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EJ
09-15-06, 10:54 AM
Ka-Poom is a Rhyme not a Repeat of History

In a World of Floating Exchange Rates and Fiat Money, What Goes Down, Must Come Up

by Eric Janszen

September 18, 2006

I've been reading Nassim Taleb's <a href="http://www.amazon.com/gp/product/0812975219?ie=UTF8&tag=wwwitulipcom-20&linkCode=as2&camp=1789&creative=9325&creativeASIN=0812975219">Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets</a><img src="http://www.assoc-amazon.com/e/ir?t=wwwitulipcom-20&l=as2&o=1&a=0812975219" width="1" height="1" border="0" alt="" style="border:none !important; margin:0px !important;" />. The book is about the various ways in which we humans insist on seeing patterns and determinism in random events. Taleb is cleverly entertaining as he makes his points. A few chapter headings will give you the idea: "If you're rich, how come you're not so smart?" "Too many millionaires next door." "It is easier to buy and sell than fry an egg." "Loser takes all–the nonlinearities of life." "Gamblers' ticks and pigeons in a box." My favorite, and the one most relevant to our story today, "Randomness, nonsense, and the scientific intellectual."

I recommend the book, in spite of one major flaw. Taleb reminds me of a chiropractor who is not satisfied that his treatments are highly effective for curing back problems and begins to widen their application to include more refutable claims, such as that conditions ranging from the common cold to depression can be treated by his methods as well. Taleb believes, for example, that the success of most CEOs is due to luck. I can say from personal experience that for a CEO to achieve a positive outcome for investors, far too many things can and will go wrong for much if anything to be left to luck.

A CEO may well go into the job on a rising tide–a head start in a fast growing market, a big pipeline of deals and hot new products that were in the works when the previous CEO left, or a generous swell of money from the Fed that lifts the leaky trawlers in his industry along with the racing yachts, or all three, as several lucky CEOs experienced during the dot com bubble. But the final legacy for any CEO under "normal" market conditions–should we ever see them again, uninfluenced as they have been since 1970's by the ebb and flow of bubble and anti-bubble monetary tides–has more to do with rigorous planning and, if not flawless execution, at least execution that's better than the other guy's. Admittedly, in some markets that's a low bar, but most importantly, the rule for CEOs is that they need to make their luck, and in the same way as politicians and central bankers do: by getting out while the going is good and by not rushing in where angels fear to tread.

If a CEO, politician or central banker hangs around long enough, circumstances either of his own making or not will sooner or later overtake him or her. The Genius becomes The Goat. Greenspan left the Fed Chairman job after 18 years to high fives from everyone from Joe Sixpack flipping houses in Orange County to Gastby II running his hedge fund out of Greenwich, Conn. Now that's one smart geezer. With a storm of credit collapse hitting US shores, Ben Bernanke has stepped into the biggest goat job in central banking history. And that ain't luck. Then again, Greenspan took the job just months before the 1987 stock market crash, so maybe the timing rule for politicians and CEOs doesn't apply to central bankers, they have to prove their mettle as high priests of money, and keep the believers believing through the inevitable Next Crisis.

Taleb can be forgiven for this excess–his general thesis is spot on, that much in this world that is attributed to brains and effort is little more than dumb luck. It should be required reading for all mutual, hedge, private equity, and VC fund managers.

Mindful that the positive ratio of my successes to failures at economic and market predictions to date may owe more to luck than to rigorous planning and execution, I torture my readers with constant floggings of the key hypothesis, Ka-Poom Theory, which is the framework for these forecasts. Taleb, if he were reading this, may be happier to call Ka-Poom a "prophecy." (Or maybe not. I wrote to Taleb and asked, "Which, if any, of these sins applies to me: Epistemic libertarian, Narrative discipline, Narrative fallacy, or Ludic fallacy?" He replied, "I visited the site. No sin applies to you!")

Before the latest flogging begins, a brief definition of terms that are often misused in the seemingly endless debate of post credit bubble "flations"–inflation, deflation and disinflation.

Deflation: Negative rate of inflation, e.g., "CPI inflation averaged -1.3% in 2007."

Disinflation: Declining rate of inflation, e.g., "CPI inflation declined to 2.1% in Q4 2007 from 2.5% in Q3 2007."

Inflation: To an economist, an increase in the general or "all goods" price level resulting from an oversupply of money; to a government statistician, a political football thrown onto the field as producer and consumer price indexes, continuously reformulated and subject to interpretations invented to suit various constituencies over time, such as under-reporting home price inflation via an equivalent rent formula when home prices are rising and rents are falling, in order to hide the fact of a housing bubble that is needed to keep the economy from falling into recession; to the person on the street, rapidly rising prices of non-traded goods and services, especially insurance, education, and health care, resulting from an excess of cheap credit and the inappropriate use of credit to purchase depreciating assets.

The "Ka" in Ka-Poom refers to a period of disinflation while the "Poom" refers to a period of rapid inflation.

Ka-Poom assumes that the Fed is not kidding when it says it will fight deflation as seriously next time around as the last time it encountered the threat. During the previous "Ka" disinflation, the US economy experienced actual deflation, albeit very brief; CPI averaged -3.3% for the single month of October 2001. You don't see it in Koeing's "Whither the US Economy?" chart below because his chart shows average quarterly inflation, and in the fourth quarter of 2001 CPI inflation was positive–barely. CPI inflation during 2001 averaged a mere 1.6%. Extending the metaphor I used in last week's weekly commentary, "No Deflation! Disinflation followed by lots of inflation (http://www.itulip.com/forums/showthread.php?t=417)" the economic airplane did bounce off the ground very briefly before heading back into the sky. Had the plane not been moving fast enough, because the Fed had not aggressively cut interest rates and fueled the system with enough money, it would have stayed on the ground as happened in Japan in the early 1990s. It took the BoJ and policy makers nearly 15 years to get their economic airplane back in the air.

