Sept 22, 2010
The recent intervention by the BOJ has quickly become the most contentious decision in global economic circles, with many wondering now that the world economy is off on a course of radical currency devaluation, who will be next, and how far will this game continue? If Albert Edwards, whose latest piece rhetorically asks (and answers) “what do devaluation, high unemployment, inequality and food prices spell? C-H-A-O-S” is correct, this could be the beginning of a rapid descent in which central banks around the world are all forced to use the nuclear option: ceaseless FX devaluation, but one coupled with an endless increase in the money supply a process which can only have one outcome – that predicted recently by Eric Sprott when he said that “we are now paying for the funeral of Keynesian theory.” However, the biggest threat is that this most recent invocation of the nuclear option is coming at a time when the world is least prepared to handle it – social imbalances are at unprecedented levels, and if, as many predict, the price of key food products is about to surge (courtesy precisely of these failed central bank policies) to a point where the great unwashed end up on the wrong side of hungry, from there, to armed conflict, the line is very, very thin.
Edwards looks first at the immediate reasons that prompted Shirakawa to do what he did.
Since 2009 a cyclical recovery has been met with further yen appreciation which has been tolerated by the Japanese authorities. But with the leading indicators now topping out, yen strength is no longer tolerable (see chart above) – commentators who rightly point out that the real trade-weighted yen is not that strong have missed the point. It is the change in the currency as well as its level that helps determine export growth. A rise in an undervalued currency to a less undervalued level will still hit exports and can cause a recession.
The Japanese economy is decelerating. The PMI usually proves to be quite a good early warning of changes in the cyclical wind and it has begun to turn down decisively. (The current downturn may look moderate compared to 2008, but remember GDP contracted peak to trough by 8% during this period, one of the worst GDP declines of any industrialized nation.) The current downturn in the PMI is sufficiently bad to start ringing alarm bells – see chart below.
As expected, Japan is merely the beginning, however in a non-zero sum world of competitive currency devaluation. And because he is right, and fiat is all relative to itself, except to absolutes such as gold, those calling for a local peak in gold prices may want to reevaluate their assumptions.
Our economists made a very interesting point in the Economic News,17 Sept. They believe the BoJ?s actions may be the start of a more general period of competitive devaluation; with the US authorities tacitly allowing the US dollar to decline in an environment of QE2 (no wonder gold looks so perky!). The good news is that this is not the zero sum gain that most commentators suppose. For if all central banks are printing money to drive their currencies downward, exchange rates may not change, but the money supply does. It is easier for the US to ?guide? down the dollar with its burgeoning current account deficit, and to the extent bond yields rise as foreigners back away, the Fed will just keep printing money to hold them down!
Looking at history, the one most prominent example of coordinated devaluation was during the Great Depression, which was accompanied by the confiscation of gold. Arguably, back then it kinda, sorta worked in principle (for other reasons) if not in theory, with the argument being that devaluation can prevent deflation.
This may or may not stimulate economic activity ? I do not have the certainty of Mervyn King. But one key lesson from the 1930?s was that raising interest rates to stay on the gold standard was a mugs game (see chart below). The UK quickly came off gold, devalued and enjoyed a shallower depression than most other industrialized nations. The US followed shortly after.
Edwards takes a critical detour into a topic well-known to Zero Hedge readers: the Fed’s free range authority to buy not only dometic but foreign debt (who needs FX swaps when the Fed can buy Irish debt). At least we have Ben on record telling Ron Paul he has not done so… yet.
Apparently devaluation works to head off deflation. No less than Ben Bernanke told us so in his Nov 2002 speech Deflation: Making Sure “It” Doesn’t Happen Here – link. He said “The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.
“I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange…Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it’s worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. US CPI inflation went from -10.3% in 1932 to -5.1% in 1933 to +3.4% in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.”
Hence Bernanke openly stated back in 2002 that the end game, especially when all else fails (fiscal deficit too high and QE shown to be impotent), is to print money to drive down the dollar. This is default in all but name. Investors ignore this at their peril.
All deflationists especially those with blogs and audiences – please, please read this very carefully. It tells you the blueprint for the endgame word for word.
Next, Edwards confirms what many suspect: that Japan was merely a victim of China’s cunning policy to get Japan to intervene due to its own inability to devalue its currency without angering the US.
