Ready For Year-End Fiscal Cliff Drama?

by Doug Noland

November 30, 2012

It’s imperative to constantly test one’s thesis – in my case, an unconventional view of the world of finance, the markets and the global economy. Does one’s analytical framework help explain system behavior? Of course, various perspectives come replete with biases, blurry vision and potentially perilous blind spots

Often it is too easy to simply see what one wants to see. At the same time, a sound framework and proper perspective create the opportunity for more objective analysis. I’ll add that history has shown that this all becomes keenly relevant during manias.

The U.S. stock market has more than doubled from 2009 lows. Financial conditions seemingly couldn’t be looser. November saw a record $165bn of U.S. corporate debt issuance. This year will see near record corporate debt sales. Junk bond issuance will be a new all-time high. System Credit growth will be the strongest since 2008. Recently, consumer confidence has jumped to a four-year high. The nation’s housing markets are showing signs of life. GDP would be generally OK, except for the matter of the unprecedented fiscal and monetary excess necessary to generate such limited economic expansion. 

The conventional bullish view holds that 2008 was the proverbial100-year flood.” A new secular bullish cycle has commenced that will, again, prove the naysayers wrong. The bullish view holds Dr. Bernanke’s unrelenting monetary stimulus in high regard. And while most would claim they prefer an end to fiscal profligacy, most also hold to the notion that actual fiscal tightening should be done gradually so as to not impinge the fledgling recovery. There will be a more opportune time to address fiscal issues later. Ongoing fiscal and monetary stimuli are viewed as essential for bolstering a post-Bubble economy buffeted by various headwinds from home and abroad.

The bearish thesis perspective sees things altogether differently. Fundamentally, I disagree with the post-Bubble backdrop premise - and not for the first time. When Dr. Bernanke emerged onto the scene back in 2002 to fight so-called post-Bubble deflation, it was clear to me that aggressive monetary stimulus would inflate the incipient mortgage finance Bubble. 

It became clear in early-2009 that even more incredible fiscal and monetary stimulus would inflate the fledglinggovernment finance Bubble.” And with today’s confluence of years of Trillion dollar deficits and historically inflated bond prices, the benefit of the doubt belongs with the Bubble thesis

It was another eventful week in the realm of the global government finance Bubble. Here at home, we’re now 31 short days (counting holidays!) from dropping off the “fiscal cliff.” This predicament has been on the horizon for many months, though it’s obvious that Washington has not been dealing seriously with this issue. And while pundits have been quick to explain that both sides are merely posturing, it appears that last minute negotiations are beginning with both sides somehow miles apart

The democrats are emboldened, while the republicans are no less determined. One side is focused on increasing taxes on the wealthy, the other on spending cuts. In a world of deep philosophical and irreconcilable differences, it has all the makings of a tense year-end drama

From my distant vantage point, I (“master of the obvious”) see a low likelihood of meaningful spending restraint. The serious entitlement spending issue will, not unexpectedly, be left for another day – and then another

Even republican proposals have most so-calledsavings” occurring a decade out. Not surprisingly, at least from the “government finance Bubbleperspective, the previous huge inflationary surge in federal outlays has essentially become today’s new baseline. Off the table. Non-negotiable. Instead, “cuts” are basically commitments to somehow - and in some undetermined ways - reduce future (generally 10-20 years) expenditure growth.

Not coincidently, dysfunctional fiscal policy was conjoined this week with dysfunctional monetary policy. Clearly, serious fiscal restraint will not be forthcoming until the markets forcibly squeeze it out of Washington. The bond and stock markets should today be pressuring the Administration and Congress – yet that’s not in the cards with the Fed talking $85bn of monthly QE starting in January. 

This week, Bill Dudley, president of the Federal Reserve Bank of New York, joined the ranks of Fed policymakers signaling support for greater monetary stimulus. At the same time, Mr. Dudley confidently stated that “we will absolutely take away the punchbowl when the time is right.” Well, I can state with confidence that the Fed absolutely won’t. Factually, the Federal Reserve repeatedly hasn’t (i.e. 1988, 1993, 1999, 2005/’06).

Tuesday from Paul Volcker (CNBC interview): “It’s [when to remove stimulus] a very hard judgment to make. Sometimes you’ll be wrong. But you’ve got to-- I think that is the chronic problem of any central bank because the implication is you have to begin tightening before the excess demand, before the bubbles, before the inflationary process is under way because it’s more difficult if you’re too late. But if you do it, by definition, people are going to complain. ‘Why are you removing the proverbial punch bowl before the party’s really gotten drunken?’ But that’s what a responsible host does. He waters the punch bowl in time.’”

