Why Global Growth Is So Disappointing

There is one great mystery in the high falutin’ circles of the Fed, ECB, and IMF today. Why is global growth so disappointing? There are different variations on this theme – why aren’t businesses investing more? why aren’t banks lending more? – but it’s all one basic question. First the Fed, then the BOJ, and now the ECB have taken superheroic efforts to inflate financial asset prices in order to bridge the gap between the output shock of 2008 and a resumption of normal economic growth. They’ve done their part. Why hasn’t the rest of the world joined the party?

The thinking was that leaving capital markets to their own devices in the aftermath of the Great Recession could result in a deflationary equilibrium, which is macroeconomic-speak for falling into a well, breaking your leg, at night, alone. It’s the worst possible outcome. So the decision was made to buy trillions of dollars in assets, forcing all of us to take on more risk with our money than we would otherwise prefer, and to jawbone the markets (excuse me … “employ communication policy”) to leverage those trillions still further. All this in order to buy time for the global economic engine to rev back up and allow private investment activity to take over for temporary government investment activity.

It was a brilliant plan, and as emergency intervention it worked like a charm. QE1 (and even more importantly TLGP) saved the world. The intended behavioral effect on markets and market participants succeeded beyond Bernanke et al’s wildest dreams, such that now the Fed finds itself in the odd position of trying to talk down the dominant Narrative of Central Bank Omnipotence. But for some reason the global economic engine never kicked back in. The answer? We must do more. We must try harder. And so we got QE2. And QE3. And Abenomics. And now Draghinomics. We got what we always get in the aftermath of a global economic crisis – a temporary government policy intervention transformed into a permanent government social insurance program.

But the engine still hasn’t kicked in.

So now villains must be found. Now we must root out the counter-revolutionaries and Trotskyites and Lin Biao-ists and assorted enemies of progress. Because if the plan is brilliant but it’s not working, then obviously someone is blocking the plan. The structural villains per Stanley Fischer (who is rapidly becoming a more powerful Narrative voice and Missionary than Janet Yellen): housing, fiscal policy, and the European economic slow-down. Or if you’ll allow me to translate the Fed-speak: consumers, Republicans, and Germany. These are the counter-revolutionaries per the central bank apparatchiks. If only everyone would just spend more, why then our theories would succeed grandly.

Hmm. Maybe. Or maybe what we want and what we need has been confused. Maybe the thin veneer of ebullient hollow markets has been confused for the real activity of real companies. Maybe the theatre of a Wise Man with an Answer has been confused for intellectually honest leadership. Maybe theoretical certainty has been confused for practical humility. Maybe the fault, dear Brutus, is not in external forces like Republicans or Germans (or Democrats or Central Bankers), but in ourselves.

Let me suggest a different answer to the mystery of missing global growth, a political answer, an answer that puts hyper-accommodative monetary policy in its proper place: a nice-to-have for vibrant global growth rather than a must-have. The problem with sparking renewed economic growth in the West is that domestic politics in the West do not depend on economic growth. What we have in the US today, and even more so in Europe (ex-Germany), are not the politics of growth but rather the politics of identity. At the turn of the 20th century the meaning of being a Democrat or a Republican was all about specific economic policies … monetary policies, believe it or not. You could vote for Republican McKinley and ride on a golden coin to Prosperity for all, or you could vote for Democrat Bryan and support silver coinage to avoid being “crucified on a cross of gold.”

Today’s elections almost never hinge on any specific policy, much less anything to do with something as arcane as monetary policy. No, today’s elections are all about social identification with like-minded citizens around amorphous concepts like “justice” or “freedom” … words that communicate aspirational values and speak in code about a wide range of social issues. Don’t get me wrong. There’s nothing inherently bad or underhanded about all this. I think Shepard Fairey’s “HOPE” poster is absolute genius, rivaled only by the Obama campaign’s genius in recognizing its power. Nor am I saying that economic issues are unimportant in elections. On the contrary, James Carville is mostly right when he says, “It’s the economy, stupid.” What I am saying is that modern political communications use neither the language nor the substance of economic policy in any meaningful way. Words like “taxes” and “jobs” are bandied about, but only as totems, as signifiers useful in assuming or accusing an identity. Candidates seek to be identified as a “job creator” or a “tax cutter” (or accuse their opponent of being a “job destroyer” or a “tax raiser”) because these are powerful linguistic themes that connect on an emotional level with well-defined subsets of voters on a range of dimensions, not because they want to actually campaign on issues of economic growth. Candidates have learned that while voters certainly care about the economy and their economic situation, the only time they make a voting decision based primarily on specific economic policy rather than shared identity is when the decision is explicitly framed as a binary policy outcome – a referendum. Even there, if you look at the ballot referendums over the past several decades (Howard Jarvis and Proposition 13 happened almost 40 years ago! how’s that for making you feel old?), the shift from economic to social issues is obvious.

Both the Republican and the Democratic Party have entirely embraced identity politics, because it works. It works to maintain two status quo political parties that have gerrymandered their respective identity bases into a wonderfully stable equilibrium. The last thing either party wants is a defining economic policy question that would cut across identity lines. But until the terms of debate change such that an electoral mandate emerges around macroeconomic policy … until voters care enough about Growth Policy A vs. Growth Policy B to vote the pertinent rascals in or out, despite the inertia of value affinity … we’re going to be stuck in a low-growth economy despite all the Fed’s yeoman work. I know, I know … what blasphemy to suggest that monetary policy is not the end-all and be-all for creating economic growth! But there you go. At the very moment that elections hinge on the question of economic growth, we will get it. But until that moment, we won’t, no matter what the Fed does or doesn’t do.

What reshapes the electoral landscape such that an over-riding policy issue takes over? Historically speaking, it’s a huge external shock, like a war or a natural disaster, accompanied by a huge political shock, like the emergence of a new political party or charismatic leader that triggers an electoral realignment. In the US I think that the emerging appeal of national Libertarian candidates (all of whom, so far anyway, have the last name Paul) is pretty interesting. The 2016 election has the potential to be a watershed event and set up a realignment, if not in 2016 then in 2020, which hasn’t happened in the US since Ronald Reagan transformed the US electoral map in 1980. And yes, I know that the conventional wisdom is that a viable Libertarian candidate is wonderful news for the Democratic party, and maybe that will be the case, but both status quo parties today are so dynastic, so ossified, that I think everyone could be in for a rude awakening. It’s a long shot, to be sure, mainly because the US economy isn’t doing so poorly as to plant the seeds for a reshuffling of the electoral deck, but definitely interesting to watch.

