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For nearly 30 years we
have had two Global Strategies working in a symbiotic fashion that has
created a virtuous economic growth spiral. Unfortunately, the economic
underpinnings were flawed and as a consequence, the virtuous cycle has ended. It is now in the process of reversing
and becoming a vicious downward economic spiral.
One of the strategies
is the Asian Mercantile Strategy.
The other is the US Dollar Reserve Currency Strategy.
These two strategies
have worked in harmony because they fed off each other, each reinforcing the
other. However, today the realities of debt saturation have brought the
virtuous spiral to an end.
One of the two global
strategies enabled the Asian Tigers to emerge and grow to the extent that
they are now the manufacturing and potentially future economic engine of the
world.
The other allowed the
US to live far beyond its means with massive fiscal deficits, chronic trade
imbalances and more recently, current account imbalances. The US during this
period has gone from being the richest country on the face of the globe to
the biggest debtor nation in the world.
First we need to
explore each strategy, how they worked symbiotically, what has changed and
then why the virtuous cycle is now accelerating into a vicious downward
spiral.
 
ASIAN MERCANTILE STRATEGY
The Asian Mercantile
Strategy started with the emergence of Japan in the early 1980s, expanded
with the Asian Tigers in the 90s and then strategically dominated with China
in the first decade of this century.
Initially, Japan's
products were poor quality and limited to cheap consumer products. Japan as a
nation had neither the raw materials, capital markets, nor
domestic consumption market to compete with the giant size of the USA.
To compensate for its
disadvantages, Japan strategically targeted its manufacturing resources for
the US market. By doing this, the
resource poor island nation took the first step in becoming an export economy
- an economy centered on growth through exports versus an economy like the
US, where an excessive 70% of GDP is dependent on domestic consumption.
The strategy began to
work as Japan took full advantage of its labor differential that was critical
in the low end consumer product segment, which it initially targeted.
Gradually, as capital availability expanded, Japan broadened its
manufacturing scope, moving into higher levels of consumption products
requiring higher levels of quality and achieving brand recognition.
Success soon became a
problem as the Yen began to strengthen. To combat this the
Japanese implemented the second critical component of what became the Asian
Mercantile Strategy template. It began to manipulate its currency by
aggressively intervening in the forex market to
keep the yen weak.
Further success forced
Japan to move to a more aggressive forex strategy
to maintain a currency advantage. It was strategically decided that Japan's
large and growing foreign reserves were to be re-invested back into the
US. By buying US Agency and US
Treasury debt instruments it kept the dollar strong relative to the Yen. The
more successful Japan became, the more critical this strategy became. In the 80s Japan dominated global
expansion as it brought US automotive and consumer electronics' manufacturing
to its knees.
By the early 90s the
Japanese labor advantage was quickly being lost to the Asian Tigers because
the Yen versus the Asian Tiger currencies was too strong. The Asian Tigers were following the
Japanese model. The Asian Crisis in 1997 re-enforced to all Asian players the
importance of holding large US dollar denominated reserves. This further
accelerated and reinforced the strategy of purchasing US Treasury and Agency
debt.
With China's acceptance
into the World Trade Organization (WTO), China emerged on the scene in
full force. Armed with the lessons of the last twenty years, China took the
Asian Mercantile Strategy to another level in its ongoing evolution.
The results were one of
the largest and fastest transfers of industrial power ever to occur in
history. In ten years, China
assumed the role of the world's undisputed industrial powerhouse in the world.
The virtuous cycle
further accelerated as Asia became more dominant because its reserves,
reinvested back in the US, began to have a larger and larger impact. The more
Asia bought US Treasury and Agency debt, the lower US interest rates were
forced, allowing Americans to finance more and more consumption. The more
Asia bought US securities, the stronger the US dollar was against Asian
currencies, and therefore the cheaper Asian products were relative to US
manufactured products. It was a self reinforcing Virtuous Cycle.
