Euro Drops Below $1.30

This morning the value of the Euro dropped below $1.30.  The United States should thank the European Union for the diversion it has created.  With all the turmoil taking place in Europe, little attention is being paid to the monetary and fiscal policies of the United States and the impact these policies are having on the value of the United States dollar against other major currencies. 

As can be seen in the following chart the value of the United States dollar against other major currencies in the world continues its secular decline.  In terms of monetary policy and fiscal policy, international financial markets continue to give a negative rating to the United States and continue to see further future declines in the value of the dollar.

I continue to believe that, given the current policy leanings of the United States government, that the value of the United States dollar will continue to decline in the future.  Since the early 1960s the United States government, both Republican and Democrat, has generally followed a policy of credit inflation that resulted in the United States going off the gold standard and then resulted in the secular decline in the value of the dollar since President Nixon floated the dollar’s price in August 1971.  The two exceptions to this secular decline occurred when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve System in the early 1980s and when Robert Rubin was the Secretary of the Treasury in the Clinton administration in the latter part of the 1990s.

To me, there the Obama administration has continued the policy of credit inflation carried on by his predecessors and perhaps even improved upon it. 

The only times that the value of the dollar has rebounded over the past several years has been when there has been a “flight to quality” in US Treasury securities.  Other than this the value of the dollar has continued to decline except relative to the Euro.

Again, it seems to me that the United States should thank the European officials for all their follies because they have taken attention away from the political mess in the United States and the continued weakness in the value of the United States dollar in the world.   

Debt Deflation and the Selling of Small Businesses

The Wall Street Journal carries the story, “Sales of Small Firms Are Up”. (http://professional.wsj.com/article/SB10001424052702303406104576444062140022104.html?mod=ITP_marketplace_4&mg=reno-secaucus-wsj)  “Sales of businesses with roughly $350,000 in annual revenue rose 8% from a year earlier…”

“The main driving force is the acceptance among owners that their businesses are no longer worth what they once were.  Many sellers cut their asking prices and agreed to finance a significant portion of the deals themselves.

This is the other side of the last fifty years of credit inflation.  People are in debt, business is not good, and valuations have dropped substantially. 

How do you like the story of the individual who bought a 200-seat casual restaurant in 2002 for $200,000 and “is finally selling it for just $75,000, and he is lending the buyer 25% of the selling price”?

More and more information is now coming out on the situation in the world of small- and medium-sized businesses. 

But, this has been the case in the residential housing market.  People are in debt, unemployed, facing lower incomes, and property values have plummeted.

This is also the situation in the banking industry among the small- to medium-sized commercial banks.

The FDIC has only closed 51 commercial banks through July 8 of this year, but this figure does not include banks that were acquired by other institutions.  Through March 31, 2011, there were 77 fewer insured banks in the banking system than there were on December 31, 2010.  (In all of 2010, there was a net decline in the banks in existence of 290 even though the FDIC closed only 157.)  With 888 commercial banks on the problem list the likelihood that there will be 300 or so fewer banks in existence at the end of this year is highly probable. 

My point is that this is a part of the debt deflation process going on in the economy and it is a natural progression from the fifty years of credit inflation that preceded it. (“Credit Inflation or Debt Deflation,” http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation) 

Of course, the Federal Government is doing all it can to offset the forces of debt deflation by continuing to pump more and more debt into the economy.  Yesterday, Fed Chairman Bernanke, in Congressional testimony, argued that the Federal Governments needed to get its “act together” on the federal budget.  Bernanke followed this up by saying that the Fed will “do what it has to do” if the economy remains weak.

This was immediately interpreted by the “market” that the Fed will throw QE3 on the fire if it believes it is necessary.   Gold prices rose to a new record.

Today, Bernanke backed off and said the Fed was not “prepping” for a new edition of quantitative easing.   Gold prices dropped.

The problem with the effort of the federal government to offset the debt deflation going on in the economy by more and more rounds of credit inflation is that much of the liquidity the government is pumping into the system is going offshore…that is, it is going into world financial and commodity markets! (See “Federal Reserve Money Continues to Go Offshore,” http://seekingalpha.com/article/276909-federal-reserve-money-continues-to-go-offshore.)  This is doing little or nothing to stimulate the American economy and is doing lots to inflate world commodity markets. 

And, in this condition of debt deflation we see one of the real confusing issues connected with credit inflation and debt deflation. 

To take a specific example, in the 2000s there was a terrific increase in the price of houses and the value of small- and medium-sized businesses, in asset values.  Yet, price inflation, which is measured in terms of flow price…rents and business cash flows…did not increase at the same rate.  Hence, it looked as if consumer price inflation was being kept quite low.

Now, we see just the opposite happening.  Price inflation seems to be picking up, yet the value of assets like homes and small- and medium-sized businesses are declining, sometimes quite precipitously. 

In a period of credit inflation, asset prices tend to increase more rapidly than “flow” prices and this dis-connect must ultimately be corrected.

In a period of debt deflation, asset prices tend to decrease more rapidly than “flow” prices and this tends to continue until they are brought back more nearly into line (or over adjust).

The actions of the federal government and the Fed seem to be having little or no effect on asset prices.  Owners of businesses (and houses) are forced to accept “that their businesses (and homes) are no longer worth what they once were.” 

Further rounds of credit inflation may moderate the downside of this move…but, continuation of aggressive credit inflation will only just postpone the adjustment that is needed in the economy until a later time.    

