The view from the top

Tuesday, May 25, 2010

After yesterdays look at the micro workings of the money markets lets stand back during this interlude in Nightmare on Elm Street and have another look at the really Big Picture. To make sure we're still heading in the right direction, let's have a look around...

Behind us

The US banks with a large dose of help from the accountants and regulators rebranded debt as assets, switched the money in their vaults with IOUs, lent the real money to Joe Public who gave it to China in exchange for expensive plastic chattels, who in turn spent a load of it in Australia and put the rest in a big pile. Then someone noticed the worthless promises in the bank vaults and the need to replace them with some real money. Which was a bit of a shock. So the UK and US governments kindly printed a shed load of new money and borrowed oil tanker-like ship loads of it to refill the bank coffers. Job done, "I thang yow and goodnight". Please don't call for an encore and please leave the theatre quietly.

Meanwhile, in Europe, they had found a cunning way around all that worrying middle bank bit by just lending directly from the governments to Joe Public via enormously profligate social policies. The nice up side being for Joe, or Juan or Guiseppe or Georgiou Public is that it isn't even a loan so they aren't even expected to pay it back, unlike Mr and Mrs Foreclosed on Main Street and Mr and Mrs Bust of Acacia Avenue. Instead, it's the governments who are directly left holding the can with no-one else to really blame. In the UK and US, the politicians were adept enough to pin the blame on the banks, leading the rabble on the march against the City/Wall Street. Despite Mangler Merkels late "It was 'im sir" short-selling swipe at the banks, the blame game seems weak and it is the Governments that are in the firing line. Riots in Greece, general strikes threatened in Spain (buy shares in plywood manufacturers in Madrid?). It's hard to believe that Italy is going to stay quiet through this, despite Berlesconi's apparent dash into hiding. 629,000 official government cars in Italy? (watch Fiat's next numbers!)

Where are we

So much dire gloom has been published about the state of the EU that you'd almost believe that the US and UK debt monsters have evaporated. They haven't, they just have new bedfellows. It would appear that the money that Europe is now "not" printing to help out its domestic brethren is fast leaking fast into USDs and even GBP (and, of course, CHF), giving the illusion of comfort for the US and UK. Yes, GDP may be running at a reasonable lick in the US, but how much of that is still on the back of borrowing and public spending? In fact, you have to wonder whether GDP measures are the next accounting con to unravel. Should they really ever contain public spending figures funded by increases in debt? If I borrow money and give it to the kids to buy sweets does that mean we as a family have a higher GDP and so should be lent more? Seems daft....

This European shake-up is only drawing clearer battle lines between New East and Old West. The Old West have been playing so hard for the past decade that they have ended up kicking the football over the fence into New East and are now desperately shouting over the fence to get it back "Hey Mister, can we have our ball (trillions of Dollars/Sterling/Euros/Commodities) back, please?", and the answer appears to be "No sorry, I'm going to keep it till you have learned to behave", and rather more quietly "and I'm even going to play with it myself".

Where are we going?

So where are the West going to replenish their meagre coffers? The argument of deflation appears to now be on everyone's lips but the end game cannot be. The US, UK et al. are not Japan. Japan has savings and the Yen is effectively a pension currency constantly being recycled, so a devaluation never occurs to help them inflate their way to growth (through a dodgy GDP reading again). In the West, it is hard to see the ball being returned from the East without a huge bout of inflation to alleviate the debt burden and revalue the competitive manufacturing/IP base. In the past, the West has either had a steep Intellectual Property-gradient (and weapons-gradient if you go further back) to earn (or threaten) its way to higher relative wealth. But the world is levelling out on all fronts (apart from debt where it's tipped the other way) and if there is someone willing and able to do your job for less than you, you are toast. Or on strike and toast (listen up BA crew). Western expectations of a 4 bed house, car and good education in exchange for basic jobs have to be tempered against the tidal wave of exceedingly well-educated and unemployed people out there at your ankles willing to do it for less. And if Western relative wealth has to diminish then, psychologically, folks would always rather see it eroded by inflation (blame someone else) than take a pay cut, which is a direct admission of personal failure. So having your own currency to devalue to help you on this course is of great advantage.

