Making the Same Mistakes All Over Again

Policy makers continue to base their economic and monetary policies on the contention that the problems “out there” are liquidity problems…not solvency problems.  This focus is highlighted in three articles in the morning newspapers. 

The most direct treatment of this is that of Desmond Lachman of the American Enterprise Institute, “The IMF is making the same mistake all over again”: http://www.ft.com/intl/cms/s/0/b2f38dd2-8195-11e0-8a54-00144feabdc0.html#axzz1Mnj4kmN5.

Mr. Lachman makes the argument that the policies followed by Dominique Strauss-Kahn and the IMF with respect to the sovereign debt crisis in Europe is that they have treated “the crisis as a matter of liquidity rather than solvency…” The consequence of this approach is that this philosophy has “led the IMF to eschew any notion of debt restructuring or exiting from the euro, as a solution to the periphery’s public sector and external imbalance problems.”

In another article, Scott Minerd, chief investment office at Guggenheim Partners, argues that “There will Be More Monetary Elixir After the End of QE2”: http://www.ft.com/intl/cms/s/0/96ec2b02-8146-11e0-9360-00144feabdc0.html#axzz1Mnj4kmN5. 

The motivation for QE3? “The same motivation for QE1 and QE2: namely, stimulating growth to help employment recover…Looking ahead, the expiration of tax cuts in 2011 and a government deficit reduction program will present real headwinds to growth.  Layer on top of that the fact that 2012-13 would probably be the end of the expansionary portion of the business cycle, and what is left is a recipe for a serious economic slowdown or possibly even another recession.”

And, finally, there is Alan Blinder’s opinion piece “The Debt Ceiling Fiasco,” http://professional.wsj.com/article/SB10001424052748703421204576329374000372118.html?mod=ITP_opinion_0&mg=reno-wsj.  To stay within the debt ceiling, Mr. Blinder argues, the government must immediately drop it expenditures by 40%. “Suppose the federal government actually does reduce its expenditures by 40% overnight…That’s an enormous fiscal contraction for any economy to withstand, never mind one in a sluggish recovery with 9% unemployment.” 

“Second, markets now assign essentially zero probability to the U. S. losing its fiscal mind.”  That is, the credit risk built into U. S. government securities is zero and the inflationary expectations that are now built into long-term interest rates are also roughly zero. 

And, what has allowed the United States to get into this position?  Well, “The full faith and credit of the United States has been as good as gold—no one has better credit.”  The federal government has been allowed to increase its debt at an annual compound rate of growth of about 8%, year-after-year for the last fifty years.  “Should the view take hold that threats to default are now a permissible weapon of political combat in the world’s greatest democracy, U. S. government debt will lose its exalted status as the safest asset money can buy—with unpleasant consequences for the dollar and interest rates.” 

That is, the United States government will lose its unlimited privilege to flood the world with debt and liquidity at little or no consequence to itself.

  

All three of these articles are concerned with the view that the basic problems of the economy have to do with liquidity…and not solvency.

I have argued for several years now in this blog that this has been a major problem in the analysis of the economy and the current financial difficulties we are now going through.   Right from the start of the current unpleasantness, the problem has been diagnosed as a liquidity problem and not a solvency problem.  The TARP program was designed to give liquidity to certain “troubled” assets on the balance sheets of various financial institutions.  QE1 was designed to provide liquidity to banking and financial markets.  So was QE2.  So were the bailout programs, both in the United States and Europe. 

But, liquidity problems have historically been considered to be “short-term” problems.  They have to do with whether or not an asset can be sold into the current market in real time without having to take a discount from market on the price at which it is sold.  In the past, a liquidity crisis should be over, given the appropriate monetary policy, in a matter of weeks, six- to eight-weeks at most. 

Liquidity problems did not and do not exist for three or four years!

Yet, this is what our policymakers are claiming.  They are claiming we are still in the midst of a liquidity crisis and so we must tailor our monetary and fiscal policies to deal with the lack of liquidity in financial markets.

The reason for this approach?  The models that these policymakers and their advisors are using only include debt in a cursory fashion.  The structure of conventional macroeconomic models over the past fifty years has not included debt in any meaningful way and so the existence of large amounts of debt has not really been relevant for analysis.  And, consequentially, the solvency issue does not surface.  

The focus then is placed on the “liquidity” issue, the desire of economic units to want to hold onto cash assets.  If banks and other economic units desire to hold onto cash rather than lend the funds to others or to spend the funds themselves then the economic will falter and economic growth will be tepid at best leading to high rates of unemployment.  This is a “liquidity trap.”

The solution to this problem is to flood the banking and financial markets with so much liquidity that people just can’t hold on to any more liquidity and so either begin to lend the funds or begin to go out and spend the funds themselves.  This seems to be the current thrust of economic policy, at the Federal Reserve…and throughout the world. 