What’s not a long shot – and why I think Draghi’s recently announced ABS purchase is a bridge too far – is a realigning election in Italy.

I like to look at aggregate GDP when I’m thinking about the strategic interactions of international politics, but for questions of domestic politics I think per capita GDP gives more insight into what’s going on. Per capita GDP gives a sense of what the economy “feels like” to the average citizen. It addresses Reagan’s famous question in the 1980 campaign with Jimmy Carter: are you better off today than you were four years ago? It’s a very blunt indicator to be sure, as it completely ignores the distribution of economic goodies (something I’m going to write a lot about in future notes), but it’s a good first cut at the data all the same. Here’s a chart of per capita GDP levels for the three big Western economies: the US, Europe, and Japan.

The Great Recession hit everyone like a ton of bricks, creating an output shock roughly equal to the impact of losing a medium-sized war, but the US and Japan have rebounded to set new highs. Europe … not so much.

Let’s look at Europe more closely. Here’s a chart of the big three continental European economies: Germany, France, and Italy.

Germany off to the races, France moribund, and Italy looking like it just lost World War III. I mean … wow. More than any other chart, this one shows why I think the Euro is structurally challenged.

First, why in the world would Germany change anything about the current Euro system? The system works for Germany, and how. Alone among major Western powers, the politics of growth are alive and well in Germany. “But Germany, unless you lighten up and embrace your common European identity, maybe this sweet deal for you evaporates.” Ummm … yeah, right. The history books are just chock-full of self-interested creditors with sweet deals that unilaterally made large concessions before the very last second (and often not even then).

Second, why in the world would Italy accept anything about the current Euro system? The system fails Italy, and how. The system fails other countries, too, like Spain, Portugal, and Greece, but these countries are in the Euro by necessity. Their economies are far too small to go it alone. Italy, on the other hand, is in the Euro by choice. Its economy is plenty big enough to stand on its own, and with a vibrant export potential, an independent and devalued lira is just what the doctor ordered to get the economic growth engine revved up. Short term pain, long term gain.

Why doesn’t Italy bolt? Lots of reasons, most of them identity related. Also, let’s not underestimate the power of cheap money to keep the puppet-masters of the Italian State in a Germany-centric system. The system may fail Italy as a whole, but if you’re pulling the strings of the State and can borrow 10-year money at 2.5% to keep your vita nice and dolce … well, let’s keep dancing.

Still, nothing focuses the electoral mind like the economic equivalent of losing a major war. At some point in the not so distant future there will be an anti-Euro realigning election in Italy. And that will wake the Red King.

In the meantime, Draghi will go forward with his ABS purchase scheme, a brilliant theory that will deliver frustratingly slim results quarter after quarter after quarter. Until the politics of growth are embraced outside of Germany, European banks will remain reticent to lend growth capital to small and medium enterprises. Until the politics of growth are embraced outside of Germany, large enterprises with plenty of cash and access to cheap loans will remain reticent to invest growth capital. Maybe a little M&A, sure, but no new factories, no organic expansion, no grand hiring plans. The thing is, Draghi knows that he’s pushing on a string with the ABS program and that growth won’t return until the fundamental political dynamic changes in France in Italy, which is why he is calling both countries out by name to institute “structural reforms”. But in typical European fashion this entire debate is Mandarin vs. Mandarin, with almost all of the proposals focused on regulatory reform rather than something that must be hashed out through popular legislation. So long as economic policy reform is imposed from above … so long as we are engaged in modern-day analogs of Soviet Five-Year Plans … I believe we will remain stuck in what I call the Entropic Ending – a long gray slog of disappointing but not catastrophic aggregate economic growth. That’s not a terrible environment for stocks, certainly not for bonds, and the alternative – economic reform based on the hurly-burly of popular politics, is almost certain to be a wild ride that markets hate. But to get back to what we need (real growth) rather than what we want (higher stock prices) this is what it’s going to take. Elections always matter, but in the Golden Age of the Central Banker they matter even more.

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Goldman's Former Head Of Housing Research Predicts Housing Crash, Recession Within Three Years

It's one thing for contrarian financial websites to accurately predict the transitory phase and housing price dead cat bounces which are only sustained by the unholy trinity of foreclosure bottlenecks (which are simply supply-side subsidies), offshore money laundering into US real estate (thanks to the NAR's AML requirement exemption) and Wall Street-as-a-Landlord (through REO-to-Rent and other Fed-funded programs): after all the point of such correct analyses is to be ignored and blasted as conspiracy theories until they are proven, inevitably, correct.

But when a former Goldman executive and the previous head of its housing research team comes out with a shocking analysis so contrary to what the same individual would do in his "former life" when he would be extolling the inevitably rise of home prices from here to eternity and beyond, and also throw in an open letter to none other than president Obama, predicting at least a 15% crash in home prices in the next three years, a move which would without debt catalyze the next US recession, it is time for everyone to pay attention.

Meet Joshua Pollard, who in February 2009 took over coverage of US Housing at Goldman Sachs at the tender age of 24. We can only assume he was given the responsible position because everyone else in his team who had, bullishly, covered housing right into the Lehman crash, was fired.  But regardless of Pollard's career and how he got to where he is now, what is more important is that in a report released today, the former Goldmanite has cautioned Obama on the economic impact of an imminent 15 % decline in home prices over the next three years.

In short. the former Goldmanite says that "House prices are 12% overvalued today. They have already started to decline. Today’s misvaluation matches the excess of 2006-07, just before the Great Recession... 5 of the last 7 US recessions were led by a weakening housing market... I am lamentably confident that home prices will fall by 15% within three years." Or, as some may call it, crash.

While we provide his entire extended analysis of just how this crash will take place, here is the punchline, which incidentally is spot on: when all is said and done, it will be "never-before-seen public policy reactions that determine when and where prices eventually trough."