In November 2002, Fed Governor Ben Bernanke, then gunning for the Fed Chairman goat job, made his famous speech on deflation (http://www.federalreserve.gov/boardDocs/speeches/2002/20021121/default.htm) that earned him the nickname "Helicopter Ben" in market bear circles. The speech was intended to supply a context for future Fed actions–his. At the time he made it, the deflation scare was already behind us. But the specter of deflation, in light of all the new leveraged asset bubbles forming, in everything from real estate to private equity, was certainly going to be on the bond market's collective mind in the future.

The Fed's public talk of deflation in the context of any specific financial markets crisis that threatens to spill over into the so-called "real economy," such as the collapse of the stock market bubble in 2000, is intended to explain to the bond market why the Fed is about to dramatically drop interest rates and open the floodgates. If the Fed did so without first talking about deflation, the bond market is left to wonder whether the Fed has some other intention besides economic rescue, or, conversely, is not on top of the problem. In the context of a market "event," the bond market must believe that inflation is falling and in danger of declining into negative territory, so that bond traders accept higher bond prices and allow long term interest rates to fall in line behind the Fed as it cuts rates, else a deflation may become self-fulfilling.

The Fed is never talking to you or me, nor to players in the puny little stock market that has a capitalization that is a fraction of the bond market's. When the Fed talks, it's talking to bond traders. Next time you hear Ben talk about deflation after a financial markets "event," you can be certain that the money drop is already in progress, and that the Fed has reflation Plans B, C, D, and E in case the Plan A doesn't work.

"You gotta believe!" the Preacher said

In addition to luck, "belief" makes a larger contribution to market outcomes than is generally assumed. There is an excellent piece on deflation by Adam Posen, "What Japanese deflation did and did not do (pdf) (http://www.international-economy.com/TIE_W06_Posen.pdf)," where he argues convincingly how much speech and action by the Fed on inflation targeting and deflation fighting contribute to the non-deflationary outcome. This Fed has been quite vocal on both inflation targeting and deflation fighting.

A reader of my last piece on this topic, skeptical that the Fed can win the next battle with deflation, made the excellent point that debt was not a major factor in the dot com bubble, thus the Fed was fighting mere negative wealth effects. In the case of the collapsing housing and hedge fund bubbles, the Fed will be battling both negative wealth effects and the potential bankruptcy of millions of households that took out suicide loans (options ARMs), liar loans (the banker encouraged the borrower to lie about their income), and deathbed loans (negative amortization loans). These comprise fully 36% of all mortgages in CA, according to a September 11 article by Business Week Nightmare Mortgages (http://www.businessweek.com/magazine/content/06_37/b4000001.htm?campaign_id=nws_insdr_sep1&link_position=link1). The Fed will also be dealing with the potential insolvency of the banks that made these loans. The reader also pointed out that the dot com bubble collapsed rapidly while the housing bubble will collapse slowly.

I agree wholeheartedly on both points. Housing Bubbles Unlike Stock Bubbles (http://www.itulip.com/forums/../housingnotlikeequities.htm) made the point in Jan. 2004 that housing bubbles end by seizing up and decline slowly over five to seven years, or longer (http://www.itulip.com/housingbubblecorrection.htm). As for household bankruptcy and bank insolvency, the difference between healthy and unhealthy deflation is that the latter is associated with a dysfunctional banking system and the former is not. Whether the deflation egg makes the banking system dysfunction chicken or the other way around is endlessly debated by economics historians. As far as the Fed's concerned, rather than try to get the economy out of the egg-chicken deflation cycle, best to keep one from starting in the first place. As a matter of policy, the Fed clearly believes that deflation cannot be healthy and can lead to banking system dysfunction, which can lead to further deflation, and so on, so don't let the process start in the first place.

To give you an idea how serious the Fed is about staying on top of deflation, I'll point to two papers issued since 2002. The first predates Ben's November 2002 speech by a few months. It makes essentially the same point as Ben's speech: when staring down the hole of deflation the Fed needs to get creative and aggressive.

Board of Governors of the Federal Reserve System
International Finance Discussion Papers – Number 729 – June 2002
Preventing Deflation: Lessons from Japan’s Experience in the 1990s (pdf) (http://www.federalreserve.gov/pubs/ifdp/2002/729/ifdp729.pdf)

"Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan’s experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus–both monetary and fiscal–should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.
The second comes from Evan F. Koenig, Vice President (http://www.dallasfed.org/research/indepth/2003/id0304.pdf) (pdf), Senior Economist, Federal Reserve Bank of Dallas, May 2003, where Bernanke's helicopter speech is colorfully embellished, complete with a picture of an actual helicopter.


http://www.itulip.com/forums/../images/USdeflation.png

Don't let this happen




http://www.itulip.com/forums/../images/Japandeflation.png

Or this




http://www.itulip.com/forums/../images/USnodeflation.png

Do use all means to keep inflation above the zero bound, like this




http://www.itulip.com/forums/../images/moneydrop.png

Drop tons of money if needed




http://www.itulip.com/forums/../images/feasibleinstruments.png

If necessary to drop tons of money, change the rules to reclassify
previously restricted instruments as unrestricted so that the Fed can
print money and buy them



Given the level of commitment by this Fed to change whatever existing rules need to be changed to keep inflation above zero in the face of deflation, that leaves us with the question: Will it work?

