Friday, July 31, 2009

Showdown With the Bond Vigilantes; Bill Bonner on the Idea of a Counter-Cyclical Stimulus

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The Daily Reckoning
Friday, July 31, 2009

  • Modern economics is an intelligence-destroying trade...
  • Inflation will cost the Chinese a pretty penny...
  • The IMF reports that a global recovery is not yet underway...
  • Bill Bonner on the idea of a counter-cyclical stimulus...and more!

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    Showdown With the Bond Vigilantes
    by Bill Bonner
    Paris, France

    It's time for summer vacation in France.

    "You can forget about getting anything done in the month of August," said colleague Simone Wapler. "The French are busy with serious things...real painting shutters and picking green beans...fixing curtains and making strawberry jam. They don't want to hear about economics or markets..."

    France begins its summer vacation today. We've come to join them...

    But we will keep an eye on the money anyways...because it's just getting interesting...

    Two interesting things are happening. First, the feds are facing a showdown with the know, the people with money - $2 trillion worth of reserves, $1.5 trillion of it in U.S. Treasury paper. They've got to convince them that they'll protect their investment. If they fail, the vigilantes sell their bonds...cause the dollar to collapse...and force up U.S. interest rates - which will come down like Round-Up on those green shoots of recovery.

    Meanwhile, stocks are not only anticipating a recovery, they're counting on it. And for that, they depend on stimulus from the feds. But what Bernanke gives in stimulus, the vigilantes are likely to take away...

    More on that in a minute...

    The other big thing that is going on is the rally in the worlds' stock markets. On Wall Street, for example, the Dow rose 96 points yesterday. How far will this rally go? Should you try to take advantage of it?

    As a rough rule of thumb, a bounce can be expected to recover half of the losses from the crash. The Dow went down 7600 points below its pre- crash high. So, we can expect a rebound of about 3800 points - which would put the index back around 10,300. By that measure, this rally could still have a lot of life in it - enough to convince practically everyone that the depression will soon be over. Don't believe it. This depression is going to last at least a few years...and the bear market isn't over. The Dow will eventually close below 5,000. At least...that's our story and we're sticking with it.

    [Our commodities man, Alan Knuckman has been staying far, far away from stocks - and benefiting greatly from that choice. This morning, he cashed out of one trade for 107% profits, and another one for 143% - in a little over one month. Get in on this killer winning streak by clicking here.]

    But let's go back to poor Ben Bernanke. And poor Tim Geithner. The poor fellows don't seem to know what they are doing. But why should they? Ben Bernanke spent his career as a professor of economics. Modern economics is fundamentally an intelligence-destroying trade. The longer you spend in economics, the less you know about how the economic world functions. Many years ago, the profession got the wrong idea of what it was up to. Ever since, it's been barking up the wrong tree. (More below...)

    As for Geithner, he is a smart young man...destined for hackdom almost from the day he was born. Ivy league firms...government - a protégée of Robert "Nobody Saw the Crisis Coming" Rubin - you can't blame Geithner either; he hasn't had time to think about how an economy really works.

    But at least their mission is clear: to convince the world of two things at the same time...both impossible and mutually exclusive! The Chinese vigilantes must believe that the feds won't undermine the dollar...and the rest of the world must believe that they will! Inflation is necessary for recovery and growth in the United States...or so everyone believes.

    It was French economist Jacques Rueff who revealed the scam more than half a century ago. The whole idea of Keynesian stimulus, he explained, was to cause inflation...which would reduce the real price of labor. In a modern democracy, politics prevents wages from falling. But in a correction, if wages don't fall people don't get jobs. Keynes' didn't mention it, but the only reason his stimulus works is because it pulls the wool over the eyes of the working classes - reducing their wages by inflation so employers can afford to hire them again. Ergo, no recovery in the job market. No recovery in the job recovery in the economy.

    But inflation will cost the Chinese plenty. And they've let it be known they won't sit still for it. Keep reading...

    Let's turn to The 5 Min. Forecast for more news:

    "The U.S. economy shrank at a 1% annualized rate in the second quarter, the Commerce Department estimates today," reports Ian Mathias in today's issue of The 5.

    "Since that's better than the 1.5% contraction the Street had predicted, we see headlines of 'the pain is easing,' and 'recession easing' left and right. True, the latest GDP number is better than previous quarters, but here are some of the stats that really got our attention:

  • The U.S. economy has now contracted four quarters in a row, the worst streak since the Great Depression
  • GDP has contracted 3.9% in the last year, the worst fall since at least 1947, when the Commerce Department started keeping track
  • First quarter GDP was revised down heavily, from a 5.5% to 6.4% - the biggest quarterly GDP drop in almost 30 years
  • The Commerce Department revised 2008 down too, from a 0.4% annual contraction to a 1% decline
  • Consumer spending, 70% of U.S. GDP, contracted 1.2%. Their retrenchment was largely replaced by government spending, up 10.9%
  • Employment compensation rose by just 1.8% over the last 12 months, the slowest rate on books that go back to 1982.

