The Post Developed Market Debt Explosion.. 2008 to 2012 ‘A Two Tier Monetary System’
From 2008 to now, those in the developed world have experienced a two tier financial system. Capital has been abundant and cheap for banks and governments.
But it has been scarce and expensive for consumers and small and medium sized firms.
Wages have fallen as prices have risen. A paradoxical world where capital is scarce but liquidity abundant and seemingly endless. The expected inflation has remained contained for the moment.
Here below is a quick a review of this system of the last 4 years and some projections of the impications of these developed market policies.
The Neo Agenda – A ‘Progressive’ Planned System of Capital Allocation..
It is clear that the developed nations of the world continue to implement a system of financial polarization. A system that covertly necessitates cheap or even free money for some whilst at the same time expensive or unavailable money for other groups. Cheap and limitless or expensive and limited money depending on who is the borrower. Money has always been priced differently of course but what is different in this system is that no commercial decision is effecting the price and availability of this money. This system represses two thirds of the economy to recapitalize the one third, namely the public (government) and banking balance sheets. The pillars of government and banks are implicitly deemed the most important to developed society. Private capital must to be expropriated, over time, from the people and small and medium sized firms to repair and support government and banks.
The one third is deemed more important than the two thirds. It is for the good of everyone that capital is allocated accordingly, ‘in this time of crisis’, argues the progressive agenda.
The Polarized Interest Rate Enabled Balancesheet Recapitalization – Winners and Losers..
We notice interest rates near zero in most of the developed nations. We notice (almost) interest free loans to the banks as well bad asset purchases by their central banks to also assist their banks as well as QE programs to purchase government debt to further subsidize the cost of borrowing for government as well as provide bottom line support to their banks.
The Banks, in response, focus their balance sheets on purchasing western government debt, which continues to rise. The unintended beneficiary of this partnership between state and banks are large highly capitalized corporates if their bonds are investment grade.
Their cost of borrowing has reduced
with the result that earnings are booming.
This corporate earning effect was unintended though welcome as it pushes up capital market valuations and so improves bank balance sheets and consumer wealth where they hold equity. Of course this boom in corporate earnings has occured as the real economy struggles to grow with ‘official’ growth anemic. An ‘official’ growth which massively understates inflation using hedonic statistical changes, etc and therefore overstates growth. Adjusting ‘official’ GDP growth using prior statistical measures of inflation based on US BLS methodologies complied by shadow stats creates a very different looking GDP chart but one which many in society may feel reflects their own experience of economic conditions in the last decade or two.
Overall the main losers during this government bank partnership is the consumer and SME companies. The large corporates are accessing investment grade debt markets and so are benefiting from the lower rates as above but the vast majority of companies are still experiencing high interest rates. Equally consumers cannot access this cheap new liquidity. Therefore, housing markets and consumer spending has not bounced in the same way as corporate stocks, etc. Effectively government and corporate borrowers are squeezing out the SME and consumer borrowers. This strategy has, for now, kept a lid on consumer price inflation. But this is not ideal for the central bankers. Remember central bankers desire inflation of some assets eg housing and stocks but deflation of others eg consumer staples and discretionaries.
Government obligations (most of which are fixed) are too high for their income so, in commercial language, they have sought to drive up their earnings by reducing their borrowing costs. This has helped to drive deficits down to between 5 to 10% for developed nations. Clearly this is not enough when inflation is between 3 and 5%. In spite of the fiscal benefit of the lower cost of finance for government the economic uncompetitiveness and structural weaknesses continue. As these are greater than the positives of the lower of cost of borrowings the situation is worsening not improving for most developed nations.
The situation in Greece is a good example of what could occur. Eg A continuation of money printing to purchase the banks troubled assets as well as money printing to monetize government debt alongside reducing the costs of government expenditures on salaries and commitments. The continued losers in this strategy are the current recipients of benefits who must receive less as well as the middle class savers who face a combination of negative interest rates on savings as well as the dilutive effect of money printing. Consumer price inflation is unlikely in the immediate term as consumers have limited access to debt and government cost cutting will keep unemployment high and also limit salary increases for those still employed.
The current is a scenario of ever diminishing real economic activity where middle class capital is endlessly consumed by a partnership between bank and government.
The Inevitable Flaws Will Show Themselves..
I) The Developed Market Consumer..
Why I believe this bouncing along the bottom scenario is unlikely to sustain for too long? The above scenario is a contained unit where liquidity overspill is limited and confined to large corporates. As outlined, consumers are kept outside of the party as if they were allowed in again we all know consumer price inflation would immediately jump upwards. Inflation takes many forms. It is termed structurally embedded when wage push inflation occurs. This wage push inflation is deemed unlikely in the west as unions have much less power than they once had and unemployment is high and the fabled ‘spare capacity’ is high. But people are not perfect and the twins in this modern alliance are very imperfect.