Ka-Poom Theory is a hypothesis that not only will stimulus "both monetary and fiscal–beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity" succeed in preventing deflation, these unconventional means will work too well. The main reason is that during the deflationary depresssion in the US in the 1930s and the deflationary recession in Japan in the 1990s, both countries were net creditors whereas today the US is a net debtor. The Fed now needs to be mindful that there are trillions of dollars held overseas by creditors who will want to see the US take some of the same medicine the IMF demands be taken by debtor countries that are using freshly money borrowed from other countries to restructure after blowing the last money they'd borrowed: fiscal discipline in the form of higher taxes and spending cuts. Indeed the Fed proposes the opposite policy strategy for the next round of post-bubble deflation fighting–even further cuts in taxes, even more government spending and all manner of new kinds of printing to pay for it all. If the Fed intends to "go it alone," then these creditors will worry that the US intends to pay them back on the cheap (http://www.itulip.com/bankrupt.htm). If you were in their shoes, what would you do?

In other words, I don't think these laxatives can cure the next post-bubble economic constipation without causing severe monetary diarrhea.

"History does not repeat itself, but it rhymes." - Mark Twain

Sharp eyed iTulip forum member Jim Nickerson (http://www.itulip.com/forums/member.php?u=109) noticed something in the graph titled "Worse-case scenario: Great Depression" above, a distinctly "Ka-Poom" like event that happened between 1928 and 1933. Jim is the first person to ever note the source of the original source of my Ka-Poom idea.


http://www.itulip.com/images/USkapoom1.png



Ka-Poom happened before and it will likely happen again,
and for similar reasons, but in not quite the same way



http://www.itulip.com/images/KaPoom2006Q.gif


The differences between our circumstances today and the 1930s are many, which is why Ka-Poom is a rhyme not a repeat of history.

First, what are the similarities? Ka-Poom Theory says that three primary antecedents for a massive deflationary impulse are the same now as in the 1930's followed by a major inflation.

First, historically high total credit market debt-to-GDP levels.


http://www.kwaves.com/debt_gdp.gif
Source: Gabelli Mathers Fund


Second, extremes of income and wealth distribution.


http://www.cobraf.com/ForumF/immagini/R_66748_1.jpg

Peaks of income inequality


http://www.itulip.com/images/wealthdistribution.png
Peaks of wealth inequality



There are three important differences between the 1930s post credit bubble period and today's.

First, going into the 1930s crisis, the US was a net creditor to the world. When borrowers, especially the UK, defaulted, this made matters much worse for the US from a reflation standpoint. Creating inflation is generally more difficult for creditor nations because the nation's currency tends to appreciate during periods of credit contraction, as occurred in the US in the 1930s and in Japan in the 1990s.

Second, the US dollar operated on a gold standard. The spike of inflation that can be seen in 1932 was accomplished as follows. On April 5, 1933, President Franklin Delano Roosevelt issued Presidential Executive Order 6102 (http://www.the-privateer.com/1933-gold-confiscation.html) calling in gold owned for the purpose of "hoarding." However, long before that order was in place, most wealthy holders of gold had already turned in their gold to the government voluntarily. Private citizens were paid for the gold in dollars at a going rate of $20.67 per ounce. The Treasury then reset the price of gold to $35 per ounce, thus devaluing the dollar and boosting the gold-backed dollar money supply, resulting in the near instantaneous 25% inflation spike that you see in the chart.

Third, the US is in its sixth year of economic "recovery" since the post 2000 stock market crash, yet unlike the 1920s boom period, this recovery has created very few jobs. As a result, unemployment and underemployment are both high, and far higher than is reported.

http://www.itulip.com/images/payrollemployment2006.png
Source: Northern Trust


The implications of the private and public debt overhang are obvious, and why the Fed and the IMF are constantly fretting about deflation. The US now requires $4.50 of new debt creation for every dollar of GDP versus $2 in 1975. It is hard to accept the argument that the US economy can grow its way out of a debt that it has amassed over 25 years as the US economy requires increasingly more debt as a percentage of GDP just to maintain current growth rates.


http://mwhodges.home.att.net/nat-debt/natdebt-vs-natincome.gif

$2 total debt per $1 GDP in 1977
$4.5 total debt per $1 GDP 2005


The implications of poor distribution of wealth are less obvious. What happened in the 1930s will likely happen again. In a recession, a small minority of the nation's population that garners most of the income and holds most of the nation's wealth and assets cannot generate enough demand to re-employ the majority. As the credit bubble winds down, the US government will find itself with a politically similar challenge as in the 1930s: How to get the wealth spread around and the economy going again? But inflation is much easier to create today without the constraints of the gold standard. Stubborn adherence to the gold standard was in fact blamed for much of the pain, and The Great Depression could have been avoided if only the Fed had been free to print money and buy stuff, just as they are today.

Conclusion

The economic, monetary, financial market, and political antecedents are all in place for a Ka-Poom event. As I mentioned last week, the disinflationary part of the event appears to have started, but no one can say how far it will go before policy makers reverse course, making the transition difficult to time and trade.

Ka-Poom Theory provides a framework for a long term forecast. In the short term, Taleb's points about randomness apply. We'll keep an eye on the markets and economy and discuss Ka-Poom events here as they unfold.

