The dollar decays, the dollar decays and falls,
The banks writedown their assets to the ground,
Bernanke comes and tills the field and lies beneath,
And after many a summer dies the swan.
with apologies to Alred Lord Tennyson, Tithonus
Here is an exposition of the view that we are heading into a Second Great Depression. Ambrose Evans-Pritchard lays out the facts well and makes some fine distinctions about the role of currencies, especially the dollar. This is critical in understanding events as they unfold.
We are not so certain that this is the correct path of events. Its aids us in making the case as to why a monetary deflation is a much less likely outcome for the US than it was for Japan. But this is certainly a scenario worth watching.
The global economy is at the point of maximum danger
Sunday, July 20, 2008
Ambrose Evans-Pritchard
UK Telegraph
It feels like the summer of 1931. The world's two biggest financial institutions have had a heart attack. The global currency system is breaking down. The policy doctrines that got us into this mess are bankrupt. No world leader seems able to discern the problem, let alone forge a solution. (They know what the problem is, and also the solution. They are afraid to be the first to reveal the truth for fear of backlash, pressure from The Interests, and the blame for causing the bust when the abyss opens - Jesse)
The International Monetary Fund has abdicated into schizophrenia. It has upgraded its 2008 world forecast from 3.7 percent to 4.1 percent growth, whilst warning of a "chance of a global recession." Plainly, the IMF cannot or will not offer any useful insights. (Will not. - Jesse)
Its "mean-reversion" model misses the entire point of this crisis, which is that central banks have pushed debt to fatal levels by holding interest too low for a generation, and now the chickens have come home to roost. True "mean-reversion" would imply debt deflation on such a scale that would, if abrupt, threaten democracy. (Its more a matter of imbalance than degree we think, which is the dirty little secret. The vested Interests would rather a deflation or inflation than a redistribution of their ill-gotten gains to something more equitable. Better the lord of hell than a servant in heaven and all that. - Jesse)
The risk is that these same central banks will commit a fresh error, this time overreacting to the oil spike. The European Central Bank has raised rates, warning of a 1970s wage-price spiral. Fixated on the rear-view mirror, it is not looking through the windscreen.
The eurozone is falling into recession before the US itself. Its level of credit stress is worse, if measured by Euribor or the iTraxx bond indexes. Core inflation has fallen over the last year from 1.9 to 1.8 percent.
The US may soon tip into a second leg of this crisis as the fiscal package runs out and Americans lose jobs in earnest. US bank credit has contracted for three months. Real US wages fell at almost 10 percent (annualised) over May and June. This is a ferocious squeeze for an economy already in the grip of the property and debt crunch.
No doubt the rescue of Fannie Mae and Freddie Mac -- $5.3 trillion pillars of America's mortgage market -- stinks of moral hazard. The Treasury is to buy shares: the Fed has opened its window yet wider. Risks have been socialised. Any rewards will go to capitalists.
Alas, no Scandinavian discipline for Wall Street. When Norway's banks fell below critical capital levels in the early 1990s, the Storting authorised seizure. Shareholders were stiffed. (This is closer to what ought to have been done in the US - Jesse)
But Nordic purism in the vast universe of US credit would court fate. The Californian lender IndyMac was indeed seized after depositors panicked on the streets of Encino. The police had to restore order. This was America's Northern Rock moment.
IndyMac will deplete a tenth of the $53 billion reserve of the Federal Deposit Insurance Corporation. The FDIC has some 90 "troubled" lenders on watch. IndyMac was not one of them.
The awful reality is that Washington has its back to the wall. Fed chief Ben Bernanke thought the US could always get out of trouble by monetary stimulus "a l'outrance," and letting the dollar slide. He has learned that the world is a more complicated place. (Ben is just playing for time, trying to get lucky and avoid sharp objects and the blame for this - Jesse)
Oil has queered the pitch. So has America's fatal reliance on foreign debt. The Fannie/Freddie rescue, incidentally, has just lifted the US national debt from German AAA levels to Italian AA- levels. (At the end of the day the US dollar as global reserve currency is a Ponzi scheme, along with everything that it underpins. No one wishes to face this. Its down to a jockeying for power into the next phase. - Jesse)
China, Russia, petro-powers, and other foreign states own $985 billion of US agency debt, besides holdings of US Treasuries. Purchases of Fannie/Freddie debt covered a third of the US current account deficit of $700 billion over the last year. Alex Patelis from Merrill Lynch says America faces the risk of a "financing crisis" within months. Foreigners have a veto over US policy.
Japan did not have this problem during its Lost Decade. As the world's supplier of credit, it could let the yen slide. It also had a savings rate of 15 percent. Albert Edwards from Societe Generale says this has fallen to 3 percent today. It has cushioned the slump. Americans are under water before they start. (And this is why a monetary deflation is not a viable policy option for the US. We wish more people would 'get' this, and the fact that with a fiat currency with no pegs it is just a choice of policy. - Jesse)
My view is that a dollar crash will be averted as it becomes clearer that contagion has spread worldwide. But we are now at the point of maximum danger. Britain, Japan, and the Antipodes are stalling. Denmark is in recession. Germany contracted in the second quarter. May industrial output fell 6 percent in Holland and 5.5 percent in Sweden. (This is the view that we all go down together, and that some are quicker to rise again than others. Think 1930's. - Jesse)
The coalitions in Belgium and Austria have just collapsed. Germany's left-right team is fraying. One German banker told me that the doctrines of "left Nazism" (Otto Strasser's group, purged by Hitler) had captured the rising Die Linke party. The Social Democrats are picking up its themes to protect their flank.
This is the healthy part of Europe. Further south, we are not far away from civic protest. BNP Paribas has just issued a hurricane alert for Spain.
Finance minister Pedro Solbes said Spain is facing the "most complex" economic crisis in its history. Actually, it is very simple. The country was lulled into a trap by giveaway interest rates of 2 percent under EMU, leading to a current account deficit of 10 percent of GDP.
A manic property bubble was funded by foreigners buying covered bonds and securities. This market has dried up. Monetary policy is now being tightened into the crunch by the ECB, hence the bankruptcy last week of Martinsa-Fadesa (E5.1 billion). With Franco-era labour markets (70 percent of wages are inflation-linked), the adjustment will occur through closure of the job marts.
China, India, east Europe, and emerging Asia have all stolen growth from the future by condoning credit excess. To varying degrees, they are now being forced to pay back their own "inter-temporal overdrafts."
If we are lucky, America will start to stabilise before Asia goes down. Should our leaders mismanage affairs, almost every part of the global system will go down together. Then we are in trouble. (This is 'The Second Great Depression" scenario. - Jesse)
