The Great Ocean of Global Liquidity

HOBART TASMANIA – There is nothing important to report about the stock market this morning. It keeps going up. Both the Dow and the ASX look like finishing the year in record territory. Virtually everything is up.

What will be different in 2007? Is there any reason why the good times can’t keep rolling? Our bet is that grains and gas will outperform, at least in the early part of the year. Gas, the natural kind, is set for a big year. You can get electricity from natural gas, it’s cleaner than coal, and Australia’s gas is close to Asia’s demand.

Grains are set to go up because they are now viewed as an alternative fuel, the kind of thing you can substitute in to your plans when you don’t want to spend hard currency on rising natural gas and crude oil. And then there’s the little fact that producing grains takes arable farmland-which is itself a valuable commodity these days.

But all that is for next year. Even markets, whose job it is to look ahead, seem to have taken the week off. Mother nature and Father time are still on the clock though. And so is the Grim Reaper. The Hardest Working Man in Show business, the Godfather of Soul…none other than James Brown died earlier in the week. And then Gerald Ford, another icon of American culture, died at age 93 yesterday.

They say famous people die in threes…so who’s next? Fidel Castro? Saddam Hussein? Or was it Augsto Pinochet who started the run off?

All we know is that people die everyday, famous or not. And for each death there are private tragedies that never make the headlines. Death is the ultimate democracy, the great assembly in the sky (or in the dirt) to which we will all be elected sooner or later. Personally, we have lost a few good friends to the parliament of the deceased in 2006, and will not be sorry to see the calendar turn over.

A carnival sprang up on the Elizabeth Street pier while we were working yesterday. At the centre of the midway was a “The World’s Oldest Galloping Horse Ride.” It’s a steam powered carousel, built in 1885. We were intrigued because the boiler is fired by coal briquettes. We found this out by asking a young man operating the machine.

“Yeah it’s a coal-fired steam boiler…but the trouble is they don’t make the coal briquettes we use for the boiler any longer. So….”

“So what happens when you run out of the briquettes?”


Finally, we spent some more time reading up on why the world demands dollars. The folks at Independent Strategy in London have a good answer. And since it is a slow newsday in a slow news week, we will explore their answer to this important question at greater length.

Every New Era needs a new set of laws or commandments that can be proclaimed before the world. Examples are Moore’s law…love one another as I have loved you …and in the ear of New Monetarism…anything can become an asset as longer as there is an investor willing to buy it.

The New Monetarism we talked about yesterday shows that central banks are just a small frigate on the great ocean of global liquidity. (by the way Macquarie Bank (ASX: MBL) is buying the bankrupt operator of the cross-Sydney tunnel…and they used to say a gold mine was a hole in the ground with a liar standing over it…a modern update is that an asset is a hole in the ground with a banker standing over it, selling it to you at a premium.)

Independent Strategy’s research shows what they believe to be the nature of the continued demand for dollars in global asset markets…and why the economic imbalances that grab ink (American fiscal and federal deficits, trade deficits, current account deficits) don’t seem to fundamentally alter the demand for dollars.

That’s because the volume of dollar-denominated transactions in the asset markets (a volume which only the dollar, with help from the euro and the yen, can accommodate) dwarfs the dollar volume of economic imbalances in the real economy. This clarifies just what is going on with dollar demand and shows both that it can last a lot longer and that when it ultimately fails, the failure will be greater.) It’s all there in a chart we’ve posted.

The chart shows that derivatives account for 75% of global liquidity (802% of Global GDP). Next comes scrutinized debt at 13% of liquidity and 142% of world GDP. Then broad money supply, at 11% and 122%, and finally central banks at 10% of global GDP and just 1% of liquidity.

That doesn’t mean the central banks have totally lost control…they could raise the cost of capital above the natural rate of interest…and kill off the speculation that’s led to an explosion in speculation. But as pseudo public officials with questionable independence from elected officials, how willing will central bankers be to raise interest rates on millions of deeply indebted borrowers (home-owners?) Not very, we predict.

