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Episode II: Stagflation Godzilla Returns, Attacks Finance-Based Economy! - Janszen

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  • Episode II: Stagflation Godzilla Returns, Attacks Finance-Based Economy! - Janszen

    Global Central Banks Send Anti-Inflation King Kong to Fight Back!

    Episode II: Stagflation Godzilla Greases Anti-Inflation King Kong with the Oil Destroyer!

    Will the Finance-Based Economy Survive or be Destroyed in the Great Battle?

    by Eric Janszen

    Link to Movie

    (Background: In the first Godzilla movie, the monster destroys Tokyo during an unstoppable rampage. In the end, he is encased in ice by the Oxygen Destroyer, a weapon used by its inventor against the beast to save the world from destruction. The inventor himself dies in the attack. At the end of the next movie in the series Godzilla Raids Again, Godzilla is released from his iceberg and in the next movie King Kong vs. Godzilla, the monster once again rampages through Japan. When King Kong is brought to Japan, he encounters Godzilla and both creatures fight for supremacy. An earthquake sends both creatures into the depths of the ocean, but King Kong later resurfaces and returns to his home island, victorious.)[/i]

    In our last episode of Stagflation Godzilla Stagflation Returns... Paul Volcker single handedly put Stagflation Godzilla on ice by hiking rates to 19% in 1980, sending the U.S. economy into an on-and-off again three year recession. Starting in 2001, two years of low interest rates, tax cuts, deficit spending and rising energy costs followed by too gradual rate hikes by the Fed melted Stagflation Godzilla's iceberg where Volcker left him frozen in 1983.

    Stagflation Godzilla came ashore in late 2005, bent on economic rampage. Western aligned global central banks bring Anti-Inflation King Kong from his island home to fight Stagflation Godzilla in Q1 2006. In May, the two titans start to fight it out, stomping on speculative grade stocks, emerging markets and commodities, in a fight to the death.

    Who will win? Can the Finance-Based Economy be saved? Will it survive the great battle?

    Episode II: Godzilla Greases King Kong with the Oil Destroyer!

    What is the Oil Destroyer? It is a new version of an old economic weapon, oil price fixing... but with a major enhancement. No one expects this weapon to ever be used again because it can wreck the economies of the nations desperate or foolish enough to use it, or so many believe. Like the nuclear weapons that inspired the original Godzilla movies, the Oil Destroyer is seen as an end-game weapon, and the previous version was so. OPEC used it in the late 1970s and it backfired.

    Contrary to popular belief, rather than cut off oil supplies, OPEC did not stop selling oil to the US but rather forced the US to buy oil through intermediary countries at high prices. At their peak, prices spent the month of December 1979 at the equivalent of $100 a barrel in 2006 dollars. Then OPEC learned about supply and demand and the power of the Fed.

    The US did not have much oil to produce to make up for the shortage of cheap oil but had plenty of oil to conserve. The reduction in consumption is clearly seen in the graph below by the Association for the Study of Peak Oil and Gas:


    The US also had unions and other institutions that tended to transmit high energy prices to a higher general price level via wage increases. Labor had pricing power. The Fed took it away by creating massive unemployment, and demand and prices fell like a rock. Just as the oil price spiked, Paul Volcker brought the Fed funds rate up to 19%. The world went into recession on and off for three years and oil demand collapsed, soon followed by prices. Around the same time, as James Rogers pointed out in an interview here in May, new capacity was coming on-line. By the end of 1983, both oil prices and demand hit bottom, setting the stage for 20 years of relatively stable prices. The Oil Destroyer V1.0 failed.

    But that was Oil Destroyer V1.0. Now for Oil Destroyer V2.0. How does it work?

    We now take you to Milan, Italy where on June 22, Saul Eslake, Chief Economist of the Australia & New Zealand Banking Group, Ltd, presented The Emergence of Oil Producers as Net International Creditors: Possible Implications for the Global Financial System to the International Conference of Commercial Bank Economists. A few excerpts.

    "The sustainability thus far of large US current account deficits and East Asian surpluses highlights the fact that both the United States and the countries of East Asia have a strong (albeit rarely explicitly stated) mutual interest in their being sustained." (See Economic M.A.D.)

    "The sustained rise in oil prices since the beginning of 2002 is significantly altering the distribution of current account surpluses and deficits around the world. Between 2002 and 2005 the value of oil exports has risen by $437bn to nearly $800bn, resulting in a substantial redistribution of income from oil importers to oil exporters."