In other words, if the timing of Pollard's forecast is correct, the last thing on anyone's mind in mid-2015 will be a rate hike. Instead, what people will be talking about, if and when the housing market crash begins, is how to finally engage in Bernanke's favorite para-dropping activity...

Here is how Pollard classifies the three stages of home price decline:

3 Stages of the home price decline

Unless the calculus of history is a poor guide, there is a 60% chance that home values decline materially, in fact, the correction is already underway. This probability rises when new negative shocks emerges. The home price decline will be defined by 3 Stages:

Stage I: Hot to Cool: Active since Summer 2013*, Price growth is slides across the country as flippers lose money outright in the red-hot investor markets (NYC, San Francisco and Las Vegas); New home absorption rates - sales per community - are declining; investors slow their home purchases; total home sales decline year over year; developers lose pricing power, press outlets shift from positive to mixed about the health of the housing market.

Stage II: Demand to Supply: Small shocks convert demand pools into supply ripples. A first wave of investors begin trimming prices to get ahead of future declines; discounts increase to incentivize purchasers as purchasers increase their delays for better deals; developers reduce land budgets as cancellations tick up; major financial press outlets take a more negative tone toward housing lowering confidence overall.

Stage III: Deflation & Response: Falling home prices create a negative deflationary feedback loop that foreshadows a once-in-a-lifetime policy response. Deflationary economics take full hold; leveraged bets on real estate unwind in quarterly ripples due to the public reporting cycle & asset manager redemption schedules; willingness to lend shrinks; the broader consumer finally understands it is a bad time to buy a home, a shrinking housing market negatively impacts jobs causing recession; the estimated effects of never-before-seen public policy reactions determine when and where prices eventually trough.

Some details on timing and where we are now:

Rates & Shocks

We are 16 months into Stage I. A sooner-than-expected rise in mortgage rates - or other adverse shocks - will domino the decline into Stage II unintentionally. Because financial markets rely heavily on Federal Open Market Committee (FOMC) communication and the fed funds rate is near zero, “forward guidance” shifts have as much impact as yesteryear’s rate increases. To that end, two recent policy communications raise immense concern that Stage II of the home price decline could be incited soon: the first public speech of Loretta Mester and a recent letter from the ranks of the Federal Reserve Bank of San Francisco.

September 5, 2014: Loretta Mester, President and CEO of the Federal Reserve Bank of Cleveland, in her first public address since becoming a FOMC voting member welcomed and expects increased volatility following future Fed guidance and rate changes. Mrs. Mester, the FOMC’s newest communication sub-committee appointee, described volatility as a “necessary part of price discovery.” Her personal view is that forward guidance should be tied to actual progress, anticipated progress and the speed at which progress is being achieved (volatility); progress toward full employment and 2% inflation has occurred faster than she and the Fed expected. While stock market volatility has hovered near all-time lows during the Fed’s most recent communication expansion, home price volatility is at extremely elevated levels.

September 8, 2014: A letter from Jens Christensen, a senior economist at the Federal Reserve Bank of San Francisco, highlighted a concerning expectation gap between investors and the Federal Reserve regarding future interest rates. In the letter titled Assessing Expectations of Monetary Policy, the author showed that public investors are expecting a more rate-accommodative policy than the Federal Reserve and these investors are more confident than the Fed in this stance.

As public policy makers debate seminal decisions on “forward guidance” and unconventional monetary stimulus we note that each 1% increase in mortgage rates drops home values by 4%. At a 2% fed funds rate, where Fed officials and investors expect to be by the end of 2016, today’s over-valuation of 12% grows to 20%. Respectfully, the United States can not afford another housing driven recession.

With home price volatility at an all time high, the escalation from Stage II to Stage III is difficult to predict today. At Stage III, the virtuous cycle of housing, a unique mix of causal financial and social relationships, breaks. At these points in history unique governmental intervention provided the only spark that reignites demand. Price discovery is volatile around each new catalyst of information, and the trough will emerge as consumer and investor confidence rebuilds at lower prices. I believe confidence rebuilds at 15% lower valuations without premptive positive shocks.

Unless, of course, the momentum ignition mentality, made so prevalent in capital markets thanks to HFTs in recent years, takes over and the 15% threshold to "rebuild confidence" and BTFD is really 30%, or 40% or more...

Taking a step back, here is the analysis that Pollard uses to base his opinion that housing is due for a 15% crash within three years:

House prices are 12% overvalued today. They have already started to decline. Today’s misvaluation matches the excess of 2006-07, just before the Great Recession. Since World War II home prices have been tightly correlated to income and mortgage rates (R2 = 96%). Investors/cash purchasers, which make up 50% of home sales, have driven real estate volatility to unrivaled levels in trackable history. As public policy makers debate seminal decisions on “forward guidance” and  unconventional monetary stimulus we note that each 1% increase in rates drops home valuations by another 4%; at a 2% fed funds rate, where fed o cials and investors expect to be by the end of 2016, the overvaluation equals 20%. Respectfully, the United States can not a ord another housing driven recession. The facts and correlations - the tenets of probabilities - suggest it is more likely than not that home prices fall 15% in the next three years.

Read the entire article 

How Banks Continue FX Rigging Right Under The SEC's Noses

The good news is that the rigging of the FX markets - now conspiracy fact, not conspiracy theory - has, according to Bloomberg, forced the world’s biggest banks to overhaul how they trade currencies to regain the trust of customers and preempt regulators’ efforts to force changes on an industry tarnished by allegations of manipulation with the "modernization of processes that probably should have been brought in 15 or 20 years ago." However, the FX market is far from 'clean' as Bloomberg notes, while banks can limit access to details about client orders on their computer systems, they can’t keep employees from talking to one another. Some traders also are still communicating with clients and counterparts at other firms via Snapchat, circumventing their company’s controls right under the nose of the SEC. As one trader commented, "these [reform] changes look like fig leaves."

As Bloomberg reports, positive changes are happening (on the surface)...

The world’s biggest banks are overhauling how they trade currencies to regain the trust of customers and preempt regulators’ efforts to force changes on an industry tarnished by allegations of manipulation.

Barclays Plc, Deutsche Bank AG, Goldman Sachs Group Inc., Royal Bank of Scotland Group Plc and UBS AG, which together account for 43 percent of foreign-exchange trading by banks, are introducing measures to make it harder for dealers to profit from confidential customer information and take advantage of clients in the largely unregulated $5.3 trillion-a-day currency market, according to people with knowledge of the changes.