If you'd like to know what to do about Ka-Poom, I recommend you buy America's Bubble Economy (http://www.amazon.com/exec/obidos/redirect?link_code=as2&path=ASIN/047175367X&tag=wwwitulipcom-20&camp=1789&creative=9325): Profit When It Pops (http://www.amazon.com/exec/obidos/redirect?link_code=as2&path=ASIN/047175367X&tag=wwwitulipcom-20&camp=1789&creative=9325) for specific advice.

As for a short term forecast, I defer to Doris Day, whose classic song about forecasting is lip synched (sort of) below.


crazylittleblonde
Qué Será, Será (http://www.youtube.com/watch?v=1yLdcArry8s)



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PeterM
09-18-06, 08:39 PM
Thanks for clarifying it again.
Do I read you correctly that you are shortening the 'inflation box', and move the second 'disflation-Ka box' to the arrow?

http://www.itulip.com/images/KaPoom2006Q.gif

I tend to agree with you that the politicians worldwide will try to inflate their way out of their debt. But I still wonder about the role of the FED and their willingness to go for that end-game. Deflation and problems at non-FED banks may create some nice 'opportunities' to consolidate the financial service sector in the hands of a few member-banks.

The consequenses for the happy few might even be beneficial. Even if the top .1% would loose money in nominal terms, it wold not matter to them if through decreased asset values their spending power would enable them to get 90% of the wealth. I don't want to get in the conspiracy theories here but I always wonder 'who benefits' and 'who has the means' to realign the circumstances so they get what they want. Not that everything is orchestrated but a pack of greedy individuals and political enablers can make a big mess. The quality of life of the masses is not always their top priority.

But I agree, ... if the future rhymes with the past decades we must expect massive liquidity and inflation. Where does that lead us?
Do you have any ideas about the level of inflation and if it will result in hyperinflation? e.g. Weimar style.
Did a high inflation ever had a good outcome .... that is ... debt inflated away and slow contraction to normality. Or will the big boom be followed by an even nastier Ka?

Another point I can't get my mind around how it would work out with the lender countries. I live in Holland and from my perspective we too have an official low CPI, with stagnent wages and a central bank creating 9% money out of nothing. I think I read China is pumping double that, India too. So what if every central bank pumps the money supply and we all race to devalue our currency?

Is it possible to inflate your debt away if the lender devalues at the same rate?

jk
09-18-06, 10:32 PM
The Fed now needs to be mindful that there are trillions of dollars held overseas by creditors who will want to see the US take some of the same medicine the IMF demands be taken by debtor countries that are using freshly money borrowed from other countries to restructure after blowing the last money they'd borrowed: fiscal discipline in the form of higher taxes and spending cuts. Indeed the Fed proposes the opposite policy strategy for the next round of post-bubble deflation fighting–even further cuts in taxes, even more government spending and all manner of new kinds of printing to pay for it all. If the Fed intends to "go it alone," then these creditors will worry that the US intends to pay them back on the cheap (http://www.itulip.com/forums/../bankrupt.htm). If you were in their shoes, what would you do?
well, what WOULD you do? or is it: what would YOU do?

the ka-poom model is illuminating, but its light doesn't shine much beyond u.s. shores. in this ever more globalized world, we need a model that embeds a u.s. ka-poom in the global economy. one model is the schiff scenario, discussed in a couple of threads under "general discussion." the schiff scenario hinges on a sharp devaluation of the dollar.

the big background question is whether the u.s. follows a japanese path, or an argentine one. i'm reminded of an interview with an argentine economist or finance ministry official, who was asked what happened to all the dollars that were lent to argentina. why couldn't argentina pay its debts? where did the money go? "we enjoyed it very much," was the reply.

the hitch in the argentine metaphor has been the fact that the u.s. dollar is the international reserve currency. we borrow in our own currency, so we can print it. argentina enjoyed the money very much, but it didn't have that ultimate luxury - being able to print its payments.


Another point I can't get my mind around how it would work out with the lender countries. I live in Holland and from my perspective we too have an official low CPI, with stagnent wages and a central bank creating 9% money out of nothing. I think I read China is pumping double that, India too. So what if every central bank pumps the money supply and we all race to devalue our currency?
the schiff scenario posits that the dollar drops significantly against the yuan and other asian currencies. the reduction of u.s. demand during a u.s. slowdown/recession, coupled with current levels of global supplies, allows the chinese, to pick a non-random example, to see that their savings and incomes can suddenly buy a great deal. They can afford much improved lifestyles. The global economy chugs along with americans consuming relatively less and asians, in particular, consuming relatively more than has been the case to date.

So the schiff scenario depends upon the pboc allowing the dollar to drop faster than the yuan. This in turn would depend on the level of confidence among chinese leadership that the chinese domestic economy is strong enough to get through significant shrinkage of the u.s. export market. But chinese malinvestment in state owned enterprises and redundant export production capacity makes the chinese economy vulnerable.

It’s hard for me to see the chinese allowing the dollar to drop sharply against the yuan within the next few weeks or months. Several years from now it might be conceivable. I think these processes will take a long time to play out.

Another question, though, is whether the pboc will have a choice in the matter of the yuan-dollar exchange rate. If the u.s. consumer is tapped out because of high debt levels and the end of the housing bubble, then there IS no u.s. export market for the chinese to sell to. there is no more attraction to accumulating dollars or dollar assets, and the dollar assets they hold will be diminishing in value. getting back to what would I do if i were a foreign holder of american bonds/dollars - i'd spend every american cent i had buying assets and capital goods, as quickly as i could.

so maybe it won't take such a long time to play out, after all.

