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Thursday, October 14, 2010


the task of depression is margin compression

serious economic downturns can be characterized any of inflation, deflation or price stability. what they all have in common is margin compression -- where the change in the price level of raw inputs and unleveraged assets rises relative to the price level of finished goods and leveraged assets. while many consider the great depression of the 1930s to have been a deflationary event (and it surely was) it is instructive to note that commodities deflated by far less than finished goods, and those by far less than the value and income generated by financial assets. what made the economy of the 1930s so destructive was the inability of businesses, beginning in late 1930, to sell products in any meaningful quantity at prices that covered their cost of manufacture. this has been true in every serious depression to my knowledge.

today, the federal reserve is attempting -- brazenly -- to raise the general price level of the economy as a whole by exchanging financial assets with the private sector, substituting income-generating instruments for newly-created cash reserves. this is an effort to undo some of the tremendous balance sheet damage in the private sector, as well as improve terms of trade for american exporters (as the trade value of the dollar is expected to fall under such circumstances). an examination of the fed's h.4.1 will show that the size of the fed's balance sheet continues near an all-time high of $2.3tn. more asset purchases are likely underway -- the fed's POMO schedule of acquisitions continues relentlessly, and an explicit program of quantitative easing is expected in response to ongoing economic weakness.

here's why i think the fed may be forced to relent.

the leveraged asset market that the fed would like to raise from the dead it cannot touch. housing is titanically oversupplied, and the fed's efforts to cheapen rates have served mostly to increase the percentage take of the banks in refinancing rather than increase purchasing power of new buyers.

chris whalen spoke on this point sharply last week. banks used to take a half-point in loan-making; now they are taking 400-500bps in an effort to raise their income. little or no economic benefit is flowing to the borrower at this point from declines in long-end interest rates. moreover, because of ZIRP, the actual cash flow through the banks is declining precipitously -- while interest margins remain wide, dollars earned are shrinking. this as non-interest expenses -- the cost of foreclosing on millions of delinquent loans, which is turning banks into REITs -- is exploding. whalen forecasts the large banks (JPM, BAC, WFC) to actually go cash flow negative in the next six months (though the suspension of foreclosures thanks to the surfacing MERS lien perfection issue may delay this).

the upshot is that borrowers can no longer refi in large numbers to their benefit, and banks are in no position to make new loans to purchasers. there is little benefit from QE here except to the banks' balance sheet.

on the commercial side, with a large output gap, high unemployment and significant unutilized capacity, there is no prospect of wage inflation -- average hourly earnings have not rebounded. without real final sales approaching something like strong growth, companies that are in a position to borrow to either invest, hire or raise wages have little incentive to do so. what capex growth that has been seen recently has been largely self-funded and from depressed levels; what borrowing that exists is being done in the corporate bond market, largely refinancing to cut down the income stream to creditors.

the result is that systemic income growth is dependent almost entirely on government fiscal stimulus -- a significant portion of which has flowed overseas through our again-growing current account deficit. the lack thereof has aggravated the decline in systemic credit as few borrowers either want or have the cash-flow capacity to increase borrowing as income remains sparse -- quite the opposite -- and has pushed borrowers toward default.

but the effect of the fed's actions on inelastic raw inputs is another story altogether. anyone looking at the commodity markets can attest to the power of the fed to spark speculative fervor with zero rates, cash substitution and debasing intentions. in spite of record stocks in storage thanks to depressed demand, oil is trading over $80/bbl. yet less elastic agricultural commodities have put in a far more impressive advance. this is where the fed's activities have been felt, and a reflexivity loop all but ensures that, for so long as the fed continues, a large part of its liquefaction will flow into raw inputs. there is already talk of popular unrest and the prospect of food riots in emerging markets.

so this is what the fed is accomplishing. it can do little to overcome the continuing deleveraging of the private sector as banks shed loans, which continues to drive down property prices. it can do little to increase income in the economy -- indeed, by increasing the take of banks in an effort to offset their as-yet-unrealized losses, it is redirecting income from the private sector into loss cancellation to the tune of $750bn a year on whalen's estimate, with deflationary implications offset only by expansive fiscal deficits. but, by devaluing the currency and encouraging speculation in raw inputs, it has raised the operating costs of the private sector (households and businesses alike) significantly within the dollar economy.

in short, the fed seems to have become a vehicle of margin compression and profit destruction -- increasing costs relative to revenues, reducing income, amid a deleveraging cycle.

if this policy is pursued further, we may well see margins compress further as commodity prices rise relative to all else while income stagnates or falls, driving huge numbers of private sector participants cash-flow negative and into bankruptcy. i've sometimes said before, with respect to the inflationary implications of QE, "call me when the fed balance sheet gets to $10tn" -- and in light of the above reasoning it's frightening that, as noted by ed harrison, paul krugman gets into the same ballpark. taken up something on the order of that target, i don't expect quantitative easing to avoid or even curtail bankruptcy and depression. the work of depression is margin compression -- and QE may be less a deterrent to that than a facilitator.

and all the while, there remains the latent but significant risk scenario that such moves will spur capital flight from the united states.

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The result is that systemic income growth is dependent almost entirely on government fiscal stimulus — a significant portion of which has flowed overseas through our again-growing current account deficit.

Not sure if I understand this..why is a significant portion flowing overseas?

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Hi Gaius

Wondering if you could answer the above question

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sorry, anon, i missed it the first time.

because we run a significant current account deficit, a fraction of american spending ends up in foreign pockets. when someone buys a chinese toy, the producer in china ends up with dollars -- most of which his government then exchanges into yuan, recycling them into treasury bonds.

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