Credit Inflation or Debt Deflation?

The world never stands still.  It is either moving one way…or moving in another way. 

In terms of the macro-economy, the world is either experiencing a credit inflation…or a debt deflation. 

For the past fifty years or so the United States (and Europe) has experienced a period of credit inflation.  Now, with debt levels so high, there is a real possibility that the United States (and Europe) will experience a period of debt deflation.

The fundamental response of many is that the United States government must continue to “jack-up” economic stimulus and create even more dramatic extensions of the credit inflation that has put the United States in the position it now finds itself in. 

The still unanswered question in the current situation is whether or not credit inflation can continue to be extended or will it ultimately reach a position in which the economy is so saturated with debt that further credit inflation is unsustainable.

The further question that accompanies this question is whether or not we have currently reached the tipping point in which further credit inflation is unsustainable. 

If credit inflation cannot continue then debt deflation must take over…it is either one or the other.

The reason for this conclusion is that credit inflation…and debt deflation…are cumulative movements.  That is, credit inflation builds on itself…just as debt deflation builds on itself. 

The basis for credit inflation is that the creation of more and more debt in the economy exceeds the possible growth of the whole economy, in the aggregate sense, or exceeds the possible growth within a sector, in the case of bubbles like the housing bubble in the decade of the 2000s.

For the economy as a whole, the gross public debt of the United States government rose at a compound rate of growth of more than 8 percent over the past fifty years.  The real economy was able to grow at a rate slightly in excess of 3 percent.  This is the foundation for the credit inflation that took place over this time period.

The cumulative effect of the credit inflation can be seen in the increased risk-taking that occurred over this time period as actual inflation “buys out” dumb decision making through price increases.  Financial engineering prospers during such a time as financial institutions and business firms benefit from more and more financial leverage and the assumption of interest rate risk.  Furthermore, one finds financial innovation thriving during such times as more and more opportunities present themselves for the “slicing and dicing” of cash flows.  Finally, finance triumphs over manufacturing as companies devote more and more resources to financial transactions.  In the 1960s, who would have thought that General Motors and General Electric might, at some time in the future, earn more than two-thirds of their profits from their financial wings?

Private sector debt, depending upon the series used, grew at a compound rate of 10 to 12 percent over the past fifty years.

The cumulative build up of debt on balance sheets results in two things.  First, economic recoveries become weaker and weaker over time as more and more people fight to overcome their debt burdens in order to “get spending again.”  Second, the economy bifurcates into two groups, one that is over-burdened with debt, and, one that is in control of its finances.  As the cumulative effects of credit inflation pervade the economy, the proportion of people in the first group grows relative to the proportion of the people in the second group.  This change makes it harder and harder for the economy to recover over time. 

A recent article by Amir Sufi, Professor of Finance at the University of Chicago, titled “Household Debt Is at Heart of Weak Economy” (http://www.bloomberg.com/news/2011-07-08/household-debt-is-at-heart-of-weak-u-s-economy-business-class.html) makes this very point.  “From 2001 to 2007, debt for U. S. households increased to $14 trillion from $7 trillion, and the ratio of household debt to gross domestic product was higher in 2007 than at any time since 1929.”

William Galston writes on this dilemma in The New Republic (http://www.tnr.com/article/the-vital-center/91856/economy-recovery-foreclosure-housing-prices): “To understand the burden this imposes on households, let’s took at a key measure: the ratio of household debt to disposable income.  Between 1965 and 1984, the ratio remained steady at 64 percent.  Between 1985 and 2000, it rose virtually without interruption to 97 percent.  And then, it shot into the stratosphere, peaking at 133 percent in 2007.  Four years later it has come down only modestly…118 percent of disposable income.”

But, many businesses, especially small- and medium-sized ones, at in similar straights. 

How many commercial banks in the United States are going to fail or be merged out of business?

And, what about many state and local governments?

And, what about the federal government?

The start of this period of credit inflation began in the early 1960s.  The philosophy behind this period of credit inflation is Keynesian, although a corrupted Keynesianism because Keynes argued that the government should balance its budget over the credit cycle, creating budget surpluses during the “good times” to balance out the budget deficits that were needed during the “bad times.”  The “bastardized” Keynesian approach argued for continuous budget deficits to create higher and higher rates of economic growth. 

Robust economic recovery becomes harder and harder to achieve as the cumulative credit inflation continued.  The burden of the financial leverage built up in the past becomes heavier and heavier.  At some point, this burden becomes too great and the continued efforts of the government to inflate credit become unsustainable. 

Evidence that we have reached this point or are getting closer and closer to the point is abundant.  First, we see that the fiscal stimulus programs of the United States government have achieved very little over the past four years or so.  Second, the massive failure of the Federal Reserve to “jump start” the economy through QE1 and QE2 is also an indication that credit inflation may not be working at this time. 

If we are going to enter a period of financial de-leveraging in spite of the efforts of the government, what does this mean for the stability of the economy and financial markets? 

It means that there will be a fundamental restructuring of the economy.  Those people and businesses that have been financially prudent up to this point will prosper.  Those that have not still have a bunch of pain to go through.  There will be a substantial restructuring of industry as those that have will take advantage of those that don’t have.  Also, there is still a major restructuring to come of the banking industry. 

A period of restructuring means opportunities.  I see a substantially different America in the next five-to-ten years.  The goal is to identify where the opportunities are.