Banks have capped what employees can charge for exchanging currencies, limited dealers’ access to information about customer orders, banned the use of online chat rooms and pushed trades onto electronic platforms, according to the people, who asked not to be identified because they weren’t authorized to discuss their firms’ practices.

“This is finally bringing the FX market into the 21st century,” said Tom Kirchmaier, a fellow in the financial-markets group at the London School of Economics who specializes in the governance of banks. “What we’re seeing is a modernization of processes that probably should have been brought in 15 or 20 years ago.”

But, beneath the surface, nothing changes...

“The banks are very concerned about what the regulators are going to do, and this makes them look good,” said Colin McLean, founder and chief executive officer of SVM Asset Management Ltd. in Edinburgh, which oversees more than $900 million. “Maybe they think it protects them somewhat from future regulatory changes.”

While banks can limit access to details about client orders on their computer systems, they can’t keep employees from talking to one another. Some traders also are communicating with clients and counterparts at other firms via Snapchat, a mobile-phone application that sends messages that disappear, to circumvent their company’s controls, according to a person with knowledge of the practice.

Not everyone is buying the changes...

“For some of the more naive clients, there is still probably gaming going on by the banks because the incentives are there for doing so,” SVM’s McLean said. “These changes look like fig leaves.”

Source

US Corporate Executives to Workers: Drop Dead

The Washington Post has a story that blandly supports the continued strip mining of the American economy. Of course, in Versailles that the nation’s capitol has become, this lobbyist-and-big-ticket-political-donor supporting point of view no doubt seems entirely logical.

The guts of the article:

Three years ago, Harvard Business School asked thousands of its graduates, many of whom are leaders of America’s top companies, where their firms had decided to locate jobs in the previous year. The responses led the researchers to declare a “competitiveness problem” at home: HBS Alumni reported 56 separate instances where they moved 1,000 or more U.S. jobs to foreign countries, zero cases of moving that many jobs in one block to America from abroad, and just four cases of creating that many new jobs in the United States. Three in four respondents said American competitiveness was falling. 

Harvard released a similar survey this week, which suggested executives aren’t as glum about American competitiveness as they once were… 

Companies don’t appear any more keen on American workers today, though. The Harvard grads are down on American education and on workers’ skill sets, but they admit they’re just not really engaged in improving either area. Three-quarters said their firms would rather invest in new technology than hire new employees. More than two-thirds said they’d rather rely on vendors for work that can be outsourced, as opposed to adding their own staff. A plurality said they expected to be less able to pay high wages and benefits to American workers. 

The researchers who conducted the study call that a failure on the part of big American business. They say the market will eventually force companies to correct course and invest in what they call the “commons” of America’s workforce. “We think this mismatch is, at some fundamental sense, unsustainable,” Michael Porter, one of the professors behind the studies, said in an interview this week. 

But what if it’s not? 

Why, if you were a multinational corporation, would you feel a need to correct that mismatch? Why would you invest in American workers? Why would you create a job here? 

At what point does it become a rational business decision for American companies to write off most Americans?

It’s hard to know where to begin with this. First, Harvard Business School is hardly a bastion of socialist thinking. Porter and his colleagues are correct to call out short-sightedness in the incumbents of C-suites. And there’s nary a mention of the role of the long-overvalued dollar, thanks to the lessons that China and the Asian tigers learned in the wake of the 1997 Asian crisis: keep your currency pegged low, run a big trade surplus so you have such a large foreign exchange warchest as to never again be subject to the tender ministrations of the IMF.

But second, and more worrisome, is a vastly larger intellectual failure on the part of the Washington Post and even the Harvard investigators. They’ve completely lost sight of whose interests are at work. The HBS grads are looting the American economy for their own personal profit. Making better products and developing new markets is hard and it takes time for that effort to pay off. Cutting costs is easy. Getting a pop in the price of your stock due to investors’ belief that offshoring and outsourcing will lower costs is even easier.

It’s far from a given, particularly at this juncture, that more outsourcing and offshoring is good for anyone aside from top executives, well-placed middle managers, and the various intermediaries in the outsourcing industry (yes, there is such a thing). We’ve been writing for years that even in the 1990s, we were hearing from executives at companies that sent operations overseas that the business case was weak, but they went ahead regardless to please Wall Street. Chief investment officers have said flatly that outsourcing is overrated as a cost saver.

In the early 2000s, we heard regularly from contacts at McKinsey that their clients had become so short-sighted that it was virtually impossible to get investments of any sort approved, even ones that on paper were no-brainers. Why? Any investment still has an expense component, meaning some costs will be reported as expenses on the income statement, as opposed to capitalized on the balance sheet. Companies were so loath to do anything that might blemish their quarterly earnings that they’d shun even remarkably attractive projects out of an antipathy for even a short-term lowering of quarterly profits.

And even when these projects actually do lower costs (as opposed to transfer income from lower-paid workers to middle managers, who need to do more coordinating, and senior executives), there are hidden costs in terms of extended supply chains, lost flexibility, and ceding the opportunity to develop expertise to vendors. In other words, even when profits improve, it’s typically achieved by making the company more fragile.

This unwillingness to invest represents a failure of capitalists to do their job on a massive scale. US-style short-termism has become all too common around the globe. As yours truly and Rob Parenteau wrote for the New York Times in 2010:

For instance, IMF and World Bank studies found a reduced reinvestment rate of profits in many Asian nations following the 1998 crisis. Similarly, a 2005 JPMorgan report noted with concern that since 2002, US corporations on average ran a net financial surplus of 1.7 percent of GDP, which contrasted with an average deficit of 1.2 percent of GDP for the preceding forty years. Companies as a whole historically ran fiscal surpluses, meaning in aggregate they saved rather than expanded, in economic downturns, not expansion phases. 

The big culprit in America is that public companies are obsessed with quarterly earnings. Investing in future growth often reduces profits short term. The enterprise has to spend money, say on additional staff or extra marketing, before any new revenues come in the door. And for bolder initiatives like developing new products, the up front costs can be considerable (marketing research, product design, prototype development, legal expenses associated with patents, lining up contractors). Thus a fall in business investment short circuits a major driver of growth in capitalist economies. 

