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Never have so many been promised so much by leaders with so little intention to pay up.
by Eric Janszen
Interest created by the “Next Bubble” Harper’s article that's now available online has put me way behind on mail from subscribers. Unfortunately, I can’t answer all the great questions. I’ll focus on two that are representative.
The first question comes from a subscriber who asks:
Q: “What would EJ do it he were Ben Bernanke?”
A: The easy answer is: I wouldn’t be Ben Bernanke. I said when he started: “With a storm of credit collapse hitting US shores, Ben Bernanke has stepped into the biggest goat job in central banking history.” (see Ka-Poom is a Rhyme not a Repeat of History). But that’s too easy. Or right after I got the job I could go to Congress and say, “This central banking institution is so broken we’re better off getting rid of it and coming up with something else.” While that approach certainly lets me off the hook, it's not realistic. Where would Congress get the money to fulfill every election promise made if not the Fed's digital printing press? Besides, if the Fed were abolished tomorrow a private institution will step in to fill the role. Which one? I’d put my money on Goldman Sachs. That might be an improvement – at least GS had the good sense to avoid the worst of the housing bubble whereas the Fed made it happen. For all I know if GS were acting as the central bank in 2001 it might have tried to protect itself from losses later and seen to it that lending laws were not broken and crazy securitized debt products not sold.
If I was unable to avoid the Fed Chairman’s job or get out of it by convincing Congress to abolish the Fed, what can I do when faced as Bernanke is with the choice between a deflation spiral and an inflation spiral as the debt deflation progresses? Anything I do to cure one just makes the other worse.
The first thing I’d get my head around is the fact that no matter what I do if I do the right thing I’m going to be unpopular. Never have so many been promised so much by leaders with so little intention to pay up. The Fed has promised both “no recessions” and “price stability.” As it turns out, policies employed to fulfill this misguided political mandate are resulting in both recession and inflation.
I’d hold rates where they are and allow the recession to take its course. I’d take only the best credits at the discount window. Insolvent banks will fail and solvent banks will pick up the good assets. I’d write off the FIRE Economy. The real estate industry will revert to being the ancillary industry it is in other countries. The insurance and finance industries will revert to their pre-1980s role of supporting industrial development versus replacing it. I’d focus all of our monetary policy firepower on those sectors of the economy that can allow the US to develop into sustainable economic growth at a 1:1 ratio of debt to GDP growth versus a multiple; industries like biotech, health care, agriculture, energy, technology, and public infrastructure will lead the way.
Now you’re probably wondering, what about all of the unemployed? I expect unemployment to rise well into the double digits. The fact is they are going to be a lot of unemployed sooner or later anyway. For every job created since 2001 combined public and private sector debt has increased by $1.8 million. Did anyone seriously think that could go on forever without the dollar falling and inflation rising? The ill-conceived finance-based economy is destined to wind down in any case.
This is no great mystery. We all know what needs to happen. The US economy needs to restructure to look more like the Germany’s, with a focus on modern industry, production, and saving and less on finance and debt. It is from these new industries that the new jobs will come.
Entrenched interests in the finance, insurance, and real estate industries will be trying mightily to peg me and I won’t get to finish my run but maybe my successor will. It’s a goat rodeo either way and I’d rather be a head hunter* than a dragger or a trotter.**
* Head Hunter (BR) - A bull that is constantly looking for someone to charge.
** Dragger or Trotter (TR) - A steer that hangs his head and doesn't run after being roped, many times trotting or stopping.
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The second question is a actually a series of questions asked by a subscriber who is a CPA. He is also a practicing lawyer, but don’t hold that against him. Some of our best friends are lawyers. He questions the idea of a coming boom in transportation, energy, and communications infrastructure.
Q: Isn't America's credibility in jeopardy? Given the losses foreign investors have sustained and will sustain in the ongoing mortgage meltdown won't foreign investors be chary of anything that smacks of another American bubble? As in "once burned, twice shy"?
A: CDOs and securitized debt products that funded the housing bubble where "common" shares sold to private institutional investors and governments but with no rights or protections attached so that when the housing bubble collapsed, they were left holding “shares” that lost most of their value. A similar fate befell the same investors after the technology bubble of the 1990s, except that the funding mechanism that time was venture capital (See How Venture Capital is Ruining the Internet, July 2000). The question this is not once burned, twice shy but twice burned, more than twice shy?
