. So what was the total? 3.2 trillion dollars.

#14) Social Security and Medicare expenses are wildly out of control. Once again, with millions of Baby Boomers now at retirement age there is simply going to be no way to pay all of these retirees what they are owed.

#15) So will the U.S. government come to the rescue? The U.S. has allowed the total federal debt to balloon by 50% since 2006 to $12.3 trillion. The chart below is a bit outdated, but it does show the reckless expansion of U.S. government debt over the past several decades. To get an idea of where we are now, just add at least 3 trillion dollars on to the top of the chart....

#16) So has the U.S. government learned anything from these mistakes? No. In fact, Senate Democrats on Wednesday proposed allowing the federal government to borrow an additional $2 trillion to pay its bills, a record increase that would allow the U.S. national debt to reach approximately $14.3 trillion.

#17) It is going to become even harder for the U.S. government to pay the bills now that tax receipts are falling through the floor. U.S. corporate income tax receipts were down 55% in the year that ended on September 30th, 2009.

#18) So where will the U.S. government get the money? From the Federal Reserve of course. The Federal Reserve bought approximately 80 percent of all U.S. Treasury securities issued in 2009. In other words, the U.S. government is now being financed by a massive Ponzi scheme.

#19) The reckless expansion of the money supply by the U.S. government and the Federal Reserve is going to end up destroying the U.S. dollar and the value of the remaining collective net worth of all Americans. The more dollars there are, the less each individual dollar is worth. In essence, inflation is like a hidden tax on each dollar that you own. When they flood the economy with money, the value of the money you have in your bank accounts goes down. The chart below shows the growth of the U.S. money supply. Pay particular attention to the very end of the chart which shows what has been happening lately. What do you think this is going to do to the value of the U.S. dollar?....

#20) When a nation practices evil, there is no way that it is going to be blessed in the long run. The truth is that we have become a nation that is dripping with corruption and wickedness from the top to the bottom. Unless this fundamentally changes, not even the most perfect economic policies in the world are going to do us any good. In the end, you always reap what you sow. The day of reckoning for the U.S. economy is here and it is not going to be pleasant.

"

Stop the Presses! by Jeremy Granthma of GMO

It is easy today to be confused, for this is a remarkably complex time. I argued two years ago that we were all part of an elaborate experiment, the inputs to which were completely new. We had an unprecedentedly low risk premium on every asset class and a stew of new and badly understood nancial instruments. That was bad enough, but isn’t the picture even more complicated and without precedent now? We have never in our lifetime seen a nancial and economic bust such as the one we just had. We have never had two great asset bubbles break in the same decade. We have never wiped out so much wealth in all asset classes as we have this time: $20 trillion at its worst point, on our reckoning. We have never experienced such rapid deterioration in the government’s budget and in the balance sheet of the Fed, nor witnessed such moral hazard, with bailouts flying around like this. What hope do we really have in making accurate predictions of how the world will recover from all of this, and in what ways it will be changed? Very little.

My view of the economy’s future is boringly unchanged: “Seven Lean Years.” I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average pro t margins and P/E ratios, so that it would feel more like the bumpy (bumpy, but not so disastrous) 1970s than the economically lucky 1990s and early 2000s.

Playing with Fire

Whenever the Fed attempts to stimulate the economy by facilitating low rates and rapid money growth, the economy responds. But it does so reluctantly, whereas asset prices respond with enthusiasm.

Fed has been reckless in facilitating rapid asset booms in the tech and housing bubbles. As we know, the of cial policy remains to avoid trying to contain asset bubbles, but to ameliorate the pain of any setbacks should asset prices reverse course and collapse. Indeed, the Fed claims never to have been sure that bubbles even exist. Non- nancial corporations and the Treasury were lucky that they went into the tech bubble in good nancial shape and into the housing bubble in reasonable shape, except for the overstretched consumer. Now, though, after our massive stimulus efforts, the Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II. The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third go-

around in the bubble forming and breaking business. Up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and nancial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which is supremely dangerous this time because its arsenal now is almost empty.

Investors, traditionally reluctant to burn their ngers badly twice in a generation, line up to buy risk and bid down spreads as if eager to suffer for a third time in a decade. Scientists believe that some wild animals that are threatened constantly by predators quickly forget the worst episodes lest they become so completely traumatized that they dare not return to nibbling grass. Normally, investors appear to have longer memories than rabbits, but not this time! And the Fed, having learned nothing, still worships at the Greenspan altar. Overstimulus was painful in the 2000 break and extremely painful in 2008, but the Fed soldiers on with its failed strategy like Field Marshal Haig in World War I (“The machine gun is a much over-rated weapon.”).