Companies, while claiming they maximize shareholder value, increasingly prefer to pay their executives exorbitant bonuses, or issue special dividends to shareholders, or engage in financial speculation. They turn their backs on the traditional role of a capitalist – to find and exploit profitable opportunities to expand his activities. 

Some may argue that lower investment rates are the result of poor prospects, but the data does not support that view. Corporate profits have risen as a share of GDP since the early 1980s, reaching unprecedented levels right before the global financial crisis took hold. Even now, US profit margins are nearly two thirds of the way back to their prior cyclical high, despite a subpar recovery.

More than four years later, those sorry trends have continued, with profits now at a record share of GDP. But the top brass has been handsomely rewarded for its sorry behavior. They’ve discovered that the more they squeeze workers, both here and abroad, the more they can keep for themselves.

And in a bit of unintended irony, the Washington Post shows a headline for another way they’ve succeeded in making the greater public subsidize their profits: How the Postal Service subsidizes cheap Chinese goods. As readers know, the sources of corporate welfare are legion. Walmart’s super low wages are subsidized by $6.2 billion a year in public assistance, a significant portion of its $17 billion in reported 2013 profits. And that’s before you factor in the value of state and local tax breaks that Walmart gets by pitting communities against each other when it is planning new store locations. These concessions are particularly dubious given that Walmarts don’t create jobs, but do a combination of destroy them (by putting smaller retailers out of business) and steal them (by syphoning retail sales and hence other jobs) from neighboring communities.

While Walmart is the poster child of subsidized profits, the Bentonville giant has plenty of company, including large financial firms (so heavily subsidized and backstopped as to not be properly considered private companies), Big Pharma (a huge beneficiary of decades of NIH-funded research) and Big Auto (which has played the “pit communities against each other” game as adeptly as Walmart in securing subsidies for moving plants into union-hostile Sunbelt states).

Unfortunately, Porter appears to have characterized the problem accurately when he depicts the attitude of these self-serving executives as a looting of the commons of labor, meaning much of America. And the precursor of the early industrial period show that this can be a sustainable strategy until workers finally rebel. The Bolshevik revolution, which was actually a peasant revolt, was more than a century after the enclosure movement began its successful program to turn independent yeoman farmers into desperate factory wage-slaves. So while history suggests that capitalists will push workers beyond their breaking point, that rupture can be a very long time in coming. 

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The U.S. National Debt Has Grown By More Than A Trillion Dollars In The Last 12 Months

The idea that the Obama administration has the budget deficit under control is a complete and total lie.  According to the U.S. Treasury, the federal government has officially run a deficit of 589 billion dollars for the first 11 months of fiscal year 2014.  But this number is just for public consumption and it relies on accounting tricks which massively understate how much debt is actually being accumulated.  If you want to know what the real budget deficit is, all you have to do is go to a U.S. Treasury website which calculates the U.S. national debt to the penny.  On September 30th, 2013 the U.S. national debt was sitting at $16,738,183,526,697.32.  As I write this, the U.S. national debt is sitting at $17,742,108,970,073.37.  That means that the U.S. national debt has actually grown by more than a trillion dollars in less than 12 months.  We continue to wildly run up debt as if there is no tomorrow, and by doing so we are destroying the future of this nation.

The chart that I have posted below shows the exponential growth of the U.S. national debt over the past several decades.  Anyone that would characterize this as "under control" is lying to you...

This is the greatest government debt bubble in the history of the world, but very few people seem to have any desire to do anything about this anymore.  We are literally gorging on debt, and most Americans seem to think that it is just fine and dandy.

Perhaps that it is because we have never really experienced any serious consequences for going into so much debt yet.

But when it comes to running up debt, a day of reckoning always comes eventually.

Just ask Greece.

And the absolutely insane spending policies of this administration and this Congress are hastening the day when our day of reckoning will arrive.

Consider the following facts...

-The U.S. national debt has increased by more than 7 trillion dollars since Barack Obama has been in the White House.  By the time Obama's second term is over, we will have accumulated about as much new debt under his leadership than we did under all of the other U.S. presidents in all of U.S. history combined.

-The U.S. national debt is now more than 5000 times larger than it was when the Federal Reserve was first established in 1913.

-If the U.S. national debt was reduced to a stack of one dollar bills it would circle the earth at the equator 45 times.

-Right now, the United States already has more government debt per capita than Greece, Portugal, Italy, Ireland or Spain.

-In August, the average rate of interest on the government’s marketable debt was 2.028 percent.  In January 2000, the average rate of interest on the government’s marketable debt was 6.620 percent.  If we got back to that level today, we would be paying well over a trillion dollars a year just in interest on the national debt.

-At this point the U.S. government has accumulated more than 200 trillion dollars of unfunded liabilities that will need to be paid in future years.  In other words, we have made more than 200 trillion dollars worth of promises that we do not have money for yet.

Thomas Jefferson once said that "the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale."

What we are doing to future generations is absolutely unconscionable.  We are stealing trillions upon trillions of dollars from our children and our grandchildren, and we are willingly consigning them to a lifetime of debt slavery.

I have said this before, but it bears repeating.  If future generations get the chance, they will look back and curse us for what we have done to them.

And shame on anyone that would dare to suggest that we should continue to run up more debt that future generations will be expected to repay.

But government debt is far from the only massive debt bubble that we are dealing with as a country.

40 years ago, the total amount of debt in our nation (all government debt plus all business debt plus all individual debt) was sitting at a grand total of about 2.3 trillion dollars.

Today, that total has grown to 59.4 trillion dollars.

As the chart posted below shows, our total debt bubble is now more than 25 times larger than it was just 40 years ago...

If you were to take all forms of debt in our country and divide it up equally to each person, the average family of four would owe approximately $735,000.

This is not anywhere close to being sustainable, but most Americans don't seem to care.  They just continue to recklessly run up even more debt.

However, there are signs that we are starting to hit a wall with all of this debt.

For example, an astounding 35 percent of all Americans have debts that are so overdue that they have been referred to collection agencies.

Our nation has become an ocean of red ink from sea to shining sea, and the only way to keep the bubble from bursting is for the total amount of debt to continue to grow much faster than the overall economy is growing.

