Financial markets still don’t get it

 Apologies if the title of this Schlichter-file sounds somewhat arrogant but after the events of the past three weeks I may perhaps be forgiven for feeling a bit emboldened in my views. Of course, this is often the point at which the pendulum swings in the other direction and developments take a slightly different turn, if only for a short time. After all, big trends almost never go from A to B in a straight line. So let’s stay modest and nimble. But there can be no denying that the events of that past two to three weeks have been very supportive of my views: signs are accumulating everywhere that we are in the twilight of the fiat money era. The system is fairly beyond repair. And its demise is accelerating.

I have not been following events and market debate quite as closely as usual as I have been in Italy for the past three weeks, from where I am writing this. Italy is, of course broke, but it is still a lovely place and, thankfully, so far riot-free. I should probably correct the last sentence: the Italian state is broke, the tax-funded overinflated public sector, not the individual Italians. This is a difference that the politicians and the statist media tend to ignore. Private citizens are often income producing and even wealthy and quite capable of looking after themselves. Most of them never signed up for all this state debt. It seems beyond doubt to me that the productive part of society – and thus, in the long run, all of society – will benefit greatly when the ever-growing, overspending, taxing, meddling, regulating welfare state finally meets its well-deserved demise in a string of spectacular sovereign defaults. Of course, the political establishment have a vested interest in constantly portraying their financial plight as a massive problem for the entire nation. The Swiss novelist Duerrenmatt famously said that the state calls itself “fatherland” whenever it is set on waging war. It may be added that it does so too when it is set on expropriating more in taxes, or when it debases the money in order to fund its profligate ways.

Remember, the state is not the people! Therefore, embrace default!

What we have learnt in the past weeks.

In any case, even from the comfortable distance of the sunny hills of Tuscany it is clear that the past three weeks must have driven home the following points to even the most starry-eyed Pollyanna out there:

First, this is not a cycle, at least not in the way that it is portrayed so lazily in the mainstream media. It is now four years since the U.S. subprime market nosedived. The economy’s statistical bean-counters (sometimes incorrectly referred to as economists) tell us that the recession ended two years ago. Yet, the Federal Reserve last week promised near-zero interest rates for years to come. Wake up! This is no cycle! We are not just in another economic downturn. This is not just another recession, or even – oh stupid phrase! – a double dip. We cannot say that ‘we have been here before’, and that it will just take a bit longer till we get out. ‘All this great stimulus will ultimately kick-start the economy into higher gear.’ Rubbish! We are witnessing systemic disintegration! A dysfunctional economic architecture – built on the quicksand of ever-expanding fiat money, artificially low interest rates and ever-higher piles of debt – has reached its logical endgame. This is systemic failure, not cyclical fluctuation.

Photographer Graeme Weatherston.

Second, there is no exit strategy. The central banks are firmly boxed in. They are trapped. Back in April, when the ECB enacted its first rate hike and the market commentary was awash with predictions of a coming tightening cycle, I wrote Don’t believe the hype! Why the ECB rate hike doesn’t mean anything. Don’t be fooled by some verbal sabre-rattling and some cosmetic rate adjustments. The ECB cannot and will not remove monetary accommodation. The balance sheet of the central bank will not shrink. It will grow. The ECB will not be allowed to pull the rug from under the European banks and governments. Banks and states can sustain the mirage of solvency only with the help of the ECB’s printing press. I also predicted that the ECB would buy more government bonds. All of this received ample confirmation in recent weeks. The ECB’s statement that it does this to maintain liquid markets and to effectively conduct its monetary policy is such a laughably thin-veiled attempt at keeping face that it borders on insulting our intelligence.

Paper money systems are always creations of the state, and fiat money is always a tool of the state. Hence, ‘central bank independence’ is always an oxymoron but never more so than when the paper money inflation is reaching its tipping-point and the printing press becomes the last line of defence against sovereign default and bank collapse.

Even the U.S. Fed, among the major central banks the most enthusiastic monetary inflationist and blower of bubbles, a few months ago enjoyed a brief spell of openly contemplating a return to tighter money. That moment has clearly passed. After the events of July and early August, we know that Wall Street will now have to be continuously funded at zero cost, and that QE3 is practically around the corner.

Third, it is now all but official that the major states are bust. Public finances are firmly beyond repair. The modern state – legitimized by electoral majority of the one-man-one-vote type and endowed with the privileges to tax all income generators in its territory and to print money without limit – cannot live within its means, it cannot shrink and it cannot save. It is destined to become ever bigger, until it chokes on its own inconsistencies. If you needed any evidence it was provided by the childish theatre of the U.S. debt-ceiling debate, the outcome of which had never been in doubt. U.S. politicians agreed with themselves that they were not broke and that they could spend more. Anybody surprised? The so-called spending cuts that resulted from all those tough negotiations are simply a bad joke. The U.S. state machinery has casually accumulated another $ 2.7 trillion in debt over the past 2 years, yet those at the head of this out-of-control Leviathan now give themselves 10 years to cut a mere $2.4 trillion from the ever-growing pile of liabilities. How can anybody outside Planet Washington take this nonsense seriously?

I hear that S&P is getting a lot of flak for cutting Uncle Sam’s credit rating. And they should! AA+? What are they thinking? That is still way to high! U.S. government finances are simply out of control. Not only is Washington unable and unwilling to repay this debt, it will not even manage to stabilize it. By the logic of the modern democratic welfare state, ‘saving’ means spending less than one would like to and has previously decided to.