But back to the current BoJ intervention: our Chief Economist, Michala Marcussen, thinks that the Chinese, in starting to buy Japanese assets, have pushed up the yen and effectively forced the BoJ to intervene. She writes, “China may thus be the big winner from Japan’s intervention; winning on three levels (1) diversifying reserves (albeit still only a small amount) and reducing its exposure to the US dollar, (2) escaping the title of currency manipulator, and (3) placing Japan in the hot seat ahead of the G20, thus detracting attention away from itself.” -? link.
I would contend that China is now playing a very, very dangerous game. With the US trade deficit deteriorating again (see top right-hand chart above), and ? much to my surprise – the Chinese trade surplus widening, patience is rapidly running out in the US with China?s currency policies. I believe we are now nearer to an outbreak of trade war than at any time since the 1930s. Any downturn in the global economy back into recession would almost certainly guarantee such a result, as the political pressure to do something mounts.
Yet even without a trade war or competitive devaluation, any descent back into outright recession will result in intolerable social stress. We had previously highlighted the extreme levels of income inequality that prevailed even before this crisis.
In addition to the inequality, absolute levels of poverty have been exacerbated by this recession. The US Census Bureau last week published a report showing that 43.6 million people were living below the poverty line, a 50-year high- link.
For those curious why we posted the BIS report on core differences between Japanese and US households, hopefully this explains it (and those who wish to reread it, may do so here). Going into a double dip, a redepression, or a brand new recession, whatever the semantics, with the current level of developed world inequality is recipe for social disaster, and possible civil war.
Inequality, unemployment and poverty are all at crisis levels in the immediate aftermath of this financial and economic debacle. To put it into a human context, one snippet caught my eye. David Rosenberg of Gluskin Sheff believes conditions now are so bad that they can be reasonably described as a depression. He reported a few weeks back that “In a depression, radical changes occur in terms of social norms and spending behavior. In recessions people don’t cancel their life insurance policies – as one example. But in a depression, tragically, this is what happens – almost 35 million Americans (a third of US households) now have no such coverage, up from 24 million five years ago. This reflects the focus by households to pay down debts at all costs and how companies have bolstered profits, by eliminating benefits (see ?More Go Without Life Insurance’ ? WSJ 29 Aug -? link).”
Many commentators, including myself, believe it is no accident that before this crisis inequality in the US and the UK reached extreme levels. Many believe there is a causal relationship from extreme levels of inequality to the crisis. How? Central bankers, by pursuing policies thatallowed the middle classes to borrow against rising asset prices, kept them consuming despite the stagnation of their incomes and hence disguised the effect of government policies that allowed the rich to acquire virtually all of the gains in GDP growth. – link.
Additionally, this is not merely a horizontal event, but a vertical one, as one class steals from the future of all other classes.
And in the process of ?robbing? the middle classes and now still attempting to keep asset prices artificially high, they are also robbing our children of the ability to buy a house at an affordable price. Yet central bankers still see QE as key to maintaining the illusion of prosperity and stoking consumer spending! I will write more about the role of high levels of inequality in causing the recent crisis in a future paper (James Montier has passed me some interesting papers). But with youth unemployment rocketing in recent years (can you believe it is 40% in Spain), policymakers had better start manning the barricades for the backlash. For as my mother used to say “?the devil makes work for idle hands”.
Lastly, to provide all the ingredients for social upheaval, not only is social inequality at all time records, but soon, courtesy of the very same policies adopted by the central banks, the great unwashed mass may soon have little if anything to eat.
For one idea of what might drive the poor to breaking point in the coming years, read my colleague Dylan Grice?s excellent report on the likelihood that we will see a structural spike in higher grain prices from these already high levels – link! For he notes that the grain markets today are at a very similar level of tightness to the oil market in the early 1970?s when the US turned into a substantial oil importer. This made the market very vulnerable to a supply shock (such as the 1973 Arab embargo), in a way that it wasn?t in 1967. China is in that same situation today for grains (see chart below). If the devil makes work for idle hands, history is full of examples of what happens when those same hands are owned by the poor and hungry.
So for all those who have been wondering if Mike Krieger, and recently Nic Lenoir’s anger at visualizing precisely the scenario where the Fed’s ongoing disastrous policies result in social and/or global war are overblown, the answer is no. We are getting to the point where absent a dramatic intervention in the Fed’s all or nothing gamble on preserving Keynesianism will almost certainly result in armed conflict. And if those who know and understand this do not act, nobody else will. The ability to postpone that most critical intervention in this generation’s lifetime is ending. Very soon we will have only ourselves to blame for not having done the right thing. We hope by then it is not too late.
This article was posted: Wednesday, September 22, 2010 at 3:40 am