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Wednesday, June 10, 2009


peter schiff and richard duncan

via clusterstock -- here's my comment appended:

i dislike seeing schiff on the public stage because, while he has the consequences right, i think he clearly has the causes wrong. it's not "the fed" -- the fed doesn't set the long term interest rates that dominated consumer credit during the housing boom, as they just proved by having the mortgage market clobber them over the head. you can argue that the deficit spending of 2000-current was tragically stimulative, but that's not monetary policy.

the crisis has its origin in foreign exchange, and i've never heard schiff talk about that. has he? asian (and german) mercantilism created the large capital account imbalances that are always and everywhere precursor to massive national leverage booms. the suppression of asian consumerism in favor of export-oriented policy flushed the asian corporate sector with american cash -- which it levered before recirculating it to the united states, where it forced credit availability into incredibly easy terms as it sought an outlet. THAT is the artificial stimulus that pushed americans into ever deeper consumerism and debt.

why has not that analysis seen the light of day past the likes of richard duncan and john hempton?

duncan's book has been on my bookshelf for a long time and is overdue for some attention. this interview gives the outline of his book, which i think was prescient (having been written in 2002) in a way that even michael panzner should be a bit jealous of.

[U]nprecedented trade imbalance has created extraordinary disequilibrium in the global economy. The countries that build up large stockpiles of international reserves due to large current account or financial account surpluses — such as Japan in the 1980, the Asia Crisis countries in the 1990s and China today — develop bubble economies. When those bubbles pop, as they inevitably do, they leave behind banking crises and excess capacity. The governments of those countries must then go deeply into debt to bail out the depositors of the failed banks. At the same time, the excess capacity in the economy results in deflation. Economic bubbles and systemic banking crises can be expected to reoccur and deflationary pressure can be expected to persist so long as the US Current Account deficits continue to flood the world with dollar liquidity. ...

Ironically, the US current account deficits also helped fuel the New Paradigm Bubble in the United States. The surplus nations earn their surpluses in US Dollars. They must either invest those dollars in US dollar denominated assets or else convert the dollars into their own currencies. If they convert such large amounts of dollars into their own currencies, those currencies would appreciate sharply, putting an end to their trade surpluses and perhaps driving their economies into recession. Consequently, they park their surpluses in US dollar denominated assets instead. By investing their dollar surpluses in US dollar assets, the trading partners of the United States helped fuel the stock market bubble, facilitated the incredible misallocation of corporate capital, and, by acquiring Fannie Mae debt, contributed to the dangerous rise in US property prices.

The imbalances in the current international monetary system are also bad because they are unsustainable. The United States cannot continue going into debt to the rest of the world at the rate of $1 million a minute indefinitely. The net indebtedness of the US to the rest of the world is already approximately $3 trillion or 30% of US GDP…and its now growing at roughly 5% of GPD per annum. [the net international investment position of the US was in excess of $2.4tn at the end of 2007, and has very probably been adversely affected by the asset crisis of 2008 -- gm.] The economies of most of the United States’ major trading partners have grown dependent on exporting much more to the US than the US imports from them. When the United States current account imbalance returns to equilibrium, and it eventually must, the era of export led growth will come to end and the world will find itself without an engine of economic growth.

the figures are dated, as duncan wrote in the aftermath of the dot-com bubble. he carefully hedges in his book, making reference to the housing boom that was then only entering its manic blowoff phase -- but i doubt he anticipated that the "unsustainable" trend in foreign exchange could run to such extremes as we saw in 2005, 2006 and 2007.

duncan's observations are critical to properly anticipating how the credit bubble will now deflate. china, while very much a bubble economy, is faced in the collapse of global trade which has followed the asset shock and balance sheet recession in the united states with massive excess capacity which it has no hope of utilizing domestically. but it at least is likely (owing to years of maintaining a large mercantile current account surplus) to be flush with excess deposits which the chinese government can utilize to both sustain at least the domestic component of GDP through government spending and bail out chinese financial institutions. this is the process well outlined by richard koo.

the united states, given its heavy dependence on wholesale funding for its banking system as a result of its sustained current account deficit, probably faces a rather different path out of crisis. as duncan notes, current account surplus countries do not have to keep their dollars in dollars; they could choose, rather than reinvesting trade gains into united states treasuries, crash the dollar and stregthen their domestic currency by selling dollars for their own. in a different interview with prudentbear also in 2002:

If new US Dollar debt instruments of this magnitude [sufficient to absorb the american current account deficit] are not forthcoming, the surplus nations will have no choice but to convert their Dollar surpluses into their own currencies, causing them to skyrocket and the Dollar to plunge, thereby killing the export goose that laid the golden egg.