So we get back to the inflation vs. deflation argument. It would appear that the deflationary function we are currently seeing in various European countries is a short term adjustment as the consumer stops spending. This reduction in spending should swiftly impact the currency via the debt servicing load and result in it falling RELATIVE TO THOSE with the savings and hence an increase in imported inflation. The trouble is, years of promises to public sector workers have resulted in very large (in some cases, larger than the "official" national debt numbers) inflation-indexed pension liabilities being run up, neutering the inflation argument somewhat. But there are plenty of examples of debtor countries treating external creditors in a different way to those domestically. We must stop focussing on EUR/USD, EUR/GBP and start looking instead at EUR/USD/GBP block vs. savers. Once this massive deleveraging event has run its course, it will be back to plan A: buy things of limited availability that other people want.

And that won't be EUR, GBP or USD. The USD and GBP have all had their turn as a funding currency... now it's the Euro s turn....

...right, interlude over. Back to our seats for the main billing...

Posted by Polemic at 10:09 AM  


So are you calling for another bout of deflation followed by major inflation?

Thanks for taking over the blog, btw.It's much appreciated.

Bill said...
12:38 PM  

Good orientation.
MM has done well to delegate the blog. I am glad this space still breathes.

Ati said...
2:45 PM  

Yes. That seems about right.

Once we get through DELEVERAGING, PART DEUX and the 10y is down in the 2.00-2.50% area again, then we will be back to buying commodities again to anticipate the inevitable reflation brought about by the advent of QE2 and Son of Stimulus, and so the cycles will continue....

But in the mean time, the ongoing carry trade unwind and associated commodity/equity bust might end up popping the Aussie, Chinese and Canadian housing bubbles.... oh that's right, housing only goes up in those countries, I forgot.

Leftback said...
5:45 PM  

Loved the post.

Isn't the problem with the New East that while they make all manner of shiny things, their people don't want to buy the shiny things. Though this is as much by design as anything!

That, and they (well China) have learned accounting tricks well from the Old West, and stacked their debt up in contingent liabilities that can't be seen until...

Our Man in NYC said...
6:16 PM  

re that view on inflation -yes
And thanks..

Ati - thanks very much

Leftback - I'd love to see that unwind carry right through to the chinese property market. Talk about a lever that needs deleveraging ...

Our Man in NY - Yes they do want to buy shiny things but tend to do it on the old premise of our parents - earn the money first. Unless it's a Chinese house of course, in which case borrow up to the hilt because as LB says - can only go up right? ho hum .,.

Polemic said...
9:52 PM  

I'm still solidly linked to the deflation camp. How inflation is going to pour through the system remains the question as long as an increase in purchasing power for the big spender lacks.
His purchase power can only rise if prices fall while his income remains stable at least, his income rises and prices remain at least stable or interest rates drop and gives him more room to consume.
I even doubt labor income will stay index-linked in a Europe that is going to make a tour de France in austerity policies.

But the difference with Japan with its pension currency and the debt laden Western economies is an interesting take.

wildebeest said...
6:15 AM  

i think the US/EU/UK-as-Japan risk is bigger than you seem to give it. true the foreign assets are perpetually yen-bullish, but even if the flows slow down the east is still going to denominate reserves in western currency. and it's not clear at all that the big western banks have really written things off enough that they will restart lending anytime soon, and even if they did the consumer is still way overlevered.

also worth pointing out that on a per-capita basis japan's not been that poorly off through the lost decade(s), because their pop doesn't grow. slowing pop growth certainly in UK/EU (though not in US) might actually keep things disinflationary for a long time. from a policy perspective, you can envision an aging western country actually preferring a stronger currency even as they are delevering. for an american consumer, they still want cheap plasma TVs even if they are unemployed.

savageblogger said...
6:04 PM  

Reflationary maneuvers will be largely unsuccessful. With half the population retiring and 25% unemployed (U6) it is a little difficult to see who will drive demand for anything but basic consumer goods, so how are retailers going to be able to raise prices (which must increase to generate cost-push inflation)...? It doesn't work against an aging demographic backdrop, does it?

Leftback said...
7:04 PM  

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