The result was a
staggering 46,000 factories transferred from the US to Asia over the same 10
year period. The transfer set
the stage for chronic unemployment and public funding problems, but it was temporarily hidden by
equally massive increases in debt spending.
The low interest rate
driven housing bubble, being of historic proportions, made Americans feel
richer than they were. They took on excess debt in various forms such as Home
Equity Loans (HELOCs) at unprecedented levels. The acceleration of debt materially
impacted both the GDP and employment
of the nation through Real Estate, Construction and Mortgage Finance
job growth further hiding underlying problems.
US DOLLAR RESERVE CURRENCY STRATEGY
Since President Richard Nixon took the US off the Gold Standard in
1971, the US has adopted what I refer to as the US Dollar Reserve
Strategy. After the Second World
War, at the Bretton Woods Conference, the US dollar
was accepted as the world's reserve currency and as such was pegged to Gold
at a fixed rate of $35/oz. due to massive Vietnam war costs and President
Johnson Great Society, the US
could no longer honor its agreement.
In 1971, when France demanded conversion payment in Gold, the US
refused. At this point the US become a fiat currency, not backed by anything other
than the full faith and credit of
Washington politicos.
What were other countries to do in retaliation? What quickly became
evident was there was little they could do. The fact was that international
trade was conducted in US dollars as a matter of necessity due to the
dominance of US export trade; and as such, nations were
forced to have US dollars to transact international trade.
Additionally, the US established agreements with oil producing Middle
East countries that oil could only be sold in US dollars. Since energy is a
dominant import cost for most nations, this secured the strategic position
and requirement that the US dollar would be maintained as the preeminent
reserve currency by trading nations.
What this strategy meant to the US was that it could now print money,
and effectively export the potential inflationary consequences of its
actions. The 1970s were initially marked by dramatic increases in US
inflation as the strategy took hold and was implemented. By the time of
President Reagan's presidency, the strategy was working thanks to some
herculean efforts by Chairman Volker at the Federal Reserve. This well
executed strategy is what I refer to as the US Reserve Currency Strategy.
The strategy allowed Regan to implement 'Reaganomics' and his new
Supply Side economic policies which launched the longest bull market in US
history. Further enhanced by an
extremely loose monetary policy under Greenspan, relaxed reserve requirements
under Clinton, and tax cuts under George Bush II,
the US moved quickly from being the world's richest country to being the
world's largest debtor.
Historic debt growth was built up without the disease of inflation
infecting the US economy. This is explained by inflation that was effectively
exported whenever increasing levels of US dollars were printed by the US
Treasury.
Any threat to this strategy was rapidly challenged by US military
power. As an example, when Saddam Hussein, President of Iraq, decided to sell
Iraq oil denominated in Euros, he was invaded by US forces three months later
and removed from power. When Libyan leader Muammar Gaddafi wanted gold in
exchange for Libyan oil, he almost immediately found himself the target of US
planned military intervention.
Presently, oil is still sold only in US dollars, but more and more
trade deals are being negotiated between China and its trading partners. This
is a serious threat to the US and the US Dollar Reserve Strategy.
One of the reasons the
US Reserve Strategy has worked for as long as it has, is because there was an
incentive by other countries to sterilize the US dollars they received. This, in the case of Asia, was because
of the Asian Mercantile Strategy they were executing. By sterilizing US
dollars, they held down their currency's exchange rate, which helped their exports
though creating potential domestic inflation. Until recently, these inflation
pressures have been manageable.
In the case of Europe,
the Euro was only coming into existence in the late 90s, but then quickly
moved from well below par to nearly 1.50 to the US dollar, causing
competitive problems for European export trade for many peripheral countries
(PIIGS).
The Asian Export
Strategy and the US Reserve Dollar Strategy were symbiotic for a number of
reasons:
1. Though the Asian Export Strategy was an Export Trade
Imbalance game and
the US Dollar Reserve Strategy a Volume Trade game, both were centered on global trade.
