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Monday, November 10, 2008


why it's important

david merkel makes more sense on limited sleep than most people do nine hours' rest.

The aggregate capital structure of the economy is not a matter of indifference. If there are many debt claims, and firms with debt finance other firms via debt, who finance other firms via debt, etc., then we set up a bunch of financial dominoes, where a disturbance can knock one down and carry others with it.

This is why the total debt to GDP ratio matters so much. Economies stop functioning when they have high levels of embedded debt and a slowdown hits. That is where we are now, at levels of Debt to GDP that exceed those of the Great Depression. Until we get that ratio down from 350% down to 150%, normalcy will not return. (more on this from merkel.) Air is leaking out of the debt bubble, and the ability to reflate is not there, because the market value of the assets have sagged to such a level that even a zero Fed funds rate will not raise the market value to the levels where the assets are booked.

People are not reliable; they sin; they default. Economic systems that are primarily equity financed are better able to deal with the nature of man, because they have more flexibility. Economic systems that are more heavily debt financed face more problems when someone cannot live up to his promises, because it means that others relying on the performance may not be able to live up to their promises also.

Things are different now. In past economic cycles, there were sectors of the economy that could be stimulated by the Fed lowering the Fed funds rate. But now, because of too many fixed committments, there is no sector of the American economy that can absorb more debt, and stimulate everyone else.

Thus the task of levering up falls to the Federal government. But will they be able to honor all the promises that they have made? Given that they control the printing press, the answer is yes in nominal terms, but no if in inflation-adjusted terms.

the caveat "inflation-adjusted terms" is all important to those who are doomed to invest on nominal terms. we are in a liquidity trap and experiencing a deflationary debt collapse; a response of quantitative easing is on the way. this feeds directly to the argument over what comes next, inflation or deflation. mish is in such a debate with peter schiff, but close reading is required.

After that initial opening, Schiff jumps off the deep end with a "print print print" rant about hyperinflation, ... finishing up with "There is no way the dollar can possibly survive what is coming". ...

Schiff ignores ignoring monetary printing in China, huge bank bailouts in Europe, housing bubbles in Australia, Canada, Spain, and the UK, all bigger than in the US. The stock market bubbles outside the US were even bigger than the stock market bubble here.

Furthermore, there has been more monetary printing in China this year than in the US. And as noted above China just announced the same reckless measures the US did in trying to stimulate the economy. ...

Deflationary pressures have never been greater in the US, UK, EU, Canada, Australia, and other countries. Collapsing debt bubbles, rising foreclosures, rising defaults, and rising unemployment are deflationary forces. And those forces are global, not just in the US.

Yes, the US is going to print but so is everyone else. In isolation, what looks awful for the US, does not look so awful in relation to what every other country is doing.

This should be a good backdrop for gold and that is another point on which I agree with Schiff. Intermediate term, we could both be wrong.

I certainly am not bullish on US equities, nor am I in favor of the programs that are likely to come out of Congress. However, when it comes to global conclusions and the US dollar, I think it's a case of Hugely Right, Enormously Wrong, at least over the intermediate timeframe. After the debt bubble unwinds, then and only then will inflation become the primary threat.

mish is describing a series of competitive devaluations as monetary authorities seek to reduce real debt burdens by inflation and/or maintain mercantilist stances favorable to exporters. what are the logical consequences of such a competition?

increased volatility in currency markets would seem probable, but the goal of the competition would for most players be a maintenance of something like current levels against the dollar, which is still the medium of international exchange and the currency of what remains the world's largest export market. so the result of success would look like dollar stability, if not strength.

even with all currencies being simultaneously debased the time-honored relative adjustment dealt by depression -- that is, the repricing of assets and finished goods down in relation to raw inputs to reflect the contraction of finance, which we've been seeing dramatic examples of -- would soldier on. success in currency debasement, however, would mean that asset prices may not deflate as much in currency terms -- and raw inputs prices as measured in any currency could advance smartly provided that printing is on a level competitive with the size of the deflation in credit.

that is indeed a sticking point, as the size of the credit bubble is incredible. but the potential of the dynamic to render futile investment in any asset but the physical stock of goods as a store of value is undeniable. will it work that way in practice? i don't know that anyone can say. but i have begun to wonder if it isn't prudent to store savings in physical goods -- obviously gold, but also perhaps platinum or silver, both of which have been halved in the last few months by virtue of their industrial applicability.

UPDATE: more from andy xie in china international business.

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The people who founded the Republican Party and the hard-money Democrats like Cleveland agreed that the key to future prosperity was to have Congress observe its Constitutional duty to "regulate the value" of the U.S. dollar (Art. I, Sec. 8). Asset prices and incomes should be expected to fluctuate dramatically in the markets as they always have, but the value of the currency should be fixed by the promise to pay something that was real and not subject to counterfeit or fraud - a measure of gold. Even the humblest of citizens should be able to know what their money was "worth". That was the wisdom behind the "barbaric relic" of the gold exchange standard, and the explanation for the extraordinary development of America in the years between the Civil War and the election of Woodrow Wilson. People can perform wonderments of thrift and invention if they have confidence that the government will not put its thumb on the scale when they go to cash in their chips. But how is this to be done in an age of manipulated exchange and interest rates? The paradoxical answer may be to bring back the Gold Room, to revive the notion of gold certificates and the Jacksonian idea of Federal depositories. The new Bank of the United States would accept Federal Reserve notes in exchange for gold certificates - a U.S. currency exchangeable on demand for a fixed measure of gold. Establishing a competing currency for savings may be the only way for the Treasury to fund the workout of a banking system whose assets have failed and whose leverage went far beyond prudence.

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I also have been following the Mish Schiff debate.
What I always wonder is why would the Chinese continue on the path of matching US dollar printing?

In times of severe stress human nature seeks to defend self interest.

I find it more probable for the Chinese and Russians to throw the USA under the "fiat" bus.

The only thing keeping the plates spinning for the US is the fact that no other country has refused to step up to the "fiat" printing press. The first nation that does so stands to benefit greatly. The exit out of the burning theater is small and the house is full.

If it all goes to hell I have no idea if the Russian people or Chinese people comes out on top but I'll will take all bets that an American consumer will come in last place.

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