…how does it all work?

We’re doing some serious thinking this week. What is it that actually causes a depression? A stock market collapse? Or too much debt? How come government can appear to cure the problem sometimes – 2001-2007 – but not other times? How come the Japanese were not able to increase consumer prices? Even now… Japan’s inflation rate is negative. And how come, despite the most massive effort at monetary inflation ever undertaken, the US bond market still forecasts an inflation rate of less than 2%?

An interview with Richard Koo, author of ‘The Balance Sheet Recession,’ and a new book by Ken Rogoff and Carmen Reinhart are helping us understand what it going on. More to come…

In the meantime, the Dow went down 42 points on Friday. Gold dropped $7. Still no sign of the Chinese coming to the rescue in the gold market.

“Global rally shows signs of running out of steam,” says the Financial Times.

Reuters says the job data will “test the rally.” The New York Times says the ratio between job seekers and jobs available has never been worse.

The Wall Street Journal, on the other hand, tells us that greater than expected profits will support the rally. So far, the increase in stock prices has not come from increased earnings. It’s come from increased P/Es… based on the hope of higher earnings. In terms of forecast earnings, the Dow is selling at a P/E ratio of 27. But in terms of actual, reported earnings… the ratio is 180.

A friend made the mistake of asking us what to expect from the economy. We said it would go do down.

“You mean, you expect a W-shaped recovery,” he said… “a double-dip recession?”

“No… we expect no recovery at all. It’s a W without the last stroke… ”

Of course, we were exaggerating. But not much. We do not think that the economy of the Bubble Era can ever be revived. It will never recover; because it is dead.

But that doesn’t mean we will march backward forever. The economy may lose 10% of GDP… maybe 20%. But we do not expect to be slithering in the mud of the Middle Ages, with each man planting his own wheat and brewing his own beer. No, not at all. It only means that the depression must continue until it comes to an end.

“But when will it come to an end?” you ask.

“When it is over.”

A depression ends when it has done its work. It must correct mistakes. It must punish errors. It must destroy the bubble economy… and the mindset of the Bubble Era. Only then can new real, sustainable growth begin again.

So far, in 2009, 95 banks have gone broke. How many more need to go broke before the depression is over? We don’t know. This is where is gets complicated. Because the feds are determined to keep us from finding out!

Here’s how it works. The Fed lends the bankers money. Then, the bankers turn around and lend it back to the feds. The banks are happy; they’re making money on a risk-free trade. The regulators are happy; what could be safer in a bank’s vault than US Treasury bonds? Investors are happy; it looks like the financial sector is making money again. And the feds are happy; they’re able to finance their deficits.

Who’s not happy? So far, so good. But hold on…

“This is not a sustainable recovery,” says fund manager Crispin Odey in the Financial Times.

What a spoilsport! You mean, you can’t build a lasting recovery on debt and shell-game finance?

Nope. Apparently not. Just look at what has happened to the auto industry. The feds borrowed money to help Americans pimp up their rides. And this Thursday, when September sales figures come out, we find out how sustainable that boost was. Many Americans got new wheels. But now they don’t need new wheels. And now the feds are out of the auto-incentive business. So now we get to see what happens next.

“Oh Daddy, I felt so sorry for Annabel… ”

Maria was on the phone. She was telling about one of her friends… and money worries…

“She was sitting on the couch. And all of a sudden she burst into tears. She was crying because she is out of money…

“Her car broke down and she doesn’t have the money to get it fixed. And she had to go and have some medical work done. She just doesn’t have any money left…

“And she’s already working all she possibly can. She works with me at the studio. And she picks up bartending jobs on the side. She works all day… and then works at night too. But I think it is getting to her. She just can’t go on…

“I asked her if her folks could help her out. But she said that her father lost his job in the recession… and they don’t have any money to lend her.

