Wednesday, 18 August 2010

KRIS SAYCE: On the edge of a crisis

_Kris_Sayce Guest post by Kris Sayce 

    If you’re after a perfect example of everything that’s wrong with mainstream economic thinking can I suggest you get hold of a copy of yesterday’s Australian Financial Review (AFR).
    Once you’ve bought it, take it home, lay it on the table and then slowly turn to page 26.
    But before you start reading, grab a notepad and a pencil and then settle down to read the article by “Market monitor” Glen Mumford.
    Why the notepad and pencil? So you can take notes. So you can write his arguments out for yourself in your own handwriting. We’ll guarantee that when you read it back and try to make sense of it you’ll be amazed that anyone could make the kind of mindless argument that Mumford makes.
    But with any luck you’ll resist the urge to stop reading at the end of the second paragraph. A paragraph that goes:
    “Perhaps Dr Strangelove was on the right track all those years ago when he told us to stop worrying about the bomb. Instead, we should learn to love it.
“Maybe it’s time US Federal Reserve chairman Ben Bernanke and his policy-setting colleagues did the same with inflation.”
    And perhaps Mr. Mumford would do well to recall that the Dr Strangelove character was also a raving lunatic. A raving lunatic with an involuntary twitch that caused him to do a fascist salute.
    But then, likening central bankers to fascists is rather appropriate we think. Not that Mr. Mumford would have intended the comparison.
    Our good friends at Wikipedia provide a neat definition of fascism:
“Fascism… is a radical and authoritarian nationalist political ideology. Fascists seek to organise a nation according to corporatist perspectives, values and systems, including the political system and the economy… Fascists believe that a nation is an organic community that requires strong leadership, singular collective identity, and the will and ability to commit violence and wage war in order to keep the nation strong. They claim that culture is created by the collective national society and its state, that cultural ideas are what give individuals identity, and thus they reject individualism.”
    If – as your editor does – you consider taxation as a form of violence against the individual then the definition of fascism can easily be used as the definition for so-called Western democracy.
    We like Mark Latham’s idea of encouraging Australian voters this Saturday to just spoil their ballot papers. Make no mistake, it won’t matter which party wins the election, the result will be the same – money from your pocket going into the grubby paws of Canberra bureaucrats.
    But anyway, keep reading Mr. Mumford’s article, because it gets worse… much worse.
    I won’t go into any further detail here because it just contains more of the same old story from the mainstream – inflation good, deflation bad. Rising prices good, falling prices bad.
    However, I will quote one more comment from the article. Last week we wrote how the Federal Reserve was institutionalising money printing by vowing to keep the Fed balance sheet at the current level.
    It was going to do this through buying more longer dated US treasuries when its existing holdings of mortgage-backed securities matured. In other words, rather than removing liquidity from the market – as all the mainstream commentators this past year insisted the Fed would do – the Fed will keep the money in the system.
    Which, apparently isn’t good enough for the likes of Glen Mumford:
“Instead of talking about ‘maintaining’ its [the Fed's] balance sheet, it needs to embrace a major expansion; at least $US1 trillion ($1.1 trillion) more – possibly a whole lot more.”
    No explanation of course where the magical $1 trillion will come from. Mumford doesn’t explain that it will just be created out of thin air.
    And there’s no explanation of why the next trillion will be any more successful in helping the economy than the previous trillions. But that’s probably because like the rest of the mainstream drones, Mumford doesn’t have a clue.
    It’s like the gambler who insists they’ll have one more bet. Except the gambler doesn’t have any money left and so instead has to pinch it from the wallet of a friend – “It’ll be OK, I’ll pay him back after I’ve won…”
    Except the casino gambler never wins, not over time anyway.
    The sad difference with the casino analogy is that it’s the Fed doing the gambling, except it has never used its own money, because it doesn’t have any. The only money it has is what it has taken through taxation via the government, or what it has created from thin air.
    Either way, it has built its balance sheet through stealing from the pockets of the nation. Either directly or indirectly.
    Already the US Federal Reserve holds over USD$777 billion in US government debt.
    Yet Mumford thinks that isn’t enough. More must be done. An extra USD$1 trillion if Mumford has his way.
    To be honest, I’m just as dumbfounded by all this as you are. To me it just doesn’t make sense that such economic idiocy has been embraced by the mainstream commentators. I mean, let’s see exactly what the US government and the US Federal Reserve have conspired to do…
    As you’re aware, the US government has consistently spent more money than it has taken from taxpayers.
    Therefore it has a budget deficit. Similar to you having a budget deficit if you spend more than you earn in wages. The difference being that you have to earn your money through the exertion of your labour whereas the government takes the money from you on the, erm, exertion of your labour!
    So, because the government consistently spends more than it takes in tax revenue it has to come up with another way of getting cash. So, it sells bonds to investors.
    Those foolish investors unwittingly use the money that they’ve earned and which they could otherwise have invested in private enterprise or saved in the bank, or even spent on something for themselves, and give it to the government. The government then spends it on wasteful projects or on the lazy, inefficient and useless public servants.
    In return for lending the government money, the government promises to pay interest on the loan. For instance 5% per year over three years. That’s roughly how it used to work anyway.
    However, the more it spends on wasteful projects that don’t produce a profit, the more the government has to borrow to spend on new projects and to maintain the old ones.
    Another analogy would be if you kept borrowing money to buy new cars without selling the old cars.  You’d still have to maintain the old car – servicing, fuel, rego, etc – plus you’d have the cost of buying and maintaining the new car too.
    The problem with borrowing money is that typically lenders (investors) will – annoyingly – want to know how much else you’ve borrowed. The more you’ve borrowed the greater the fear by investors that you’ll find it harder to repay the loan.
    Plus, the more you borrow, the greater the incentive you’ll need to give investors to encourage them to lend the money.
    What kind of incentives would an investor look for? That’s right, a higher interest rate.
    That’s obviously a big problem when you’re already several trillions of dollars in debt and you know you’ll need to borrow several trillions more.
    The last thing you’d want to do is cause interest rates to rise.
    For most borrowers it would be tough luck. That’s the consequences. The outcome would be that you’d slow down your spending or you’d just go bust.
    Luckily for the government – and unluckily for the citizens, government’s have no such constraints.
    The government can just tap their pals on the shoulder at the money printers – in this case the Federal Reserve – and ask them to buy the government debt.
    And for the government, the central bank is the perfect buyer. It has no profit motive – despite being a private company – so it doesn’t care what interest it receives, and secondly it has the ability to create as much money as it wishes in order to buy the bonds issued by the US Treasury.
    What impact does that have on the market and interest rates? Naturally enough it artificially pushes the interest rate lower.
    You can see that from an interesting chart produced by the guys at Zero Hedge:

The race to zero

Click here to enlarge
Source: Zero Hedge

    Just to explain, the chart above shows the historic bond yield curve between 1990 and 2010 for the three month to thirty year bonds.
    As you can see yields at the short end of the curve (3 months to two years) are close to zero. Even a seven-year US bond is only providing an income of 2% per year. Forget about the 5% I mentioned above. You can’t even get that for a 30-year bond!
    Would you want to lock your money away for seven years with only a 2% return? Or how about 30 years for a 4% annual return?
    I know I wouldn’t. But the Fed would certainly do it because it doesn’t care what return it gets. All it cares about is keeping the paymasters happy – the government.
    And now, thanks to the latest decision by the Fed, we can expect to see the longer end of that yield curve starting to fall even further. That’s because the Fed intends on buying up even more ten-year bonds.
    According to Mr. Mumford’s nice little chart in today’s AFR, the Fed already holds about 17% of the bonds with a maturity of greater than a 10 years, and about the same percentage of those with a five to ten year maturity.
    But with mainstream investors seeking supposed safety in the sovereign bond markets, it led our Slipstream Trader Murray Dawes to say this earlier today, “We’re on the edge of crisis time. Look at this”:

Crisis time

    In a nutshell the chart shows you the spread between the US 10 Year Note and the US Treasury Bond fast approaching the levels last seen towards the end of 2008 when the market went into meltdown.
    What it tells you is that bonds are in big demand, despite the already crazy low yields. Yields, that if history repeats could see the final rush to safety force yields even lower.
    And according to Bloomberg News:
“Money managers are moving more money than ever out of stocks and into bonds. About $185 billion was sent to bond funds through July 31, the most on record, according to the Investment Company Institute.”

    Institutional investors are loading up on government bonds because they’ve convinced themselves that if the worst happens, the US government won’t default on its debt. Not directly anyway.
    Chances are it will do so indirectly as it tries to inflate its way out of trouble.
    What does this all mean?
    It means financial markets are in big trouble. It means that while the mainstream numpties trumpet on about the strength of the economy, and the greenshoots of an economic recovery, their actions are speaking much louder than their words.
    Their actions are telling you what they really think about the market. And I agree. And that is that there’s big trouble brewing.
    The problem is, what the big investing boys consider to be safe haven assets – bonds – are actually no safer than holding your money as cash under the mattress.
    Because if the US Fed does as we suspect it will, and expand its balance sheet almost to infinity then the likes of Mumford and the other mainstream commentators are certain to have their inflationary dreams come true.
    As Mumford wraps up his article: “The only way to avoid this [deflation] is for the Fed to stop worrying about inflation and instead look at embracing it a little. Love it, even.”

Kris Sayce
For Money Morning Australia

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