Keep in mind, however, that most foreign investment in US in the past several years in terms of capital flows has not been by private individuals and institutions into US corporate stocks and bonds but by sovereign states in US treasury and agency debt via central banks. With the recent development of Sovereign Wealth Funds (SWF)since 2006 that trend is likely to expand to include other assets classes, including stocks and corporate bonds that have become increasingly difficult to market to “more than twice shy” overseas institutional and individual investors. So how will these mega-projects be funded?
Over the next five years many Public Private Partnerships (P3) will be formed to develop major, capital-intensive for-profit transportation, energy, and communications infrastructure (TECI) projects in the US to bring the US out of an economic depression. Think of it as a New, New Deal™ versus the 1930s old New Deal. The stocks and bonds issued to finance these firms will be guaranteed by the US government much as Fannie Mae mortgage bonds carry an implicit government guarantee, or perhaps more explicitly in the P3 corporate charter. Think of these as "Class A Preferred" shares in these for-profit projects versus the securitized debt, dot com stocks, and other garbage dumped on 30 year old managers of foreign pension funds. You are correct: that won’t work again.
Q: Given the losses foreigners (and Americans) the Fed's rate-dropping, will there be the wherewithal to fund another bubble? For example, if the dollar continues to drop, and with low interest rates, surely buying dollar-dominated assets is a losing proposition.
A: After the last major debt deflation in the US in the 1930s, FDR went to primary wealth holders in the US with an offer better than their counterparts were getting in Europe at the time. In the current instance, the US is a debtor not a creditor as it was in the 1930s, and so the onus is on US creditors to help the US not default on its debt. They are motivated to assist the US in managing its debt deflation and rolling recessions without further externalizing these, as the US has already by allowing the dollar to depreciate over 35%. The US will offer its creditors a workout deal composed of: one, inflating away of debt; two, the sale of capital and assets via sovereign wealth funds, treasury purchases via appropriations, and central bank funds; and three participation in the re-industrialization of the US via investment in for-profit P3s and start-ups developing next generation national transportation, energy, and communications projects and technologies. In this way, China, Japan, and oil producers can invest their dollar denominated reserve assets, such as treasury bonds, that they cannot spend at home. This will also have the effect of reducing dollar depreciation, thus reducing losses to inflation.
The alternative is possibly another period of de-globalization and global economic depression, and possibly worse as in the 1931 to 1945 period, the worst outcome for debtor nations and creditors alike.
Q: If money keeps getting pumped into the US economy both from the fiscal side (the "stimulus" package) and the monetary side, don't we run the risk of hyperinflation?
A: The risk is that things don't get bad enough fast enough. If politicians can muddle through to the November 2008 presidential elections with tax rebates and Fed liquidity injections without rapidly rising unemployment and major market dislocations then the new administration will likely be a new version of the old, irrespective of party. After elections the new administration, whose campaign will have been funded by current interests, will make Japan 1990 on style valiant attempts to perpetuate current arrangements and interests – that is, the FIRE Economy – and indeed a further 50% or more depreciation of dollar may occur. Dollar depreciation, undertaken as a key reflation policy tool in 2004, is already starting to not work; the short term boost to exports and profits has, a few production cycles later, turned into an inflation spiral, as input costs and wages rise. Consumers who saw wages rise 6.1% year over year in Nov. 2007 still think they're getting richer, but oil, food, and gold prices say otherwise; eventually they will figure out how much purchasing power they are losing and businesses will discover that the purchasing power of revenue and profits is also declining. That happens when demand declines hit oil prices, and petrodollar recycling volume falls and US interest rates rise.
If the economy and markets deteriorate at a more natural rate without government bailouts then a new administration will have greater license to make policy changes that are politically inexpedient except in crisis. So, paradoxically, if one is hoping for a radical shift of the US economy from its current FIRE orientation toward re-industrialization, a rapid descent into a serious economic and market crisis is preferable.
Q: And aren't there some other bubbles about to burst, such as bond insurance, commercial paper, consumer debt, and student loans?
A: And on and on, including fallout from the LBO bubble that ended August 2007, and don’t forget the coming crash in commercial real estate. Friends in the banking industry tell us that a Japan style debt deflation has begun for the US, the UK and Australia. The key difference is that the US is a debtor not a creditor, so as you say monetary injections to prevent the banking system from falling into a liquidity trap will feed into the inflationary spiral and that can get out of hand quickly. We’ve warned of this for years but now it’s front page Wall Street Journal news. For this and the reasons cited above, a boom in Transportation, Energy, and Communications Infrastructure (TECI) by late 2009 is critical.
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