Money Will Eat Itself

“I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.”

-      Thomas Jefferson, Letter to the Secretary of the Treasury Albert Gallatin, 1802.

Karl Marx would have been proud. The author of ‘Das Kapital’ held that the capitalist economic cycle was prone to increasingly severe crises, and that the need for a constantly expanding market would ultimately cause the system to collapse upon itself. But the extent of the current financial emergency is playing out like one of the more outrageous James Bond plotlines – only with Cold War spies replaced by frostbitten banks. The most resourceful member of SMERSH would have been hard pressed to inflict more damage on the western financial system than its banks have managed on their own, whether via venal lending or by comparably facile investing. We have, of course, been here before. Nassim Taleb pointed out in ‘The Black Swan’ that after defaults in Latin America,

“In the summer of 1982, large American banks lost close to all their past earnings (cumulatively), about everything they ever made in the history of American banking – everything.”

And history seems to be repeating itself, to the extent that the Savings and Loan crisis of the 1980s, in which a real estate bubble was a proximate cause, led in turn to a slowdown in financial services and property markets that triggered recession in 1990/91. Markets of course are more efficient today – so the recession should appear more quickly than in the past. We have yet to experience a full-blooded systemic collapse, but in some markets the distinction between a collapse and a wholesale evaporation of liquidity is moot. Wall Street has cunningly avoided a fire sale in the grisliest mortgage products by simply refusing to trade them altogether. But feigning illness does not defer the maths test indefinitely. Last week, equity markets finally woke up to the reality that has been plaguing credit markets all summer and a growing sense of foreboding finally replaced wholly irrational complacency. Just to leaven the prevailing sense of gloom, jittery markets have been accompanied by sporadic moments of high farce – the $161.5 million payoff for Merrill Lynch’s Stan O’Neal, for example, or the seizing up of the London Stock Exchange just prior to Wednesday’s close. Memo to the LSE: electronic trading systems are meant to buckle during a market meltdown, and not beforehand. Perhaps the outsized payment for the former Merrill boss is confirmation of Wall Street’s own secret fears about the dollar – that it is essentially worthless, in any quantity. Perhaps the mountains of cash being shovelled at rent seekers throughout the market free-riding off other people’s (leveraged) capital reflect a fin de siècle black joke by the forces of karma, just ahead of the ultimate collapse in the value of all paper money. As Brady Willett understatedly puts it,

“If investors head to the safety of gold en masse during a major financial crisis, the global financial system as we know it ceases to exist.”

For some, that might be no bad thing – particularly if continuation of the status quo involves an international banking market where banks no longer trust each other enough to lend, where investment banks go from ‘marking to market’ to ‘marking to model’ and end up ‘marking to make-believe’, and where central banks can be counted on to “rescue” Wall Street interests if they only bleat loudly enough. And where the noise of property market-related shoes dropping will soon, quite probably, be deafening.

China did its own bit for demolishing its own portfolio value contributing to the currency debate when Cheng Siwei of China’s National People’s Congress suggested that, “We will favour stronger currencies over weaker currencies, and will readjust accordingly,” and when Xu Jian of the central bank observed that the US dollar was “losing its status as the world currency”.

Market timing is admittedly fraught at the best of times, but the chorus of dollar bears (ourselves, admittedly, lilting from the sidelines) is now deafening enough to warrant a vicious counter-trend reversal. And while one acknowledges that the US economy remains, in the words of Accrued Interest, “amazingly dynamic”, the stock market and the economy are not quite the same thing, and the stock market function of discounting future trends (namely a deteriorating property market, less “wealthy” consumers and thus less consumer spending, and the possibility if not probability of recession) seems to be broken – like so many other functions of the capital markets. And given the ongoing poor visibility of both losses and future revenues, it is still too soon to be buying financials.

All of which makes the challenge of capital preservation in real as well as nominal terms exquisite. At what point does central bank capitulation to the markets in the form of lower rates actually detract from government bonds inasmuch as it uncorks the inflation genie from the bottle ? Academic question perhaps - this genie is in any case already at large. The benignly disinflationary impact of Asia on western asset markets has gone into reverse. Jeff Matthews quotes from ACCO Brands’ most recent quarterly earnings call:

“..within China, we’ve seen significant labour inflation, coupled with a reduction of what used to be what I’ll call start-up incentives that were given through Chinese VAT. Those.. plus the significant labour inflation is starting to cause an inflationary spiral coming out of China which you can then couple with the flotation of the Yuan with the US dollar.. So, my biggest concern from a price pressure point of view right now, is China followed by oil and its trickle down effect to all the other commodities and energy..”

Jeff Matthews adds, somewhat archly,

“So the only price pressures ACCO is seeing are:

1.    “An inflationary spiral coming out of China”

2.    Oil

3.    “All the other commodities”

4.    Energy

5.    Ocean freight.

Other than that, I guess the Fed has it all under control !”

So the ‘fright to quality’ argument underpinning government bonds is undermined by the inflationary aspects of a) weaker fiat currencies, b) hard assets, c) China and d) baffled central bankers taking direction from the likes of Jim Cramer. Cash has already largely disqualified itself. Inflation-hedging then, perversely, comes in part from the very assets that are already exploding in price – resources, particularly gold and oil. Property would, under normal circumstances, be an alternative, but in most developed markets it now looks like a sick joke. Perhaps the recent strength of equities is less of a surprise, after all. But it is unlikely to be a lasting one.

Comments

[j]

No bonds, no cash, no gold, no commodities, no oil, no real estate, no stocks. What, then? Ming vases?

[timprice]

Conventional bonds might not work, but inflation-linked should help. Cash for liquidity, but not as a store of value in an inflationary crisis. Gold yes. Commodities yes - but I was referring to higher prices here too, which runs the risk of a nasty short term correction. Oil yes (but with the same caveat). Real estate perhaps in markets with more robust relative prospects (central / eastern commercial property; parts of Asia ?) Stocks yes, but only the better quality variety, and those exposed to global (as opposed to local) tailwinds.. In short, those things that will benefit from relative scarcity that haven't appreciated too much already. Which is not a big list..

[Tradebot]

Great article Tim. Not really keen on the inflation linkers - after all they are linked to government sponsored statistics such as CPI - which grossly understates the true inflation in the system - ie. the rise in cost of living on the inelastic stuff, like food, energy, taxes, etc. Not very useful for capital preservation.

However, there are plenty of structured products available now for retail market which should allow the investors to take short side of the trade.

Agreed re: commodities, especially softs - they are not cheap, but the fundamentals are strong.

[timprice]

I don't disagree - but I'm looking at all options and linkers aren't the worst, even though I agree about CPI manipulation.

[bbl]

Expect the Fed to give in and help out the bankers. After all there are future consulting jobs at risk here and no one wants to be blamed for a recession. For my part, I just hope Mr. Volcker is in good health 3 or 4 years from now when we need a fed chairman with balls.

From my blog http://derivativemusings.blogspot.com/2007/10/bernanke-between-inflation-or.html

[David]

Pardon my pedantry, but linkers are based on the RPI, which is at least significantly higher than the CPI, albeit subject to the same hedonic sleight of hand.

[timprice]

Just to complicate matters: RPI for Gilts, CPI for US Treasuries..

[Stinging Spankings]

emm.. luv it..