critical issues in America stem from minimally a blatantly ineffective
public policy, but overridingly a failed and destructive Economic
Policy. These policy errors are directly responsible for the opening
salvos of the Currency War clouds now looming overhead.
Don’t be fooled for a minute. The issue of Yuan devaluation is a political
distraction from the real issue – a failure of US policy leadership. In my
opinion the US Fiscal and Monetary policies are misguided. They are wrong!
I wrote a 66 page thesis paper entitled “Extend
& Pretend” in the fall of 2009 detailing why the proposed Keynesian
policy direction was flawed and why it would fail. I additionally authored
full series of articles from January through August in a broadly
published series entitled “Extend & Pretend” detailing the predicted
failures as they unfolded. Don’t let anyone tell you that what has
happened was not fully predictable!
Now after the charade of Extend & Pretend has run out of momentum and more
money printing is again required through Quantitative Easing (we predicted
QE II was inevitable in
March), the responsible US politicos have cleverly ignited the markets
with QE II money printing euphoria in the run-up to the mid-term
elections. Craftily they are taking political camouflage behind an
“undervalued Yuan” as the culprit for US problems. Remember, patriotism is
the last bastion of scoundre s
The United States is
facing both a structural and demand problem - it is not the cyclical
recessionary business cycle or the fallout of a credit supply crisis
which the Washington spin would have you believe.
It is my opinion that
the Washington political machine is being forced to take this position,
because it simply does not know what to do about the real dilemma
associated with the implications of the massive structural debt and
deficits facing the US. This is a politically dangerous predicament
because the reality is we are on the cusp of an imminent and
collapse in the standard of living for most Americans.
The politicos’ proven
tool of stimulus spending, which has been the silver bullet solution for
decades to everything that has even hinted of being a problem, is
clearly no longer working. Monetary and Fiscal policy are presently no
match for the collapse of the Shadow Banking System. A $2.1 Trillion YTD
drop in Shadow Banking Liabilities has become an insurmountable problem
for the Federal Reserve without a further and dramatic increase in
Quantitative Easing. The fallout from this action will be an intractable
problem which we will face for the next five to eight years, resulting
in the “Jaws of Death” for the American public.
In the wake of the sovereign debt crisis, Europe has
chosen to respond with measures of austerity as various
euro-zone countries pledge to cut spending dramatically in
order to bring their respective budget deficits down to a
few percentage points of GDP apiece. These measures also
come in the much bigger wake of the credit crisis of 2008.
Even more severe is the United Kingdom’s recently revealed
plan to cut £81 billion or a sum equivalent to 4.5% of
projected GDP and characterized by the FT as “the most
drastic budget cuts in living memory, outstripping
measures taken by other advanced economies which are also
under pressure to sharply reduce spending.” In fact, the
UK’s public sector will lose 500,000 jobs as a result of
these cuts. The United States, on the other hand, is
favoring stimulus to austerity by maintaining near-zero
rates and planning another round of quantitative easing or
the buying of longer-term Treasury securities to flood the
system with liquidity. The exact amount and timing of QE2
is unknown, but it comes on top of the $1.7 trillion
pushed into the system by the Fed starting in 2009.
Mandelbrot was not the only analyst to warn that our financial
system was headed for a reckoning. However he zeroed in with
unusual specificity on the besetting flaw – models that
understated risk – and his conclusions grew out of rich and varied
work in the natural sciences. After a career at IBM, Mandelbrot
taught at Harvard, Yale and the École Polytechnique. He invented
the science of “fractals”, geometric shapes that, if submitted to
a simple mathematical operation, generate ever smaller, related
shapes and a pattern of increasing complexity. Fractals were just
as fruitful in generating metaphors and analogies. In the 1960s,
Mandelbrot showed Britain’s coastline could never be measured in a
way that would produce a consensus on its length. An inch-long
stretch was not necessarily less complex and jagged than the
coastline as a whole – it just looked that way. As your
instruments got more sophisticated and measured more crannies, the
coastline got longer and longer.
When Mandelbrot began writing about markets half a century ago,
he was struck by self-similarity, there, too. Markets “scaled”.