    "Oil exporters have thus far spent a somewhat smaller share of the additional revenues attributable to higher oil prices than during the oil shocks of the 1970s. The combined current account surpluses of 23 oil-exporting economies have risen from $87bn in 2002 to $422bn (equivalent to 9.7% of their combined GDP) in 2005, and are forecast by the IMF to reach around $520bn this year and next. Excluding the three OECD countries in this sample (Canada, Mexico and Norway), the combined surpluses have widened from $62bn in 2002 (5.2% of GDP) to $353bn (16.2% of GDP) in 2005, and are expected to reach $428bn in 2006 and 2007."

    "As Deutsche Bank's Chief Economist Norbert Walter has observed, this amounts to a 'substantial shift in the balance of power in the global economy' and one which 'has not received the attention it deserves.'"

    You don't see many talking about it now, but within a few years we may be talking about little else.

    "The United States accounts for only 8 1/2% of oil-exporting nations' total exports, a proportion which has declined by 5 3/4 percentage points since the second oil shock, while the oil-exporting nations source only 8% of their imports from the US, a decline of 11 1/2 percentage points since the second oil shock. And, as discussed in more detail later in this paper, the political relationships between the United States and many of the more significant oil exporters are much more fraught than those between the US and its major East Asian trading partners.

    "It is thus quite possible that, should the private sector become again unwilling to finance the bulk of the US current account deficit, oil exporting nations will be far less willing to play the role of 'financier of last resort' to the United States in the way that East Asian nations did in 2003 and 2004. And this could in turn provide a hitherto unanticipated source of instability in the global financial system."

    In other words, our new oil producer creditors, unlike our Asian goods-exporter creditors, can stop funding the finance-based economy without causing their local economies much pain. Eslake goes on to point out what happened last time oil producers used oil price fixing before.

    "In the mid-1970s, oil producers re-cycled the surpluses resulting from the first oil shock (of 1973) predominantly into bank deposits and money-market instruments, including the (at that time) relatively immature Euro-currency markets. A good deal of these funds were on-lent by international banks to eager borrowers in the developing world, ultimately sowing the seeds of the 'third world debt crisis' of the early 1980s, when those borrowers were skewered by a combination of another sharp rise in oil prices (the second oil shock) and higher interest rates (reflecting the 'Volcker' shock of 1979).

    "By contrast, oil producers appear to have been accumulating most of their recent increases in oil revenues in portfolio investments assets, rather than in bank deposits. Although there is almost no information regarding the currency composition of these assetsll, the relative stability of the US dollar over the past three years suggests that the bulk of these assets have been held in US dollars and that oil exporting nations have, thus far at least, also contributed to the orderly financing of the US current account deficit.

    "However, the gap between interest rates on US$-denominated financial instruments and those denominated in other currencies is likely to start to narrow after some point during the next few years, as interest rates reach a peak in the United States (and possibly begin to decline some time in 2007 or later) but continue (or in the case of Japan, begin) to rise in other financial centres."

    We expect interest rates to rise ala Ka-Poom Theory, but our model can conform to Eslake's prediction if one assumes that by "interest rates"
    Eslake means "real interest rates." Ka-Poom Theory, first proposed in 1999, assumes that interest rates will rise during the "Poom" inflationary phase but lag behind inflation. So far, this prediction has proved correct.

    "In those circumstances, is it reasonable or sensible to assume that oil-producing nations (or, for that matter, East Asian nations, many of whom will also still be running large current account surpluses) will continue to choose to hold the bulk of their foreign assets in US dollars?

    "As noted earlier, many of these countries have a much smaller direct interest in the continued health of the US economy than East Asian economies. And this question becomes even more pertinent given the deteriorating political relationship between the United States and many of their number."

    Eslake goes on to point out that major oil producers and creditors Russia, Venzuela and Iran fall into the Not Our Friends and Don't Need the US camp. His comment on Iran, world's third largest oil exporter, is especially pointed:

    "Iran was nominated by US President George W. Bush as one of the three members of the 'axis of evil' in his 2002 State of the Union Address. Perhaps not surprisingly - from its point of view - Iran, witnessing the contrasting experiences of the other two countries nominated by President Bush as co¬members of that 'axis' (Iraq and North Korea), appears to have drawn the conclusion that the best way of avoiding 'regime change' is to acquire both nuclear weapons and a leader who can convince the world that he might be crazy enough to use them. In President Mahmoud Ahmedinejad Iran has found the latter, and appears to be devoting considerable effort to obtaining the former."