“Honestly, I felt so lucky to have you behind me. I don’t know what I would do if I didn’t have the family supporting me. I guess I just wouldn’t be able to keep going either. I’d have to give up the idea of being an actress because it’s almost impossible to support yourself and still go to all the castings and try-outs.”

Elizabeth added a comment:

“I was talking to [a French friend]. He thinks it is typically American to expect each generation to make it on its own. Americans think they should put aside enough money to pay their retirements, and that’s all. They don’t worry about their children. They think the children should take care of themselves. Anyway, that’s what he thinks Americans think… and he’s probably mostly right about it.

“The French attitude is much different. They keep the children closer… and help them more. He’s got five children and he wants to be able to leave them something. He’s just begun a new business venture, because he says he wasn’t able to earn enough in his job.

“He makes a good point: when you have to start from nothing, you just won’t get as far. You know, it’s a bit like what Newton said. He was able to make spectacular progress because, as he put it, he could ‘stand on the shoulders of giants.’ But that’s true for everything. One generation stands on the work of the one that came before it. And if there is nothing to stand on… they have to start from scratch. They are able to do more… if they have a firm foundation to stand on. And there are somethings they couldn’t do at all without it. Maria, for example, would be forced to get a more serious job, if we weren’t helping her with her bills while she’s getting established. And Jules, too. He wants a career in music. But if he couldn’t count on us to help him, he’d probably have to do something that pays better now.

“There’s a lot to be said for the American can-do emphasis on self-reliance. But there’s something to be said for the French attitude too. The ideal is to give your children the spirit of self-reliance and the confidence that comes from making it on their own… but also to give them something to work with… so they don’t have to start at the very bottom.”

Until tomorrow,

Bill Bonner

Source: Correcting Mistakes and Punishing Errors

This week’s news told us that good times are over. “For the time being, at least,” said the Governor of the Bank of England, “the ‘nice’ decade is behind us.”

Of course, just because an economist or a central banker says something, it doesn’t make it so. And when a central banker who is also an economist says something, it should be treated with the skepticism of an airline schedule.

“I am obviously biased, but I find it sad to conclude that the role of serious economists in financial institutions is very limited today,” said Han de Jong, Chief Economist at ABN Amro Bank to the Financial Times on February 21, 2008. ” We are little more than clowns, whose purpose is to entertain clients….”

Mr. de Jong is too modest. Economists are essential to the financial industry. They distract the customers while the boys on the sales desks pick their pockets.

We say that not in contempt but admiration; the role of the financial industry – like the contemporary art market or like Las Vegas – is to separate the punters from their money. Economists help them get the job done.

This they did in the last two decades with a variety of gaudy theories. It didn’t seem to matter that the theories were contradictory and absurd. On the one hand, prices were said to move randomly – permitting them to ‘model’ risk and sell extravagant securities. On the other hand, private equity experts and fund managers pretended to know which way the ‘random’ movements would go; they claimed to be able to produce “alpha” – above market returns – on a such a regular basis they could charge “2 and 20″ for it.

But while economists are usually wrong about things, the burden of the present essay is that Mr. King is right this time.

Last week, we argued that ‘alpha’ was a mountebank. The financial industry doesn’t often add much value, we pointed out. Instead, fair winds and convenient tides are what usually get investors’ little barks where they want them to go. Most of the results investors get depend upon setting sail at the right hour, from the right place, in other words, not in having a Wall Street hotshot at the tiller. Put an alpha-seeking whiz-kid out in a storm and he’ll sink along with everyone else.

In the 20-year period ’83 to ’03, for example, the price of oil barely moved. Sheep could graze peacefully in the Mideast, confident of being undisturbed. Now, everywhere they go, someone’s setting up an oil rig. The latest figures show oil exploration up 400% since 2000.

Almost a whole generation of investors got nothing from that greasy sector. Then, all of a sudden, in the following 5 years the roughnecks suddenly had money in their pockets and the wind at their backs.