Full note here:

Quarterly Letter

Big year for European sovereign bonds

Big year for European sovereign bonds: "

Big year for European sovereign bonds

With national deficits soaring around the world and the recent panic over Greece’s economic crisis, it has been clear for some time that 2010 is shaping up as a big year for sovereign bond issues.

Nowhere more so than in Europe.

Now, Fitch Ratings has put a figure on it, estimating in a new report that European states will need to borrow €2,200bn ($3,100bn) from capital markets this year to finance their budget deficits.

The projected borrowing is a 3.7 per cent increase on the €2,120bn raised in 2009, says Fitch, as governments continue to issue sovereign bonds and short-term bills.

This record issuance, in turn, will put pressure on public finances amid rising yields and volatility.

And, as Fitch notes, short-term sovereign debt issuance — which has to be rolled over once every three or six months — will raise refinancing risks for European governments, leaving them increasingly at the mercy of bond markets.

An expected surge in issuance of short-term Treasury bills in France, Germany, Spain and Portugal increases the market risk facing these countries — notably exposure to interest rate shocks, adds Fitch.

Overall, among Europe’s top issuers this year, France will be the biggest, raising an estimated €454bn. Then comes Italy at €393bn, Germany at €386bn and the UK at €279bn.

As a percentage of GDP, borrowing is expected to be the largest in Italy, Belgium, France and Ireland — at about 25 per cent.

The year is likely to see greater volatility as the liquidity premium enjoyed by sovereign issuers diminishes amid hastening recovery — and that, says Fitch, means a material risk of a rise in government funding costs as yields rise. The agency continues:

“Combined with concerns over the medium-term fiscal and inflation outlook, this will likely cause government bond yields to rise, potentially quite sharply.”

On the bright side, high-grade sovereigns are unlikely to have problems accessing markets, though they will have to pay higher rates, according to Fitch.

And separately, on another happy but related note: if there are any concerns about investor uptake for this tidal wave of European sovereign issues, just look to Greece.

As the FT reports on Tuesday:

International alarm over Greece’s debt crisis abated on Monday when investors flocked to buy the government’s first bond issue of the year, an indication that it may run into less trouble than anticipated in meeting its short-term financing needs.

Investors placed about €20bn ($28bn) in orders for the five-year, fixed-rate bond, four times more than the government had reckoned on. However, in a sign that Greece is being made to pay for years of fiscal profligacy, the bond carried a record high interest rate spread relative to the rate for German bonds, the eurozone’s benchmark.

The message seems to be, give them enough incentive and investors will overcome anything — even fear of a Greek implosion."

Scandal: Albert Edwards Alleges Central Banks Were Complicit In Robbing The Middle Classes

Scandal: Albert Edwards Alleges Central Banks Were Complicit In Robbing The Middle Classes: "

We apologize in advance for the NY Magazine-style headline, but this is a report that has to be read by all Senators who are preparing to reconfirm Bernanke for a second term. When voting for the Chairman, be aware that all of America will now look at you as the perpetrators who are encouraging the greatest inter and intra-generational theft to continue, and as prescribed by Newton 3rd law, sooner or later, an appropriate reaction will come from the very same middle class that you are seeking to doom into a state of perpetual penury and a declining standard of living.

America spoke in Massachusetts, and will speak again very soon if you do not send the appropriate signal that you have heard its anger - Do Not Reconfirm Bernanke.

You have been warned.

We present Albert Edwards' latest in its complete form as it must be read by all unabridged and without commentary. These are not the deranged ramblings of a fringe blogger - this is a chief strategist for a major international bank.

---

Theft! Were the US & UK central banks complicit in robbing the middle classes?

by Albert Edwards, Societe Generale

Mr Bernanke’s in-house Fed economists have found that the Fed wasn’t responsible for the boom which subsequently turned into the biggest bust since the 1930s. Are those the same Fed staffers whose research led Mr Bernanke to assert in Oct. 2005 that “there was no housing bubble to go bust”? The reasons for the US and the UK central banks inflating the bubble range from incompetence and negligence to just plain spinelessness. Let me propose an alternative thesis. Did the US and UK central banks collude with the politicians to ‘steal’ their nations’ income growth from the middle classes and hand it to the very rich?