The US won by increased global trading and the growing requirement for the US
dollars it required - dollars that could be increased to pay for the military
industrial complex without increasing taxation and used as reserves for
global banking growth. Asia won by getting an ever increasing share of a
growing volume of trade.
2. The US as a 70% consumption economy needed cheap
financing to sustain its insatiable consumption. Asia needed consumption to
absorb its growing exports.
3. The US needed a strong dollar to attract financing
for its debt. Asia saw US debt as a store for its growing reserves that
additionally reduced financing costs for its export products. In a way Asia
was offering a form of vendor financing or 'lay away' financing.
4. US corporations saw 'off-shoring', 'outsourcing' and
'rightsizing' as major productivity improvements. The Asian Mercantile
Strategy offered American corporations an opportunity to significantly
increase profitability while Asia needed every increasing and larger market
segments to penetrate. US corporations brought know-how, branding and capital
to the Asian economies who desperately needed these
strengths to employ unskilled populations, increase standards of living and
reduce the always present and potential social unrest.
5. The US economy which had shifted from an industrial
economy to a services economy was quickly becoming a financial economy with
44% of the stock market being financials. The financial economy needed
increasing capital inflows to sustain itself.
WHAT HAS CHANGED
So what could possible
stop this ideal symbiotic relationship from continuing to feed on itself?
A number of factors,
all of which are now coming together to end this Virtuous Cycle.
I recently authored a
paper entitled Debt Saturation & Money Illusion , that if you have not read, I encourage you to read
since it would take up too much space here. It makes the case that the global
economy has reached the point where annual debt costs are now outstripping
the global economy's ability to support the exponentially increasing burden.
Additionally, stimulus
spending by governments has now reached the point where it is actually
counterproductive.
The above chart shows that even using government numbers for inflation
(which are disgracefully inadequate and understated) the real rates in the
old industrialized economies are negative. By contrast, rates in emerging
economies are positive.
This means central banks are effectively paying banks to take money,
yet commercial banks cannot find sufficient investments to actually absorb
the money. Like pushing on a
string, the global economy simply cannot absorb debt at the levels required
to sustain required growth rates which must exceed inflation rates.
The level of nonperforming bank assets is growing at such a rate that
global banks have serious concerns with their existing loans and potentially
their own solvency.
Growth in Non
Performing Bank Loan Levels is shown below.
MALINVESTMENT
I found a recent
article entitled: Technology firms struggle to cover interest payments in the Korean Times to be very instructive. Despite
Asian economies growing rapidly and now dominating the global electronics
industry, the study by the Korean Times found alarmingly that:
a.
One in three firms traded on the Kosdaq stock exchange failed to earn sufficient money to
cover their interest payments in 2010.
b.
280 out of 876 Kosdaq-listed
corporations, or 32 percent, could not reach the benchmark reading of one in
the interest coverage ratio. The interest coverage ratio, otherwise dubbed
times interest earned (TIE), refers to the measure of a firm’s ability
to honor its debt payments.
This is classic
mal-investment in the truest sense of the Austrian School of Economcis.
Corporations now have
balance sheets so leveraged with debt that their business models are barely
able to cover debt payments even when interest rates are at historic lows.
What does this suggest for possible debt default and forced unwinding going
forward?
Private Equity
corporations with leveraged takeovers and buyouts dominated the US financial
landscape for years. These takeovers left corporate balance sheets severely
damaged and barely able to pay the debt burdens they were forced to assume.
Additionally, we have
learned since the days of Enron, there are significant amounts of debt held
off balance sheets today in Special Purpose Entities (SPEs). There is no
investor transparency to these obligations. This debt and other forms of
'contingent liability' reporting presently allow corporations to assume ever
larger amounts of debt without impacting their corporate credit ratings.
Everything works fine until growth slows.
Corporations over the
last decade are acting more as highly leveraged hedge funds with the
consequential exposure of margin or collateral calls. This is a highly risky
and unstable situation in the longer term.