But, what if a large number of economic units are insolvent.  In such cases, even with large amounts of liquidity on their balance sheets, they will not lend, or will not borrow any more, or will not go out and spend this excess liquidity because of their balance sheet problems.  What about homeowners who find that they cannot pay their loans or find that the value of their home is less than what they have borrowed?   What about banks who hold large amounts of delinquent residential mortgages or commercial real estate loans on their balance sheets?  What about businesses that owe way too much debt and have little or no current cash flows to cover the debt?  What about State and Local governments that have obligations far in excess of their current revenues?  And, what about sovereign nations who face similar problems?

If the problems are ones of solvency, liquidity is going to do very little for those who have a negative net worth other than postpone the day of reckoning. 

This is the problem of debt.  America (and Europe) has done a very good job over the past fifty years of inflating people, organizations, and governments, out of their increasing debt burdens.  The inflation of housing prices was a wonderful “piggy bank” for the middle class during this time period.  Maybe, the United States government went a little overboard in trying to push down this “piggy bank” to more and more people who even with the inflation could not support the debt.  The credit inflation did wonders for building up the salaries and pension funds of state and local governments.  Unfortunately, history shows over and over again that there are limits to the amount of debt people can carry.  But this is a solvency problem not a liquidity problem.

Finally, a country whose “faith and credit “ is as “good as gold” can abuse that privilege.  This, too, is a solvency problem and not a credit problem.  And, as we are finding out…once again…solvency problems cannot be postponed forever.      

Is QE2 a Bubble Machine?

One of the major contributors to world economic growth and development in the post-World War II years has been the ability of capital to flow relatively freely throughout most of the world. As capital began to flow more freely throughout the world in the late 1950s and 1960s, the rules of international monetary affairs changed. One of the most dramatic changes resulting from this freer movement of capital was the breaking down of the Bretton Woods system which finally breathed its last breath on August 15, 1971 as the United States removed itself from the gold system and began to float the dollar.

We are now experiencing some of the consequences of the free flow of capital throughout the world as the impact of the world’s central bank, the Federal Reserve System, is changing the behavior of nations.

One fear is that the changes are being made in the direction of imposing controls on the flow of
capital. As Nobel-prize winning economist Joseph Stiglitz has declared, the world seems to be evolving into fragments. Not exactly what the Federal Reserve had in mind.

This concern is captured by work being done within the International Monetary Fund that points to “the rising tensions as governments impose blocks on cross-border movements of speculative money.” (See “Surging Capital Flows Pull IMF into the Fray,” http://www.ft.com/cms/s/0/85907e38-1924-11e0-9311-00144feab49a.html#axzz1AGISipQS.)
“Emerging markets from Brazil to South Korea to Indonesia are complaining that a growing flood of money is boosting the value of their currencies and undermining their competitiveness. They have imposed different restrictions on investment to try to make sure those funds can’t leave the country suddenly.” (http://professional.wsj.com/article/SB10001424052748703675904576064233644690302.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

“Fundamentally, the IMF wants to expand its oversight of capital flows and determine when restrictions make sense and when they are being misused.”

Up to now, the implied culprit causing this situation to occur has been the monetary policy of the United States, specifically the program of Quantitative Easing (QE2) initiated and executed by Chairman Ben Bernanke and the Federal Reserve System. The low interest rates created by the Fed, keeping its Federal Funds target in the 0.0 to 0.25 basis point range since December 2008 while flooding the financial markets with more than $1.0 trillion in liquidity, has provided the catalyst for the international flows of speculative money.

As international tensions continue to grow, more and more explicit focus will be placed on the behavior of the Federal Reserve System. Experts are expecting that the whole issue of capital controls to become a “big part” of this year’s discussion of the G-20. French President Nicholas Sarkozy, chairman of the Group of 20 in 2011 is seen as a role-player in raising the international profile of the issue.

These international flows of speculative money are also being given credit for a good deal of the world-wide run-up in commodity prices. Speculative movements of funds have been given credit for increases in the prices of oil, gold, silver , and copper, among other non-food commodities.

Now, the rise in world food prices is gaining attention and concern. Today,the Financial Times leads with an article that includes the claim of “Food Price Shock” (http://www.ft.com/cms/s/0/524c0286-1906-11e0-9c12-00144feab49a.html#axzz1AGOW6ARZ). The Food and Agricultural Organization of the United Nations has warned that the world faces a “food price shock” as its benchmark index of farm commodities prices “shot up to a nominal record last month, surpassing the levels of the 2007-2008 food crisis.” This speculative crisis may be exacerbated if certain disturbing weather forecasts for 2011 are realized.

The concern is over the unrest that these higher food prices might have on potential unrest in many developing nations. There is even fear that this unrest could reach some developed countries including those in the Eurozone.

There has been growing discussion about the role that the Federal Reserve has played in the explosion of commodity prices throughout the world. Again, there are lots and lots of dollars “out there” and the cost of borrowing dollars is close to zero, especially in markets that are experiencing various degrees of inflation. Of course, this leads to the question of “bubbles”.

No one has really gotten a handle on the concept of credit bubbles and so there is a lot of discussion about what a credit bubble actually is, if credit bubbles even exist. Like pornography, credit bubbles seem to be whatever an observer wants to define them as.

