FYI | Jun 29 2010
By Greg Peel
Germany may not have yet won the World Cup, but it certainly won the G20 (or more specifically the G8). It is unusual in such meetings that the opinion of the US is rejected in favour of those proffered by others. President Obama tried in vain to convince the European members of the G8 – Germany, France, Italy and the UK – that what the world needs in order to prevent the GFC recovery rolling back into a GFC2 is ongoing fiscal and monetary stimulus. Europe instead went the other way.
The European crisis is based on bloated levels of sovereign debt, so the Germans, known globally for their frugality, have opted to cut fiscal spending rather than pump it up and to raise taxes in the face of a slowing eurozone economy. France, Italy and the UK have agreed. As many a commentator has since pointed out, budgets were also cut and taxes raised after the Crash of '29. Thereafter followed the Great Depression.
Indeed, such history was oft recounted in earlier G8 and G20 meetings – those held before the Greek debt crisis surfaced. Members were then standing shoulder to shoulder with the plan to continue fiscal and monetary stimulus as long as was necessary in order to avoid making a similar mistake. But now everything has changed. The EU may have a 760 billion euro rescue package standing at the ready (including the IMF's promised contribution) but it does not want to have to use it.
Obama may have seemed meek in conceding to European pressure, but the reality is the president is saying one thing and doing another. He is advocating further stimulus while having recently cut off the extended benefits to those unemployed beyond six months, the London Daily Telegraph's Ambrose Evans-Pritchard notes, and he also intends to increase capital gains tax. At the state level, California's US$19bn 2010 budget cut is greater than the budget cuts of Greece, Portugal, Ireland, Hungary and Romania put together. Across all 50 states, US$112bn of budget cuts are needed just to comply with state laws.
In his most recent monetary policy statement, Fed chairman Ben Bernanke suggested growth in the US economy was no longer strengthening because the European crisis was now weighing. This was the first “downgrade” in outlook following subtle “upgrades” all through 2010. It was those upgrades which led the Fed to cease the last of its quantitative easing programs (buying mortgages) in March as scheduled. Likewise, the government's home buyer tax credit program has expired. The US recovery seemed sufficiently strong that many on Wall Street speculated the first interest rate rise was just around the corner. Bernanke had stuck to his “exceptionally low rates for an extended period” guns nevertheless, and now no one expects a rate rise. Not in 2010 and maybe not even in 2011.
It is well known that Bernanke is a “scholar” of the Great Depression. His exceptional/extended policy stems from being well versed in the mistakes of history noted above. And as Evans-Pritchard points out, Bernanke is also known for making a speech on his debut as a freshman Fed governor eight years ago which included the statement:
“The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost”.
It was this attitude which saw Bernanke finally jerk into action in 2008, implementing a quantitative easing (QE) program by purchasing US$1.75 trillion of US Treasury bonds, mortgage securities and Fannie & Freddie bonds in order to prevent a systemic financial collapse. At the time, Bernanke had pencilled in an upper limit of US$5 trillion. But the V-bounce recovery from March 2009 meant such a figure was never needed. Indeed, in 2009 the Fed began to wind down its QE programs.
But Europe has reignited GFC fears, China is playing games, and a 33% drop in new home sales in the US in May has starkly alerted America to what can happen if fiscal stimulus is withdrawn too early. The Baltic Dry Index is a measurement of shipping costs and is a lead indicator of commodities demand. It has fallen 40% in a month. The Economic Cycle Research Institute's lead indicator, notes Evans-Pritchard, is now plunging faster than at any time post-War.
The MSCI Asia Pacific (ex-Japan) Materials Index has fallen 14% from its recent peak. The Asia Pacific analysts at RBS are expecting another leg down for resource stocks as the economic recovery “rolls over”. Having built significant stockpiles of commodities in 2009, China will not be back to save the world again in 2010, RBS suggests. Steelmakers are already losing money, so it follows that iron ore and coal producers must be next.
Citi's equivalent analysts are also expecting markets to continue downwards over the northern summer, troughing around September. At that point Citi expects concerns over global growth to abate. Not so convinced is Societe Generale's noted bear Albert Edwards, who is tipping a “deflationary maelstrom” is on its way given the “stinking fiscal mess” the world is in.
Edwards believes we are about to see another round of money printing which will make the first round of QE programs seem insignificant. Which brings us back to Bernanke. The statement noted above came from Bernanke's 2002 speech entitled “Deflation: Making Sure It Doesn't Happen Here”.
The Fed cannot cut its funds rate to below zero, as that basically means paying US banks to borrow money. However the Fed can effectively replicate a negative funds rate through QE, including the simple “monetization of debt” method of buying US Treasury bonds (lending the US government money) with freshly printed banknotes.
Given the levels of idle capacity and unemployment in the US at present, the San Francisco Fed has argued the funds rate should be the equivalent of minus 5% to provide the necessary monetary stimulus. Taking QE to date into account, the current rate is only minus 2%. In crude terms, suggests Evans-Pritchard, the Fed must buy another US$2 trillion worth of bonds in order to prevent a return to recession, and more if the European situation worsens. And despite the rescue package the EU has begun to implement, Greek credit default swaps are now trading at a higher level than ever before. The world is not confident in EU, and the EU is attempting to force deflation, not fight it.
So if the Fed's effective funds rate is too high, why hasn't it already reimplemented QE programs, particularly given its recent US economic forecast downgrade?
Word from inside the Fed is that key members of the Fed's five-man Federal Open Market Committee board are indeed considering a fresh burst of asset purchases, but there is dissent in the ranks. The Kansas Fed chief, for one, has been pushing for an increase in the funds rate to prevent a fresh round of asset bubbles. It was asset bubbles in property in particular which got us into this mess in the first place, with stocks, commodities and other risk assets following suit.
So here we are again. In 2008, the great debate was all about “moral hazard”. Was it morally acceptable to bail out the greedy banking system with taxpayer funds? No, said some. No choice, said others. To allow the global financial system to collapse would be to bring much greater hardship upon taxpayers than money printing could ever do. The decision thus made in the US, and in Europe, and in the G20 was to spend, spend, spend to save the world and then address the global debt situation later. Everything was going swimmingly until Greece spoilt the party when the newly elected government found the previous government had been cooking the books.
And so now the global debt situation is being rapidly addressed, particularly in Europe, at a time which is supposedly premature when compared to the original plan. The risk is a plunge back into recession if more money is not printed. The risk of printing more money is to never actually solve the original problem of excess debt. Damned if you do, damned if you don't.
There is a growing expectation the Fed will have no choice but to act again, and act soon. It's a far cry from expectations of an imminent Fed funds rate hike evolving back in April. But then global sentiment is very different now to that in April. The V is looking more like a W, and even a W is optimistic in some analysts' eyes.
It must be noted that gold has now set a new record high price in nominal terms. Despite a global recovery seeming underpinned as we entered 2010, the gold market has continued to reflect a fear of monetary inflation.
So the bad news is that the global economy is looking like it might roll over once more, sparking a fresh round of QE from the Fed. The good news is that fresh stimulus would be supportive for the stock market.
The other bad news is that three years on from the time Bear Stearns declared the billions of dollars worth of CDOs in two of its hedge funds to be worthless, there seems no end in sight to the global debt crisis.