    "At the outset it was noted that the financing of the ever-increasing US current account deficit has proceeded with almost none of the widely predicted adverse consequences for the stability of the US dollar, the level of US interest rates or the continued expansion of the US economy. However, it was also noted that this was in no small part due to the fact that for most of this decade interest rates on US$-denominated financial instruments have been higher than those on instruments denominated in plausible alternative 'safe haven' currencies; that during the period when this was not the case (2002¬2004), Asian central banks were willing to play the role of 'financier of last resort'; and that one of the reasons for this willingness was the strong self¬interest which Asian countries have in the continuing strength of the US dollar and of the US economy."

    Why is Stagflation Godzilla reaching for the Oil Destroyer V2.0 now?

    "First, US interest rates may be approaching a peak, while interest rates in other leading financial centres have only recently (or have not yet) begun to return to more 'normal' levels, implying that the premium between interest rates in the US and other financial centres is likely to narrow over the medium term, reducing the attraction of the US as a destination for private sector investments.

    "Second, most Asian economies are now confronting either rising inflation, or (in China's case) uncomfortably strong growth in domestic credit, which may make them less willing to 'print money' in order to prevent an appreciation of their own currencies against the US dollar, should the dollar come under downward pressure for any reason.

    "And third, Asian economies no longer account for the majority of the surpluses which are the counterpart to the US current account deficit. The significant increase in oil prices over the past three years, and the prospect that oil prices are likely to remain at elevated levels for the foreseeable future, means that oil¬producing nations will accrue surpluses that are (in total) larger than those of East Asia. Moreover, these nations may be less inclined to ascribe as much value to sustained economic growth in the United States as East Asian nations have done."

    "Indeed some of them may, perversely, welcome instability in the US dollar or weakness in the US economy in the context of their (in many cases) less-than¬amiable political relationship with the United States.

    "After all, if Norway's Government Pension Fund is willing to make investment decisions on grounds other than prospective investment returns, it should hardly come as a surprise if the governments of other oil-producing nations take political or strategic considerations into account when allocating their new-found wealth.

    "Most disturbingly of all, there appears to be only a limited understanding on the part of a broad range of policy-makers in the United States as to the risks associated with these developments.

    "Of course, for as long as oil-producing nations run current account surpluses, they will of necessity be capital exporters; and while the US incurs current account deficits of the magnitude it has in recent years, and is expected to in the years immediately ahead, the bulk of those capital exports will inevitably end up in the US in some form or other - albeit perhaps intermediated through other countries. However, that does not guarantee that the terms on which the US imports capital, directly or indirectly, from oil-producing nations will remain as favourable as those on which it has previously imported capital from East Asia.

    "For all these reasons, the emergence of oil-producing nations as some of the world's largest international creditors represents an under-appreciated potential source of instability in the global financial system."

    Eslake presented his paper on June 22, 2006.

    As if on cue, days later...

    June 28, 2006 - Mideast investors switching money from US

    HOUSTON, United States (AFP) - Political tensions have encouraged Arab investors to shift from depositing oil profits in US investments to Europe, India and China, the head of Citigroup's emerging market bank said.

    "Quite honestly today the investment going into the US is extremely limited," said Shirish Apte, chief executive officer of Citigroup's Central and Eastern Europe, Middle East and Africa Corporate and Investment Banking unit.


    July 3, 2006 - UAE Central Bank set to enter the gold market - (AME Info FN)

    The UAE Central Bank Governor this week gave his strongest hint yet that the emirates will shortly enter the gold market and also purchase euros as a diversification of the national currency reserves presently held in US dollars. With the US dollar ripe for devaluation this seems a timely initiative.

    The Oil Destroyer V2.0 combines a constrained oil supply with limited access to foreign capital by the US. If it works, this time oil demand will fall in a recession as in the early 1980s but the dollar price of oil will not. Oil producers get to have their cake and eat it, too.

    Will it work? We hope not!

    Next, Episode III: Stagflation Godzilla Heads for Wall Street

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    Last edited by FRED; 03-16-07, 02:42 PM.