Fortunately for the near term outlook for the Dollar, the US government has once again begun running massive budget deficits. And, there’s no doubt, that the US government can service the interest on its own debt. This year the US budget deficit is expected to exceed $500 billion. However, the Current Account deficit will be $600 billion or more. So even if the surplus nations buy all of the US government bond issues (which is unlikely for a number of reasons) that’s still not enough to absorb all of their Dollar export earnings. They would still have to buy more than one hundred billion of other Dollar denominated assets each year.

Nonetheless, the re-emergence of very large government bond sales will provide a safe home for a good part of the Dollar export earnings of the surplus nations. Consequently, it will relieve some of the pressure on the Dollar, since the United States’ trading partners will be able to park at least a significant portion of their Dollar earnings in US Treasuries, instead of being forced to choose between, one, investing them in over-indebted US corporations with questionable accounting standards or, two, throwing their economies into recession by converting their dollar earnings into their own currencies, and thereby causing them to appreciate sharply.

Still, this state of affairs cannot continue indefinitely. The United States cannot continue increasing its net indebtedness to the rest of the world at the rate of 5% of GDP per year. And, not even the US government can continue running $500 billion Dollar a year budget deficits forever.

but it can certainly try, and is of course embarking on a multiyear experiment in $2tn government fiscal deficits. what comes of this when the end of indefinitely becomes today?

Either government finances will snap under the strain of bailing out failed banking systems, or deflationary pressure stemming from global excess capacity will undermine corporate profitability to such an extent that unemployment will soar, causing a backlash against free trade, or the rest of the world will eventually lose faith in the ability of the United States to finance its ever growing indebtedness and, in a panic, dump their US Dollar-denominated debt instruments, making it impossible to finance further deficits.

One way or the other, this global credit bubble will — like every credit bubble before it — come unwound, the Dollar will lose much of its value, and the US Current Account deficit will correct.

this again reminds of john hempton's analogy to 1998 korea.

regardless, the global consequence is deflationary -- and this is how schiff, despite getting the outlines of the consequences right, has thusfar failed his investment clients by anticipating a large inflation as the outcome. duncan:

The US current account deficit is flooding the global economy with dollar liquidity. When the dollar earnings of the surplus nations are deposited into their domestic banking systems, those dollars, being exogenous to those banking system, act as high powered money and spark off an explosion of credit creation. Excessive credit creation permits over-investment, which, in turn, causes excess capacity and deflation. So long as the huge US current account deficits continue to flood the world with dollars, global deflationary pressures are very likely to continue to build, as reckless credit creation results in more industrial capacity than can be absorbed at the prevailing price level.

this obviously has some implications for trade intermediation, but not for trade.

Many benefits are derived from trade between nations. However, the trade system that evolved following the collapse of the Bretton Woods System produces very serious side effects as well as benefits. In fact, the existing trade arrangements are destabilizing the global economy by creating economic bubbles, banking crises and deflationary pressures. ...

A new international monetary accord is needed. The new system must prevent persistent trade imbalances, and it must put in place a mechanism that would allow the growth of the global money supply to be controlled and allocated in an orderly and rational manner. Otherwise, the existing flaws in the international monetary system are going to continue destabilizing the global economy as they have over the last two decades.

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Peter Shiff gives the root cause of the problem. He is really on the same page as you. Our Current account deficit comes from a lack of savings and an over reliance on anti-savings or debt. Both the federal reserve board and congress and the president have had a policy of stimulating consuption at the expense of savings. The federal reserve has punished savers by reducing the value of the dollar and keeping interest rates too low.

Why would anyone want to save dollars when they decline in value year in and year out, and taxes and low interst rates eat up the rest? In fact it is only the person who is in debt that benifits from our policies.

If we had a federal reserve and government that encouraged sound currency and prudent savings, then these problems would all go away in the long run.

One more point. You can't improve the current account deficit in the long run by having government reduce the value of there currency and overpending. If these policies worked to correct deficits, then countries like Zimbabwe and all of the countries like them in history would have large current account surpluses and all be rich.

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"and this is how schiff, despite getting the outlines of the consequences right, has thusfar failed his investment clients by anticipating a large inflation as the outcome."

I'm not sure why you say this. I am a Schiff client. Been making good money too. He has me out of the US Dollar, in foreign equities that pay dividends in foreign currencies. And some gold.

In light of what you quoted from Duncan:

"One way or the other, this global credit bubble will — like every credit bubble before it — come unwound, the Dollar will lose much of its value, and the US Current Account deficit will correct."

... I'm still pretty happy with where he has positioned me.

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