FedUpUSA

Archive for July, 2011

Systemic causes of global financial instability include the “normalcy bias,” super-low interest rates, central-bank induced inflation and loss of faith in institutions.

Some causal factors of global financial instability are mental constructs, others are pernicious policies. Money is the ultimate mental construct, of course; it is our faith in the promises issued by central banks and governments that gives paper money its value.

The same can be said of markets: it is our faith in their transparency which makes them “free markets.” Once we discern that a market is manipulated, then we lose trust in it and exit that market for good.

The most pernicious policy is central-bank engineered inflation, which rewards debtors and punishes capital accumulation, a.k.a. savings. Push these incentives to debt hard and long enough, and you get a crippled, top-heavy economy like the U.S. economy, crushed by debts so staggering that the only way to service the debt is to borrow more money at insanely low rates of interest.

This is an excerpt from my new book An Unconventional Guide to Investing in Troubled Times which has just been issued in Kindle ebook format; a print edition will follow in September. (You can read the ebook now on any computer, smart phone, iPad, etc.–see below.The 30% discount expires tonight.)

Here are six systemic causes of global financial instability. (Here is yesterday’s list: The Coming Global Instability, Part I.)

1) The human mind has a number of default settings which have proven advantageous as “short cuts” in most circumstances, one of which is called “the normalcy bias.”  As events spiral out of control and dangers rise exponentially, our tendency is to underestimate the risks and potential losses. As long as a few shreds of normalcy remain intact, we view these as evidence that “it’s really not so bad.”

Most of the time, this trait pays off as most systems are self-correcting and catastrophe is avoided. But when self-reinforcing negative trends take hold, this complacency is ultimately self-destructive.

2) The financial Status Quo, already discredited in the eyes of most well-informed observers, will eventually lose all credibility, and global stock markets will languish as participants abandon them.

If this sounds farfetched, recall that 70% of all shares traded in the U.S. stock market are exchanged in opaque “dark pools” operated by Wall Street and “too big to fail” banks, and high-frequency trading executed by “black box” algorithms account for the majority of the remaining 30% of publicly traded shares.  This means that some 90% of stock market activity is hidden from non-insider investors.

The idea that we can rely on opaque markets for our financial security will increasingly be discredited.  As  heavy-handed interventions fail to restore stability, public faith in these institutions will decline. This delegitimization will further destabilize global markets, and those who accepted the implicit guarantees of stability, transparency and liquidity may find instead that their financial security has vanished in a cloud of “impossible” disruptions and dislocations.

This loss of faith is already evident.  As the U.S. stock market doubled from its March 2009 lows, U.S. households withdrew hundreds of billions of dollars from domestic equity mutual funds, and quadrupled their holdings of “safe” U.S. Treasury bonds.  If you look at a 10-year chart of volume in U.S. stocks, you will see a steady erosion of participation in the stock market.  These are the actions of people who have lost faith in the stock market, the nation’s financial and political institutions and the official “story” of permanently rising prosperity.

Once trust is lost, it cannot be won back easily or quickly.

As the financial authorities attempt to keep the system from crumbling beneath their feet, they will take increasingly drastic actions as markets destabilize: investment rules that were presumed to be eternal will be changed overnight, without warning, and then changed again. Decades of low volatility that encouraged people to buy long-term bonds, annuities and dividend-paying stocks will be upended by unprecedented financial and political volatility.  Seemingly permanent low interest rates that lured investors to pile into high-risk gambles will suddenly leap up, wiping out gamblers who weren’t even aware they were playing a game rigged in favor of the “house.”

Such expectations are well-grounded in history. Most investors have forgotten that the U.S. stock market was summarily closed for months during World War I, and that in 1933, the Federal government seized “hoarded” privately held gold.  These actions were, at the time, considered necessary and prudent by the authorities. More recently, in 2008 speculating that banking stocks would decline (that is, shorting banking stocks) was summarily banned. The rules governing the market were changed to defend the Status Quo, and speculation was only allowed if it flowed in one direction—the one favored by the financial authorities.