EJ
09-18-06, 11:15 PM
well, what WOULD you do? or is it: what would YOU do?

Refer to the original Ka-Poom circa 1999:


Original 1999 Ka-Poom Theory


National currencies are primarily valued by the relative economic strength of trading partners with floating currencies, except for the U.S. dollar.
A major component of dollar strength is the unique demand for dollars due to the dollar's reserve currency status.
Dollar demand and thus price is supported by all nations trading with the U.S. and among each other as all need dollars for international exchange, especially for oil.
If dollar reserve currency status declines, either gradually via euro diversification or suddenly due to an event that causes a loss in confidence in the future purchasing power of the dollar, dollar demand and value declines in kind.
U.S. interest rates are low mostly due to demand for U.S. debt from foreign central banks of nations, especially Asian, that seek to keep U.S. consumers borrowing at low interest rates to purchase their exports using strong dollars, e.g., Asian "vendor financing."
Ka: A random exogenous event (e.g., a stock market crash predicted in 1999 for year 2000 and recession predicted for 2001) intensifies disinflation created by Asian vendor financing, causing the Fed to shift from bubble fighting to anti-deflation polices.

Fed responds with an excessive cheap money policy, targeting Fed funds rate below the inflation rate.
The Fed keeps interest rates too low for too long, creating a new asset bubble. But in what? We did not know in 1999. The answer: real estate and other credit sensitive assets.
Poom: A random or not so random (http://www.middleeastforex.com/index.php?section=215) exogenous event that has not yet happened (the stock market crash we predicted for 2000 did not have the impact we expected but a collapsing housing bubble may do it) exposes the true level of risk to lenders that is inherent in this unbalanced system, causing lenders to loose confidence in the future purchasing power of the dollar and seek alternative reserve assets.

Interest rates and inflation rise rapidly as dollar demand and value falls, import prices rise, and the Fed moves to raise rates to stem the tide or dollar repatriation.
The first foreign central banks to move will be those with the least exposure to losses in national income from sales of exports to the U.S. or depreciation in the value of the dollars they are holding as reserve assets (e.g., France).http://www.itulip.com/retrospective2006.htm

EJ
09-19-06, 12:13 AM
Thanks for clarifying it again.
Do I read you correctly that you are shortening the 'inflation box', and move the second 'disflation-Ka box' to the arrow?

http://www.itulip.com/images/KaPoom2006Q.gif


In my previous commentary I concluded that Ka-Poom is not tradable. It may be too short. In fact, the disinflation may have even already come and gone. I only know how to confirm the begining of the Poom, not the end of the Ka.


I tend to agree with you that the politicians worldwide will try to inflate their way out of their debt. But I still wonder about the role of the FED and their willingness to go for that end-game. Deflation and problems at non-FED banks may create some nice 'opportunities' to consolidate the financial service sector in the hands of a few member-banks.

The consequenses for the happy few might even be beneficial. Even if the top .1% would loose money in nominal terms, it wold not matter to them if through decreased asset values their spending power would enable them to get 90% of the wealth. I don't want to get in the conspiracy theories here but I always wonder 'who benefits' and 'who has the means' to realign the circumstances so they get what they want. Not that everything is orchestrated but a pack of greedy individuals and political enablers can make a big mess. The quality of life of the masses is not always their top priority.

But I agree, ... if the future rhymes with the past decades we must expect massive liquidity and inflation. Where does that lead us?
Do you have any ideas about the level of inflation and if it will result in hyperinflation? e.g. Weimar style.
Did a high inflation ever had a good outcome .... that is ... debt inflated away and slow contraction to normality. Or will the big boom be followed by an even nastier Ka?

Another point I can't get my mind around how it would work out with the lender countries. I live in Holland and from my perspective we too have an official low CPI, with stagnent wages and a central bank creating 9% money out of nothing. I think I read China is pumping double that, India too. So what if every central bank pumps the money supply and we all race to devalue our currency?

Is it possible to inflate your debt away if the lender devalues at the same rate?
If you were an American traveling overseas, who did so every year since 2001, what is happening is obvious. You only need to go as far as Canada where the US and Canadian dollar are close to parity, or Mexico, now no longer a cheap vacation destination for US travelers.

The US economy is supposed to have restructured around the depreciated dollar by now, with a significant increase in exports. They have increased by only 20% 2001 - 2005, from US$729B to $904B...

US Exports (http://www.census.gov/foreign-trade/statistics/product/enduse/exports/c0000.html)

...while the dollar depreciated 25% against a basket of currencies and NIIP increased 38% (http://bea.gov/bea/newsrel/iip_glance.htm) from negative $6.2T to negative $10T.

The US increasingly relies on sales of capital goods to fund cash flow. But the cheap dollar has its upside.... it's pleasant to see Mexican, Canadian, European and Asian travelers in NYC and other places again.

As I have pointed out before, central banks are run by people. A hyperinflation is the end result of a series of previous bad decisions dating back many years. The analogy is a company, like Ford, that has failed to invest enough in R&D or in the right kind of R&D (USA, Inc. is strong on Marketing and Sales) and finds itself stuffing the sales channel one quarter to buy time to figure out how to either increase end user sales or borrow more money to make payroll, except payroll in the case of a government is owed to the voters who keep the government in office. That's how a hyperinflation starts. One bad quarter leads to another, and if the country has as much debt as the US has, things can turn ugly very quickly and little warning.