Ben Bernanke?s recent speech at the American Economic Association made me feel sick. Like Alan Greenspan, he is still in denial. The pigmies that populate the political and monetary elites prefer to genuflect to the court of public opinion in a pathetic attempt to deflect blame from their own gross and unforgivable incompetence.

The US and UK have seen a huge rise in inequality over the last two decades, as growth in national income has been diverted almost exclusively to the top income earners (see chart below). The middle classes have seen median real incomes stagnate over that period and, as a consequence, corporate margins and profits have boomed.

Some recent reading has got me thinking as to whether the US and UK central banks were actively complicit in an aggressive re-distributive policy benefiting the very rich. Indeed, it has been amazing how little political backlash there has been against the stagnation of ordinary people?s earnings in the US and UK. Did central banks, in creating housing bubbles, help distract middle class attention from this re-distributive policy by allowing them to keep consuming via equity extraction? The emergence of extreme inequality might never otherwise have been tolerated by the electorate (see chart below). And now the bubbles have burst, along with central banks? credibility, what now?

After reading Ben Bernanke?s speech, once again denying culpability for the bubble, I really didn?t know whether to laugh or cry (remember that Ben Bernanke, like Tim Geithner, was a key member of the Greenspan Fed). I feel like Peter Finch in the film Network, sticking my head out of the window and shouting 'I'm as mad as hell and I'm not going to take it anymore!' Although criticism of the Fed (and the Bank of England) has now become louder and more widespread, I feel my longstanding derision for their actions during the so-called ?good years? puts me in a stronger position than some to offer further comment.

Opening my 2002-2005 file of old weeklies I did not have to go any further than the first paragraph of the top copy (end of December 2005). “As far as Alan Greenspan’s tenure at the Fed is concerned, we have spared few words of derision. We have made plain our views that the supposed US prosperity that has accompanied his tenure has been based on a grotesque mountain of debt. We have likened the economy to a Ponzi scheme which will ultimately collapse. He has allowed the funding of strong economic activity by mortgaging the US’s future against one bubble (equity) and then another (housing), which is now beginning to implode”. These are almost consensus thoughts now, but not then.

The pigmies that populate the political and monetary elites prefer to genuflect to the court of public opinion. Blaming the banks is simply a pathetic attempt to deflect the public fury from their own gross and unforgivable incompetence. We have stated before that banks are not the primary cause of the bust. Just as in Japan, a decade earlier, bank problems are a symptom of the bust. It is the monetary and regulatory authorities that are responsible for this mess. And it is not just obvious in retrospect. It was perfectly obvious from the beginning.

I was shocked by a recent survey of Wall Street and business economists, published in the Wall Street Journal (see Bernanke View Doubted 14 Jan? link). Asked whether they agreed or disagreed with the proposition ‘excessively easy Fed policy in the first half of the decade helped cause a bubble in house prices’, some 42, or 74% agreed with the proposition. So unbelievably there are still 12 economists surveyed who did not agree! Even more incredible, a majority of academic economists did not agree with the proposition. Maybe they have sympathy for a fellow academic or maybe they actually believe the preposterous proposition that the western central banks were not in control of the bubbles which were primarily due to tidal waves of surplus savings washing across from Asia.

John Taylor shows this to be nonsense. There was no global savings glut (see chart below)

John Taylor is well known for his famous ?Taylor Rule? for the appropriate level of interest rates and he has been very vocal in his criticism of Fed laxity in the aftermath of the Nasdaq crash in his paper ?The Financial Crisis and Policy Responses: An Empirical Analysis of What Went Wrong’, Nov. 2008 and elsewhere - link. His thesis is simple. Lax monetary policy caused the boom in housing upon which euphoric credit excesses were built. The subsequent bust was an inevitable mirror image of the boom. This simply would not have occurred had the Fed (and the Bank of England) acted earlier to tighten policy as shown in the Taylor?s counterfactual profiles (see charts below).

More recently, the San Francisco Fed published a paper this month showing that those countries which saw the steepest run-up in house prices over the last decade also saw the largest rise in household sector leverage (see charts below and link). Of course the causality runs both ways. Loose monetary policy generates higher borrowing which pushes up house prices. Subsequently this prompts other households to borrow against the rising value of their houses to finance consumption via net equity extraction.