Debate still exists about the “housing bubble” of the early 2000s. Again, the Federal Reserve kept its target interest rate extremely low for “an extended period of time” in order to insure that the economy did not collapse into a severe recession. Housing prices exploded in this period at double-digit rates of increase every year. The Fed Chairman at that time, Alan Greenspan, still refuses to acknowledge the existence of anything like a bubble in housing prices. Economist Ben Bernanke provided Greenspan with the justification for not acknowledging that a bubble took place.

So, a housing bubble took place in the early 2000s, unless it didn’t take place.

Is the flow of money into world commodity markets creating a credit bubble there? Is the flow of money into the currencies and stocks of developing countries creating a credit bubble there? Is QE2 the “bubble machine” of the world?

Something new has taken place in the world. The information Congress forced out of the Fed confirmed that the Federal Reserve System became the central banker of the world beginning in 2008. A consequence of this change in roles for the Federal Reserve is that, connected with the free flow of capital throughout the world, the Fed can become the “bubble maker” for the world. What the Fed does, does not stay at home!

I have frequently quoted the work of Raghuram Rajan, winner of the Financial Times/Goldman Sachs award for the best business book of 2010. (See a review of his award-winning book “Fault Lines,” http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan.) I now refer to a book written by Rajan fellow University of Chicago professor Luigi Zingales titled “Saving Capitalism from the Capitalists” (Princeton University Press). They write: “Bubbles are often pumped up by a whole new set of investors who do not have the experience or knowledge to invest carefully…There is no guarantee that even in a developed financial market the next new sector with limitless possibilities will not attract it own set of gullible investors.”

The international markets are attracting all sorts of money, a lot of it is money that is inexperienced in the investment in world commodities or the securities of emerging markets. These are the markets that have achieved a high profile in investment circles over the past twelve months or so.

QE2 seems to be working but maybe in ways that would not be recognized by Chairman Bernanke. But, he still denies that the early-2000s monetary policy of the Fed might have created a housing bubble.

You Can't Lead Out Of Weakness: The IMF Meetings

With each international meeting it is becoming more and more obvious, the United States is dealing from a weakened hand.

The New York Times makes it very clear: “Despite loud calls from the United States; and more muted appeals by Europe, Japan and other countries, the annual meeting of the International Monetary Fund did not succeed in placing significant pressure on China to allow a prompt and meaningful rise in the value of its currency.” (See “Financial Leaders Decline to Press China on Currency,” http://www.nytimes.com/2010/10/10/business/global/10imf.html?_r=1&ref=todayspaper.)

The language in the concluding statement of the policy-setting committee of the IMF “was benign.” Everything was postponed to the G-20 meeting in Seoul, South Korea in November.

The United States took a strong position on the value of the Chinese currency and the behavior of the Chinese government with respect to this value. The United States Congress made its will known in late September. Treasury Secretary Geithner also spoke out about the need for action on the part of the Chinese. President Obama has even made mention of the issue.

But, policy-makers are “wary about pressuring China too severely.”

Right now, China seems to hold the cards and no one is willing to move strongly against their position.

Most revealing is the fact that the United States seems to be in no position to press its points with its own actions and does not seem to be strong enough to command support among the other nations that might side with it.

Furthermore, the central bank of the United States, the Federal Reserve System, appears to be on the verge of another round of “quantitative easing”, something that world financial markets have reacted to by selling dollars. The world investment community has not given the United States a very good grade in terms of how its government has managed the monetary and fiscal policy of the country over the past eight years or so and sees these additional efforts as just a continuation of the lack of foresight and discipline and will in its economic policymaking.

If this is the prevailing attitude in the world about the economic policy of the United States, then one can only project further declines in the position of this country in the evolving discussions about world financial arrangements.

The United States has dealt itself a weak hand in world economic affairs. Unless it steps back and re-assesses how it got here and what it needs to do to change the situation, it will just continue to further weaken its position. And, it is very hard for a nation to lead when it is continually hurting itself.

The IMF Bowl: the United States versus China

With the IMF annual meeting taking place this weekend in Washington, D. C., it is hard to pick on any other topic than what is happening in economics and finance in the world.

The underlying story: the United States has not been challenged, financially as well as economically, in many years and has grown comfortable with its position as the Number One Player (NOP) in the World.

Plot line: the United States will not fall from its position as NOP but other countries are becoming relatively stronger, especially China.

Scenario: China smells weakness in the United States position. When an “opponent” smells weakness, that “opponent” steps up its game. Most experts expected China to “step up its game” at some time in the future, but they did not expect this behavior to happen so soon.

Response: the NOP calls “foul”! The first reaction of the NOP is to claim that the “opponent” is cheating or playing dirty. The NOP tries to get those on the sideline into the game in order to overcome the pressure that the “opponent” is applying to the NOP. China bashing has become de rigueur in the United States, especially for those running for office in this fall’s elections. (“China-Bashing Gains Bipartisan Support,” http://professional.wsj.com/article/SB10001424052748704689804575536283175049718.html?mod=ITP_pageone_2&mg=reno-wsj.)