''How did you go bankrupt?"
''Two Ways. Gradually, and then suddenly."
Ernest Hemingway, The Sun Also Rises

Here is a well stated counter-argument. (http://www.foreignaffairs.org/20050301facomment84201/david-h-levey-stuart-s-brown/the-overstretch-myth.html)

sparki
09-19-06, 09:54 AM
hello from germany,

i would just say "thank you" for all the fantastic posts.

i really enjoy reading the site and all the profound comments.

jan-martin aka sparki

http://immobilienblasen.blogspot.com/

BK
09-19-06, 10:12 AM
I read the book and enjoyed it - The most valuable take-away is the reminder that volatility is a part of life (and financial markets) - reminds you to be suspect of stocks the increase in straight line linear fashion - perhaps its a great investment or perhaps earnings and numbers are being managed.

Too often the US CEO must focus on straight line linear result to please the financial market mavens - no matter what the long term cost. Sometimes the best long term investments have lots of volatility and you need to be able to ride out the troughs.

jk
09-19-06, 10:41 AM
my take-away from "fooled by randomness" was that unusual events, "black swans" you can't even conceive of until you see them, happen far more often than expected. fat tail events happen.

PeterM
09-19-06, 01:29 PM
Thank EJ,



If you were an American traveling overseas, who did so every year since 2001, what is happening is obvious. You only need to go as far as Canada where the US and Canadian dollar are close to parity, or Mexico, now no longer a cheap vacation destination for US travelers.

The dollar has dropped, but was that not mainly against economies that were propped up by resource exports? I don't know too much about Mexico but I am curious how the Mexican economy will fare if the oil output of that Canterell field is about to drop as some report.



As I have pointed out before, central banks are run by people. A hyperinflation is the end result of a series of previous bad decisions dating back many years. The analogy is a company, like Ford, that has failed to invest enough in R&D or in the right kind of R&D (USA, Inc. is strong on Marketing and Sales) and finds itself stuffing the sales channel one quarter to buy time to figure out how to either increase end user sales or borrow more money to make payroll, except payroll in the case of a government is owed to the voters who keep the government in office. That's how a hyperinflation starts. One bad quarter leads to another, and if the country has as much debt as the US has, things can turn ugly very quickly and little warning.

I had to laugh about that one as former manager of the Eu Process R&D of a large US multi-national. Exactly. Even if companies try to beef up innovation, the short term and finance/sales remains top priority. Setting strategy and taking decisions is done by people driven by their personal career and finance interests and contained by their knowledge and imagination. That includes culling R&D as cost now to secure bonuses of tomorrow. The mentality of people, and especially that of your ‘Jocks’, is the same throughout every human activity, being industry, banking or government.



well stated counter-argument. (http://www.foreignaffairs.org/20050301facomment84201/david-h-levey-stuart-s-brown/the-overstretch-myth.html)
Thanks for the link, I read it twice with a coffee-break to ponder. Their arguments fail to convince me, mostly because I don't agree with a central premise of their reasoning. They see a lasting hegemony of the US as knowledge exporter, I don't.

That premise can be found at several placed in their piece, e.g.
Despite the persistence and pervasiveness of this doomsday prophecy, U.S. hegemony is in reality solidly grounded: it rests on an economy that is continually extending its lead in the innovation and application of new technology, ensuring its continued appeal for foreign central banks and private investors.,
There are key differences, however, between those emerging-market cases and the current condition of the global hegemon. The United States' external liabilities are denominated in its own currency, which remains the global monetary standard, and its economy remains on the frontier of global technological innovation, attracting foreign capital as well as immigrant labor with its rapid growth and the high returns it generates for investors, and
The United States--thanks to its openness, its low regulatory burden, its flexible labor and capital markets, a positive environment for new business formation, and a financial market that supports new technology--has dominated every phase of this technological wave. The spread of the IT revolution to additional sectors and new industries thus makes a revival of U.S.-bound private capital flows likely.

I hear the same argument in the Eu. We 'the smart' innovate and export out knowledge. They 'the cheap workers abroad' will make the stuff. May be true 20 years ago, but nowadays India and China produce vast volumes of high quality engineers. Just compare the quality of import cars. Do you still feel the US cars have a technological edge?
Furthermore and IMHO (don't want to offend anybody) part of the innovation in the US did and still rests on imported brains. You have brilliant ‘native’ Americans, but I was always impressed by the large percentage of highly qualified immigrants I found in R&D areas.

I expect the continuation of several developments that will decrease the 'innovation advantage' of the developed industrial world. First the living standard in emerging countries will rise, so there is less incentive for the best and brightest to move to the US. Secondly the amount of well trained people in the emerging countries will eclipse the output in the US. Thirdly, IMHO the desire of the 'average youth’ to get educated in the developed world is less than the urge of the youth who is fighting to improve him/herself in the developing counties. And fourth IMO the quality and resources spend on education in the West is less than desirable.
I don't know when this will influence economic balances, developments often take much longer that I expected.

Unfortunately only a fraction of the population has the education and intellect to be competitive on the international knowledge based market that some promote. I am not trying to be elitarian here nor judgmental, I would rather not have it that way, but I see it as an unavoidable result of earlier choices. Without trade barriers and with international wage arbitration I see a future where a small ‘intellect geek’ and ‘intellect jock’ group will have good jobs, another group that caters (housing, health, etc.) for this group, and imports of everything that can be produced cheaply abroad. The result being a smaller middle class, and many that will fall back in life style. I cannot see how such a smaller ‘knowledge based’ group can function as the consumption engine of the world.

