Possible October Surprises

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Economists’ crystal balls are clouded right now. They see signs of a burgeoning global recovery, but retail sales and other key data surprise with their weakness. There is no sign of inflation, yet commodity prices are extraordinary strong, given we are in the depths of a major recession. The reality is that fiscal and monetary experiments have been tried that have never been tried before, and their combined effect is only beginning to be felt.

Conventional wisdom, based on the experience of the 1970s, holds that over-expansionary monetary policies should lead to inflation, while large budget deficits should lead to higher interest rates. Yet there is little sign of accelerating consumer price inflation at present (although Federal Reserve Chairman Ben Bernanke’s 3 a.m. fear of deflation has also not appeared), while interest rates have trended down in the last few weeks, contrary to expectations of “crowding out” from the U.S. Treasury’s unprecedentedly large budget deficit.

Were the adverse effects of excessive money creation and huge budget deficits not to appear at all, much of economic theory would have to be rewritten. It would mean that excess money creation could magically disappear, leading to no real world effects. It would also mean that budget deficits ad infinitum could be financed, as the global pool of capital simply expanded to accommodate them. Economically, the world would have invented a perpetual motion machine, in which government could create resources at will without adverse side effects.

Perpetual motion machines being impossible in the physical world,  one’s natural skepticism supposes them to be impossible in the economic world. Hence the adverse effects of excessive money creation and budget deficits must either be delayed or be appearing in some novel form, so that observers looking for a repetition of the 1970s do not spot them.

As soon as the problem is posed in this way, the evidence becomes obvious. Commodities prices are far higher in real terms than they were at the top of the 2000 boom, while gold is on the verge of breaking through its record high and soaring into unknown territory. In itself, that makes no economic sense; in a deep recession such as the current one, where markets are allegedly fearful of deflation, commodities and gold prices should be extremely weak.

Commodities and gold therefore are the destination of this year’s hot money, and are forming the new bubble. They are a hedge against inflation, obviously, but they are also a hedge against prolonged recession, since the authorities have made it very clear that in such a case they would continue ad infinitum their current loose money policies.

That makes sense. Stocks, the most likely bubble suspect, are held back by recessionary earnings and prospects. It becomes impossible for even the most enthusiastic Wall Street analyst to push up stocks beyond a certain level if the raw material of “stories” is not there and in this economy the stories are decidedly absent. China of course sees its stock market soar to ever greater heights, since its domestic funding sources have lots of money and very few alternatives, but that market is still largely independent of the world as a whole. As for housing, in most national markets there is a huge inventory overhang, together with a backlog of borrowers heading slowly for foreclosure, so that too is unlikely to see much of a takeoff.

Bonds are an interesting case. From December to June, 10-year Treasury bond yields backed up from 2.07% to 4%. That’s what one would expect with the ludicrous levels of deficit, more than 10% of Gross Domestic Product in both 2009 and 2010, that the United States is currently running. However, yields then backed off; the 10-year Treasury bond is currently yielding about 3.4% and the Treasury is able to fund hundreds of billions of new confetti-like financing with the utmost ease.

That suggests a fair sized bubble has developed in the T-bond market. With the world in recession, yet Asian central banks and other institutions generating massive cash flows because of easy money, the most obvious place to put those flows remains T-bonds. If this is a bubble, however, it is an extraordinarily vulnerable one. At any moment, a modest resurgence in U.S. inflation or difficulty in a long dated T-bond auction could cause confidence to flee the Treasury bond market and yields to leap uncontrollably upwards.

The current situation is unstable. The problems caused by excessively lax fiscal and monetary policies are indeed appearing, but not yet in a form that forces policymakers and economic participants in general to take action. The rise in commodities prices will remove purchasing power from Western economies and push up their consumer price indices, but it has not yet done so since it has been offset by the natural deflationary effects of recession.

