EconomicReason

Right to the conclusions:

The current crisis can be viewed as the result of two decades of misguided tampering with the economy and financial markets by central bankers educated and guided by academics suffering from physics envy. Instead of addressing the fundamental flaws of the macroeconomic paradigm, the superstructure of the paradigm is being further expanded. Failure to address these flaws could lead to even bigger problems later on and might eventually have much wider consequences than just economic costs. The bailouts that might become necessary by the end of the next boom-and-bust cycle at the latest could become so large that they might cause sovereign defaults. For countries that have a currency of their own, resorting to the printing press is the most probable default option. For the investor, the future promises tremendous opportunities, but also holds large risks.

Source: Rethinking macroeconomic policy by UBS economist.

Debt levels, in particular in some Western countries, are very high. Many analysts predict that the solution to the debt problem will be either default or inflation, the latter being synonymous with default. Analysts then usually go on worrying about the effects of an impending default on the debtors (the Western countries, their currencies, their banking systems, and financial market prices). However, they rarely talk about the implications of a default on the creditors.

One man’s debt is another man’s savings. Every dollar borrowed is a dollar lent. If a debtor has a problem, then a saver has a problem. If there are doubts about whether debts will ever be paid back, then there should be equal doubts about whether savings are safe.

Whose savings are we talking about? Total US credit market debt is above 350% of GDP, which amounts to more than 50 trillion USD. Total reserves of China are slightly above 2 trillion, i.e. just 4% of outstanding US debt. Throwing in a few more trillion from other Asian and oil-exporting countries does not change that picture – the West is not indebted to Asia, it is indebted to itself. The largest creditors are our own pension funds.

The debt and consumption spree of the past 15 years happened mainly at the expense of our own old age and not at the expense of Asia. Money which was supposed to be invested was in fact not invested, but spent for consumption. Therefore, in the aggregate, not enough capital was invested, and out of the capital that was invested, much of it was malinvested, for example in housing. As there is not enough capital backing the outstanding debt, there is no source of income to service that debt, let alone to pay it back.

Note that social security systems can either be funded by savings (via capital transfers across time) or by taxes (via transfers across demographic segments of the population, from the working to the retired). Adding insult to injury, not only will the transfers via time turn out to be much smaller than planned, but also the redistribution from a shrinking working force to a growing amount of pensioners will become more and more difficult. If we indeed should be worried about debt, then we should be equally worried about our social security systems. 

Eric Kraus from Moscow: A Shattered Globe.

Since the outbreak of the financial market crisis, around 120 US banks have failed. The median cost of a bank failure to the FDIC has amounted to a staggering 28% of that banks assets. Furthermore, the cost of a bank failure has gone up steadily in the past two years and is now around one third of a failed banks assets. In its latest Quarterly Banking Profile, the FDIC counts 416 “problem” institutions with aggregate assets of around $300 billion. The Deposit Insurance Fund is basically exhausted. Bottom line: the FDIC will need a whole lot more money.

Eric Kraus from Moscow: Un Animal Triste.

No, it’s not a bubble, it is the cumulated number of failed U.S. banks (mostly regional banks, excluding the likes of Lehman Brothers and Bear Stearns) since the onset of the financial market crisis as listed by the FDIC. The green shoots which have been popping up on the seas more and more often recently are in fact the rotting carcasses of U.S. regional banks which have come belly up. The graph does not look like it will level off soon – bank defaults will become even more common in the upcoming months.

Two years ago, nobody, with the exception of some cranks, saw the financial market crisis approaching. However, with the wisdom of hindsight, it is obvious that two years ago, the outcome had already been baked into the cake – bad loans had been granted, housing prices had climbed to unsustainable levels, and the bursting of the bubble was just a question of time. A critical mind could have been able to read the signs on the wall. A few critical minds actually did read the signs and became rich and famous.

We are currently in uncharted territory concerning the consequences of the huge monetary and fiscal stimuli applied to counter the financial crisis and the economic downturn. Consequently, we are confronted with an elevated potential for surprises and black swans. However, nothing has been learnt from the abject failure to predict the financial market crisis. Although some analysts may indeed be concerned about “extreme” outcomes (2-3 sigma events), the true black swan events (4+ sigma events) are probably not given enough consideration, and hedges against them are probably underpriced by financial markets.

There are, by definition, no black swan “seers” – a black swan is, by definition, unexpected. Therefore, don’t rely on the cranks-turned-celebrities who warned of the financial market crisis to warn you of the next black swan, because the signs on the wall will be written in a different language. Those few who were able to read these signs two years ago won’t be able to read them next time, and those who warned of the crisis, but were right only by chance, won’t be able to read them either. It will be different cranks and different lucky analysts who will turn out right next time.

Many analysts agree that we are currently in a deflationary period, although they might disagree strongly about the outlook for inflation.

I think we are already inmidst serious inflation. Although consumer prices are falling in many countries, this does not imply we are experiencing deflation. Inflation is not defined as rising consumer prices, inflation is defined as a fall in the value of money because of an excessive increase in the quantity of money. Consumer prices are one (out of several) indicators of inflation. Because consumer prices are sticky, i.e. consumer goods are not traded on liquid markets, consumer prices are a lagging indicator of inflation. Most real-time indicators of inflation point to rather high inflation: growth rates of monetary aggregates around the world are massive, and the purchasing power of the US dollar has been falling on almost every liquid market for several months now (foreign currency, commodities, stocks). Consumer prices will probably follow other prices in due time.

Excellent analysis, by Eric Kraus from Moscow: Green Chutes.

Another excellent analysis by Eric Kraus from Moscow: Happy Families.