Script: the battle goes on. This conflict is not going to be resolved this weekend. Nor is the conflict going to be resolved at the G-20 meetings in November. The conflict, for the time being, is going to be played out on the playing fields. The “opponent” is going to push the NOP and is going to hit the NOP on many different fronts.

For example, another move by the “opponent’ is the effort by the Chinese to make its currency, the yuan, more global. Last week, electronic trading of the yuan began. Further efforts are underway to expand this trading to banks in the United States and in Europe. (“Yuan Goes Electronic in Global Market Bid,” http://professional.wsj.com/article/SB10001424052748704011904575537754269611906.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.)

“China’s government has made a series of moves in the past year to encourage the yuan’s use outside China, an effort to become less dependent on the dollar for trade and investment. The moves are allowing pools of yuan to accumulate in bank accounts outside of China, particularly in Hong Kong.

Hong Kong banks have been trading the currency among themselves, but through over-the-counter trades where the banks contact each other directly or through brokers.”

This new move will mean that prices and trading amounts will be posted for all to see.

The effort to improve its relative position in the world is not going to stop. China is making efforts on many fronts to strengthen its position in the world. The contest is on.

Leaders in the Obama administration, from the President to the Secretary of the Treasury on down, are speaking out more forcefully against the actions of the Chinese.

World leaders are observing this conflict and are trying to keep the discussions civil and “in bounds”. This is why someone like the managing director of the IMF, Dominique Strauss-Kahn, as well as others, are attempting to temper the rhetoric and bring things into the existing organizations that deal with trade and international finance. (“IMF Chief Steps into Dispute over China’s Currency Policy,” http://www.nytimes.com/2010/10/08/business/global/08currency.html?ref=business.)

Players crying “foul” can only achieve so much. Sooner or later the NOP will have to modify its game plan and raise its play to another level. The “opponent” is not going to lessen its pressure as long as weakness in perceived in the NOP.

And, where does this weakness show? One very prominent place this weakness shows is in the value of the dollar. Since the early 1970s when the dollar was taken off the gold standard, the value of the dollar has declined by about 40%. Except for the “flight to quality” periods experienced during the financial unpleasantness of the 2008-2009 period, the dollar has continued to be in decline from the level it reached during the Clinton years. The international investment community is not “in love” with the fiscal and monetary policy of the United States government.

This contest between China and the United States is for real. The pressure from the Chinese is not going to abate anytime soon. The “rest-of-the-world” is not in any position to contain this conflict unless it shuts down world trade, something it will not do.

This means that the United States must get its act in order. The United States cannot compete with 20% to 25% of its industrial capacity not being used. The United States cannot compete with 20% to 25% of its labor force under-employed and not trained sufficiently to work in the modern economy. The United States cannot compete when its government creates incentives for people to protect themselves from credit inflation rather than engage in productive pursuits.
And, fiscal stimulus by the government and quantitative easing on the part of the monetary authorities will not correct these problems. They will only indicate to the Chinese how weak the United States has become.

This contest between China and the United States is for real. The only way the United States can “raise its game” is by focusing on what can make it more competitive. I don’t believe that the United States will ever again get the “free ride” it benefitted from over the past thirty years or so. So, the United States government must change the way it does business.

The Chinese are only the first in line to “take us on”. Right behind them are the Brazilians, the Indians, and, of course, the Russians, again. And, right behind them is a whole host of other nations.

United States Losing Financial Clout?

There are growing signs that the United States is losing its financial clout. One of these signs is the growing talk about adding other currencies to the list of currencies used as international reserves. The Premier of China has been raising this issue for quite a few months now. French President Nicolas Sarkozy gained attention last week by not only supporting discussions on the issue but also suggesting that France and China work together in developing such a change. The proposed venue: the upcoming G-20 talks in Seoul, South Korea.

There has also been talk within the International Monetary Fund about the need for change, both in terms of representation (the governing body of the IMF is heavily weighted toward the Europeans) and the makeup of international reserves.

The fact is that these initiatives are becoming more and more credible. A change is not imminent, but it is expected that discussions will grow about more co-ordination between countries or the inclusion of other currencies as international reserves.

The United States continues to attack the foreign-exchange policies of the Chinese, but Chinese leaders have worked hard behind the scenes to build relationships and to act in a way that is supportive rather than divisive. A recent example is the announcement that China will buy Greek government bonds to show support of the effort being made in Greece to restore confidence in the economic policies of that government.

“The U. S. plans to use IMF meetings and sessions of the Group of 20 in October and November as venues to coordinate international pressure on Beijing, rather than press its views unilaterally.” (See “IMF Talks on Currency Restraints,” http://online.wsj.com/public/page/news-business-us.html.)

Yet those that seemingly support a broader base for international reserves are getting most of the press and any real publicity condemning the actions of the Chinese appear to be mostly coming from the United States. The support the United States does get seems half-hearted, at best.