The recent modest decline in Treasury bond yields conceals an increasingly unstable bubble, and it is only a question of time before that bubble bursts. Given the current predilections of the world’s central bankers, it is likely that when the T-bond bubble bursts, they will rush to the printing presses, the Fed buying Treasuries in a frantic attempt to stabilize the bond market. In all but the shortest term, that is unlikely to work; it will cause a spiraling increase in gold, oil and other commodities prices that will make it clear to the doziest Federal Open Market Committee member that the punchbowl has been drained dry and the party of monetary profligacy must end.
October 2009 is unlikely to produce another banking crisis. It may very well, however, produce a crisis of confidence in the Treasury bond market, followed by an economic relapse as interest rates are forced upwards and high commodity prices reduce purchasing power in those Western countries that are heavy net consumers of commodities.

If October 2009 fails to produce a full-scale T-bond rout, it will not be long delayed thereafter; the resurgence in consumer price inflation caused by continually rising commodity prices will eventually cause even central bankers to demand higher yields.

Either way, the flood of money that has poured into commodities, bonds and the stock market cannot prop them up for much longer. Like previous such floods, it must eventually reverse, and its reversal will cause yet another round of bankruptcies and unexpected disasters. The “Great Moderation” of which Ben Bernanke spoke so lovingly before the present unpleasantness was always a myth. In reality, the flood of easy money from 1995 caused a succession of bubbles, each one more devastating than the last once it burst. Monetary policy since 1995 has been wholly immoderate, expanding the St. Louis Fed’s broad measure of money, MZM, by 8.7% annually since spring 1995, 82% faster than the 4.7% annual rise in nominal GDP. Its long-term results have been and will continue to be equally immoderate.

The laws of economics have not been repealed. It is indeed not possible to run a huge fiscal deficit without destabilizing the bond market; attempting to finesse the problem by creating excessive money simply causes spiraling commodities prices and subsequent inflation. Equally, an over-stimulative monetary policy will find an outlet either in consumer prices or in asset prices, though it may take a considerable time to do so.

Apart from instability, the long-term costs of excessively cheap money are beginning to be seen in the U.S. economy itself. By allowing money to remain so cheap for so long, and by running incessant payments deficits, the United States has surrendered the advantage of its superior long-established capital base, narrowing its capital cost advantage over emerging markets and exporting that capital to countries with less profligate approaches. Huge budget deficits, themselves worsening the trade deficit, merely export yet more U.S. capital to the surplus nations. That makes it inevitable that the years ahead, in which the United States will no longer enjoy a capital advantage over its lower-wage competitors, will see highly unpleasant declines in U.S. living standards.

Job losses within the United States in the current downturn are steeper than in any previous recession, even though the output decline is only equivalent to those of 1973-75 and 1981-82. Income differentials have widened unpleasantly, as the working class jobs in manufacturing are outsourced to Asia while the cheap money has created a parasitic and unpleasant class of financial manipulators at the top of the distribution. Only a decade of sound money and sound budgets will rectify these problems, and halt the decline in U.S. living standards. Needless to say, we are a very long way from even the start of such a decade.

There really are no free lunches in this world. And of all the attempts to create a free lunch, or a perpetual motion machine, the delusion by government that it can create wealth is the most dangerous.


Martin O. Hutchinson is a Contributing Editor to both the Money Map Report and Money Morning (http://www.moneymorning.com/). An investment banker with more than 25 years’ experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets. At Creditanstalt-Bankverein, Hutchinson was a Senior Vice President in charge of the institution’s derivative operations, one of the most challenging units to run. He also served as a director of Gestion Integral de Negocios, a Spanish private-equity firm, and as an advisor to the Korean conglomerate, Sunkyong Corp. But it was Hutchinson’s work in Bulgaria, Croatia and Macedonia that solidified his reputation as a true “hands-on” expert on the developing economies. As the U.S. Treasury Advisor to Croatia in 1996, he helped the country establish its own T-bill program, launch its first government bond issue, and start a forward currency market. Hutchinson returned to the United States, was named Business and Economics Editor at United Press International, and was able to jump-start the financial-news operation of that historic wire service. In October 2000, Hutchinson began writing “The Bear’s Lair,” a weekly investment column that appears on the Prudent Bear Web site. Hutchinson earned his undergraduate degree in mathematics from Cambridge University, and an MBA from Harvard University. He lives near Washington, D.C.