  • "But as you'd expect, the market has clung to the expectations-beating, lower than usual headline GDP. Thus stocks are currently holding on to yesterday's gains and hovering around breakeven."

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    And back to Bill, with more thoughts:

    "China seeks assurances that US will cut its deficit," says a New York Times report:

    "China sought and received assurances from the Obama administration that the United States would reduce its budget deficit once an economic recovery was under way, a senior Chinese official said Tuesday at the end of two days of high-level talks between the countries.

    "Attention should be given to the fiscal deficit," said Xie Xuren, the Chinese finance minister. He said Treasury Secretary Timothy F. Geithner had assured the Chinese that once the economy rebounded, the deficit would gradually come down from its current record levels.

    "Mr. Geithner confirmed that, saying, 'As we put in place conditions for a durable recovery led by private demand, we will bring our fiscal position down to a more sustainable level over time.'"

    Did you notice, dear reader? Geithner promised a "durable recovery led by private demand." In other words, it won't be government spending that pulls the United States out of its slump, he told the Chinese.

    He must have had his fingers crossed behind his back. At this stage, what other kind of demand is there? Are factories being built? Are they hiring? Are consumers borrowing and spending more? As we pointed out yesterday, private demand has collapsed ...and it's likely to collapse even more.

    But let's stick with our vigilantes for a while. Inflation would cause them to lose money. More importantly, it would cause them to lose face. American officials have told them not to worry; the Chinese seem satisfied. But woe to the debtor who lies to his creditor; he gets cut off.

    Meanwhile, a report from the IMF names Britain and the United States as the world's two biggest spendthrifts...and sees no end coming soon.

    A global recovery is "not yet under way" and likely to occur at different times around the world, so pulling back public spending and investment may be "premature," the IMF staff said.

    Additional discretionary spending may be needed in 2010, the report said.

    The staff report also said inflation expectations are picking up, posing a risk to a rebound in economic growth.

    "Preserving investor confidence in government solvency is key to avoiding an increase in interest rates, thereby not only preventing snowballing debt dynamics, but also ensuring that the fiscal stimulus is effective," the report said.

    The IMF noticed the fix U.S. officials are in.

    "On the one hand, a too hasty withdrawal of fiscal stimulus would risk nipping a recovery in the bud," the report said. "On the other hand, with a delayed withdrawal investor concerns about sustainability may increase, leading to higher interest rates on government paper, undermining the recovery and increasing risks of a snowballing of debt."

    The IMF staff urged countries to develop medium-term strategies to rein in rising debt levels. Some countries already have begun to do so, the report said.

    The economists at the IMF see this as a problem of "balancing risks." Here at The Daily Reckoning, we see it differently. To us, it is lies colliding with each other. Stimulus will not produce genuine prosperity. You can't cure a credit-caused crisis by offering more credit; it just won't work. But rather than let the system correct itself, the feds are determined to 'do something!' What can they do? They can only destroy the dollar - or try to - thereby destroying the value of China's $1.5 trillion treasure.

    Now, more on why private demand is going to weaken, not increase.

    As the boom of the post-war period continued, consumer spending played a larger and larger role in the economy. It averaged 64% of the GDP during most of the period, but increased to 70% in 2007. Likewise, debt service as a percentage of disposable personal income rose too - from less than 5% in the '50s and '60s to over 14% now.

    If, as we suspect, the trend towards more and more consumer debt has finally peaked out; consumption should have peaked out too. We should now see the percentage of the economy devoted to consumption go down...year after year...until it reaches the 'normal' level. Private debt too should go down, until it is at a more 'normal' level.

    We calculated that during the last 7 years of the Bubble Epoque consumers added $1.4 trillion in debt per year. That was the spending that made the old mare go. But now what? They are now adding no debt - zero. In fact, they are paying off debt. This alone removed $1.4 trillion in private demand from the economy.

    [It's clear that the U.S. consumers won't be able to save the global economy this time around. Here's how to protect yourself from the next leg down in this epic downturn. See here.]

    The savings rate is up dramatically too - from zero to 7%. This is another way of measuring the same phenomenon: the decline in consumer spending.

    The only thing that would cause consumer spending to go would be a substantial increase in real wages. This would allow Americans to buy more - while simultaneously paying down debt. But with 16% unemployment (Rosenberg's estimate) it will be a long time before real wages increase at all...let alone substantially.

    Keep reading for today's essay...

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    The Daily Reckoning PRESENTS: Everyone remembers the television show that swept the nation in the late '90s: Jackass. Though the phenomenon has fizzled out in recent years, you can still enjoy the Jackass genre - all you have to do is read the news. Bill Bonner explores, below...

    We Are All Jackasses Now
    by Bill Bonner
    Paris, France

    For whatever reason, the French newspaper, Liberation, chose to recall a grim event last week. On February 4, 1912 Franz Reichelt, also known as the 'flying tailor,' put on his contraption - a homemade outfit designed to work like a parachute - went up to the first observation level of the Eiffel Tower, hesitated...then stepped over the rail and jumped.

    Alas, he did not fly. Nor even float. He fell "like a stone," the paper reported.