I respect Mr. Volcker. He is among a select very few with real inflation-fighting credentials. Yet I also don’t believe he recognizes the nature of current inflationary manifestations. Mr. Volcker warns of the need for reducing stimulus before the “inflationary processcommences, without appreciating the monetary Bubble already unleashed by profligate Federal spending coupled with profligate Federal Reserve monetary policy. Dudley, Volcker and others can surmise a timely removal of the punchbowl, yet I recall Mr. Henry Kaufman arguing convincingly back in 1999 that there would be severe consequences associated with the Fed having badly missed its timing. Little did we know at the time

My thesis remains that we are at the late-stage of a historic multi-decade global Credit Bubble. At its core, this monetary fiasco is about a failed experiment with unconstrained global electronic-based finance. Using history as a guide, Credit Bubbles and associated manias tend to turn highly unstable near a cycle’s end. From an inflationary cycle perspective, one can expect increasingly desperate policy measures in a fateful effort to sustain the unwieldy Credit boom. One would also hope to see more vocal dissent from those opposing a further ratcheting up of monetary inflation.

Last week, I profiled a refreshingly hawkish view espoused by Jeffrey Lacker, President of the Richmond Fed. I was encouraged further by similar thinking this week from another prominent Federal Reserve official. 

Tuesday from Bloomberg (Stefan Riecher and Aki Ito): “Federal Reserve Bank of Dallas President Richard Fisher said he advocates putting limits on U.S. quantitative easing. The Fed could announce ‘a limit as to how much we are going to acquire of treasuries and mortgage-backed securities, say up to a limit of X, up to a point where our balance sheet reaches that,’ Fisher said… ‘It is my personal preference to do it sooner than later, perhaps at the next meeting.’ Fed officials plan to meet Dec. 11-12 to assess whether record accommodation is fueling economic growth and reducing 7.9% unemployment, and to debate whether to extend the Operation Twist stimulus plan, which expires next month. Fisher… has been among the most vocal Fed officials against more easing. Fisher said there are lessons to be drawn from Germany’s experience of hyperinflation during the 1920s. While today’s situation is different and he wasn’t suggesting accommodative monetary policies would lead to inflation, Fisher said they can’t be left in place forever. ‘There is no such thing as QE infinity,’ he said. ‘QE infinity gets you into trouble.’”

One can hope that perhaps the more responsible Federal Reserve officials have seen just about enough. Despite loose financial conditions, booming debt markets, strong/speculative risk markets, massive federal deficits and robust system-wide Credit growth - the dovish contingent is nonetheless hell-bent on significantly boosting its “money printingoperations. After Mr. Lacker’s speech and Mr. Fisher’s comments, I was hopeful that the December 11/12 FOMC meeting might provide the venue for the hawks to finally take a stand. This hope was crushed (like a bug) at 3:24 pm Wednesday with the posting of Jon Hilsenrath’sFed Stimulus Likely in 2013 article on “Three months after launching an aggressive push to restart the lumbering U.S. economy, Federal Reserve officials are nearing a decision to continue those efforts into 2013 as the U.S. faces threats from the fiscal cliff at home and fragile economies elsewhere in the world.”

Hilsenrath’s article generously quotes ultra-doves John Williams (SF Fed pres.) and Charles Evans (Chicago Fed pres.). It mentions the views of Bernanke, Yellen and Lockhart (Atlanta Fed pres.). Curiously absent, however, was any reference to Lacker or Fisher. Not a peep of any internal debate regarding the size of the Fed’s balance sheet. The article instead implied the decision to loosen further had all but been made: additional QE begins in January, with total bond/MBS purchases in the neighborhood of $85bn a month. 

After trading down 100 points in the morning, the DJIA closed Wednesday’s session up 107. The dollar, having seemed to catch a Lacker/Fisher bid, reversed sharply lower. “RoRopivoted back toward risk on, confident as ever in the policy-based liquidity backstop. “Fiscal cliffworries? Well, once again, worry ensures more QE. It’s become a bad habit.