3) Stripped of mumbo-jumbo, central banks and States have only two buttons to push: Keynesian fiscal stimulus, i.e. governments borrowing and spending vast sums in an effort to stimulate demand and the “animal spirits” that drive private borrowing, and monetary easing, i.e. lowering interest rates to near-zero, and printing or creating credit electronically to flood the economy with “liquid,” easy-to-borrow money.

Central banks and States are hitting these two buttons like frenzied laboratory rats, but the machine is out of cocaine-laced pellets.  In effect, central banks and Central States are both addicted to exponential expansion of credit, intervention and Central State borrowing and spending. Each is only exacerbating the system’s risks, and as the authorities ratchet up these interventions to ever-higher levels, they’re insuring an even greater collapse.

There is a pernicious agenda at work in setting interest rates near zero while  boosting money supply and deficit spending to create inflation. By robbing savers of any return on their savings and sparking “sustainable, orderly” inflation of around 4%, central banks are in effect transferring 4% from the owners of cash to reduce the debt of the central bank/State by this same amount every year.  In a decade of this monetary scheme, savers’ wealth will be reduced by roughly 50% while the debt created by the central bank/State will decline by 50%.

“Purchasing power” is a concept while helps us understand the results of low interest rates and “politically benign” inflation: the owner of cash will find their money buys only half of what it did ten years before, while the government debt has also fallen in half.  The net result of this slight-of-hand is that government debt that was crushing becomes manageable again as savers’ wealth was invisibly transferred via carefully engineered inflation.

The key phrase in this sub rosa agenda of transferring private wealth to reduce government/central bank debt is “politically benign:” since the loss of wealth and the rise in consumer prices is “only” 4% a year, the consequences are not severe enough to trigger political resistance.  Financial and political authorities know that people quickly habituate to an “orderly” reduction in wealth and an “orderly” inflation in prices; that is, this erosion of purchasing power soon becomes “the new normal” and people plan around it.

The purpose of this central bank/State agenda is to avoid the two endgames that would destabilize the Status Quo: outright default on the Status Quo’s staggering debts, and hyperinflation, or loss of faith in a paper (fiat) currency. Either of these events would destroy the credit markets that form the foundation of the global economy.

We can see how successful this strategy of engineering orderly, “normal” inflation has been: 30 years ago, a Federal debt of $15 trillion would have unimaginable. Today, it is accepted as “sustainable” because it will never be paid back in today’s dollars, and low interest rates insure that the carrying costs of that debt remains small enough that no other government spending need be sacrificed to pay the annual interest.

This agenda has worked like magic for the past 30 years, but beneath the apparent success, the foundations of the current system– cheap energy, globalization, financialization, monetary expansion, fiscal stimulus, opaque markets and constant State/central bank intervention–are all eroding. As they dissolve then so too will the Status Quo’s implicit promises of permanent stability, low interest rates and limitless growth.

The point here that the levels of intervention required to create inflation in a  deflationary, deleveraging-of-debt era are not just stupendous– they must ratchet up to ever higher levels to maintain superficial stability as the system becomes increasingly precarious.  Ironically, increasing the heavy-handed centralized interventions only  increases the system’s precariousness—the exact opposite of the Central Planners’ intentions. This is the result of trying to manage non-linear systems with linear-system tools: all that manipulation can achieve is to extend surface stability at the cost of a more severe system crash later on.

4) The investment world is keen on probabilities as reliable guides to the future. But low-probability events occur with remarkable regularity, so it’s prudent not to put too much faith in statistical or probabilistic reassurances. All such models are based on the idea that the recent past is a reliable guide to the future. But if the thesis that the next 20 years will necessarily be very different from the previous 60 years, then this faith that the recent past offers a roadmap of the future is dangerously misleading.

