Sound or Unsound?

by Doug Noland

June 13, 2014 



Add meltdown in Iraq to the long list of geopolitical risks.

As follow-up to last week’s quarterly flow of fundsanalysis, I’ll take a brief look at the Rest of World (“ROW”) category. ROW now holds an incredible $22.971 TN of U.S. Financial Assets. To put this number into some perspective, ROW holdings began the nineties at $1.874 TN. Ballooning U.S. Credit and attendant unprecedented Current Account Deficits saw ROW holdings surge $4.335 TN, or 230%, during the nineties. Over the past 22 years, ROW holdings of U.S. Financial Assets have inflated $21 TN, or over 1,000%. Essentially, the U.S. has unrelentingly flooded the world with dollar balances. This helps explain a lot.

The consequences of the massive inflation/devaluation of the world’s reserve currency have for a long time been readily apparent. For starters, our huge trade deficits with Japan and U.S. pressure for the Japanese to stimulate domestic demand played a prevailing role in Japan’s fateful late-eighties Bubble. The Greenspan Fed’s early-nineties stimulus measures then supported the inflation of myriad foreign Bubbles, certainly including Mexico 1992-1994. The Mexican bailout then ensured catastrophic Terminal PhaseBubble excess throughout the Asian TigerMiracleEconomies in 1996. An unstable global financialsystemnurtured serial major Bubbles, including Russia, Argentina, Iceland, Brazil, etc. throughout the nineties.

After ending the ‘90s at $6.209 TN, ROW holdings of U.S. Financial Assets doubled (again) in just over six years. The mortgage finance Bubble period (2002-2007) saw ROW holdings surge $8.7 TN, or 116%, to $16.2 TN. It’s my view that the historic dollar devaluation during this period played a major role in precarious Bubble excess throughout the Eurozone (especially at the periphery). The crisis year 2008 saw U.S., European and global financial chaos. During that year, ROW holdings dropped an unprecedented $813bn to $15.386 TN.

In the 21 quarters since the end of 2008, ROW holdings have jumped $7.585 TN, or 49%. The world was once again literally flooded with dollars. The global government finance Bubble thesis posits that these dollar balances (coupled with speculative flows) inundated the emerging markets, fueling unprecedented Credit expansion, financial Bubbles and economic malinvestment. China, in particular, succumbed to Bubble Dynamics on an historic scale.

I have what should be a rather basic question: Is global finance sound or unsound? Is contemporarymoney” and Credit sound? The issue of sound money and Credit has occupied a lot of thinking and written pages over centuries. Today, everyone seemingly couldn’t care less. Anyone that argues against conventional thinking on the subject is considered a wacko.

Back in 1999 everyone was crazy bullish and there was the outward appearance of a New Age miracle economy. I didn’t buy into the exuberance for one simple reason: It was obvious to me that the underlying finance fueling the boom was unsound. In late-2007, with stocks at record highs and the economy and markets trumpeted for their impressive resiliency, I was convinced a major crisis was imminent. Why? Because there was absolutely no doubt that the underlyingmoney” and Credit was alarmingly unsound.

So, here we are in mid-2014. The financial mania is back, bigger and bolder than ever. U.S. and global markets are again lauded for resilience in the face of myriad issues. Here at home, it’s Miracle Economy 2.0. Meanwhile, the underlying finance driving the boom is the most unsound and dangerous ever. It’s as clear to me today as it was in 1999 and 2007.

It’s curious that the issue of unsound money and Credit is not today central to the economic debate. After all, history is unequivocal. Unsoundmoneyensures financial, economic and social instability. It guarantees problematic price instability, deep structural economic impairment and income and wealth inequalities. Especially after the 2008 crisis, one would think the sound money debate would be front and center. Yet somehow the doctrine of inflationism completely dominates economic curriculums, thinking, policy and discourse. The specious doctrine that deflation is the overarching risk goes unchallenged.

Simplistically, the consensus view (doctrine) holds that the financial system and economy are best served by inflation (CPI) rising steadily at a rate of two to three percent annually. A little inflation is thought to grease the wheels. A steadily rising price level is believed to ensure that the economy can consistently grow out of potential debt problems. This fallacy is highly pertinent and should be addressed.