Likewise, in America, you could have held residential housing for 100 years – from 1896 to 1996. You would have gotten nothing for your trouble but leaky roofs and cracked paint; prices rose only as much as consumer prices. Then, the next ten years, a tide of easy credit rushed into the residential real estate market; prices rose 70% in real terms.

Behind both these booms is a story too long to tell here. But the moral of it is simple enough. The average investor makes far more by accident than by fund manager. And here we venture a guess: of all the times and places in which a US investor might hope to get a decent return on his money, this is not one of them.

But the beauty of capitalism is that people get what they’ve got coming – not matter what they think. NICE is an acronym for “non-inflationary consistent expansion,” according to Mr. King. It is his way of describing what other economists called the “great moderation,” a period so agreeable that they gave themselves credit for it. Macro economists believed they had finally mastered the art of central banking – so perfectly manipulating the credit cycle as to produce growth without causing the consumer price inflation that typically accompanies it.

If economic wizards were really responsible for the Great Moderation, it would be reasonable to think they could keep it going. Alas, they can no more sustain it than they can claim credit for it. What really happened, over the last 25 years, was a unique series of events and trends that now seem to have run their course. Labor rates fell as millions of new workers entered the modern economy. Now, even in China and India, salaries are rising fast. Logistical expenses declined as computers and just-in-time inventory systems were put in place; now inventories (and associated costs) are rising again. Outsourcing, globalization, deregulation, capitalization, securitization – all these trends helped keep prices down; now, all seem to have played themselves out, gone into reverse, or backfired.

Finally, the cost of money has fallen for the last 27 years. Sometimes it fell naturally. Sometimes it fell unnaturally, even grotesquely – such as when Alan Greenspan lent the Fed’s money at below the inflation rate for more than a year. Normally, cheaper money creates boom-like conditions. But normally, it comes at a cost: consumer prices soon begin to rise. As the economy “heats up,” the domino of labor costs falls over; workers are in demand so they ask for more money. Then, that domino knocks over consumer price stability; prices rise. Then, a whole line of dominos topples over. Bond investors run for cover, for example, forcing up interest rates. Then, the economy “cools down,” as the cost of money increases.

That was what was so nice about the ‘nice’ years. The dominos wouldn’t budge. Thanks to so many things working so hard to keep prices down, the normal process of self-correction broke down. As demand for labor increased, new, cheaper workers were found overseas. And even though the supply of dollars increased twice as fast as GDP, the domino with the CPI on it stayed right where it was.

Alas, those happy days are over. The Great Moderation is finished. This week, oil rose over $130 a barrel. T. Boone Pickens said it would hit $150 this year. And America’s core producer price index registered its biggest increase in 17 years.

Of course, the real level of consumer price inflation is probably far higher than the official numbers. The raw data suggest price increases closer to 10% per year than the 4% the US Department of Labor confesses. But the economists have their ways of making the numbers say whatever they want. In March, for example, the consumer price index was “seasonally adjusted” from 0.9% down to 0.3%. In April, wouldn’t you know it, another seasonal adjustment took the number from 0.6% down to 0.2%. We don’t know what the real number should be; no one does. But Mervyn King is right; the season has changed.

Source: Not So NICE Anymore

But now the idea that the good times are over is going mainstream: not only is the “nice” decade – Non Inflationary Consistently Expansionary – ending, but the “nasty” one could well be starting, says analyst Tim Bond of Barclays Capital.

But what does that really mean? And how will Britain be dragged down into another recession?

Over to the strategy team at Legal and General. They’ve charted a ‘heat map’ of factors that could push us over the cliff edge. And it’s enough to get anyone steamed up…

…Legal and General’s SatNav is now on red alert. According the them there’s now a 95% chance that Britain is heading for recession!

While you’ll find plenty of commentators who will happily chat in gloomy terms about all sorts of possible problems, and then make a comparison with some point in history, Legal & General has taken the analysis a stage further.

Having totted up all the potential perils facing UK plc, the L&G team then rated each risk on a scale between ‘Good’ to ‘Danger’. Everything in the latter category, you won’t be surprised to hear, is coloured bright red on the heat map.