Obviously this cannot happen indefinitely, and when this house of cards comes crashing down it is going to be absolutely horrific.  For much more on all of this please see my previous article entitled "The United States Of Debt: Total Debt In America Hits A New Record High Of Nearly 60 Trillion Dollars"

The big question is how long our "bubble economy" can keep going before it finally collapses.

It has gotten to the point where even some of the biggest banks in the world are admitting that what we have been doing is completely and totally unsustainable.  Just consider the following excerpt from a recent article by Joshua Krause...

Recently, strategists for Deutsche Bank released a startling study in regards to government debt. They decided to investigate whether or not the bond market is currently in a bubble. What they found was, unlike previous eras, the past 20 years has seen no lag between economic booms and busts:

It has long been our view that over the last couple of decades the global economy has rolled from bubble to bubble with excesses never fully being allowed to unravel. Instead aggressive policy responses have encouraged them to roll into new bubbles. 

This has arguably kept the modern financial system as we know it a going concern. Clearly there have always been bubbles formed through history but has there been a period like the last 20 years where the bursting of one bubble has consistently led directly to the formation of the next?

Essentially, our current system has been dying a very slow death. It’s running out of steam.

Sadly, most Americans have no idea that we are living in a giant debt-fueled bubble that has a limited lifespan.

Most Americans just assume that since the politicians tell them that everything is going to be okay that they don't need to be concerned about any of this.

But every single day our debts get even larger and our long-term financial problems get even worse.

Someday this bubble is going to burst and then all hell will break loose.

It is just a matter of time.

Source

The Fed Fails, Um, Does Irony

In a speech in 2002, Bernanke said that the Fed would prevent the US from experiencing a Japan-like outcome.

However, the US has experienced a pattern of economic and policy developments that parallels developments in Japan.

Japan experienced a financial bubble and crisis. The Japanese authorities took actions to support asset prices and prevent insolvent businesses from failing. The growth of the Japanese economy remains so anemic that almost two decades after their financial crisis, the authorities are still introducing new stimulative measures and packages.

The US has also experienced a financial bubble, a crisis, a recession and a very slow recovery. The Fed and the Treasury took unprecedented measures to support asset prices and have prevented or helped to prevent the failure of insolvent firms. Despite the Fed’s opportunity to learn from the Japanese experience and all Fed’s efforts to promote the growth, per capita growth in the US has been slower than in Japan.

In short the US economy has experienced exactly what Bernanke said the Fed could and would prevent, save outright deflation.

In the same speech, Bernanke also said that the Fed could call on other government agencies for help should a financial crisis occur.

Despite Bernanke’s statement that the Fed would be part of a multi-pronged, multi-agency, counter-cyclical response to a serious economic downturn, the Fed has been the only macroeconomic policy game in town. There was no sustained fiscal stimulus, and supporters of the use of fiscal stimulus have argued that the package that was adopted was too small to be effective. Fed-Treasury cooperation during the crisis was limited to the Fed financing the Treasury’s de facto nationalization of AIG. This allowed Treasury to avoid going to Congress for the funding and a debate about the appropriateness and terms of the take-over.

Recently, Bernanke said that monetary policy is no panacea. However, the Fed still insists that a recovery based on monetary stimulus alone is forthcoming.

Again, there is dramatic divergence between what the Fed says or expects on the one hand and actual outcomes on the other.

Before the crisis, the Fed denied the existence of a bubble in residential real estate.

Unfortunately, there was a massive bubble. When the bubble popped, it crippled the financial system and ushered a recession with a slow recovery, high unemployment, and the pain of foreclosures.

The Fed had bet on heads only to have tails come up.

The Fed asserted that a rules-based policy regime was better than one based on discretionary decision making.

However, the rule/discretionary dichotomy has proved to be a false one. Policy makers have exercised discretion when they chose the 1) type of rule, e.g., the Taylor rule versus a nominal GDP target; 2) the variant of the rule employed, e.g., the use of CPI (as favored by Taylor) or forecasts of the PCE deflator (as favored by the Fed); and 3) the sensitivity of policy to deviation of targeted variables from targeted levels.

A truly rules-based, no-discretion-allowed regime would also have rules for when and why the rule should be ignored, as well as a rule that would govern if, who and when the rule can be changed, e.g., from the Taylor rule to nominal GDP targeting. The current regime does have any such rules.

However, the Fed did set interest rate policy in accordance with a variant of the Taylor-Rule. The adoption of this rule-based policy was supposed to insure the continuance of the Great Moderation. Prior to the crisis, FOMC members frequently gave speeches in which they took credit for the Great Moderation. Post the crisis, all we heard from them in effect was: “It cannot be our fault. We were following the rule.” A framework that was supposed to impose discipline and to enhance accountability on policy makers became an alibi for a policy failure.

Again the actual outcomes were the opposite of the outcomes and the goals that the Fed set for itself.

Prior to the crisis, the Fed promoted the idea that a rule-based, inflation-focused policy would make policy design and implementation purely technical problems. This, in turn, would insulate the Fed and its policy from political pressures and insure its independence.

The Fed has not enhanced its independence from political meddling and interference far from it. There is an unusually large amount of political pressure and interference aimed at the Fed and its independence. There are efforts in Congress to 1) require audits of the policy design process, 2) impose a quota system on the Board of Governors of the Federal Reserve System requiring that a seat on the Board be allocated to a community banker, and 3) require the Fed to adhere to a Taylor Rule framework for policy design.

The Fed also opened the door to political meddling when it financed Treasury’s de facto nationalization of AIG and the bailout of AIG counterparties, as well as when it decided to engage in a massive re-distribution of wealth and income via ZIRP.

Once again, the outcome – increased politicalization – was opposite of the desired result.

Prior to the crisis, the Fed said it would not comment on or interfere in the design of fiscal policy in yet another attempt to stay above the partisan political fray.

However, in pursuing ZIRP and QE, the Fed is actively engaged in fiscal policy. ZIRP and QE have lowered the Treasury’s cost of borrowing. The decline in interest rates paid by the Treasury directly affects its outlays and the fiscal deficit. Hence QE has a fiscal policy dimension. It may seem benign today, but when ZIRP and QE are ended the rates paid by the Treasury will rise. Other things equal the fiscal deficit will increase as a result of the policy stance and the Fed will be in a political hot seat.