5) The uneven, unpredictable process of destabilization and devolution will play out over many years as periods of apparent stability are punctuated by the re-emergence of crises which were supposedly resolved in the previous cycle of central bank/government intervention. Every era of stability will be less enduring than the last, and come to rest at a lower level of security and prosperity than the last. Every intervention will be larger, more desperate and more intrusive than the last, and much less effective.

6) Periods of creative destruction are inherent to Capitalism, indeed, essential  to its long-term success. Just as we cannot fool Mother Nature for long–for example, by reckoning we can eliminate forest fires–we cannot manipulate the global economy to eliminate creative destruction.  All the unprecedented efforts of central financial authorities to eliminate risk and instability are simply piling up more deadwood in an already tinderbox forest.

Financial risk is like water in a closed system: it cannot be compressed. As pressure mounts, the risk builds up and eventually escapes, often through whatever part of the system was considered “safe.”

Periods of great transition in which existing systems are consumed by creative destruction and a new paradigm emerges offer great opportunities as well as great risks.

If I had to summarize this book in a few sentences, I would say this: Money is a  tool; make it work for you. Don’t invest in Wall Street’s false promises, invest  with an unblinking eye on systemic risk. Invest in your own life and in the lives of others. This book explores how to do just that.

Of Two Minds

Charles Hugh Smith’s new book An Unconventional Guide to Investing in Troubled Times is available in Kindle ebook format.

Sorry guys, the clock has rung. It’s not ringing any more, it has rung and the spring-powered alarm has run out.

Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 1.3 percent in the second quarter of 2011, (that is, from the first quarter to the second quarter), according to the “advance” estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 0.4 percent.

That’s a monstrous revision to the first quarter. For those who forgot, we were told it was 1.8% on April 28th.

Oops.

Why the major change? Annual revisions. The answer is this: What recovery? Now I have to go back and revise all my working tables.

There is no recovery to speak of. Four years into this the policies of the government and Fed have failed.

It gets worse:

The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 3.2 percent in the second quarter, compared with an increase of 4.0 percent in the first Excluding food and energy prices, the price index for gross domestic purchases increased 2.6 percent in the second quarter, compared with an increase of 2.4 percent in the first.

Your standard of living is being shredded.

Real personal consumption expenditures increased 0.1 percent in the second quarter, compared
with an increase of 2.1 percent in the first.

Spending has effectively collapsed.

This puts into stark relief the reality of the government deficit spending – it is doing nothing more than covering up an economic Depression, and the so-called “exit plan” – that private consumption, investment and borrowing will “take the baton back” is not working.

The deficit spending must stop now before the tax base folds back and forces a disorderly collapse.

The Market Ticker

Discussion (registration required to post)

I remember these nights back in late 2007 and into 2008.

(S&P 500 Futures 07/29/11, 22:00)

It’s time to cut the crap.  This is the same sort of “dislocation move” that happened a number of times during period leading up to the collapse in 2008.  Tonight is back in that pattern – no liquidity whatsoever, large moves, bid and offer stacks literally disappearing, and the computer HFT machines going nuts with what little is left.

The trigger was an announcement that the Boehner bill does not have the votes to pass and will not come to the floor.  The rules committee is calling an emergency meeting in 20 minutes to tweak it to get the required additional votes, but there’s no announcement as of yet as to what’s being changed.

The problem is that just as in 2008 this is all Kabuki Theater.  There is no actual solution that avoids a downgrade and the potential tax and interest spiral that can result from it without actually balancing the budget.

Just as in 2007 and 2008, we’re getting the “tanks in the streets” threats – today from various banks and other institutions, from Geithner and Obama for the last few days, and I’m sure there will be more of them tomorrow.

It doesn’t matter though – either the underlying problem is solved now or the situation will deteriorate exactly as it did in 2007 and 2008 until the market pushes the big fat button.

No, not the one marked “EASY” – it’s the one marked “RESET.”

It will happen unless the cycle is interrupted right now.