From my perspective, there’s ample confirmation that we’re at the wildblow offphase of speculative market excess. Whether we’re late in the party – with markets rather numb to the punchbowl – or whether there’s still more of the manic endgame to endure, only time will tell. But it has reached the point where monetary stimulus has much more impact on the markets than it does on real economies. From a global perspective, the dismal economic news out of Europe is unrelenting. 

From China comes more stories and anecdotes of corruption and financial rot. It is also worth noting that both India and Brazil posted disappointing growth numbers this week, even more notable since both economies have stagnated in the face of ongoing rampant Credit expansion

Also noteworthy this weekparticularly from the perspective of unstable global finance – were two stories highlighting the ongoing difficulties experienced within the hedge fund community:
Tuesday from Reuters (Laurence Fletcher): “Hedge funds’ glory days seem a long way off as they head into a tricky 2013, with bumper profits likely to remain elusive in markets now dominated by political and central bank action. Speakers at the Reuters Global Investment 2013 Outlook Summit said the $2 trillion industry, which has disappointed investors with below-market returns this year and losses last year, faces a headache making money in an environment where markets are choppy and not as buoyant. ‘We’re now (in) a world where we recognize that the ability to make money is a lot more difficult and there aren’t that many people who can do it. There simply aren’t enough, it just doesn’t exist,’ said Saker Nusseibeh, CEO of Hermes Fund ManagersFunds have lost money in two of the four calendar years prior to 2012, according to HFRI. This year the average fund is up just 2.24% to November 23…”

And from Thursday’s Financial Times (Sam Jones): “Dismal Year for Quantitative Hedge Funds.” “Quantitative hedge fund managers are facing up to one of their worst years on record as losses mount for many of the sector’s biggest names.” The article highlighted a noteworthy list of some of the most successfulquantfunds suffering 2012 losses. “Unorthodox monetary policy and widespread political intervention in markets have left many unable to ride trends long enough to make money. Rangebound RoRo” – risk on, risk offconditions have proved particularly tricky for computers to judge.”

I have in past CBBs posited that prolonged aggressive (“activist”) monetary stimulus – and the associated atypicalinflationary process” that has inundated global risk markets with "money" – has created highly speculative/dysfunctional markets and a “crowded tradepredicament. As global policymakers have witnessed diminishing returns from their inflationary measures, they have (as historical experience would have suggested) simply ratcheted up their “money printingoperations. And, again as history has taught us, the consequence has been only heightened financial and economic instability – and greater impetus for additional monetary inflation. Moreover, the deeper Credit Bubble-related maladjustment, the easier it becomes for policymakers to justify only more outrageous fiscal and monetary excess. 

I’ll conclude with an excerpt from David Wessel’s piece from Wednesday’s WSJ: “Fed’s Easing Yields a Hidden Benefit:” 

“The Federal Reserve has been explicit about why it has been holding short-term interest rates near zero and has purchased $2.5 trillion in Treasury and government-backed mortgage bonds to push long-term rates to once-unimaginable lows: Not only does it hope cheap money will make borrowing and spending more attractive to businesses and consumers. It also wants to chase investors out of super-safe U.S. Treasurys and mortgages and into stocks, corporate bonds and other assets riskier than Treasurys. Boosting those prices, the central bank figures, will make households richer, increase the value of collateral that banks hold against loans and encourage executivesalways happier when stock prices are rising—to invest. Chairman Ben Bernanke and his allies at the Fed think all this is working as they had hoped, though they caution regularly that it isn’t enough to resuscitate the U.S. economy nor is it without risks.”

History will not be kind.