The United States seems to be losing its relative position in the financial world. Yes, it is still “Number One” but the fifty years of credit inflation that has weakened its economic base (http://seekingalpha.com/article/227990-monetary-warfare-can-nations-have-independent-economic-policies) coupled with growing strength in the emerging nations has resulted in changes in the relative position of countries in the world. The United States continues to act as if it were still the “sole act” on the stage, while many of the emerging nations, especially the BRIC nations, are finding their relative strength and their voice. (France’s Sarkozy, with no place else to go, seems to be leaning to the BRICs to show he still has some clout in the world.)

The growing conflict comes from the fact that the financial world has become increasingly interconnected. Capital mobility is greater now than many believed possible forty years ago. But, the existence of this mobility limits the choices available to countries: they can either have fixed exchange rates or they can have independent governmental economic policies.

Many, like the United States, have opted for independent governmental economic policies. This has resulted in the internal economic problems in the United States mentioned in the Seeking Alpha post cited above. The consequence of this has been a decline in the value of the United States dollar. Other countries have had to follow various paths in order to protect themselves from what they consider to be a “competitive devaluation” on the part of the United States.

These other countries are not particularly happy.

The call has gone out for nations to join in greater co-ordination: “the Institute of International Finance, the global top bankers’ club, is calling for renewed global co-ordination to address the trend towards unilateralism on macroeconomic, trade, and currency issues. Likewise, Chinese Premier Wen Jiabao has also been calling for global policy co-ordination.” (See the opinion piece by John Plender, http://www.ft.com/cms/s/0/295e207a-d09a-11df-8667-00144feabdc0.html.)

The likelihood of achieving some form of greater co-operation and co-ordination in the economic policies of member nations seems to be slim and none. This is especially true given the leanings of a majority portion of the voting body of the Federal Reserve System and the Chairman of the Bank of England concerning the use of “quantitative easy” to spur on their economies. In fact, the calls for greater “quantitative easy” at central banks has grown over the past several weeks which, of course, has had a negative impact on currencies.

In my view, we are in this conflict for the long haul. To me, the stage is set for the emerging nations to continue to press their point. There seems to be a growing sense their time is coming and that the United States is only going to become relatively weaker…although still Number One.

The model broke in the European sovereign debt crisis earlier this year and the European Union pulled together for a long enough period of time to keep things from totally falling apart. Some people had suggested that this European model of “coming together” be used in the G-20 and in the IMF.

I don’t think this is going to happen.

Greater global co-operation and co-ordination is going to have to come about someday. It is just not going to happen any time soon.

The Focus is on Europe

The recent events in Europe have captured the attention of the world and taken the heat off of China and the value of its currency, the United States and the value of its currency, and financial reform in its various forms.

The focus, in my mind, is going to stay on Europe for a while because that is where the greatest amount of disruption to world financial markets and damage to world economic recovery can take place.

How long will this disruption and damage last?

I continue to recall a piece of advice given several years ago that has never let me down. The advice is this: If you say the problem is ‘out there’, that is the problem! That is, if you blame your problems on everyone else or everything else, your outward facing focus is the problem. Maybe you had better look at what you are doing before you start blaming someone else.

I have found this true in individuals, families, organizations, communities, businesses, and governments.

Right now, Europe is over-run with self-pity blaming speculators and the ‘irrationality’ of markets.

As a consequence, Europe has responded to the difficulties it faces with a grudging move to maintain the liquidity of its financial markets while preserving as much as it can the ‘integrity’ of its economic model. Its leaders are still trying to hold onto their model of the world.

Hence, the blame must be aimed at someone else!

And, that is precisely the problem.

The fundamental problem is that the economic model used by most of Europe is faulty and the current financial problem is one of solvency and not liquidity.

The three primary perpetrators of these fallacies are President Nicolas Sarkozy of France, Jean-Claude Trichet the head of the European Central Bank (French), and Dominique Strauss-Kahn the Managing Director of the International Monetary Fund (also French).

So far, these French leaders have been the winners of the political battles for the heart of the
European Union. So far, international financial markets have given these leaders at least a D- in terms of the plan they have devised to save union.

Where can we find this grade?

The value of the Euro has declined 18% from the middle of December 2009 to this morning.

The German Parliament has voted to support the current ‘bailout’ but throughout Germany discontent is rising concerning the leadership shown by the German Chancellor Angela Merkel. She, more than any other leader within the European Union, seems to be losing her clout.

Chancellor Merkel cannot afford to follow the French leadership.

Germany has established its position within the European Union through its strong economic growth fueled by a very robust export sector. It has also been fiscally prudent and plans to reduce its budget deficit to zero by 2016. The yield on German bonds attests to the belief the international investment community has in the intent and discipline inherent in Germany to sustain these outcomes.

It is these factors, carried over to the whole EU, that have benefitted other nations within the community to the extent that they could live beyond their means and feast off of their association with the Germans.

This, as we have seen, is an unsustainable relationship. Either Germany has to give in and accept fundamental reforms to the European Union that would seriously damage German competitiveness. Or, it has to maintain its discipline and continue to adhere to its fundamental world view.

There is no question as to what I think Germany should do!