If there is any sanity in DC this cannot be allowed to happen.  If it happens there is no Federal Reserve “dry powder” available to arrest the decline, the dollar is a few cents away from breaking critical all-time low support and should this situation get away from you both the dollar and the market are likely to dive at the same time leaving all of you no good options.

I know everyone says “we can’t do that this fast.”

Sorry, we have to do it this fast.

Washington squandered the opportunity to do it in 2007, 2008, 2009, and 2010.  Now you have to do it, or we’re screwed.

I’ve been writing on this since 2007.  I and a few others spent a lot of time and digital ink in the 2008 campaign – then in the 2010 campaign and during the entire period between the two.  Washington bailed out banks instead of forcing them to eat their own cooking and shutting them down.  We still have HFT machines sitting on the exchanges quote-stuffing the hell out of the exchange – today was especially bad.  We still have huge numbers of bad loans held at bogus value on balance sheets.  And we have a Federal Government providing $1,700 billion – 12% of GDP – in false economic demand that does not actually exist!

The alarm clock is ringing right now.

Wake the hell up folks.  Band-aids will not fix this.

Oh sure, you can probably produce a rocket-shot rally tomorrow with some sort of sticksave, and I wouldn’t be shocked if it happens.  Not one little bit.  But all these sorts of wild gyrations do is destroy liquidity – they take people out of the market who either get blown up outright or who simply push the “FLATTEN” button on their terminal, push the chair back and go to the bar, saying “fuck it – I can’t play in this casino as the cards are marked.”

As in 2008 if you keep this crap up there will be a crash. This is not conjecture – it is fact.  It will come fast, hard, and without warning.  It will destroy all the so-called “progress” that Bernanke has crowed about in the stock market and bankrupt those who were foolish enough to get back in as investors, not traders, who cannot act quickly enough to protect themselves.

The time for cock-and-bull games is over gentlemen.  Mr. President, you have to stop with your Imperial attitude.  You’re not a King – you’re a President.  You have lost the consent of the governed and of the majority party in Congress. That’s the end of the discussion for you – and your puerile attempt to play the “Granny down the stairs” card has backfired.

To the Democrats, stop listening to Pelosi.  She’s a dried up old prune who has never had an honest idea in her life.  Not once.  She’s hellbent and determined to bankrupt the nation and she doesn’t give a damn what happens fiscally.  She never has and never will. You follow her, you’re going off the cliff with her.

To the Republcans, you better cut the crap too.  $90 billion in cuts the first year is immaterial and will not stop the downgrade cycle.  It will happen almost immediately if you ram this through at which point you’re screwed, blued, tattooed and done and so are the rest of us.

To all of Congress: You need $750 billion in actual cuts from today’s spending right now from today’s levels for 2012.  Then you need another $750 billion next year.

Pick a path – tax increases or spending cuts – but get there.  Yes, it will tank the economy.  I understand that.  So do you.  Suck it up – you’re out of choices.

STAND BEFORE THE AMERICAN PEOPLE – DEMOCRAT, REPUBLICAN, CONGRESSPERSON AND PRESIDENT AND TELL THE PEOPLE THE TRUTH: YOU HAVE ALL INTENTIONALLY AND MALICIOUSLY LIED FOR THE LAST THREE YEARS VIA FEDERAL DEFICIT SPENDING.  THE ECONOMY HAS NOT IMPROVED – IT HAS IN FACT DETERIORATED, AS THE DEFICIT PERCENTAGE COMPARED TO GDP HAS GONE UP, NOT DOWN.

We must face reality and we must do it now.

This path we are on – the same path we were on in 2007 and 2008 with lies from both political parties – must not be allowed to continue. You lack dry powder to address what you are going to cause to happen in the markets, which are already voting and their vote is “two thumbs down.”

In short, grow up.  The market is bigger than you are, and no amount of strutting and threatening will change a damn thing in this regard.