Europe’s Economic War of Attrition

Mohamed A. El-Erian

03 December 2012

NEWPORT BEACHI was nine years old when Egypt entered what became known as its “war of attrition” with Israel. During this period of “no war and no peace,” underlying tensions festered, and a fragile tranquility was periodically interrupted by armed skirmishes.
The war of attrition followed the June 1967 war, in which Egypt – to the immense surprise of most of its citizens and the outside world – was soundly defeated. Its air force was crippled and its army was virtually overrun, with Israel capturing the entire Sinai Peninsula.
Positioned on the eastern bank of the Suez Canal, Israel’s army was just over 100 kilometers from Cairo. And, with Israeli jet fighters still controlling the airspace, Egypt’s capital and its major population centers were greatly exposed.
The official narrative reflected little of this. Whether on state television or in government-controlled newspapers – at the time, there was no free press, Internet, or cable newscitizens were reassured that Egypt had regained control of its destiny. But they knew better.
To this day, I remember vividly the sense of general anxiety that prevailed among citizens, accentuated by deep concern about what the future might hold. People were afraid to invest, and many wondered whether they should emigrate in search of a better future.
With the underlying issues left unaddressed, the war of attrition was followed by another full-scale war in 1973 one that again surprised most people inside and outside Egypt. This time, the Egyptian armed forces won a number of early battles and secured a cease-fire that regained part of the Sinai, setting the stage for the 1979 peace agreement with Israel.
I recount this history not to draw a parallel with today’s Israeli-Palestinian conflict, which, just a couple of weeks ago, resulted in many civilian deaths, overwhelmingly in Gaza. Rather, it is because I see too many parallels with what is happening in the European debt crisis.
European citizens – particularly in peripheral economies such as Greece, Portugal, and Spain – are anxious. Unemployment is unacceptably high, and is still rising. Their economies continue to implode, leading to cumulative contractions that are setting tragic new records. Poverty is on the rise.
Not surprisingly, increased emigration to the stronger eurozone countries (such as Germany) has been accompanied by higher outflows of financial capital.
Admittedly, and fortunately, the parallels are far from perfect. Europe does not have armed conflicts. Feelings of intense insecurity are not related to bombs and sirens. The threat is economic rather than military. Yet there is a real sense of “no peace and no war.”
Europe’s economic peace remains elusive for a simple reason: governments have still not found a way to generate the trifecta of growth, employment, and financial stability. The longer this prevails, the more oxygen is sucked out of sectors that remain relatively healthy – and for three distinct reasons.
First, the eurozone economy is extremely interconnected. As such, it is only a matter of time until weakness in one part migrates to other parts. Witness what is happening in Germany, a well-managed country once thought itself immune from the troubles around it. After a period of record low unemployment, economic growth has slowed markedly, reaching just 0.2% in quarterly terms in July-September. On current trends, the fourth quarter’s growth rate will turn negative.
Second, the eurozone’s bailout bill continues to rise. Cyprus is expected to join the other three program countries” (Greece, Ireland, and Portugal) in requiring considerable official financing; and, of the other three, only Ireland is getting close to regaining normal access to capital markets. With Spain also requiring billions more to recapitalize its banks, the contingent claims on taxpayers in the core countries continue to mount. Indeed, this is one of the factors that contributed to Moody’s decision following Standard & Poor’s – to strip France of its AAA credit rating.
Finally, adverse contagion is extending beyond the 17 countries in the eurozone. The region’s debt crisis is undermining cooperation within the larger 27-member European Union, resulting in the spectacular failure of the recent summit on the EU budget. It has also contributed to the economic slowdown in China, raising concerns (which I believe are exaggerated) that the country’s new leadership may have problems engineering a soft landing for an economy accustomed to double-digit (or high single-digit) growth.
This lack of peace would have resulted in outright economic and financial war if not for the critical – and growingrole played by the European Central Bank. Under the bold leadership of Mario Draghi, the ECB has committed to provide as much time as possible for most governments to get their acts together. And it has done so by relying on innovative measures that substitute its elastic balance sheet for those of over-extended governments, gun-shy private investors, and fleeing bank depositors.
Yet it would be a grave mistake to assume that the ECB can deliver lasting economic peace. It cannot. If governments continue to dither and bicker, the most that it can do is delay the war for a while.
Like Egypt’s war of attrition, the eurozone’s underlying economic, financial, and social ferment continues. If governments continue to stumble from one patchwork remedy to another – a probability that remains uncomfortably high – the delay in implementing a comprehensive solution will eventually overwhelm the defenses that the ECB has so courageously put in place.
Some say that, just as Egypt’s war of attrition eventually gave way to a full-scale war and then a peace treaty, Europe needs a major crisis to move forward. But this is a dangerous notion, one that entails not just massive risks, but also unacceptably high interim human costs.
European governments are well advised to use the financial cease-fire that the ECB is willing to buy for them. Allowing it to expire without progress toward permanent stability would expose Europe to disruptions that would diminish significantly its prospects for long-term economic stability, growth and job creation.
.Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment company PIMCO, with approximately $1.8 trillion in assets under management. He previously worked at the International Monetary Fund and the Harvard Management Company, the entity that manages Harvard University's endowment. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, and 2011. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by the Economist.

Copyright Project Syndicate -