What’s behind this demand for ‘asset money?’ We think it’s the Baby Boomers who need inflating asset prices to increase their net worth before retirement. Thus, the creation of new asset classes is a function of automatic liquidity into the stock market from Asian savers (and institutional money from pension funds, insurance companies etc.) looking for a home in new assets that can make everyone rich. Or, in simple supply/demand terms, demographics has created a demand for financial assets. Asian savings and cheap credit and have created the supply of liquidity. Wall Street, the hedge funds, and private equity have rented a room in which the whole affair can be consummated, for a $23 billion clip of the ticket.

Because the demand for ‘asset money’ is so high, “Almost everything today can become an asset class, whether a freeway, an aircraft lease, or royalties from David Bowie’s back catalogue. All that’s needed is for someone to work out the rocket science of how to construct a security and convince investors to buy it. Recent history shows investors will buy almost anything,” as we quoted yesterday from the Financial Review.

How long can this party go on? Well, a lot longer. Governments are showing an increasing interest in adopting Australia’s superannuation model which directs private savings directly into the stock market. It’s mandatory, it supports liquidity in the stock market, in inflates pension values, and it keeps everyone in the money shuffling industry happy.

Something like this could happen soon when the new Congress meets in Washington next year. Writing about the crisis in social security in yesterday’s Washington Post, Alabama Republican Senator Jeff Sessions says, “The solution for this problem is to create a national system of personal savings accounts modelled on the successful Thrift Savings Plan (TSP) for federal employees. Federal employees pay Social Security taxes and receive the same Social Security benefits as everyone else. But the TSP program allows them to invest a portion of each pay check — along with a government match for part of these contributions — in one of six investment accounts (or some combination of these accounts), including a government securities fund and a common stock fund.”

Sessions is convinced this could make millions of Americans…millionaires. “If we begin PLUS accounts at birth and require a portion of every pay check to be invested, the average American citizen could retire with a rather sizable nest egg. For instance, given a 6.59 percent rate of return (the same rate as the TSP’s most conservative fund since 1987), someone who makes $46,000 a year — the median household income in 2005 — and contributes 1 percent of each paycheck would retire with almost $300,000. If that same individual were to contribute 3 percent over the course of his working life, he could expect to retire with over a half-million dollars (even if his employer never contributed more than 1 percent).”

He concludes that America’s, “saving rate is a big problem. It requires a big solution. We cannot tinker with the federal tax code and expect personal savings to increase dramatically. By harnessing the power of compound interest through individual savings accounts and small paycheck deductions, we can ensure that almost every American will retire a half-millionaire.”

The idea of making everyone in America a millionaire through inflating asset values in the stock market is, of course, absurd. But that doesn’t mean it won’t be tried. And that’s why the demand for dollar-denominated assets could support the U.S. dollar for a lot longer. What’s more, it may not be long before Europe’s central banks (led by a Frenchman) begin to sell euros to weaken that currency and strengthen the continent’s exports. A dollar bull? Perhaps.

Independent Strategy says, “The party can go on longer because ‘real’ economic demand for the cornucopia of currencies that form the liquidity pyramid lends stability to the whole structure. The other is that when the party ends, currency turmoil could either be a cause or an effect of the ensuing liquidity contraction, but it will for sure be a part of it, as the twin systems of trade and asset markets start to reject the weakest dominant currency – the dollar. Global trade and the heads of many an Asian central banker could be the natural- born victims of a violent adjustment. Gold and non-dollar currencies would be the winner. So will all those who don’t lose their heads in the present feeding frenzy.”

Get your party hats out. It’s nearly a new year. But don’t lose your head celebrating.

Dan Denning

Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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2 Comments on "The Great Ocean of Global Liquidity"

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i’m not sure fellas whether you’ve been reading my mind or i’ve been reading yours, but your commentaries certainly describe the reality of our times a lot better than i ever could. one question: do you think that when the crunch comes, maintaining some cohesion in our society and culture will be best served by the “focus on the future and put it (the crimes) behind us” dictum so often cited by the political and economic criminals, or by nailing some of the worst of them to the wall? not out of a desire for revenge, of course, but to… Read more »

The dollar will retain much of it’s “strength” on the ability and willingness to mobilize firepower on the behalf of it’s owners…
The moment is dictated by the biggest gun, the future by those wise enough to realize what that means.

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