Another factor causing the unwind is a tapped out US consumer. This has been forecast for over a
decade as an eventuality, but the US consumer continued to surprise everyone
with their willingness to consume and take on debt. However, since the 2008 financial
crisis things have changed. The US real disposable income has fallen and US
consumer debt loads are now impacting their ability to consume.
Consumption growth
rates in the US have slowed. The
Asian economies have consumption rates below forty percent. The consumption
growth rates of these Asian economies, though growing, are increasing from a much smaller
absolute size. This imbalance is placing further pressures on the symbiotic
relationship.
Slowly, the cycle is
reversing. What was once a virtuous cycle is now a potentially vicious downward
spiral.
The death knell for the
cycle will be:
1. A deteriorating
US dollar,
2. Rising US interest rates,
3. Sustained and chronic US unemployment,
4. Asian inflation, especially in food where 60% of
Asian disposable income is spent.
5. Pressures on Asian currency pegs
6. Collapsing values of US Reserve holdings.
BERNANKE'S BOX
I recently published another
paper entitled BERNANKE'S QEx BOX! where I argued what Chairman Ben Bernanke was
likely to do at his critical April 27th FOMC 'Signal' meeting. I was proven right as he delivered
precisely on cue. It was not a difficult call.
The reason I was so sure
is because the real problem was clear. It is about what the Basel BIS (Bank
of International Settlements) Bankers are more than aware of.
As I point out in Debt Saturation & Money Illusion
, the Shadow Banking liabilities have fallen by $5 Trillion since the
financial crisis, which is a crushing blow to global liquidity and in fact
global financial banking solvency.
An analysis of data by
Fathom Consulting for the US Federal Reserve, the European Central Bank, the
Bank of Japan and the Bank of England, showed their assets swelled from
around $4 trillion at the start of 2006 to just short of $9 trillion by the
end of February this year. The
increase in the size of G4 central bank balance sheets since mid-07 has ALSO
been around $5 trillion to end February 2011, or 8 percent of global GDP.
It is my view that the
Basel BIS Bankers have orchestrated their balance sheet growth to offset the
contracting Shadow Banking System liabilities. For those that are not aware,
Federal Reserve Chairman Ben Bernanke, Bank of England Governor Mervyn King,
ECB President Jean-Claude Trichet and Bank
of Japan Governor Masaaki Shirakawa all sit as Board Members and meet
regularly.
FED'S DUAL TRIPLE MANDATE
To do this the central
bankers have increased their balance sheets to their political limits which
can be seen in the following Federal Reserve chart from Zeal.
In the case of the US
Federal Reserve, this has meant such significant changes that effectively the
Fed's dual mandate has now expanded to three. Besides the official mandates of Full Employment and
Price Stability, a third has been added: Asset Appreciation.
This is clearly evident
when we overlay the above balance sheet growth with US equity market
appreciation, as represented by the S&P 500 in the chart below.
The top of the red Treasury
series (chart above) represents the total Treasuries, MBSs, and agencies the
Fed purchased in its quantitative-easing campaigns. That red line above
is then transferred to the second chart below as total QE.
Superimposed on top of it is the US stock markets as
represented by the SPX (blue). The strong correlation between the
Fed’s monetization and the post-panic stock-market recovery is remarkable,
perhaps even scary.
The Federal Reserve is no longer the "Lender of
Last Resort"
The Federal Reserve is now the "Buyer of First
Resort"
INHERENT LIMITER: INFLATION
There can be little
doubt, despite Federal Reserve rhetoric, that Quantitative Easing
, ZIRP (Zero Interest Rate Policy) and negative real interest rates
have caused a surge in global
inflation rates.
Recently Oil was at a
31 Month high and up 22 percent Year-on-Year. Corn was up 90 percent, Wheat
and Soybeans up 45 percent and
Rice at yet another high.
This inflation has been
acutely felt throughout Asia which has to combat this in parallel with trying
to keep their currencies competitive as part of their Asian Mercantile
strategy.