Why the likelihood of a recession is so high

So after examining sky-high personal debt levels, soaring oil prices, crimped bank lending and tension in the money markets, as well as a few other areas of possible pain, the strategists reckon that the odds of Britain suffering a recession are now about 95%. And what raises the stakes so high is the likelihood that everything will go wrong at exactly the same time. Which also makes it a racing certainty that the recession will prove to be just as bad as both the early 1990s and early 1980s.

How long will it last? The official description of recession by economists is “two quarters of negative growth” (only economists could actually talk about minus numbers as negative growth).

The Legal eagles have been pretty downbeat for some while, but until now have been telling us to expect perhaps two years of the economy going nowhere.

But recently the L&G ‘recession model’ has taken a real turn for the worse, and is now warning of a long decline in economic activity, by as much as 2% year-on-year. That may not sound huge, but if it happens, life could get very unpleasant and we’ll all feel the squeeze.

Cheap Asian imports are getting more expensive

Already there’s lots of talk about the dangers of Asian inflation and what this means for us here in the UK. Instead of picking up all those nice cheap Far East-made goods on our credit cards, we’ll soon find that the prices have gone up quite a lot (see this week’s Moneyweek for more on this).

But in future, the Legal analysts suggest that little luxuries will soon be off the menu anyway. If we do have a little leeway before hitting our credit limits, we could soon need it, plus any spare cash we can lay our hands on, just to pay the petrol bill to get to the supermarket.

Spending in the shops will suffer, profits in consumer businesses will slump and jobs will get cut. Meanwhile, the housing market will get much worse as mortgage problems mount. The Council of Mortgage Lenders now sees house prices dropping 7% this year, with transactions down by over a third on last year.

And banks will become less and less willing to lend money to all those people who’ll need it more and more. Don’t believe we can’t have a recession at this level of interest rates. If the banks close the loan shutters, we can.

Why the Bank of England is a lot gloomier than the Government

It seems the Bank of England is finally catching on, too. Today’s FT reports that the Threadneedle Street thinkers are now a lot more gloomy than official Government forecasts. Indeed, the Bank now believes that “a long period of weakness” is needed to bring inflation under the thumb, as I talk about below.

What’s more, the Government, i.e. taxpayers like you and me, won’t be able to do much about helping out, now that Gordon Brown has broken his Golden Rule by reeling in Northern Wreck.

UK public debts have now smashed through the government’s official ceiling of 40%, preliminary figures suggest, reaching 43.1% of gross domestic product (GDP) in March. And although Chancellor Alistair Darling has said that any impact on the public finances by nationalising Northern Rock would be “temporary and exceptional”, just remember Milton Friedman’s comment that “there’s nothing so permanent as a temporary government programme.”

Historically, governments have been able to use our cash to boost the economy. But Howard Archer, chief UK economist at Global Insight, said the government’s aim to keep borrowing down to £43 billion in the current financial year is “wishful thinking” should the economy slow sharply.

And because of inflation, the Bank of England won’t be able to help either. The hands of the rate setters on the Bank’s Monetary Policy Committee (MPC) are well and truly tied by the CPI (consumer price index) hitting 3% and looking like it’s going some way higher, rather than lower.

In short, there should be no more interest rate cuts on the MPC’s agenda for the moment. Not that they were doing much good anyway. What matters most to the majority of homeowners is the level of mortgage rates. These are priced off so-called swap rates, in turn based on LIBOR – the interbank rate at which lenders lend to each other. Libor rates have stayed stubbornly high, the best part of 1% above base rates, despite the MPC’s earlier antics.

This may all sound like a technicality, but it isn’t. What it’s saying is that there’s still a lot of nervousness left in the banking system. Mortgage variable rates won’t fall until the markets regain confidence in the Bank’s bank rate.

So the picture’s looking bleak on all fronts. Recession looms, consumer prices soar, public debt climbs. Not nice at all.