Generally most commentators have fallen for the populist line that the banks are to blame. Very rarely does a leading commentator pin the blame where it deserves to be ? on the central banks. Hence, I was very interested to read the Financial Times Insight column on Tuesday from the deep-thinking columnist, John Plender (interestingly his title in the print edition was “Blame the central bankers more than the private bankers” was changed to “Remove the punchbowl before the party gets rowdy” in the web edition - link).

Plender?s point is classic Minsky. An unusually long period of economic stability, also known as The Great Moderation, engineered by Central Bank laxity inevitably created the conditions for the subsequent bust. “Central banks clearly bear much responsibility for past excessive credit expansion. The Fed’s gradualist and transparent approach to raising rates in middecade also ensured that bankers were never shocked into a recognition that unprecedented shrinkage of bank equity was phenomenally dangerous. Despite the popular perception that financial innovation caused so much of the damage in the crisis, the rise in bank leverage was a far more important factor”. His point that it takes guts to remove the punch-bowl when the party is in full swing is spot on. The Fed and the Bank of England were both gutless and spineless. Their love affair with The Great Moderation meant they simply were not prepared to tolerate a little more pain now to avoid a Minsky credit bust and massive unemployment later.

But what is the relationship, if any, between this extreme central bank laxity in the US and UK and these countries being at the forefront for the extraordinary rise in inequality over the last few decades (see cover chart)? And does it matter?

I was reading some typically thought-provoking comments from Marc Faber in his Gloom, Boom and Doom report about current extremes of inequality. It reminded me that our own excellent US economists Steven Gallagher and Aneta Markowska had also written on this. To be sure, the rise in inequality has been staggering in the US in recent years (see charts below).

It is well worth visiting the website of Emmanuel Saez of the University of California who has written extensively on this subject and now has updated his charts up until the end of 2008 (data available in Excel Format ? link). The New York Times reported on the recently released Census Bureau data and showed not only that median income had declined over the last 10 years in real terms, but that this is the first full decade that real median household income has failed to rise in the US - link. What is also so interesting from Professor Saez?s cross-sectional research is how inequality has clearly risen fastest in the Anglosaxon, freemarket economies of the US and the UK (also note that France, with much higher levels of equality, saw much more subdued growth in household leverage).

Our US economists make the very interesting point (similar to Marc Faber) that peaks of income skewness ? 1929 and 2007 ? tell us there is something fundamentally unsustainable about excessively uneven income distribution. With a relatively low marginal propensity to consume among the rich, when they receive the vast bulk of income growth, as they have, then the country will face an under-consumption problem (see 9 September The Economic News ?- link. Marc Faber also cites John Hobson?s work on this same topic from the 1930s).

Hence, while governments preside over economic policies which make the very rich even richer, national consumption needs to be boosted in some way to avoid underconsumption ending in outright deflation. In addition, the middle classes also need to be thrown a sop to disguise the fact they are not benefiting at all from economic growth. This is where central banks have played their pernicious part.

I recalled seeing another article from John Plender on this topic back in April 2008. His explanation for why there had been so little backlash from the stagnation of ordinary people?s income at a time when the rich did so well was simple: ?"Rising asset prices, especially in the housing market, created a sense of increasing wealth regardless of income. Remortgaging homes over a long period of declining interest rates provided a convenient source of funds via equity withdrawal to finance increased consumption” – link.

Now you might argue central banks had no alternative in the face of under-consumption. Or you might conclude there was a deliberate, unspoken collusion among policymakers to ?rob? the middle classes of their rightful share of income growth by throwing them illusionary spending power based on asset price inflation. We will never know.

But it is clear in my mind that ordinary working people would not have tolerated these extreme redistributive policies had not the UK and US central banks played their supporting role. Going forward, in the absence of a sustained housing boom, labour will fight back to take its proper (normal) share of the national cake, squeezing profits on a secular basis. For as Bill Gross pointed out back in PIMCO?s investment outlook ?Enough is Enough’ of August 1997, "?When the fruits of society’s labor become maldistributed, when the rich get richer and the middle and lower classes struggle to keep their heads above water as is clearly the case today, then the system ultimately breaks down.”- link. In Japan, low levels of inequality and inherent social cohesion prevented a social breakdown in this post-bubble debacle. With social inequality currently so very high in the US and the UK, it doesn?t take much to conclude that extreme inequality could strain the fabric of society far closer to breaking point.