It didn’t work in 2008 and it won’t work now.

Either stop the crap or reap consequences that are far more severe than they were in 2008.

That much I can assure you.

Something To Remind You….

If you’ve wondered who or what is driving this debt ceiling debate, wonder no longer.  This little pertinent clip from Bloomberg:

Bond Dealers

Treasury officials have a previously scheduled meeting for tomorrow with Wall Street bond dealers ahead of next week’s quarterly auctions of notes and bonds. The officials will talk with the Treasury Borrowing Advisory Committee, which includes executives from financial firms such as JPMorgan, Goldman Sachs, Bank of America Corp. and Pacific Investment Management Co.

The Treasury has previously said it cannot pick and choose which bills to pay in the event it can’t borrow enough to cover all its obligations, a process members of Congress called“prioritization.”

“This ‘prioritization’ proposal advocates a radical and deeply irresponsible departure from the commitment by presidents of both parties, throughout American history, to honor all of the commitments our nation has made,” Geithner said in a letter to Congress last month.

Strange how all the banks mentioned are also those who got billions and billions of taxpayer bailouts.  Funny, huh?

What you want, dear American taxpayer, is meaningless.  Your overlords have spoken.

I told you this was going to happen…… you have not heard this on bubble vision, but all you had to do was use your brain:

Q: “There’s been a figure of $4 trillion dollars circulating as an example of the scope of  fiscal consolidation measures that could work to stabilize the U.S. debt-gdp ratios. Could you explain how that figure was arrived at since it was mentioned in S&P’s reports and where it figures in S&P analysis?”

A: “First of all, that figure comes initially from the Bowles-Simpson fiscal commission, and it was embraced by President Obama  in his April 13 speech and Paul Ryan in his counter-budget proposal. And so you had policy makers converging around the amount. Now actually the $4 trillion, depending on whether it is front-loaded or back-loaded, is not going to do the trick in terms of stabilizing U.S. government debt-to GDP ratios. But it takes you pretty far along. And I think a grand bargain of that nature would signal, you know, the seriousness of policy makers to address the fiscal issues of the United States, to actually stabilize the debt-to-GDP. The IMF says it takes  7.5% of GDP consolidation. I think we have more than that.”

For perspective: That means cutting the deficit by more than one trillion dollars a year at present run rates.

And that’s not enough either.  GDP will contract dollar for dollar as the deficit spending comes off and taxes will contract too, which means that the actual cut in spending (or increase in taxes) will be have to more that one trillion a year.

It does not matter how that difference between revenues and spending comes off.  It does not matter if you cut spending, raise taxes or some combination of the two.  The GDP impact is inescapable as is the tax receipts impact.

But so, at this point, is the downgrade.

The “most-recent” proposals cut anywhere from nothing in actual spending (Democrat proposal) for 2012 to $90 billion (Republican.)  And neither contains any actual cuts on a forward basis – the Republicans are at least honest about it and say they just “hold discretionary non-defense spending at 2011 levels.”

That’s not a cut in spending.

So here’s how it’s going to go down.  We will get downgraded, probably within days or weeks after this “short-term” blip passes Congress, however it does.  And when we do, interest rates will ratchet, at least a bit.  If the Congress refuses to respond to that downgrade with real budget cuts including the cost of the increased interest now, which means they have to be another $100 billion or so (that is, 10% more than if they did it now) we’ll get downgraded after a period (probably six to twelve months) again.

Note: I’m talking one trillion a year in cuts and/or tax receipt (not rate) increases.

Not over ten years, per year.

Somewhere between now and that second move by the ratings agencies the market will figure it out and the squeeze will begin.

By then it will probably be too late for Congress to avoid the “coffin corner.”

The door is closing fast and we’re about to be left out in the cold.

I know this is claimed to be “politically impossible.”  But mathematics – specifically, exponents and subtraction – do not care about politics.  They just are.