Then to go back to the thesis of Levey and Brown: I fail to grasp how they see a total broad US economy that remains on the frontier of global technological innovation. Even IF a smaller group is able to remain on the frontier, and is not overrun by the shear volume of well trained equally brilliant Chinese, what does the larger mass do? They had good manufacturing jobs but these jobs are gone. What is the US going to export to fund the flat screens and SUVs? How is the US going to pay for the oil and energy required to sustain current lifestyles?

Still Levey and Brown think that foreigners will pour their savings glut into the US as the US has a lasting innovation based economy combined with deep, liquid, safe and well regulated financial markets.

The U.S. dollar will remain dominant in global trade, payments, and capital flows, based as it is in a country with safe, well-regulated financial markets. Provided U.S. firms maintain their entrepreneurial edge--and despite much anxiety, there is little reason to expect otherwise--global asset managers will continue to want to hold portfolios rich in U.S. corporate stocks and bonds.

I agree that everything is relative but to call the financial markets safe and well regulated? Does this include the perceived safety net of derivatives???

And then this:
The fear is that a sudden reluctance by foreigners to continue exporting their excess savings to the United States would choke off the investment needed to sustain economic growth, sending the U.S. economy into crisis.
This explanation becomes less alarming, however, when you consider that both savings and investment are seriously undervalued in U.S. economic accounts. Capital gains on equities, 401(k) plans, and home values are excluded from measurements of personal saving; when they are added, total U.S. domestic saving is around 20 percent of GDP--about the same rate as in other developed economies. The national account also excludes "intangible" investment: spending on knowledge-creating activities such as on-the-job training, new-product development and testing, design and blueprint experimentation, and managerial time spent on workplace organization. Economists at the National Bureau of Economic Research estimate that intangible investment grew rapidly during the 1990s and is now at least as large as physical investment in plant and equipment: more than $1 trillion per year, or 10 percent of GDP. Consequently, the size and growth rate of the U.S. economy have been seriously underestimated. In fact, when tangible and intangible investment are both counted, the apparent (and much decried) increase in consumer spending as a share of GDP turns out to be a statistical artifact.

Two notes here. Do they mean that capital gains on stocks and home values should be counted as savings? (I would not agree on that). Or do they make the point that other countries do that, so to make a correct comparison you should add it? Then I would like to see a table as some specific comparisons.
The second note is about the whole concept of ‘intangibles’. Always good for endless discussions in M&A proceedings. I have trouble to believe that this research and knowledge investment suddenly grew so much in the 1990s (outside may be the IT). But then, what was the proven true value of those investments over the years and how much should be considered just costs?
I see the intangible stories more as an attempt to further beef up the perceived value of a company, and increase the value of option portfolios, fees of consultants and bankers in the M&A activities. It is a ‘dark matter’ that is quite hard to define/valuate and it can evaporate quickly. What is the value of those patent portfolios, apart from being a cost in lawyers and litigation? What is the value of a pilot plant built for a process that was abandoned?
But I have even more doubt to see an underestimation of ‘dark matter intangible investments’ as reason to define the increase in consumer spending as share of GDP as a ‘statistical artifact’. I would really like to see their statistical model of the data analysis and the p-values.

Throughout their editorial I sense a use of words designed to appease the reader, the use of terms like ‘statistical’ to convey a sense of trust and validity (that is not there IMHO), and a use of statements that are often not backed by data or references.
The rebuttal a month later by Setser and Roubini is interesting but focuses on account balances, action and reactions of the lenders, the mutual enjoyable consumer / lender dependency, etc.. Unfortunately it does not address the underlying assumptions and underpinning in the thesis of Levey and Brown (continuing innovative quality of the US economy and deep well regulated financial markets, which make the US a most desirable place to invest and preferred recipient for the global savings glut).

I do think the US has a proven track record of being resilient and innovative, and part of the US society will prosper in the future. However I don’t think the leadership of the last decades will last, and I do think a smaller part of the US society will remain middle class. Therefore I really doubt if the US consumption will be sustainable and I don't expect that the savings glut will keep flowing to the US.

Jim Nickerson
09-19-06, 02:03 PM
Thanks for your comments, Peter. I think it is great to gain some insights from those of you outside the U.S. Keep contributing.

jk
09-19-06, 02:12 PM
I do think the US has a proven track record of being resilient and innovative, and part of the US society will prosper in the future. However I don’t think the leadership of the last decades will last, and I do think a smaller part of the US society will remain middle class. Therefore I really doubt if the US consumption will be sustainable and I don't expect that the savings glut will keep flowing to the US.
once i saw the reference in levey and brown to the great national savings embedded in higher house prices, i rolled my eyes and stopped reading. i don't understand how anyone called an economist can look at rising asset prices as "wealth creation" - the usual description for this nonsense. where are the new factories and laboratories? those create wealth. the u.s. has long invested too much capital in its housing stock, and while mae west said "too much of a good thing can be wonderful," i don't think our recent housing binge will work out that way.

the nightmare scenario that levey and brown analyze, foreign holders of dollar assets, especially foreign cb's, suddenly deciding that dollars are anathema, never seemed quite plausible. why, for example, would china want to shoot itself in the factories by making it harder to export to the u.s.? however, if the u.s. goes into a housing led recession, with consumption much reduced, then the chinese no longer have to worry about losing the u.s. consumption market -- it will already be gone.