The governments are elected and desire reelection. The evidence from history suggests governments and their political leaders always and everywhere desire growth. They are seduced by power and the continuation of power. For this they will throw caution to the wind. Perpetual consumer exclusion from the easy money is very unlikely therefore. Political leaders have a political incentive to allow consumers into the party of easy money in the name of ‘growth’. Lending binges will occur forming bubbles mis-allocating yet more saver’s capital. Some of these bubbles will eventually feed back into consumer price increases. Banks also have great short term incentives to allow the consumer back into the easy money party. The bonuses from government and corporate debt markets are not enough to keep them or shareholders content for long. Profits must be maximized.
(Note there is nothing wrong with this ‘profit maximization’ by the bank’s ceos and shareholders. Indeed, the profit motive associated with liberal capitalism created almost all the advances we associate with modernity. It is the driving force for life and progress but we have move a long away from any notion of a liberal capitalistic system. Profit motive in the current money printing, crony capitalist system leads to giant mis-allocations and endemic corruption. The solution to these problems is not the end of capitalism it is the reassertion of capital, savings and an end to franchise of the central banks to expropriate their people at will).
Banking staff from the top to the bottom will seek any and every way to capitalize on the banking (monetary) franchises they enjoy. A banking license, at present, is a license to literally create money from thin air. Limiting this franchise to endlessly monetize government debt at thin margins will not be enough. It is too tempting to drink deeply from the fountain of endless monetary liquidity and rightly so.
So, it is inevitable, that the developed nation consumer will eventually be let back into the monetary party with the bubble mis-allocation implications this will mean. We are starting to see consumer lending in the US and China uptick here. It is very possible a new wave of consumer lending is already under way.
II) SMEs, Private Equity, etc.
The other group that will eventually be let back into the monetary party will be the SMEs and private equity cos. Recently, both have experienced either a freeze in credit conditions or very expensive rates for debt. As government bond markets continue to compress the hunt for yield will and is driving the excess or cheap capital into these two. We can already see high yield corporate bonds rates have reduced significantly in the last 2 months or so. And that this occurred against a back drop of worsening economic data and conditions. Example euro high yield bonds have enjoyed a 25% increase in value over the period in spite of worsening euro data and conditions. Why would capital flow to these bad assets?Simply, because there is over spill of excess cheap liquidity which is driving banks to engage in risk taking activities again as the cost of funds is either cheap or free. They are driven by the profit motive which correctly should drive all private enterprise’s allocations.
III)The Emerged New Middle Class..
We must also remember that we now have world wide asset markets. Excess liquidity in developed nation banks can just as easily flow to emerging markets consumers and smes as they can to developed market consumers and smes. This is exactly what has occurred to over the last few years and looks set to continue to occur. This has important inflationary implications. The developed nation consumer, unlike prior periods of history, now has much competition to consume. Brazil adds 5m middle class consumers every year. China adds another 20m a year. Russia, India, Indonesia, Turkey, Thailand, Vietnam, Argentina, and even some African states now are seeing sustained increases in real wages and purchasing power as their currencies are supported due to weak developed nation currencies.
Even as the middle class consumer is in decline in the west it is certain that nominal middle class numbers are on the rise in aggregate due to the much larger population sizes in emerging markets. This is period of ascendance of the world’s middle class which is why we see a boom in internationally focused consumer good companies like Apple and VW, Procter and Gamble, Nestle etc. These new consumers are being enfranchised due to structural positive tail winds locally and due to inward investment from western banks due to the excess liquidity and mis-pricing of capital they enjoy. Investment flows to emerging markets have boomed due to excess developed market liquidity, currency debasement and an uncertain treatment of private capital.
This trend has continued and is likely to hasten over the coming years. Emerging markets have emerged and this is very dangerous for consumer price inflation in itself let alone against a back drop of endless developed world monetary liquidity.
Summarizing the Paradigm.
The stage is set for a serious period of world inflation. This is the great paradox of our age. The developed nations obvious structural problems are being fixed by a system of money printing and financial repression. A two tier system of free money for government and banks and expensive money for western consumers and SMEs. As it is hard for governments and banks to limit their addiction to this easy money no real progress is made in improve their financial ratios. IE both government and bank balance sheets are not improving, indeed they are worsening. Governments are not reducing their sizes. They are not reducing debt to GDP whilst developed world central banks have stuffed their balancesheets with bad assets purchased off banks and governments alike with printed money.
Banks are increasing their balance sheets and risks once more as they will always do when interest rates are negative and central banks provide them with free money and asset purchases of bad assets. The overspill into corporate debt as well as emerged market consumers is unintended, though positive for both. As nothing structurally has been resolved it seems certain another boom and bust event will occur for developed markets in the near future. On each developed market ‘boom bust event’ their currencies weaken further and more capital will flee to emerging markets.
Where Next..
What next? How do we go from where we are to a more serious inflation, deflation, etc? We cannot predict the precise steps we will tread but we can clearly see above what are the weak areas of the current progressive system and therefore predict what are the indicators to look for as she breaks down or rather progresses.