"

McKinsey On Sovereign (De)Leveraging And Untenable Debt Loads

McKinsey On Sovereign (De)Leveraging And Untenable Debt Loads: "

McKinsey has released a very detailed report which focuses on the 'final frontier' of the global credit bubble: the migration of private sector leverage over to the sovereign balance sheet, and the viability and sustainability of this process. This is not a new topic on Zero Hedge, and as Greece just experienced today, unless a country is well equipped with the dynamic duo of a reserve currency and a printing press, surging sovereign debt usually ends with just one outcome...

The McKinsey consultants have performed an in-depth empirical study tracing the history of (de)leveraging in both the developing and developed world, at both the corporate, financial institution and consumer levels, and the corresponding offset at the sovereigns. Amusingly, analysts read the 'improvement' in the credit picture at various private sectors, while completely ignoring the vertical spike in new sovereign debt issuance. If you were wondering why everyone is on pins and needles every time there is a new UST auction, now you know: in the zero sum game of credit transfer, any improvement in the former is purely as a result of the largess of the later. A funding crisis in Greece, which at this point seems a certainty will likely start off the long-awaited European domino action which will begin at the FX level, and slowly migrate to default risk for all European countries. Once that happens, risk will promptly migrate away from Eurozone, and travel west over the Atlantic. In that regard, we still consider US CDS as very cheap, despite their doubling from the first time we suggested investors take a look.

Back to McKinsey - lot of pretty charts, which we suggest readers peruse at their leisure, coupled with insightful commentary.

Here is what happens to global leverage when you leave deranged money printers with aspirations for zero % cost of debt in charge of the whole show:

Further to today's bank earnings, a chart that demonstrates that while bank leverage has fallen from the historic average, it is still a massive 20+ for US Broker/Dealers. This is why a 5% loss in principal ends up wiping out all the equity used by the likes of Bank of America. Japan, at nearly double the US financial sector leverage, is just a crisis waiting to happen.

The major issue that administrations (should) have with deleveraging is that GDP growth following such a period is significantly stunted. Take away government stimulus (which in the U.S. you can safely say is a done deal after last night's Mass results), and GDP will promptly return to its negative trendline shortly.

Next: a very useful visualization of the relative and absolute composition of debt across different countries. The UK and Japan are in a heap of trouble.Amusingly, Greece is not even on the chart, yet all the focus falls on the small Mediterranean economy. This will soon change.

Japan's domestic reliance on debt funding (93% of total) is well known. Alas, other countries are not so lucky.

Not surprisingly, as financial institution leverage declined, household leverage took its place. Look for all these numbers to revert as saving become a key prerogative.

In America, the bulk of consumer leverage occurred precisely where the pain right now is most acute - middle-income households.

What would any leverage analysis be without at least a mention of the CRE 'pocket of leverage.'

And when discussing sovereign credit bubbles, one must always go to the source: Japan. At 471% total debt (including government, financial, non financial and household) to GDP, Japan is Keynesianism at its worst.Some variation of sovereign default/repudiation in the island country is inevitable.

Yet can America go far before hitting Great Depression economic levels? Oh yes. Government debt is nowhere near where it was during the Second World War as a % of GDP.

Yet the course is pretty much set- as the US attempts to repeat its stunning 100%+ debt/GDP ratio, here is how this would play out for the rest of the economy:

Full McKinsey report can be accessed here.

Guest Post: Government Spending, Bank Lending And Inflation

Guest Post: Government Spending, Bank Lending And Inflation: "

Submitted by Kletus Klump

In his latest weekly commentary, Inflation Myth and Reality, Dr. John Hussman makes the argument that changes-in federal government spending dictate the future path of inflation. As shown below, his data set covers the period from 1951 through 2008 and there appears to be a decent correlation.

Source: Hussman Funds, Inflation Myth and Reality

However, his data set is incomplete in 2 respects: 1. It does not include the Great Depression years and 2. It does not include data on bank lending. The relationship between government spending and future inflation was vastly different during the years of 1932 to 1941. The correlation between the 2 series for this time period is negative 0.25.

The factor causing this is change in mortgage-loan growth. (The mortgage data was sourced from Survey of Current Business, U.S. Commerce Department; National Income Unit, Bureau of Foreign and Domestic Commerce July 1944.)

Why is this important? Post WW2, year-on-year declines in bank lending have been virtually non-existent through 2008. Only 2 negative comparisons, which include 1975, -0.44%, and 1991, -0.09%.