The Fed is more deeply involved in fiscal policy than ever before. Yet again, the Fed has achieved the opposite of the goal it set out for itself.

The Fed promised to be more transparent than in the past.

In some cases, the Fed is no more and probably less transparent than in the past. The Fed releases numerous point estimates of economic variables, including the staff forecast, the forecasts of individual members of the FOMC, forecast ranges, and central tendencies. In short, a series of often inconsistent forecasts with no confidence limits attached, none of which caught the crisis or the recession and all of which have continuously over-estimated the strength of the recovery. On the other hand, the Fed does not divulge one set of numbers that it knows with certainty and that are of interest to the markets, i.e., the vote tallies at FOMC meetings. If transparency is a goal, why not report the exact vote tallies instead of characterizing the votes as “few, some, many”?

In some cases, the Fed is less transparent. The Fed has never released the rationales for targeted rates of asset purchase under the QEs, nor has it released the rationale behind the pace of tapering of the QE purchases. Policy now emerges from a black box. In addition, the Fed has not specified exactly what the expected goals of the ZIRP and the QE programs was/is. Hence the public has no way of evaluating the success of the programs.

Policy transparency is down and not up.

Prior to the crisis, the Fed attached very little if any importance to its regulatory function. As a result, it failed miserably as a financial regulator.

Despite 1) its failure as a regulator, 2) the fact that its chosen model of the economy (DSGE) does not even contain financial institutions or markets, 3) the policy rule that it employed prior to the crisis as well as the leading alternatives do not reflect financial market developments, and 4) the fact that it only pays lip service to financial stability when setting policy, its regulatory reach was expanded.

The Fed now acknowledges that regulation is important. This is precisely the opposite of what the Fed had assumed. The expansion of the Fed’s regulatory reach is the opposite of what the Fed would have argued was necessary, as well as the opposite of what the record suggests is appropriate. Alternatively, one could argue that after resisting changes the Fed has suffered a de facto loss of regulatory authority, even as its regulatory reach outside the banking sector has been expanded.

In its role as a financial regulator, the Fed presents itself as having expertise in risk management.

When ZIRP did not work to the Fed’s satisfaction, the Fed doubled down with QE1. When QE1 did not work to the Fed’s satisfaction, the Fed doubled down with QE2. And when QE2 didn’t work to the Fed’s satisfaction, it doubled down with QE3. This despite a running debate on exactly and to what extent QE has stimulated the real economy.

Furthermore, the Fed says that it should not lean against asset price bubbles because it can never be certain there is an asset price bubble. However, the Fed cannot know with certainty that there isn’t an asset price bubble either. Nonetheless, it sets policy as if an asset price bubble does not exist or are of no concern.

With a sustained satisfactory rate of growth still illusive, signs of excesses in the capital markets, no agreed upon plan to shrink the size of its balance sheet and with the Fed already in a political hot seat, society and the Fed have more on the table than they can afford to lose. The Fed has demonstrated all the risk management acumen and discipline of the London Whale.

The Fed asserts, based on its expertise and knowledge of the economy, that the markets, financial institutions and society as whole should base their behavior on its forecast for the economy, interest rates and inflation.

However, better-credentialed individuals (former full professors at prestigious universities with Nobel Prizes in economics to boot) running a fixed income portfolio at LTCM managed to make errors that threatened the US financial system in 1998. This occurred despite all the credentials and the fact that managing a fixed income portfolio is a trivial problem compared to setting and implementing macroeconomic policy.

Given that episode, the Fed’s failure to foresee the financial crisis, and the repeated incorrect calls for acceleration in growth a few quarters out, why does the Fed assume that economic agents will treat its forecast as gospel and alter their behavior beyond the impact of the interest rate stance?

The Fed employs models that assume rational expectations and efficient markets, but its assertion that current policy pronouncements can manipulate expectations implicitly assumes that economic agents do not remember or learn from the recent past.

The economic and financial systems are complex and dynamic. The fact that the Fed did not achieve all the goals that it set out for itself is not surprising. However, is more than just ironic that the Fed made decisions and pursued policies which resulted in it achieving the opposite of its stated goals and forecasted outcomes.

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Goldman Declares The "End Of The Iron Age"

Back in the summer of 2008, when crude seemed poised to take out $150, Goldman decided to declare the start of a commodity supercycle and boosted its oil price forecast to $200. Shortly thereafter crude cratered, plunging to the low double digits, and causing many to scratch their heads whether Goldman was merely taking advantage of the pre-Lehman panic to sell into the euphoria. The same questions, but inverted, will likely follow today's just as seminal note, one which this time calls for the end of a supercycle, this time of iron, with "The end of the Iron Age."

While intuitively this makes sense considering iron ore prices have tumbled nearly 40% YTD and were at multi-year lows at last check with the demand picture going from bad to atrocious, the reality is that a protracted period of deflation in this key commodity will have very adverse implications for not only China, where CapEx amounts to over half of GDP and will likely force the transition to a consumer-driven economy - something the Politburo has been delaying for years - but for the rest of the commodity suppliers countries, with the most negative impact hitting Brazil and Australia. Worse, for a country like China which has thrived on commodity oversupply and overcapacity, the collapse in the equilibrium price driven largely by demand, will mean thousands of suppliers will be left out in the cold and forced to liquidate with massive ripple effects through the fabric of the Chinese economy.

To be sure, for the time being local governments, banks and other SOEs, and the central bank, have been successful in isolating the assorted pockets of deflation that has hammered China in the past several years, but if Goldman is correct and if indeed a iron (and other commodities) are shifting from the "Investment Phase" to the "Exploitation Phase" as Goldman calls it, then watch out below not only China, but the rest of the world as well.

So what exactly does Goldman say?  Let's dig into their latest note:

The end of the Iron Age

Producers and investors have enjoyed a long period of supply tightness, cost inflation and above trend profitability; in our reports we have referred to this period as the Iron Age. In our view, 2014 is the inflection point where new production capacity finally catches up with demand growth, and profit margins begin their reversion to the historical mean; in other words, the end of the Iron Age is here.