Studying the history of cotton prices, he formed an impression,
shared with many physicists and economists, that “all charts look
alike”. Without the legends, you can’t tell whether you are
looking at a century’s worth of data or a day’s. If anything,
scalability was more pronounced in money than in science. All such
charts were hard to read, because of the way chance creates
“spurious patterns and pseudo-cycles”.
This work led Mandelbrot to study the maths that financial
analysts used to build day-to-day positions. Eugene Fama,
developer of the efficient market hypothesis, was one of his
students, but Mandelbrot
grew less impressed with such theories as years went on. The
capital asset pricing model developed by several analysts in the
1960s, Harry Markowitz’s modern portfolio theory, the
Black-Scholes equation for pricing options – all of these came in
for Mandelbrot’s scorn.
The Federal Reserve’s effort to recover taxpayer money used in
bailouts while also ensuring the stability of the financial system
puts it in a “difficult spot,” said
Charles Plosser, president of the Philadelphia Fed.
The New York Fed, which acquired mortgage debt in the 2008
rescues of Bear Stearns Cos. and
American International Group Inc., has joined a bondholder
group that aims to force
Bank of America Corp. to buy back some bad home loans packaged
into $47 billion of securities.
On the one hand, the Fed has “a duty to the taxpayer to try to
collect on behalf of the taxpayer on these mortgages,” Plosser
said today at an event in Philadelphia.
“At the same time, as a regulator, and as someone who’s trying
to preserve financial stability and manage the oversight of banks
and financial institutions, we’ve got another hat that we wear
that says, ‘Should we be in the business of suing the financial
institutions that we are in fact responsible for supervising?’”
The current market rally is not
based on a self-sustained typical economic recovery, but on blind
faith that the Fed can pull out a magic wand and cure everything
with another round of quantitative easing (QE2).
As we pointed out last
week, this a desperate attempt by the Fed to try non-conventional
means to get the economy going again after a massive dose of
conventional measures resulted in failure.
The members of the FOMC
know this, but with further fiscal measures off the table, they
are aware that they are the only game in town.The Fed's acknowledgement that the economy is in trouble is
again highlighted by the latest Beige Book released yesterday.The following are some excerpts from the report:
economic activity continued to rise, albeit at a modest
pace..consumer spending was steady to up slightly, but consumers
remained price-sensitive, and purchases were mostly limited to
necessities and non-discretionary items..Housing markets remained
weak..Most reports suggested overall home sales were sluggish or
declining..Home inventories were elevated or rising..Conditions in
the commercial real estate market were subdued, and construction
was expected to remain weak.Reports suggested that rental rates
continued to decline for most commercial property types..industry
contacts appeared to believe that the commercial real estate and
construction sectors would remain weak for some time..Hiring
remained limited, with many firms reluctant to add to permanent
payrolls, given economic softness..Future capital spending plans
appeared to be limited"
So there you have an outline of
the anemic economic picture in the Fed's own words.To be sure, they indicated some strong points as well.But the weakness in consumer spending, housing, capital
expenditures, commercial real estate and employment pretty much
accounts for some 85% of the overall economy.
In addition some of the major
problems that worried the market earlier have not really gone
debt problems of the weaker EU nations have been papered over
without being solved and are still lingering just beneath the
currency wars that were shoved down the road by the recent G-20
meeting are also a major threat to the global economy.
Furthermore the Chinese housing
bubble previously highlighted by bearish investor Jim Chanos and
others has now appeared on the front page of the New York Times.A new district of the city of Ordos, China, covering 12
square miles and consisting of tens of thousands of houses and
dozens of office buildings remains a virtual ghost town, cited as
"proof of a speculative real estate bubble that will soon pop,
sending shock waves through the banking system of a country
that..has been the prime engine of global growth."According to the article there are as much as a dozen other
ghost towns similar to Ordos.
Another looming crisis that will
not go away anytime soon is the recently revealed mess with
mortgage foreclosure paper work.This is no mere technicality that some would have you
believe.Due to the
complications introduced by securitized mortgages and the slicing
and dicing of mortgages into various tranches, it appears that
large numbers of mortgage proceedings were brought by parties with
no legal right to do so.