Look at the same chart updated through October 2009. One year of negative loan growth is a far cry from a negative 4-year average but it is worth monitoring.

Draw your own conclusions, but as for me, fears of government-spending-induced extended inflation in terms of time and magnitude are not a concern until the lending mechanism improves.

"

THE RESULT OF THE CREDIT CRISIS – MORE DEBT

THE RESULT OF THE CREDIT CRISIS – MORE DEBT: "

The developed world has quite a mess on its hands now. While we spent billions making the overly powerful and already bloated financial sector fatter and happier, the debt to GDP ratios continued to climb higher across the G-7. Bloomberg reports that the U.S. and U.K. have suffered the largest changes in debt to GDP during the financial crisis:

While Britain’s ratio of debt to GDP has deteriorated the most, it was still the lowest in the G-7 at the end of 2009, the data show. The U.K. started the year at 69 percent, while Japan’s reading was the highest, at 219 percent.

We’ve put ourselves in an unenviable position now. As Ive long said, you can’t solve a debt crisis with more debt. Although Japan currently has the highest debt to GDP ratio the U.S. appears to be well on its way to matching their fiscal catastrophe. When will our policy makers realize – IT’S THE DEBT, STUPID!

"

The Trouble with History

The Trouble with History: "

Good quote from Taleb:

It is particularly shocking that people do what is called “stress tests” by taking the worst possible past deviation as an anchor event to project the worst possible future deviation, not thinking that they would have failed to account for such deviation had they used the same method on the day before that past anchor event. [Emphasis mine]

Too Much Leverage Precedes Many Disasters

Too Much Leverage Precedes Many Disasters: "

There seems to be some confusion over what threatened to cause major banks to fail. Let me go over my list of the risks:

• Many relied on AIG to insure their subprime and other structured lending risks. Note: initially, when an insurer underprices a product dramatically and attracts a lot of business, the sellers of risk chortle, and say, “Sell away to the brain-dead.” After it has gone on for a long time, a sea change hits, where they think — oh no, we’re the patsies — the industry now relies on the solvency of AIG! Alas for risk control, and the illusion of the strength of companies merely because they are big.


• As an aside, though I have defended the rating agencies in the past, please fault the rating agencies for one thing: the idea that large companies are more creditworthy than small ones. Big companies may have more liquidity options, but they also take advantage of cheap financing to bloat in bull markets. When the tide goes out — oh well, GE Capital might not have survived without the TLGP program. Another reason why I sold all my GE Capital debt when I was a bond manager. Big companies can make big mistakes. Instead, I bought the debt of well-run smaller companies with better balance sheets, lower ratings, and more spread.


• Most of the real risks came from badly underwritten home mortgage debt, whether conventional (bye Fannie and Freddie), Alt-A and Jumbo, or subprime. Underwriting standards slipped everywhere.


• Commercial mortgage lending hasn’t yet left its marks — there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.


• In general, banks ran with leverage ratios that were too high. Risk-based capital formulas did not properly account for added risks from: securitized assets, home equity loans, construction loans, overconcentration in a single area of lending, the possibility that the GSEs could fail, etc. Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, etc.


• The high leverage particularly applies to the investment banks, which asked for a change from the SEC and got it in 2004. The only bank to not lever up was Goldman; Morgan Stanley did it only a little bit. Guess who survived?


• The Fed encouraged risk-taking by the banks by not allowing recessions to damage them. They tightened too late, and loosened too early, and that pushed us into a liquidity trap.


• Residential mortgage servicers priced their product in a way that could only work if few borrowers were delinquent.


• Financial insurers took advantage of loose accounting rules, and insured more than they could afford.


• State and local governments came to depend on increased taxes off of inflated asset values.

What I don’t see is problems from private equity or proprietary trading. These were not big problems in the current crisis, but the Obama Administration is focusing on these as if they are the enemy.

Look, my view is that banks should be able to invest in equity-like investments up to the level of their surplus, and no more. By this, I mean real common equity, not hybrid equity-debt financing vehicles.

I believe that bank risk-based capital structures need to be strengthened. I don’t care if it means that lending diminishes for a few years. Far better tht we have a sound lending base than that we head into a Japanese-style liquidity trap, which Dr. Bernanke is sailing us into. (He criticized the Japanese, and he does not see that he is doing the same thing.)

President Obama can demagogue all he wants, and make the banks to be villains. In the long run, what makes economic sense will prevail, not what scores political points.