I don’t believe there are any indicators for a reemergence of the market pricing of capital any time soon. Indeed I think it more likely that the progressive agenda will strength. That the mantra of ‘for the good of wider society’ will continue and that this is the lesson from history. That this road once embarked upon will sustain until it collapses. This is the historical probability and this is the evidence thus far from the events we have witnessed. Ie money printing is increasing not diminishing. The rule of law is becoming more arbitrary not less. The geopolitics is worsening not improving. The social control apparatus is strengthening. Political polarization is increasing not diminishing. Hayek and others laid out the indicators to watch for through this process. You can tick them off one by one as they occur. We are progressing perfectly to his check list im afraid. Recent legislation across the developed world is undeniably restrictive and arbitrary.
The Unintended Consequences..
Banks will take risks and expand their balance sheets. They are in business to profit maximize. Political leaders seek reelection or election and wont cut their deficits. So the mutually beneficial coupling of these two groups includes an obvious flaw that leads to inevitable busts along the way. On each bust the rest of society must pay. This leads to ever greater repression as capital flows to more liberal and free markets. Fortunately for us these markets exist and should be embraced. The end game of this duopoly of power and repression is a destruction of currency. The net beneficiaries are societies and systems which are relatively more free than those that are less free. Ie As the developed nations implement more repressive laws on their people and corporations they will drive down their relative competitiveness and therefore attractiveness.
Volatility Will Provide Opportunistic Bounces..
This process is long and painful. It is true that the most unloved assets will bounce the highest during reflationary periods.
Here Bank of America bouncing 80% in 8 weeks. We dont see these sorts of bounces in Asia as their companies have less leverage and so less upside. Developed market stocks often can be seen to have a higher beta vs emerging stocks reversing the phenomina of the prior decades.
Investment begets more investment so waves of investment in unloved sectors can occur on a short term basis before the move is reversed with some early investors winners and the laggards the losers. Capital will be destroyed as a process of course. This phenomena will also occur in emerged markets but as balance sheets are stronger the boom bust phenomena will be reduced. The big trend is for emerged markets to further strengthen relative to their developed market cousins. Its true that developed market assets eg leveraged empty industrial parks in Holland may provide wonderful ‘turn around’ short term investments as excess liquidity flows to these assets for short periods. But it is best to take profits on these ‘turn around assets’ when and if they occur as the real (as opposed to nominal) value of these assets will decline over time rather than appreciate, imo.
The Eventual ‘Progressive’ Agenda Loser – Your Currency
Your currency’s value is a direct function of your economy’s structural strengths. If you perpetually adopt capital destructive policies, anti competitive legislation, arbitrary systems of law, you will destroy your currency’s value over time. This is inevitable over time. Ask anyone in emerging markets in the 70s or 80s what the implications where for their country having a weak currency.
Always and everywhere the implications of your nation having a weak currency is that your ability to issue debt is limited. If too much debt is destructive no debt is almost equally as bad. Innovation and new capital formation comes to a standstill due to this. In countries with weak currencies when new debt is issued inflation quickly occurs as the ratio of new debt to currency in circulation is low. The ratio is low as international confidence in your currency is diminished and so little is held as a store of value etc. Weak currency nation’s are slow to invest and see much lower growth rates than where currencies are strong and debt can be issued.
The real consequence then of this period of history in the developed markets will be a destruction of the goose that lays the golden egg. Their currencies will be relatively destroyed through this process. And this destruction will change the world as we know it. It is worth remembering that structurally troubled fiat currencies usually loose their value gradually over time until a tipping point is reached when confidence usually evaporates and the currency exponentially loses its purchasing power. Or capital rapidly flows into alternative assets and currencies. Capital controls can and have been used to slow the process but this is merely a slowing tactic.
Enfranchisement of the Emerging Market Consumer..
In the developed markets, the combination of increasingly restrictive anti competitive legislation that will be implemented to counteract the unintended consequences of mis pricing capital and dilution of savings which will destroy currency value will make the developed markets an increasingly horrid place to invest in. Of course playing nominal growth with borrowed currency will be a way to make money but why swim against the tide better to swim with the tide and embrace the emerging market super cycle.
The trend of emerged and emerging market middle class enfranchisement looks set to continue as far as the eye can see. Why? Because of currency as they have adopted free market principles. Their currencies will relatively strengthen vs their monetary base. Or rather due to the weakness in the west emerging and strength in the emerging markets they can increase their monetary bases at will. Rather that let their currencies appreciate they can enfranchise their populations.
The sort of 1970s to 2000 debt increases we saw in the west can occur in the east and south west due to currency. Prior periods of increasing consumer debt in emerging markets ie South America in the 1990s or Asia end 1990s lead to a collapse in their currencies. This time around the west’s weakness provides the east with a decade or more of money supply expansion that will change the world. The next chapter of emerging market growth is set as its driven by developed market structural and therefore currency weakness.The emerging market train is finally decoupling from the west due to this phenomena of currency. Gold will rise of course as it is a currency but for real capital growth significant and progressive increases in allocations towards emerging markets should be undertaken over the coming months and years and beyond raw commodity investments, imo.
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