Yet, if Germany continues to encourage its competitiveness in European and world markets and maintains its fiscal discipline, others within the European community will either have to emulate them or will have to remove themselves from this union. It seems as if we are at the juncture where there are no other choices. A wishy-washy response at this time will just postpone the outcome.

Of course, the critics of Germany see such a German policy as disastrous. Following the German model of reigning in wages and social benefits and achieving real control over fiscal budgets would result in further dislocation of economic resources in Europe accompanied by social and political upheaval.

The problem is that these other European nations have put themselves into a position where there are no ‘good’ solutions! Years-and-years of profligate living eventually lead to a situation where nothing they can do provides happy answers.

The only thing these loose-living nations can hope for is for time, cause “things will get better in the future!” Yeh, sure!

I don’t know how many times I have heard this response in business and elsewhere. “The market doesn’t understand us!” “All we need is some time and things will work themselves out!” “It’s just that there are some ‘greedy bastards’ out there that want to make money off of our misfortune!”

Europe, your economic model of the world doesn’t work! The only way you are going to really get out of this mess is to change your economic model. Deficits and a lack of social discipline don’t contribute to economic health. But, it is so much easier to blame someone else and following Germany would be a disaster.

There remains a lot to work out in Europe. These issues are not going to go away overnight. How long things remain unsettled there depends upon how quickly people realize that the problems are internal and not a result of “irrational markets” and the greed of speculators. It is very difficult, however, to realize that your model of the world requires modification. Perhaps such change is generational…but, can we wait that long?

Inflation is Just Not Understood!

Funny time to be talking about inflation, but the top economist at the International Monetary Fund brought it up.

Oliver Blanchard, now serving at the IMF while on leave from MIT, has co-authored a new paper and has publically presented the results which have been reported in the Wall Street Journal: http://online.wsj.com/article/SB20001424052748704337004575059542325748142.html#mod=todays_us_page_one. Mr. Blanchard is now saying that central banks that were shooting for a 2% rate of inflation in their deliberations concerning monetary policy should shoot for something more in the neighborhood of 4% “in normal times.”

Economists of Mr. Blanchard’s philosophical bent just don’t seem to understand!

Inflation IS NOT the solution!!!

But, Inflation could very well be the problem!!!

As I keep saying, the post-World War II policy favoring an inflationary economic policy gained power on January 20, 1961. The basic format for such a program was followed, almost religiously, by Republicans as well as Democrats, into the 2000s. As a consequence, a United States dollar that could purchase one dollar worth of goods on January 20, 1961 could only purchase about seventeen cents world of goods in the summer of 2008.

Furthermore, inflation could not keep unemployment, or even more important, underemployment, down, as was originally believed and it could not keep industry working near capacity throughout the last 47 years or so. In fact, if anything, inflation forced manufacturing to focus on rising prices rather than productivity and this contributed to rising underemployment and declining capacity utilization. For more on this see my post, “The US Economy: Not Back to Business as Usual,” of January 8, 2010: http://seekingalpha.com/article/181621-the-u-s-economy-not-back-to-business-as-usual.

Inflation did create a “boom-time” for finance. Finance loves inflation because inflation that runs ahead of inflationary expectations reduces the burden of any debt outstanding. And what did we see between 1961 and 2008? We saw the greatest blooming of financial innovation in the history of the world and a rapid expansion of the finance industry relative to the rest of the economy that was even condemned by the people most responsible for the creation of the inflationary environment.

I have labeled this type of environment one of credit inflation (as opposed to debt deflation). It is referred to as credit inflation because it can incorporate price inflation, as in the case of the consumer price index) and asset inflation, as in the case of housing prices, dot.com boom, stock market boom, and so forth. Credit inflation relates to any time credit in the economy or in subsectors of the economy increases at a faster rate than the normal growth rate of that particular economy or that part of the economy.

And, this was a perfect time for financial innovation. I have just reviewed the new book titled “The Quants” by Scott Patterson, and he mentions many times in the book that the period from the 1960s into the 2000s, the period of the Quant-boom, as a period of “money ease”. In essence, monetary ease “lubricated” the Quant revolution helping to underwrite the massive growth in the financial industry and the development of the “shadow banking system.”

Of course, as Patterson describes, there were some consequences to pay for this expansion. But, I will let you read his book, or, at least, my review of his book, to gather his “take” on the subsequent financial collapse.

This gets me to the main point of this post. Blanchard, and other economists who think along similar lines, work with macroeconomic models that do not really include debt or the changing burden of debt in their models. Thus, the inflation in their models cannot provide an incentive for economic units to increase their use of debt and the subsequent buildup of debt can have no negative implications for the future performance of the economy. Inflation that causes an increased use of leverage and additional risk-taking cannot be explained in their models.

Thus, inflation remains the best solution to this brand of economist for the achievement of economic growth and lower rates of employment. The earlier debates about the Phillips curve seem to be irrelevant to them, let alone earlier discussions about debt deflation.

We are currently in a very precarious situation. Even with unemployment remaining so high and the economy staying so sluggish, more and more people are expressing concern about credit bubbles in the economy. China, who has recovered from the world economic collapse as fast as anyone, is showing tremendous concern about the possibility that bubbles may be forming in its economy and has taken measures with respect to its banking system to prevent such bubbles from occurring.