In a closed economy with generally stable finance and economic output, one might make a believable case for the benefits of steady annual 2-3% inflation. But especially during the past 25 years, we’ve seen major developments that wreak havoc on simple models and premises

Globalizationensures the closed system model is invalid. There have been as well myriad profound changes in the nature of economic output. The technology revolution, the proliferation of services throughout the economy and the rapid growth in healthcare are just the most obvious areas that have profoundly altered the nature of economic outputalong with the ability of contemporary economies to readily boost the supply of things (absorbing purchasing power). Moreover, the past 25 years have been a period of extreme financial innovation.

I have argued that it is a myth that contemporary central bankers control CPI (for starters, they don’t control Credit/purchasing power or output). Indeed, if they strive for 2-3% annual inflation these days they will ensure acute financial and economic instability. In the U.S., 2-3% inflation equates with flooding the world with dollar balances and devaluing the world’s reserve currency. Moreover, modest consumer price inflation equates with a massive inflation of Federal Reservemoney” – liquidity that has profoundly altered risk perceptions, asset prices and market behavior throughout the system. As we’ve seen with 18 months of QE3, 2% consumer inflation can equate to 30% stock market inflation and double-digit price gains in national home price indices. Two percent CPI has equated with an unprecedented flow of finance into higher-yielding securities, instruments and products, in the process fueling a massive mispricing of corporate debt. Modest inflation (“stable prices”) has equated with virulent monetary disorder across the globe.

China international reserve assets have surged $700bn over the QE3 period to a record $3.948 TN. It is worth noting that Chinese reserves began 2002 (start of mortgage finance Bubble) at about $200bn. In many ways, the Chinese Bubble is the mirror image of the U.S. Credit Bubble. China is today also at the epicenter of unsound global money” and Credit. It is my view that if not for the massive inflation of U.S. Credit (dollar devaluation), it would have been impossible for the Chinese Credit system to have operated without any constraint for so long. Unfettered cheap Chinese finance has allowed massive overinvestment throughout scores of industries (not to mention apartment units!). The world now faces the consequences: “disinflationarypressures on many things as well as the specter of major unfolding Chinese financial issues.

June 13 – Wall Street Journal (Daniel Inman, Fiona Law and Enda Curran): “The commodity-backed loans at the center of a probe into an alleged financial scam at a Chinese port are part of a ramp-up in offshore borrowing by Chinese companies that Beijing is looking to tamp down. As Chinese authorities tightened credit at home in the past year, local firms instead looked abroad for financing. Asian-Pacific banks alone had $1.2 trillion in loan exposure to China at the end of 2013, up two-and-a-half times from 2010, according to Fitch… A chunk of the borrowing has been by Chinese firms taking out short-term overseas loans backed by commodities, part of an effort to lock in gains by borrowing offshore at lower rates, and investing the money at higher rates on the mainland. This lending has complicated Chinese policy makers’ attempts to slow rapid credit growth in the nation's so-called shadow banking sector… Foreign banks have stepped up commodity-backed lending to China in recent years, a profitable business that now is looking increasingly shaky.”

I cannot blame all the world’s problems on unsound U.S., Chinese and global finance. The frightening unfolding Shia vs. Sunni debacle in Iraq and the Middle East obviously predates Western central banking, the dollar reserve system and unconstrained finance. Yet I look around the world and see initial consequences of the world’s greatest episode of unsound finance and financial mania. Asia is a tinderbox, and I fear that Chinese leadership will be tempted to lash out as their Bubble deflates. I look at Russia and the ongoing Ukrainecrisis and I see deep Russian animosity towards their view of U.S. dominated global finance and economic arrangements. It seems obvious to me that Russia, China and others will increasingly see it in their best interest to change the “world order.”

I am an analysts and not a pessimist. I actually have an optimistic nature. Without it I wouldn't be able to do what I do – including chronicling the world’s greatest Credit Bubble on a weekly basis for about 15 years.

But I look around the world today and am more worried about the future than ever beforeIraq, the Middle East, China and Asia, the emerging markets, Europe, Ukraine and Russia. The “social mood” is sour at home and abroad. Animosity. Anti-Americanism. Anti-Capitalism. Fragmentation. Conflict.