They are determining this outcome, not politics, and those who are in Congress had damn well better wise up and start demanding from their advisors who say we can manage to muddle through strict proof – not a claim, but an examination of borrowing expense and tax receipts until they project an actual balanced budget, whenever that projection is for them. If the answer is “never” those people need to be tossed out of the nearest Capitol office building window – sans parachute.

Where does this take the stock market?  That depends on whether Congress responds before the downward spiral starts.  If they do the correction will be nasty, but we’ll get through it.  But if not…..

If what I heard today in the so-called “debate” on the floor of the House is an honest indication of what we can expect from Congress we’re just plain screwed.

I’m sorry.

As the chances of a gaseous Congressional compromise to do nothing about deficit reduction grow larger, inquiring minds wonder just what might happen if nothing passes.

Contrary to popular belief, the US would not default. Troops would still be paid. Medicare and Medicaid would not stop. The Bipartisan Policy Center has a nice analysis in a PDF on Debt Limit Analysis.

NO “SILVER BULLETS” TO EXTEND DATE

• Our analysis also shows that the X Date will fall between August 2 and August 9. On July 1st, Treasury publicly reaffirmed their estimate of the X Date as August 2
• The 14thAmendment does not provide a reasonable basis for challenging the constitutionality of the debt ceiling. The Administration will not attack the debt ceiling on this basis
• Treasury has no secret bag of tricks to finance government operations past August 2. Treasury will not attempt to “firesale” assets during a crisis.
• Other ideas are impractical, illegal and/or inappropriate (gold loans, IOUs)
• There is no precedent; all other debt limit impasses have been resolved without passing the X Date
• The government shutdown of 1995 –96 does not provide a precedent

Prioritization

Obama’s, Geithner’s, and Bernanke’s statements about default simply are not credible. Nor are threats of cutoffs to military pay or Social Security. Indeed those totals allow Medicaid and Medicare to be paid.

The PDF covers alternate scenarios of what can and cannot be paid.

Interactive Map, You Decide What Not To Pay

I contend there is easily a month or more to work out a better deal. There are many programs we can easily do away with that should not be funded at all.

Please consider You choose: who gets paid (and who doesn’t)

On August 2, the federal government will not have enough cash to pay for all of its programs and obligations. The U.S. will take in a total of $172.4 billion in revenue during the month, but its total payments exceed $306 billion, resulting in a $134 billion shortfall. If a debt-limit increase is not approved, the U.S. Treasury will have to choose among 80 million monthly payments and prioritize which programs are funded and which ones are not.

Mish Choices

click on chart for sharper image

As you can see, I have $30.6 billion to spare.

The first thing TO pay is interest on the national debt. It is non-payment of interest that would constitute default. Given $29 billion is easily payable, talk of default if Congress does nothing is the height of silliness.

The first thing to NOT pay should be congressional salaries.

As you can clearly see there are many things that would be a benefit to not pay, and never pay again.

Things to Not Pay and Never Pay Again

• Department of Education – $20.2 Billion
• Health and Human Services Grants – $8.1 Billion
• HUD – $6.7 Billion
• Department of Energy – $3.5 Billion
• Department of Labor – $1.3 Billion
• Small Business Administration – $0.3 Billion
• Other Spending – $52.8 Billion

Clearly those things would have to be phased out, but the total of those things is a whopping $92.9 billion. That “Other Spending” category may have some essentials, but certainly most of it is not. Also bear in mind, I have $30.6 billion to spread around as needed. Some can go to salaries, but certainly not salaries of Congress.

In contrast, please see Boehner’s Credibility Gone in Revised Proposal; Boehner Tells Congress to “Get Your Ass in Line”; Best Deal Republicans Can Get? for Boehner’s revised cop-out.

All things considered, especially since Boehner’s credibility is gone in his latest gaseous proposal, would be for Congress to NOT hike the debt ceiling and work out a credible plan over the next month.

Mike  “Mish”  Shedlock
Global Economic Analysis