We got a lesson in the importance of macro thinking. Exploring an old family desk, we came upon a cache of our grandfather’s letters. He had come back from World War I and begun a business supplying coal to the ships that used Baltimore’s harbour.
It was a good business in the 1920s. Less good in the 1930s. And no business at all in the 1940s. His letters are marked by disappointment. ‘Sales down.’ ‘Too much inventory.’ ‘Sluggish business.’ And there are some letters in the 1930s expressing hope that ‘things will pick up when the country goes back to work.’
The country did go back to work in the 1940s. Every factory in Baltimore turned on the lights and fired up its engines. Ship traffic increased…including hundreds of new ships that took troops and war material overseas.
But it was too late for my grandfather. Ever since Winston Churchill converted the British Navy to oil, the handwriting had been on the wall for coal as a fuel for ships. Oil was denser. And more convenient.
The density of fuel is important, especially for the navy. It gives ships greater range and more power. And it frees up space for guns and transport.
Coal was doomed. And so was our grandfather’s business. He must have seen it too. He was in the wrong place at the wrong time. Either his macro analysis failed…or he was unable to do anything about it.
The big picture in the 1930s and 1940s was dominated by war. Now it is dominated by money – specifically by the actions of central banks. Never before have major central bankers embarked on such a bold program of monetary activism.
If this succeeds, it will be one for the record books. If it fails, it will be one for the history books. Specifically, it will become another important entry in the History of Financial Disasters.
If it turns into a disaster, it will be traced to President Nixon’s decision to break the link between gold and the dollar in 1971. The new, elastic currency would stretch. And recently, under government pressure to finance deficits and ‘stimulate’ lacklustre economies, central bankers have been pulling hard.
The first quantitative easing (aka debt monetization) program in the US began in November of 2008. Then it was viewed as an emergency measure to ‘stabilize’ the system.
But the private sector continued to de-leverage. Unemployment stayed high. A second round of monetary easing followed to relieve investors’ fears and otherwise grease the skids.
This happened as the eurozone fell into a squabble and a funk about how to handle its own debt problems. Whether it was true or not, analysts concluded that whatever good QE2 might have done, the crisis in Europe overshadowed it.
‘Operation Twist’ emerged in September 2011. The Fed used the proceeds from sales of shorter-term debt to buy longer-term debt. The idea was to lower yields along the curve and therefore keep borrowing costs in the economy ultra low.
The Fed deemed this critical to the housing industry as well as to major capital investments. It was about this point that the European Central Bank, under Italian Mario Draghi, joined the action with its own Long-Term Refinancing Operations (1 and 2).
Then came Draghi’s pledge to do ‘whatever it takes’ to save the euro – promising open-ended bond buying if needed. The danger of a default greatly reduced, European bond yields fell.
QE3 came to the US. The Fed extended its purchases of agency mortgage-backed and US Treasury debt to $85 billion per month. Not only that, but also it said it would continue printing money until the unemployment rate falls below 6.5% and as long as inflation remains below 2.5%.
Japan is in on the ‘QE to infinity’ act. The new government there, headed by Shinzo Abe, is committed to fighting a long downturn in the economy with more fiscal and monetary stimulus.
The great monetary experiment of the 21st century has gone global…
There is a big difference between debt in the private sector and debt in the public sector. When the private sector got the margin call in 2007 it went into panic mode. Households…businesses…and investors all knew they had overdone it. They cut back, each hoping someone else would bear the loss.
There are feedback loops inherent in the system that make most mistakes self-correcting. When people drink and drive, for example, the problem soon takes care of itself. And when you spend too much and borrow too much you eventually reach the point when you can’t make your debt payments. You have no choice. You have to reduce spending or go broke.
Which is just what the private sector did after 2007. It started to pay down debt. It is solving the problem of too much debt in a normal, natural and effective way.
But deleveraging is a bugaboo to modern economists. They think they need to struggle against it. They think they need to balance out the lack of spending by the private sector with a surplus of spending in the public sector.
‘Countercyclical stimulus’ is the idea that led the Federal Reserve to increase its balance sheet – and increase the US monetary base – by $2 trillion in four years. And at the present rate another $1 trillion will be added in the year ahead.
The Federal Reserve is buying Washington’s debt, making it cheap and easy for The Federal Reserve to continue going into debt. Instead of self-correcting, the government’s mistake – borrowing too much – is reinforced. The more money they borrow and hand out, the more hands are out to ask for it. And the more dependent on borrowing (and/or printing) the economy becomes, the more difficult it is to stop.
The officially recorded deficit for 2012 was just over $1 trillion. But the real deficit was seven times more – about $7 trillion. That number includes the unfunded cost of promised pensions and health benefits that any business would have to include in its financial statements. As reported here, that number is more than 20 times the growth in the US economy, which was about $320 billion.
My old friend Jim Davidson points out that most of the ‘growth’ in the US economy since 2001 has been phony. It is not genuine private sector growth, but merely an expansion of federal spending.
If you compare the growth in the official US debt to this real growth in the productive economy, you find that it is 3,000 times greater. If you compare the growth in GAAP-based debt to the growth in the real economy, you find it is almost infinitely more. In other words, debt is running wild – far in excess of the growth in the economy that has to pay it.
‘There are risks here,’ writes Sebastian Mallaby for the Financial Times, perhaps understating the situation. ‘The Fed is gambling…’
The Fed’ s new ‘transparency’ is supposed to reassure us. Bernanke tells us he will continue his program of zero interest rates and monetary intervention unless or until the official rate of consumer price inflation reaches an annual rate of 2.5%. Which almost makes it seem like the situation is under control. If inflation reaches 2.5% the Fed will pull the plug. Problem solved!
Imagine a bus driver who has lost his mind. He drives down Sunset Blvd. at 100 miles an hour. ‘Stop!’ you yell.
‘Don’t worry,’ he replies, ‘I’ll stop if something gets in my way.’
The Fed might not be able to stop on a dime either.
And there’s no reason to think the people driving the bus will even be able to see the dime or find the brakes. These are drivers whose permits should have been taken away years ago.
Ben Bernanke drove off the road back in 2005, saying that he thought derivatives posed no threat to the financial system because ‘they are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve’s responsibility is to make sure that the institutions it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well managed and do not create excessive risk.’
Then, two years later, he was DUI again:
‘At this juncture…the impact on the broader economy and the financial markets of the problems in the subprime markets seems likely to be contained…’
Again, in 2008:
Fannie Mae and Freddie Mac were ‘adequately capitalized’, he said. They were ‘in no danger of failing.’
In the financial pileup of 2008-09, derivatives did, in fact, create so much risk that the system couldn’t handle it. Subprime crashed. Almost every financial school bus was dented. And practically all of Wall Street…and Fannie and Freddie too…had to be towed away by the Fed.
And now Ben Bernanke…blind as a bat to financial disaster…is driving the whole world economy.
The direction he is taking is described as an experiment. And it is, in the sense that no one knows exactly how it will turn out. These circumstances have never existed before and never will again.
That’s why central banking bears no resemblance whatever to science. Initial conditions are always different. Results are never reproducible. And results never confirm nor disprove the hypotheses.
But this is not the first time we’ve run this experiment. The last time, when it was run in France, it took at least three generations of Frenchmen to forget the painful lessons of paper money in the late 18th century.
Under pressure from World War I, Britain and France went off the gold standard. They returned to it later…but never with the same resolve. Then, after years of fiddling with it, the US unhooked the entire world from the gold standard in 1971.
We are now in the middle of another grand experiment with paper money. Will it turn out any better than any of the others? We don’t know. We may have to wait years more to find out.
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