Compounding the problem, I see wildly distorted global central bank-induced Truman Show securities markets. I see a mirage of prosperity fueled by surging values of all kinds of financial (and real) assets. And I see endless electronic debit and Credit entriescontemporary finance – that is supposed to equate with unprecedented global wealth. Yet there’s a massive gulf between perceived and real wealth. I see incredible bullishness and denial in the face of deep structural issues for both U.S. finance and our economy. I see the mirage of U.S. prosperity dependent more than ever before on highly accommodating central bankers and unending bull markets. I just don’t buy the view of the U.S. as an oasis of prosperity impervious to global degradation.

On an almost globalized basis, there is this very troubling divergence between highly speculative and inflated securities markets - and a really uncertain future. I’ve argued that central bankers can’t make things better – that their monetary inflation only makes things worse

It seems obvious that a most protracted period of unsoundmoney” has created one hell of a mess. As for geopolitical risk, Ukraine and Russia remain issues. Asia is an accident waiting to happen. And, now, instability in the Middle East risks a blowup that could wreak havoc on global energy markets not to mention a horrific human tragedy.


June 13, 2014 12:13 pm

Investor distrust drives rise in cash holdings



It is an immutable truth of investing that you should sell at the top and buy at the bottom. And it is almost as immutable a truth that most of us do exactly the opposite, buying at the top and selling at the bottom.

Professional investors are prone to this. But nobody suffers it worse than retail investors. Over history, they tend to be sucked in at the top of a bull market, turning optimism into euphoria; and to give up just when all hope has been lost and the foundations for a fresh rally have thus been built.

In the US, mutual funds took in $259.5bn in 2000, when the market peaked and crashed. In 2002, a great time to buy on the verge of a strong recovery, investors removed $24.7bn.

These basic facts are well known. They do not necessarily suggest that retail investors are stupid. At market bottoms, families tend to be cash-strapped. It is harder to put money away in long-term stock plans. Stock markets, in which only the affluent can participate, become an engine to drive inequality even further.

One new survey suggests the problem is even worse in this post-crisis environment. This bull market has endured for more than five years but has not made people happier.

The reason, it appears, is that many stayed out of the market. Indeed, as the rally has continued, the proportion of savings that investors park in cash has significantly increased.

That is the core finding of a survey of retail investors in 16 countries by State Street. Globally, retail investors have raised their cash allocations from 31 per cent in 2012 to 40 per cent in 2014. In the US, where rising share prices should directly reduce the share of cash in portfolios, cash allocations jumped from 26 to 36 per cent.

This cannot be attributed to retiring baby boomers. Millennials, under the age of 33, increased their allocations to cash just as fast as boomers, aged 49-67.

Japan had the highest cash allocation at 57 per cent, so a jaded public failed to enjoy the stock market boom sparked by Abenomics. This also implies that the rise in asset prices will not have the hoped-forwealth effect” and prompt consumers to spend more.

So not only do investors distrust the market, but their distrust has also grown as the rally has continued. Why? To quote State Street, “the crisis of 2008 is burnt into their memories”. After two sell-offs in 15 years, younger investors simply do not trust financial companies.

When asked their best investment to date, easily the most popular was “land or property”. It outstripped equities, bonds, commodities and mutual funds. And two-thirds said their best investment had been entirely” their own decision, speaking volumes of their distrust of financial advisers.

To be clear: there were good reasons to distrust this rally, which has been driven by the aggressive monetary policy of the US Federal Reserve. But a prudent strategy would keep putting some cash into the stock market, just for diversification. As stocks have risen far faster than bank deposits, it is hard to see any good reason for cash reserves to rise in this way.




Other results speak badly both of consumers and of their advisers. Some two-thirds of investors globally said they did not know the fees they paid for their investment because it was too difficult to find out.

Most spent more time reading free catalogues than reading investment statements. Almost two decades after Arthur Levitt, then head of the US Securities and Exchange Commission, attacked the prose in mutual fund prospectuses for “flowing like peanut butter”, basic communications to retail investors are no better.

There are two powerful implications for people in financial services. The first is that nobody trusts them. Trust, even more than credit, is the essential lubricant for capitalism, so this is a serious problem. Governments and regulators might help bankers and fund managers regain trust by staging a genuine reckoning for the crisis and punishing those financiers who deserve it. That could leave the industry with a cleaner slate than it has now.

The second implication is rosier. If retail investors are still in cash, and do not believe this rally, then the bull market has longer to run, even though stocks are already expensive. For years now, the greatest reason for optimism has been that so many remain dubious. If so much has stayed in cash, then greed has not yet swamped fear and an overpriced stock market has not yet turned into an exuberant bubble.