Across Asia, interest
rates and bank reserve requirements have been increased, and in some instance
capital control restrictions implemented. Pressures are such that many,
including China, are now at the point of surrendering sacrosanct currency
appreciation.
The problem is food
inflation. Food must be imported and a stronger currency would help avoid
consumer sensitive food inflation, at the expense of assisting with its own
export strategy.
Sixty percent of
disposable income in Asia, according to the Asian Development Bank (ADB) in a
major report entitled: Global Food & Price Inflation & Developing Asia, is spent on food. Food is presently expected to average
10 percent inflation in 2011. This has created tremendous pressures on the
population and potential social unrest for Asian governments.
64 Million people have already been moved into the category of
poverty, which the ADB classifies as
below $1.25/day. With 3.5 Billion consumers, it is expected that 190
Million will be pushed into poverty if food inflation continues. Food prices
were up 30% in February's report, so the 10 percent Asian food inflation is
no doubt seriously too low.
 The efforts to fight inflation are now impacting the
7.8% Asian growth rate, which is now demonstrating the expected signs of
slowing.
US Gross domestic
product was recently reported as rising only 1.8 percent from January through
March, after a 3.1 percent pace in the last three months of 2010. Taking out
inventory builds this number as only 0.8 percent.
Britain reported 0.5
percent growth and is now on the edge of a double dip.
The Federal Reserve and
most economists are all revising 2011 GDP growth lower, as a steady stream of
negative news hits the markets.
If GDP numbers were
adjusted for true inflation, rather than the suspect government CPI
distortions, real GDP would be negative. Considering government deficit
spending is now 20-25 percent of the US economy, can there be any question
that we have effectively very negative economic growth?
The Basel BIS Bankers
are acutely aware of this.
So what is to be done?
I believe a decision has been taken to temporarily
remove some of the pressures off increasing money supply before resuming
expansion of money and credit later in Q3 or Q4. There is little choice.
Make no mistake about it however, central bank money
printing must continue and at an accelerated rate. I suspect it will emerge not as QE
III, but in another form to address the massive and growing problems with
non-performing assets, foreclosures and REOs occurring at Fannie, Freddie and
the FHA.
Don't get fooled. Watch the balance sheets of the
central banks. They will by necessity continue to grow to stop the vicious
spiral from accelerating.
The Basel BIS Bankers
fully understand the underpinnings of the shift from a Virtuous Cycle to a
Vicious Spiral presently underway.
They are doing
everything within their power to offset it. Policies of "extend and
pretend" and "kick the can down the road" are all just
attempts at buying time.
Unfortunately time is
working against them, as existing debt only increases as interest owed is
relentlessly and cumulatively added.
The Basel BIS Bankers
have no real answers. The eventuality of a fiat currency crisis is ordained
and has been since the early warnings in 2007 of the Financial Crisis. The
roadmap has been clear to all that actually wanted to look.
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Global Macro
Issues for non-mainstream listeners looking
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Gordon T. Long
Tipping
Points
Mr. Long is a former senior group
executive with IBM & Motorola, a principle in a high tech public start-up
and founder of a private venture capital fund. He is presently involved in
private equity placements internationally along with proprietary trading
involving the development & application of Chaos Theory and Mandelbrot
Generator algorithms.
Gordon T Long is not a registered
advisor and does not give investment advice. His comments are an expression
of opinion only and should not be construed in any manner whatsoever as
recommendations to buy or sell a stock, option, future, bond, commodity or
any other financial instrument at any time. While he believes his statements
to be true, they always depend on the reliability of his own credible
sources. Of course, he recommends that you consult with a qualified
investment advisor, one licensed by appropriate regulatory agencies in your
legal jurisdiction, before making any investment decisions, and barring that,
you are encouraged to confirm the facts on your own before making important
investment commitments.
© Copyright 2010 Gordon T Long. The information herein was obtained
from sources which Mr. Long believes reliable, but he does not guarantee its
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