The gravity of the situation is
highlighted by the fact that the New York Federal reserve bank and
Freddie Mac along with giant investment houses such as Pimco,
Blackrock, Neuberger Berman and Met Life, sued Bank of America to
take back securitized mortgages that they bought from the bank or
its Countrywide subsidiary.Other leading banks may subsequently be sued as well, and
other purchasers are likely to join the fray.
In addition the situation
is being investigated by the FBI, various federal regulatory
agencies and most of the states' attorney-generals. With the
huge sums of money involved, it does not take much imagination to
realize that this could turn out to be another big threat to the
All in all it seems to us that
the market rally is based on the shaky assumption that the Fed can
now solve all the above problems with unproven, non-conventional
monetary measures that couldn't be solved by the massive stimulus
provided by either conventional monetary or fiscal tools.With the prospect of QE2 already baked in the cake, we
think the market is highly vulnerable in the period ahead.
GYEONGJU, South Korea (Reuters) - The United States sought to
corral reluctant finance leaders into a deal that would commit
emerging markets to cut their current account surpluses and allow
their currencies to rise at a meeting on Friday.
G20 finance officials started their formal meetings on Friday
with nations from the developing world and Japan dismissing the
U.S. proposals which it says are aimed at defusing tensions that
economists fear could trigger trade wars.
U.S. Treasury Secretary Timothy Geithner, in a letter to
finance leaders that was seen by Reuters, said "countries with
persistent surpluses should undertake structural, fiscal and
exchange rate policies to boost domestic sources of growth".
In return, countries such as the United States that are running
big budget and trade deficits would adopt "sustainable medium-term
Geithner's overtures have already been rejected by countries as
diverse as India and Japan and markets are sceptical of a
universal deal that would address global economic imbalances and
tackle attempts by many emerging economies and others to weaken
While the G20 won praise for coordination of stimulus packages
during the global financial crisis, its sense of unity has
gradually evaporated in the face of strains resulting from
unprecedented efforts to revive global growth.
"There is an action plan, but there is an awful lot of
complaints, proposals," Russian finance official Andrey Bokarev
said ahead of the meetings.
A financial source who met with Geithner in South Korea said
that the U.S. official had asked countries to limit their current
account surpluses or deficits to 4 percent of gross domestic
product, something that few G20 members felt able to accept.
China, India, Saudi Arabia and Russia are all running
substantial surpluses while the U.S. is in deficit.
"We need to talk about it first, but numerical targets are
unrealistic," Japanese Finance Minister Yoshihiko Noda said.
The issue of addressing "undervalued" currencies will also tax
leaders, although Canadian policymakers said that China had agreed
in principle to move towards more foreign exchange flexibility.
The U.S. dollar was down 0.27 percent against a basket of six
major currencies , near a low for the year struck last Friday and
currency strategists said there would be further weakness if the
CURRENCY ISSUE REMAINS UNANSWERED
Geithner's letter made no reference to the anticipated language
of the final communique on foreign exchange arrangements.
He did state that G20 countries "should commit to refrain from
exchange rate policies designed to achieve competitive advantage
by either weakening their currency or preventing the appreciation
of an undervalued currency".
The best the meeting could hope for, other officials said, was
a statement on avoiding competitive currency undervaluation and
some indicated there would not be any significant hardening of
"The reference to avoiding 'competitive currency
undervaluation' as a goal between big economies is not new but
appeared in a previous G20 meeting in the UK. It will likely
appear again in the communique this time," a senior G20 negotiator
who spoke on condition of anonymity told Reuters.
Many emerging market policymakers are loath to allow their
currencies to rise substantially and blame the United States for
financial mismanagement that led to the global financial crisis
and accuse it of engaging in its own devaluation by flooding
markets with liquidity from its quantitative easing policies.
That has had the effect of pushing a wall of money into
emerging markets like Brazil, spurring them into action to stem
capital flows which have boosted their currencies and asset prices
and complicated fiscal and monetary policy.
The language of the last G20 summit stressed the need to
"refrain from competitive devaluations" and anything stronger
would mark a significant move from countries like China and host
South Korea , said Credit Suisse currency strategist Olivier
"You would have to commit to allowing your currency to
appreciate," he said.