Source: Why There’s a 95% Chance of a Recession

There was a message waiting for me from Zolgarg, Supreme Overlord of this sector of the galaxy. I put off opening it, because communications from Galactic Command Central (GCC) are always a big hassle for me, and I am always torn between doing my usual lazy job by just making something up and taking the rest of the day off, or doing a really good job and maybe getting transferred off this stupid planet as my reward, thus allowing me to get away from a population of moronic people that actually believe such stupid crap as “everyone can make money by investing for the long-term”, “inflation should be above zero”, and “the government can painlessly buy its way out of any mess it can make, just by creating the money to pay for it.”

Finally, I knew that my delaying the inevitable was starting to look bad, so I opened it. What he wanted was the worst of all; a report on the economic situation on Earth, since Earthlings are of particular interest to economists throughout the universe, being that Earthlings are considered by advanced civilizations to be one of the rather lower-middle forms of life in the universe, in that many Earthlings, culminating in Ludwig von Mises and the Austrian school of economics, proved that the species has the intellect to conceive of the idea that excessive inflation in the money supply leads to inflation in consumer prices, which leads to social upheaval.

And the people of this planet have discovered universal reading and writing, and so they know from their own history books what happens to any idiot country that uses, and then abuses, a fiat money and bank debt until the sum total of debt becomes literally un-payable.

What makes Earthlings so interesting is… Why don’t they do what they know they should, especially since the freaking Constitution of the United States of America requires that money be only of only silver and gold, so that a fiat currency would be impossible?

Of course, the next thing is… How can we make a bet on it? And that is, I suspect, the essence of this latest message from Zolgarg, as rumor has it that he already has more Quatloons wagered than he can afford on when the economy collapses, and another big wad of Quatoloons on the exact day the U.S. government declares war on Iran so as to start World War Three as a distraction to an angry, bankrupted citizenry and country, and we all figure that one day Zolgarg is going to find his bookie coming over there with a couple of goons and they will break off one of his tentacles.

I mean, it’s no secret that that we know what will happen when you let a government allow the money supply be constantly expanded; disaster!

And everybody, even unto the farthest reaches of interstellar space, knows what happens when a government uses that money to expand itself, like now, when the federal, state and local governments now employ one out of seven workers and collectively spends one-half of GDP; disaster again!

But Zolgarg obviously overestimated the collective smarts of Earthlings in protesting with riots and recall elections, and underestimated the sheer degree of frantic desperation of the Federal Reserve and governments.

I tried to warn him that even Keynes himself said that “Markets can remain irrational longer than you can remain solvent”, but nobody listens to me, and neither did he..

But his answer is logical; if you’re going to bet, you gotta got with the fundamentals, and so by virtue of a corrupt and intellectually-bankrupt Federal Reserve perpetually lowering interest rates, using a fiat currency, using literally zero reserves in the banking system, with a complicit corrupt Congress (except Ron Paul), it is just a matter of time, and the payoff is knowing HOW much time!

None of this is going to help me, or him, but he is not going to believe me, and it just means more work for to write the stupid report.

In the end I reverted to my slug-like, worthless ways, and just sent him a copy of Jim Willie of the Hat Trick Letter saying, “The Bear Stearns and Fannie Mae stories are loud billboard statements that the United States is now MONETIZING BANKRUPTCY. A profound USDollar risk remains constant. The US system is now insolvent, from the USGovt to USEconomic trade to US banks to US households.”

I added an Executive Summary of “Not yet, but soon, because we are freaking doomed!”

To hopefully lighten the mood, I included a cartoon by Dan Piraro at bizarro.com with my report, which shows a business executive explaining to his staff the downward-sloping graph on the wall behind him. He says, “I wouldn’t say the ship is ’sinking’, but the mast is broken, we’re out of food and water, sharks are circling and the captain is insane.” Hahahaha!

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Source: The Earthling Economics Experiment