Still, our banking system contains $1.1 trillion in excess reserves and the Federal Reserve is faced with the problem of “undoing” this injection of reserves into the financial system. See my “Tightening at the Fed”: http://seekingalpha.com/article/187292-tightening-at-the-fed-get-ready-for-the-undoing.

Some economists still believe that re-flation is the only real solution to the current situation of a stagnant economy and massive federal deficits.

To me, Oliver Blanchard and these other economists that think like him just don’t get it! Yet they stick with the models that they have used over and over again and claim, if anything, that the reason why their solutions to the problem have not worked is because they either have not been tried or that they have not been implemented in a large enough size.

To my mind, their models and the solutions they have presented, have been tried and they have been found wanting. To me, to come up with a call for accepting higher rates of inflation in the future is, at a minimum, absurd. In fact, it scares me!

The Changing World Financial Order

The economic and financial order of the world is changing. The Group of 20 met in Pittsburgh last week and clearly showed that it was the international body to contend with rather than the G-7. This past weekend there was the annual meetings of the World Bank and the International Monetary Fund. On Friday, Dominique Strauss-Kahn, who leads the IMF, referred to G-7 as the “late G-7”.

The organizations that deal with world financial and economic issues are broadening their base and becoming more inclusive of nations that are playing a larger and larger role in the world. What is clear, implicitly, if not explicitly, is that the United States is being challenged, not only in terms of its leadership of the world, but also financially in terms of the role that the United States Dollar plays in the world.

The economic leadership of the United States, in pre-conference statements, defended the position of the dollar in the world by “mouthing” their commitment to a strong United States Dollar. Before the weekend meeting, both Mr. Geithner and Mr. Bernanke spoke in support of the dollar: “Top U. S. officials threw their weight behind the dollar Thursday, with the Treasury chief stressing the importance of a strong dollar and the Federal Reserve chief addressing concern about the greenback’s future as a reserve currency.” (Wall Street Journal: http://online.wsj.com/article/SB125440283756156107.html.)

The problem with this is that their assurances were exactly the same as those issued by Treasury Secretaries O’Neill, Snow, and Paulson and that of a Federal Reserve chief with the name of Greenspan. For eight years the Bush (43) administration voiced its support of a strong dollar and the value of the dollar dropped more than 40% against other major currencies!

Geithner, Bernanke, and the Obama administration continue on the defensive as the value of the U. S. Dollar is down both against the Euro by about 11% and against major currencies by about 10% since January 20, 2009.

Given the stance of both the Bush (43) administration and the Obama administration over the past nine years the credibility of U. S. leadership in international circles is not very high.

Although the world community speaks very softly on the issue of the changing nature of international financial and economic cooperation, the talk “off-the-record” is expanding with more call for change surfacing from time-to-time. And, the position of the United States continues to weaken as the government continues to pile up huge deficits which ultimately lead to the further decline in the value of the dollar.

The United States cannot have it both ways. It cannot continue to be fiscally irresponsible and financially powerful.

Another piece of evidence supporting this conclusion is the continuing sale of physical assets in the United States to foreign interests. As the value of the dollar has declined over the past eight years, Sovereign Wealth funds as well as private interests have continued to acquire all or parts of U. S. companies. This move to foreign ownership is not going to cease given the fiscal path the United States is following.

And, it is going to be very difficult and take a good piece of time for the government to change the direction it is heading in. First, the mindset of Washington has to change and there is no evidence that anything of that kind is in the works.

We are in the midst of a major change in how the world is organized. It is not going to happen overnight, but, it is going to happen. The United States will continue to be the most powerful nation in the world, but, its relative position is changing and will continue to change. Furthermore, given these shifts, the United States cannot “get away” with the behavior that it has exhibited in the past. It is going to have to cooperate with others and this includes acting responsibly in terms of its fiscal and monetary policy. Until this happens continue to expect a weak dollar.

The BRICs Are On The Move!

In the midst of the current economic and financial crisis the world is radically changing. Comparisons are constantly being made between the collapse of the global economy that is now being experienced and the collapse the world went through in the 1930s. Whereas most of the discussion has limited itself to the extent of the downturn and the methods being used by policymakers to avoid a repeat of the severity of the earlier depression, I would like to focus on another area in which comparisons can be made. The specific area I would like to focus upon is the relative shifts that are taking place in economic and financial power in the world.

At the start of World War I there was no question that Great Britain was the number one economic and financial power in the world. The 1920s and the 1930s represented a turning point in the economic structure of the world and a change in the location of the center of financial power. The change in economic structure related to the final triumph of the industrial sector over the agricultural sector in the most advanced countries in the world. This movement favored the United States over Europe. The center of financial power in the world shifted from London to the United States. The changes in industrial structure helped to explain parts of the economic dislocations of the Great Depression that were not fully absorbed until World War II. The shift in financial power was not really recognized until after the war.