Finster
09-20-06, 02:32 PM
once i saw the reference in levey and brown to the great national savings embedded in higher house prices, i rolled my eyes and stopped reading. i don't understand how anyone called an economist can look at rising asset prices as "wealth creation" - the usual description for this nonsense. where are the new factories and laboratories? those create wealth. the u.s. has long invested too much capital in its housing stock, and while mae west said "too much of a good thing can be wonderful," i don't think our recent housing binge will work out that way.

Here here! Rising asset prices are usually the canaries in the inflation mine. Wealth, on the other hand, is productive capacity. Inflation does not lead to higher standards of living, wealth does.

akrowne
09-21-06, 08:28 PM
Great post.

Some musings of mine on what form the reflation might take, and whether its possible to pull it off in a way that saves face:

http://www.autodogmatic.com/index.php/sst/2006/09/16/what_kind_of_inflation

As you said, the challenge is to "spread the wealth around" while still getting business off the ground again. I don't think they really know how to "create" this situation, especially after just giving money to the already-rich has been tried. What is needed is some grassroots capitalism; but central planners don't understand grassroots anything.

aD Neal
09-22-06, 07:14 AM
What is needed is some grassroots capitalism; but central planners don't understand grassroots anything.

It's no coincidence that "Central" planning and "grassroots" efforts are practically antonyms.

c1ue
01-22-07, 12:05 PM
Mr. Janszen, other readers of this thread,

I was wondering how instructive would be the yen denominated gold behavior was during the Japan bubble era as well as the immediate aftermath.

I ask because while the interest rate policy in Japan would seem to be an attempt to 'mildly' inflate out of their predicament and would thus not hold exact parallels to our present US situation, but a behavior similarity could be useful given the likely inflationary scenario out of the present credit vicious cycle.

As such, I created a table based on the 'average' price of gold (also max/min) during a given year vs. the 'average' yen/$ price. For the heck of it I also inserted high/low gold vs. high/low yen but this is not so useful as the relative dates are likely different.

Source data was http://www.finfacts.ie/Private/curency/goldmarketprice.htm for gold/$ and http://www.boj.or.jp/en/type/stat/dlong/fin_stat/rate/cdab0780.csv for yen/$

http://www2.snapfish.com/slideshow/AlbumID=144263573/PictureID=2924528526/a=86568889_86568889/t_=86568889

The graph does not show a major gold spike - but it does show a very consistent trend of yen strengthening vs. gold.

I would like to hear opinions of this.

(Sorry for the junk around the picture - I don't have a personal web site for posting photos so I chose this one as the first to pop up on Google!)

EJ
01-23-07, 10:08 AM
Mr. Janszen, other readers of this thread,

I was wondering how instructive would be the yen denominated gold behavior was during the Japan bubble era as well as the immediate aftermath.

I ask because while the interest rate policy in Japan would seem to be an attempt to 'mildly' inflate out of their predicament and would thus not hold exact parallels to our present US situation, but a behavior similarity could be useful given the likely inflationary scenario out of the present credit vicious cycle.

As such, I created a table based on the 'average' price of gold (also max/min) during a given year vs. the 'average' yen/$ price. For the heck of it I also inserted high/low gold vs. high/low yen but this is not so useful as the relative dates are likely different.

Source data was http://www.finfacts.ie/Private/curency/goldmarketprice.htm for gold/$ and http://www.boj.or.jp/en/type/stat/dlong/fin_stat/rate/cdab0780.csv for yen/$

http://www2.snapfish.com/slideshow/AlbumID=144263573/PictureID=2924528526/a=86568889_86568889/t_=86568889

The graph does not show a major gold spike - but it does show a very consistent trend of yen strengthening vs. gold.

I would like to hear opinions of this.

(Sorry for the junk around the picture - I don't have a personal web site for posting photos so I chose this one as the first to pop up on Google!)
Your graph is hard to see, but I think I get the idea. Japan is not an appropriate comparison for two reasons:
1) The Bank of Japan made the mistake of allowing inflation to fall below 0%, as the Fed did in 1930. The Fed did not make the same error in 2001 and won't again; the Fed has explicitly stated its intention to monetize everything in sight, if necessary, to prevent that from occurring. There is some debate on whether buying mortgages, stocks, and so on, will effectively stop deflation. My position is that it is as likely to work too well as not work at all, resulting in a loss of confidence in the currency and a hyperinflation.
2) Japan was running a current account surplus before their stock and real estate bubbles collapsed, much as the US did in the 1920s. When the domestic debt market contracts, countries that run a current account surplus encounter deflationary currency appreciation versus countries like the UK in the 1930s and the US since the 1980s which have been running current account deficits and are instead vulnerable to inflationary currency depreciation.

FRED
02-26-07, 10:47 PM
This just in...

Gov. auditor says fiscal outlook is 'spiraling out of control' (http://www.rawstory.com/news/2007/Gov._auditor_on_fiscal_outlook_spiraling_0226.html )
Feb. 26, 2007

Congress's auditor warned in a monthly update released last Friday that the latest data on America's fiscal outlook shows "a federal debt burden that ultimately spirals out of control."

The January update was based on new data supplied to the Government Accountability Office by the Congressional Budget Office, and identified spiraling national health care costs as the main culprit for the country's budgetary woes. The report also challenged a key assumption about the nation's fiscal future made by President George W. Bush in his release of the 2008 budget.

Using a pair of different simulations of government outlays, the GAO bluntly states that "the Nation's long-term fiscal future is 'at risk.'" It considers different futures in which discretionary spending grows more quickly or slowly, and in which tax cuts are renewed or allowed to expire.