  • #2
    it's not just interest rates, it's also exchange rates

    Originally posted by ej

    "However, the gap between interest rates on US$-denominated financial instruments and those denominated in other currencies is likely to start to narrow after some point during the next few years, as interest rates reach a peak in the United States (and possibly begin to decline some time in 2007 or later) but continue (or in the case of Japan, begin) to rise in other financial centres."

    We expect interest rates to rise ala Ka-Poom Theory, but our model can conform to Eslake's prediction if one assumes that by "interest rates"
    Eslake means "real interest rates." Ka-Poom Theory, first proposed in 1999, assumes that interest rates will rise during the "Poom" inflationary phase but lag behind inflation. So far, this prediction has proved correct.

    "In those circumstances, is it reasonable or sensible to assume that oil-producing nations (or, for that matter, East Asian nations, many of whom will also still be running large current account surpluses) will continue to choose to hold the bulk of their foreign assets in US dollars?

    episode ii above is a terrific exposition of some terrifying realities. [i guess that makes horror movie analogies particularly apropos.] in the discussion of interest rates quoted, however, eslake's hasn't directly addressed exchange rates. [i haven't had time to read the eslake directly, so perhaps he does discuss this.]

    the following is from a note by paul van eeden:

    Japan has been a major source of international monetary liquidity since 2001 when it embarked on a (near) zero interest rate policy coupled with a managed exchange rate between the yen and the dollar. Essentially it meant that large institutions (read hedge funds) could borrow yen at almost zero interest and invest the borrowed money in Europe and the US. Even with low US interest rates there was still a lot of money to be made: if you can borrow yen at say 0.35% and invest the money in US bonds at say 3%, you make 2.65% a year. Now, if you have say $100 million in capital but you borrow $1 billion in yen and make 2.65% on that money, you actually make a 26.5% return on your capital. That's a lot of money, and it only requires a 3% yield on the bonds you buy. You can add another 10% return on capital for every 1% additional yield assuming you have 10:1 leverage.

    The scheme works as long as Japanese interest rates remain low but, far more importantly, it only works as long as the yen does not appreciate against the dollar (or the euro if that's where you invested the borrowed funds). If the yen appreciates by more than the interest rate differential then a potential profit will quickly turn into a real loss, and with the amount of leverage typically employed by hedge funds it would not take a large increase in the yen exchange rate to wipe out a lot of capital.

    Recall Greenspan's bond market enigma? Short-term interest rates were rising but medium and long-term rates were falling or, at best, staying flat. Obviously there was a lot of demand for medium and longer-term US bonds. Some of that demand came from the central banks of China and Japan who used US dollars they received in trade to buy US Treasuries in support of the dollar, and some of the demand came from international hedge funds, who were making good use of the yen-dollar carry trade as discussed above.

    Japan started warning the world in early March that it had reached the end of its zero interest rate policy and current estimates are that the Bank of Japan could start raising rates as soon as next week or no later than August. This means an end to the yen carry trade, not just because profit margins will get squeezed, but more importantly because Japan will most likely allow the yen to start appreciating at the same time. The profit margins of the yen carry trade have actually never been better, since interest rates, especially in the US, have been rising while they remained low in Japan. It is therefore not a contraction of the nominal difference in interest rates that becomes the biggest risk for the carry trade, but the prospect of currency exchange losses if the yen appreciates.

    The yen is already up 1.9% against the dollar since the beginning of the year, eroding a large part of the yen carry trade profit. It has also become quite volatile. From the first week of March, when Japan announced its intention to abandon the zero interest rate policy, to mid-May, the yen appreciated by more than 5% before correcting again. Hedge fund managers long on dollars and short on yen must have had more than one sleepless night during that time.

    In addition to shutting down the yen carry trade, the Bank of Japan is also reducing the monetary base. Since January, Japan's monetary base has declined by almost 20% -- that is a massive decline and, as far as I know, unprecedented in history. There is no doubt that Japan is serious about curtailing the expansion of its money supply. The combination of less money supply and rising interest rates will put a serious dampener on yen liquidity and, by extension, international liquidity since Japan has been a major source of liquidity during the past five years.

    so the change in relative interest rates is important, and that change feeds into currency shifts with the potential of undermining the dollar. the diminished support of bond prices will raise rates and slow the dollar's decline, i suppose, but the dollar's future looks bleak. perhaps this will be discussed in episode iii. i can't wait.