An important and interesting history of this period can be found in the book “Lords of Finance” by Liaquat Ahamed. I have written a review of this book for Seeking Alpha and this can be found at http://seekingalpha.com/article/121616-financial-collapse-a-lesson-from-the-20s.

I am bringing up this history because I believe there is a similar shift in economic structure and financial power that is going on in the world at the present time. It is important to understand these changes because they are going to influence what is going on in the world for a long time.

Like the 1920s and 1930s there is an economic restructuring going on. To me, the emerging dislocations in the world are related to advances in information technology and the global changes in energy needs. I have no idea how these dislocations are going to work themselves out but there are huge changes coming. The innovation in financial instruments markets over the past forty years or so are the result of the new information technology and the intense study of what are now called “Information Markets” is going to lead to transactions and trading opportunities that have not fully been realized yet. I believe that the collapse of the auto industry is just one part of the mammoth changes that are coming in the area of energy sources and uses.

The other shift that is taking place is in the location of financial power within the global marketplace. Yesterday it was announced that Russia and Brazil will each acquire $10 billion of bonds from the International Monetary Fund (See Brazil, Russia Trade T-Bills for IMF Clout, http://online.wsj.com/article/SB124463884266502011.html). China is planning to purchase $50 billion in IMF bonds and it is said that India will also make a similar purchase. The BRIC countries are on the move!

The reason given for the purchase of the IMF bonds is to increase the clout that these emerging nations have on world economic and financial affairs. The BRIC nations believe that they have earned and therefore deserve to play a bigger role in what is going on globally. Hence, the movements of these countries are not surprising and are not uncoordinated. The leaders of the BRIC nations have been meeting regularly and communicating frequently. Their next group meeting begins June 16 in Russia.

The important thing for the leadership in the United States to realize is that they must take the world into consideration when making decisions relating to U. S. fiscal and monetary policy. I have gotten comments on my recent posts about the dollar that question the need for policy makers to be concerned about the value of the dollar in their decision making. I agree with Paul Volcker that the most important price in a country is the price of its currency. The United States, even more than in the past, will not be able to afford to ignore what the rest of the world is saying about the direction its budget policy and monetary policy are going. All too often in the past, and especially in the past eight years, American leadership has thumbed its nose at world opinion. The rise of the BRICs indicates that this time is over and real attention needs to be paid to what others are saying and doing. Although the United States will continue, in the near term to be the major financial power in the world, the times are changing and will continue to move in the current direction over the next ten to twenty years.

There are two reasons for saying this. First, Brazil, Russia, India, and China are going to continue to become more powerful economically and financially. Whereas there may not be an absolute shift in world power in these areas, there will be a relative shift with the BRIC nations becoming relatively more powerful. This, in my mind, is not going to stop.

Second, some form of international organization is going to evolve that will oversee global financial institutions and financial markets. The IMF is a natural place to look for such leadership. In the past it has not quite lived up to its possibilities. Now, however, it looks as if there is a new focus on the possibilities it presents. The BRIC nations seem to be eying the IMF as a place where they might be able to exert their growing economic and financial clout to attain the recognition and influence they want and believe they deserve. The IMF is certainly not an unwilling recipient of such attention and is actively seeking more funding.

What does all this mean for investors? I would like to focus on just two points related to the financial issues. First, the United States seems headed for a clash with the rest of the world in terms of monetary and fiscal policy. The current and future budget deficits appear to be unsustainable and the Obama administration has not yet presented any credible plans to reduce the amount of debt the government will be creating. In addition, the Federal Reserve has already put so much liquidity into the financial system that Bernanke’s statements about removing the liquidity as the crisis retreats seem less than serious. The added concern is what role the Fed will play in helping the Treasury place all the debt that it must issue. As I have stated before, history has repeatedly shown that this is not a good combination either for keeping interest rates low or for keeping the value of the currency up. Such movements over time will be brought on by the international markets. The only response that will avoid this is to bring the budget under control and take the pressure off the central bank to support the placing of the debt.

The second point refers to the shift in world economic power. If the BRIC countries find that they can work with the IMF, a new power structure will emerge in global finance. Financial and non-financial companies in emerging markets will become much more relevant. Important financial centers will be distributed throughout the world rather than being concentrated in just one or two cities. As with the evolution of the financial power in the 1920s and 1930s, these changes will not take place overnight. What I am suggesting, however, is that we are seeing the beginning of a shift in financial power in the world that will continue to evolve over the next ten to twenty years.

This has important ramifications for the regulation or re-regulation of the United States financial system. As usual, Congress and the Administration are fighting the last war. Right now the policy makers in charge in Washington D. C. are responding to the populist discontent being expressed in the country. Get rid of greed! Regulate salaries and bonuses! Emasculate the role of derivatives! This is not the way to prepare the economic and financial system for the future.

Yes, the world is changing. The economic base of the global economy is shifting and the resulting need to restructure is the reason for the severity of the current recession. Financial power in the world is being re-distributed and this trend is just beginning to show itself. These movements are going to define the conditions for investment in the coming years. It will require new and creative thinking.