The Fed has engineered the devaluation of the US-dollar, by
issuing a steady drumbeat of threats to unleash QE-2, upon the
world money markets. Bond dealers reckon the Fed could print a
minimum of $500-billion in the months ahead, or it might decide to
monetize the entire US-budget deficit for this fiscal year,
projected at $1.2-trillion. Also greasing the skids under the
US-dollar has been the steady slide of US Treasury yields compared
to German bund yields.
US-lawmakers and President Obama
have seized upon America's widening trade deficit, which reached
-$49.7-billion in June 2010, to take aim against the Chinese yuan.
Over the last 12-months, the US-trade deficit with China reached
$257-billion, and is running 21% above the pace from a year
earlier. The deficit with China as a share of America's balance of
payments is now over 40%, compared to just 20% in 2001.
Year-to-date imports from China are $229-billion, while exports
are only $55.8-billion, leaving the ratio of imports to exports at
4.9.The average for all nations' imports-to-exports with the
United States is a ratio of 1.6.
regularly in its foreign exchange market to rig the value of the
yuan, and it's acquired a massive $2.65-trillion in FX reserves,
while keeping the Chinese yuan undervalued by 40% against the
US-dollar, on a trade weighted basis. Democrats and Republicans in
the US-Congress aren't willing to wait for Beijing to revalue the
yuan at a snail's pace over the next several years. In Hong Kong,
the 12-month yuan forward contract is trading at 6.4425 /dollar
indicating that traders figure that Beijing would only allow the
yuan to rise by a paltry +3.2% rise against the dollar over the
US-lawmakers aim to level the playing filed
in one fell swoop. On Sept 29th, the US-House passed legislation
by an overwhelming margin, 348-79, to allow the Commerce
department to apply tariffs on Chinese goods entering the United
States. In the past, the Senate has pushed for tariffs of 25% on
Chinese imports. "There is no question that China manipulates its
currency in order to subsidize Chinese exports," said Republican
Senator Richard Shelby of Alabama. "The only question is: Why is
the administration protecting China by refusing to designate it as
a currency manipulator?" he asked.
On October 16th,
Treasury chief Geithner backed away from a showdown with Beijing
over the value of the yuan, by delaying a much-anticipated
decision on whether to label China as a currency manipulator until
after the Group-of-20 summit on November 11th. "Since September 2,
2010, the pace of the yuan's appreciation has accelerated to a
rate of more than 1% per month. If sustained over time, this would
correct a significantly undervalued currency," the Treasury said.
On October 16th, Treasury chief Geithner backed away from a
showdown with Beijing over the value of the yuan, by delaying a
much-anticipated decision on whether to label China as a currency
manipulator until after the Group-of-20 summit on November 11th.
"Since September 2, 2010, the pace of the yuan's appreciation has
accelerated to a rate of more than 1% per month. If sustained over
time, this would correct a significantly undervalued currency,"
the Treasury said.
"The global financial system continues to be unsound in
the same way that a Ponzi scheme is unsound: there are not
enough cash flows to ultimately service the face value of all
the existing obligations over time. A Ponzi scheme may very
well be liquid, as long as few people ask for their money back
at any given time. But solvency is a different matter -
relating to the ability of the assets to satisfy the
John Hussman No Margin
of Safety, No Room for Error
Gordon T Long is not a registered advisor and
does not give investment advice. His comments are an expression of opinion
only and should not be construed in any manner whatsoever as
recommendations to buy or sell a stock, option, future, bond, commodity or
any other financial instrument at any time. While he believes his
statements to be true, they always depend on the reliability of his own
credible sources. Of course, he recommends that you consult with a
qualified investment advisor, one licensed by appropriate regulatory
agencies in your legal jurisdiction, before making any investment
decisions, and barring that, we encourage you confirm the facts on your
own before making important investment commitments.ont>
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Gordon T Long
is not a registered advisor and does not give investment advice. His comments
are an expression of opinion only and should not be construed in any manner
whatsoever as recommendations to buy or sell a stock, option, future, bond,
commodity or any other financial instrument at any time. While he believes his
statements to be true, they always depend on the reliability of his own
credible sources. Of course, we recommend that you consult with a qualified
investment advisor, one licensed by appropriate regulatory agencies in your
legal jurisdiction, before making any investment decisions, and barring that,
we encourage you confirm the facts on your own before making important