So, to summarize, there is no recovery, no exit strategy and no fiscal stabilization. Debt accumulation continues, increasingly funded via central bank debt monetization. The system staggers on, increasingly relying on the printing press. Needless to say, I feel entirely vindicated. I may also add that this is just the beginning.

What have markets learnt?

So much for the backdrop of fundamentals, now let’s have a look at markets. Here the picture is more mixed. Some markets behaved as I would have expected, others continued to defy logic -my logic at least – completely.

Not surprisingly, the race to the bottom among the world’s major paper currencies continued. Gold – the oldest, most international and apolitical form of money – was the winner. All paper monies lost versus gold. Okay, the Swiss franc may be the one-eyed man among the blind. But last week the Swiss policy establishment thankfully reminded us that even the Swiss franc is, at the end of the day, still toilet paper money, even if it is of the super-soft, three-ply variety. “Switzerland needs to print more money!” one Swiss politician demanded, evidently to help the export industry. Again, every form of paper money is a political tool. Gold remains the only self-defence asset in the twilight of the fiat money era. So far so good. So far as predicted.

Additionally, there was a lot of talk of crisis in equity markets, and bank shares in particular got dumped. So my initial reaction was that the inevitability of paper money collapse was finally sinking in. Or was it?

It was my good friend in Switzerland, Tristan Geschex, who set me right. “Detlev, the market is still not trading paper money collapse. Quite the opposite. Look at the bond market! People are buying government bonds. U.S. Treasuries and German Bunds are rallying hard. They are still considered safe havens. People still believe that the big governments can pay their debt or that, if they should need the printing press to repay, that the resulting inflation will be modest and bearable.”

Of course, Tristan was spot on. The system is evidently disintegrating but nobody wants to bet against the system. Portfolio managers do what they always did at times of crisis: look for the protective embrace of the state and buy government debt. In this environment, this seems to be the stupidest of stupid knee-jerk reactions but it is hard to bet against the herd. Governments around the world cannot curtail their spending, so the endgame is default or inflation, probably both. But the financial market lemmings collectively jump into sovereign debt or paper cash, the sure death traps of collapsing paper money systems and even call this ‘de-risking’ with a straight face. Governments go ever deeper into debt, heading towards inflation and default, yet market participants are falling over one another to buy their debt and sell shares in Walt Disney and McDonalds.

No, this does not make sense. It is madness. But old habits die hard. I honestly believe that this can only be explained with today’s predominance in markets of the professional money manager whose number one concern is not to protect the long term purchasing power of the wealth entrusted to him, but to beat some nominal index – and to keep his job. “Hey, nobody ever got fired for buying a government bond.”

The asset management industry does not want to give up the comforting belief that within the vast universe of inflated paper assets it is operating in, there still remains a big and liquid home base to which it can retreat safely at times of turmoil.

The short of the century

Well-connected (Photo by Pete Souza)

Geschex also stresses that the mass of investors is under the spell of the theories provided by the financial elite. They are looking to the establishment for guidance, and who could be more of an establishment figure than Warren Buffett, the billionaire defender of the statist quo, the writer of adoring thank-you-for-the-stimulus-letters to the central government, the gold-sceptic and advocate of higher taxes. Buffett was reported to be really mad at S&P, claiming that the U.S. of A. deserves to be a “quadruple A” credit. Really? Why?

Here is Buffett at his latest boondoggle to celebrate his investment genius at the end of April, on the ability of the U.S. government to service and repay its debt

“Buffett says the U.S. will not “have a debt crisis of any kind as long as we keep issuing our notes in our own currency.”  Inflation resulting from a “printing press” approach, however, is a serious threat.”

Ah, you see? Buffett has some sympathy with my position. What he does not appreciate is that with every day that passes, the printing press approach is the only viable option left. U.S. Treasuries are irredeemable pieces of paper. They will never be repaid with anything of real value. They will instead be serviced and repaid with irredeemable paper money to be produced – as Bernanke himself reminded us – “at no cost and thus practically without limit”.

More and more market participants realize that debt monetization is the next step, yet they seem to think that this is just a naughty but not completely inelegant way to reduce debt. It is just a re-run of the seventies, a period of somewhat higher inflation and bad hair.

This is a misconception. The U.S. Fed has now been actively engaged in debt monetization for some time, providing super-low funding rates for overstretched banks and funding the government’s entire bond issuance directly with the printing press. Has the debt load been reduced? Of course not! This policy has allowed the state to accumulate debt faster than ever before!

At the end of the seventies, Volcker had to step on the brakes to squeeze inflation out of the system. This was root-canal treatment for the economy. Very unpleasant indeed. Today it would be many times more painful. Debt-loads are multiples of what they were then. The financial system is now much more addicted to cheap credit. Nobody will have the guts to do a Volcker now. And with help from the Fed, new debt is being added every day. The addiction is constantly being fed.

The thinking on bonds will have to undergo a paradigm shift. In my opinion, this could happen soon. It could happen any day. It could have happened on the back of the events of the past three weeks but it didn’t. Bill Gross was too soon, and I was too soon in backing him. But when the paradigm shifts, fixed income, in particular government bonds, will be the short of the century. This will mean a massive shift in market behaviour. It will offer an opportunity that is not to be missed.

In the meantime, the debasement of paper money continues.