Iron ore has entered a new exploitation phase

As we have previously argued3, a period of overinvestment in production capacity has ended, giving way to an exploitation phase where supply growth comes mainly from more efficient utilization of existing capacity. Production volumes grow with a certain time lag behind the investment decision; the lag in the mining industry between investment approval and production at full capacity is typically between 5 and 10 years. Based on historical trends, we believe that many market dynamics are reversed in the shift from investment to exploitation, and the current exploitation phase in iron ore could last for a decade (Exhibit 20).

On the demand side, lower prices for iron ore and steel are unlikely to boost demand in a material way. Instead, the day when steel production in China will peak gets  ever closer. In the past decade, the Chinese economy added steel to its economy at a rate three times faster than the US did during the 20th century. On a per capita basis, the average household in China is accumulating steel at a rate equivalent to the purchase of a new car every 8 months (without disposing of its older cars). In other words, the volume of steel stock in China is racing towards the US level of 13 tonnes per person (Exhibit 21). If China is to converge towards the US level, steel consumption will eventually have to stabilize and steel recycling will play a larger role.

On the supply side, the capital stock of the iron ore industry in Australia, Brazil and China increased by US$180 billion during the period 2003-12; this will fuel production growth for years to come (Exhibit 22). Now that the market has transitioned to an exploitation phase we expect new approvals for capital intensive projects to become increasingly rare, largely because the economics of greenfield projects will be challenging in an oversupplied market. However, projects approved in the later stages of the investment phase will support production growth in the years ahead, and low cost brownfield expansions at Tier 1 producers will remain attractive.

Can prices recover once marginal supply is gone? We don’t think so

In principle, the displacement of marginal producers should eventually lead to a balanced market with a high level of concentration among the top 4 miners, raising the prospect of a price recovery further down the road. In practice, we believe that market fundamentals will continue to see supply growth outpacing demand growth by a ratio of 3 to 1 over our forecast period. Not only is the growth pipeline set to deliver several large projects over our forecast period (Minas Rio, Roy Hill, Serra Sul as well as large expansions at Rio Tinto and BHP Billiton), but the supply side will also have many idled mines waiting on the sidelines and ready to resume production should prices recover.

Moreover, iron ore markets went through a 20-year period of declining prices in real terms during the previous exploitation phase that ended in 2004. The iron ore price in 2003 was the same as in 1983 in nominal terms; this is equivalent to an annual deflation rate of 3% in real terms (Exhibit 23). In our view, iron ore prices will display a similar trend of cost deflation in the current exploitation phase.

Cost curves become flatter via the loss of marginal supply and they shift downwards via rising productivity and weaker commodity currencies. Commodity currencies have started to depreciate relative to the US dollar; the weighted average across five of the largest seaborne exporters has lost 16% since January 2011 (Exhibit 24). Given that a majority of production costs are denominated in local currency, this has a direct impact on the level of marginal production costs. On the productivity front, the increased focus on efficiency and the ramp-up of production has already resulted in a modest decline in unit costs among some producers; we expect this trend to continue.

Many moving parts but China remains the key question

The veil on Chinese iron ore production and the level of cost support it would provide to seaborne prices was supposed to be lifted as the market moved into surplus during 2014. But instead of a clear answer, recent data from China only raise further questions regarding the scale of the supply response low prices. In the seaborne market, the delivery of new projects in Australia and Brazil more than offsets the closure of marginal producers. Meanwhile, slower growth in low grade ore supply should see grade discounts normalise.

Chinese riddle: making sense of production statistics

The Chinese iron ore sector is highly fragmented and the data on supply trends is rather limited, but official statistics on price and volume have been roughly consistent in the past: high domestic prices coincided with growth in raw ore production, while market corrections in 2H 2012 triggered production cuts among marginal miners. On that basis, the recent decline in domestic concentrate prices should have led to another deceleration or even contraction in raw ore volumes. Instead, NBS statistics suggest that volume growth has accelerated (Exhibit 3). We find this highly counterintuitive. First, media reports from Platts and other sources indicate that many small mines stopped production from Q2 2014 onwards. Second, a rising volume of domestic ore would be inconsistent with the reported statistics on steel production and iron ore imports which show high growth in Fe supply but low growth in Fe consumption (Exhibit 4).

What does this all mean? We consider the following hypotheses:

• Official statistics do not reflect actual iron ore production. Provincial governments may set GDP or tax revenue targets at the start of the year, and set iron ore production estimates accordingly.
• Official statistics only capture some production. The smallest miners may slip through the cracks if they fall below the threshold used in data collection, preventing the closure of small private mines from appearing in official statistics.
• Production can cut at the concentrator rather than the mine. Mines may choose to suspend sales to concentrators but continue to operate in order to minimize disruption to their operations.

In our view, a combination of these factors could be responsible for the muddied picture, forcing us to look for alternative ways to assess current trends in Chinese iron ore supply. One option is to calculate the implied production of iron ore from statistics on crude steel production and iron ore imports. Taking into account the changes in iron ore inventory and the modest variations in the grade of imported ore, this analysis suggests that Chinese iron ore production on a 62% Fe basis grew during Q1 (partly reflecting limited disruption from a mild winter) before contracting in the following quarter; implied production in the year to July is down 11% yoy (Exhibits 5 and 6). Importantly, the timing of this contraction coincides neatly with the decline in the price of domestic concentrate in Hebei.

Industry sources also suggest that some Chinese supply has been displaced. The MySteel survey shows that utilization rates began to drop in May 2014 when the domestic price of concentrate was heading towards Rmb900/t, with the smallest mines reporting the lowest rates of utilization (Exhibit 7). Meanwhile, the consensus view at a recent conference on Chinese iron ore was that many private mines had indeed closed, even if the aggregate impact on production was limited due to their small size. However, producers also indicated that efforts to expand domestic production are ongoing, as implied by the volume of investment in the sector (Exhibit 8).

Given this wide range of sometimes conflicting indicators, we assume that future Chinese iron ore production would remain roughly stable before mine closures, as new projects and depletion at existing mines offset each other. We continue to assume that the average grade mined in China will remain stable at c. 20% Fe based on a) the reported grade of new projects and b) the fact that closures are likely to affect mines with below-average grades the most. After factoring in mine closures, we forecast domestic production to decline by c.9% per year on a Fe adjusted basis.

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