    Immortality was achieved, but not the way he had hoped. His stunt was captured by the new motion picture technology of the time. That silent film inspired the very popular Jackass videos, which show people engaged in reckless acts of mischief and mortality.

    But we do not have to go to Youtube to enjoy the Jackass genre. We have only to read the news. All over the world the authorities are strapping on their absurd parachutes...and climbing to very high places. In Europe, banks borrowed 442 billion euros last month from the European Central Bank. Much of it is lent back to European governments. In America, stimulus funds are used to fix public toilets, as well as to repair Wall Street's balance sheets. Trillions of dollars have been put at risk in these adventures - $23 trillion in the United States alone. And yet, despite the most daring experiment in stimulus ever, by the end of June, the British economy was 5.6% smaller than it had been a year before, paralleling the decline that followed the crash of '29. As for the United States...we await the figures...
    "In the past, workers were quick to move to where the jobs were. The Sun Belt traditionally bounced back first. But Florida, California, Arizona and Nevada have been flattened even more than the rest of the nation - by record foreclosures, government cutbacks and bankruptcies. Now, the jobless stay put...and stay unemployed."

    On the evidence, stimulus programs aren't working. In fact, where they are tried the most they work the least. For proof, we go to Stimulation Nation itself. From America last week came news that new house sales had finally turned up. They were up 11% in June, according to the papers. That was the monthly figure. According to the annual numbers, they were down 21% from the year before - at the second lowest since they began counting in 1963. And since the population is much bigger than it was 52 years ago, this was relatively the worst June in history for new house sales. And now that the economy is in a slump, the rate of new household formation has been cut in half. Faced with lower incomes and worsening jobs prospects, people are less eager to set up new households - reducing the demand for new houses.

    Unemployment shows no sign of improving, either. The stimulus program was supposed to cap joblessness at 8%. Officially, the rate is now 9.5%. Economist David Rosenberg puts the real unemployment rate almost twice that high. And businesses are cutting jobs even faster than expected. Economist Arthur Okun suggested a rule of thumb for predicting unemployment levels in a downturn. But firms are not only laying off redundant workers; they are laying off workers who would normally be spared. What's more, those who are left are working the shortest weeks ever recorded.

    In the past, workers were quick to move to where the jobs were. The Sun Belt traditionally bounced back first. But Florida, California, Arizona and Nevada have been flattened even more than the rest of the nation - by record foreclosures, government cutbacks and bankruptcies. Now, the jobless stay put...and stay unemployed.

    Currently, the excess capacity in the United States is staggering - both in labor and capital. Capacity utilization is only 65%; in theory, output can increase 35% before any new capital investments are made.

    Recovery? "Forget it," says Rosenberg.

    Now that the facts are out of the way, we end our critique of stimulus...and turn to laugh at the stimulators. "Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back," wrote John Maynard Keynes. And now it is Keynes' voice they hear.

    "We are all Keynesians now," said Richard Nixon as he strapped on a crash helmet.

    Keynes probably got the idea of a counter-cyclical stimulus in Bible class. And a good idea it was. Simple...intuitively correct...practically demonstrated...and theoretically sound. But he and his followers still managed to screw it up.

    First, Keynes' General Theory is no theory at least not in the scientific sense. It can't be tested. The results aren't reproducible. Instead, it's merely an idea about how things should work, based on an Old Testament story.

    Pharaoh had a dream. He dreamt he saw seven fat cows devoured by seven scrawny, misbegotten cows. He didn't know what the dream meant, so he called for a young Hebrew man who had interpreted dreams for his master. Joseph told Pharaoh that Egypt was to enjoy seven years of abundance followed by seven years of famine. He told him what he should do about it too. He should store all the grain he could from the fat he could pass it out when the going got tough.

    This is a story we all know. It is easy to tell and easy to understand. But modern economists twisted it as though it were an inflation statistic. They maintain that when the business cycle turns down, it's just like a drought. And they can counteract the effect of the drought by giving the economy stimulus - liquidity - from the public sector.

    Trouble is, they missed the point completely. Do you recall any public official urging the public to stop spending so much in the bubble years? Do you remember any Treasury Secretary or Fed Chairman suggesting that the U.S. government run real budget surpluses in the fat years? Does any headline from any paper in the nation mention a storeroom in which grain or treasure was stored for the lean years? Not at all! Instead, the feds encouraged people to eat their grain! Governments ran deficits even during the bubble years, with the biggest deficit in history in 2008, just as the lean years began. Now they have no real grain to offer. So they turn to a reckless, disaster-defying stunt - passing out phony money, like sawdust muffins...

    Future generations will watch the video and laugh until their stomachs hurt.

    Enjoy your weekend,

    Bill Bonner
    The Daily Reckoning

    Editor's Note: Bill made the final presentation at the Agora Financial Investment Symposium last Friday - and even if you weren't able to join us this year, you can still be privy to all the investment advice that Bill (and all the rest of this year's presenters) bestowed upon us. That's because we recorded all of the main session presentations, and you can get them delivered straight to your front door at an amazing value.

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    Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis.

    Bill's latest book, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics, written with co-author Lila Rajiva, is available now by clicking here:

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