That could yet happen if, as in 1999 and 2000, retail investors at last decide to flock into stocks.

It is not inevitable. The Bank of England’s warning that the UK could see rate rises earlier than expected is a reminder that the Fed could do the same and suck life out of the stock market. What appears to be turning into an outright war in Iraq, not at all on investors’ radar screens even weeks ago, could also change the calculus.

But if retail investors still have so much in cash, then the conditions for a future stock marketmelt-upare in place.


Copyright The Financial Times Limited 2014


The Infrastructure Solution

Martin Neil Baily, Robert Palter

JUN 11, 2014

Newsart for The Infrastructure Solution

TORONTOInfrastructure, by the nature of the word,” former US Secretary of State Madeleine Albright said in February 2013, “is basic to the functioning of societies.” And yet infrastructure has arguably been the forgotten economic issue of the twenty-first century. Indeed, failure to make the right infrastructure investments has impaired many countries’ potential to boost economic growth and employment.

Though the debate about infrastructure tends to focus on the need for more money and more creative financing, the real problem is not insufficient investment. Rather, the built environment is deteriorating as a result of a fragmented approach to infrastructure planning, finance, delivery, and operation, which emphasizes cost, asset class, and geographical location.

Developing a new approachbased on a broad, systemic perspective – should become a top priority of those with the capacity to deliver change, including CEOs and senior public officials. That is precisely what McKinsey’s Global Infrastructure Initiative, which held its second meeting in Rio de Janeiro last month, aims to do, by promoting practical global solutions aimed at raising the productivity and efficiency of every aspect of infrastructure.

Without such solutions, an estimated $57 trillion of infrastructure investment would be needed in 2013-2030, just to keep pace with GDP growth. That is more than the value of the entire existing stock of infrastructure.

More productive infrastructure could reduce the world’s infrastructure bill by 40%, or $1 trillion annuallysavings that could boost economic growth by about 3%, or more than $3 trillion, by 2030. This would facilitate higher infrastructure investment, with an increase equivalent to 1% of GDP translating into an additional 3.4 million jobs in India, 1.5 million in the United States, 1.3 million in Brazil, and 700,000 in Indonesia.

Increasing infrastructure’s productivity begins in the planning phase. A more pragmatic approach to selecting infrastructure projects in which to invest – including a systematic evaluation of costs and benefits, based on precise criteria that account for broader economic and social objectives – could save the world $200 billion annually.

Some countries are already reaping the benefits of such an approach. South Korea’s Public and Private Infrastructure Investment Management Center has reduced infrastructure spending by 35%; today, officials reject 46% of the proposed projects they review, compared to 3% previously.

Similarly, the United Kingdom established a cost-review program that identified 40 major projects for prioritization, reformed overall planning processes, and then created a cabinet sub-committee to ensure faster delivery of projects, thereby cutting infrastructure spending by 15%. And Chile’s National Public Investment System evaluates all proposed public projects using standard forms, procedures, and metrics – and rejects as many as 35%.

Additional opportunities for savings – to the tune of $400 billion annuallylie in more streamlined delivery of infrastructure projects. There is massive scope to accelerate approvals and land acquisition, structure contracts to encourage innovation and savings, and improve collaboration with contractors.

In Australia, the state of New South Wales cut approval times by 11% in just one year. And one Scandinavian road authority reduced overall spending by 15% by updating design standards, adopting lean construction techniques, and taking advantage of bundled and international sourcing.

Opportunities to save are not limited to new capacity. Governments could save $400 billion annually simply by increasing the efficiency and productivity of existing infrastructure. For example, smart grids could cut power infrastructure costs by $2-6 billion annually in the US, while reducing costly outages.

Similarly, intelligent transportation systems for roads can double or triple the use of an assettypically at a fraction of the cost of adding the equivalent in physical capacity. The UK’s intelligent transport system on the M42 motorway has reduced journey times by 25%, accidents by 50%, pollution by 10%, and fuel consumption by 4%.

Congestion pricing can also reduce the need for new capacity, while providing significant savings in terms of fuel costs and time. Such a charge has enabled the City of London to cut congestion by 30%.

None of these solutions is particularly earth-shattering. They simply require a less fragmented approach within government, and more cooperation between the public and private sectors.

This goal is achievable in rich and poor countries alike. Switzerland’s Department of the Environment, Transport, Energy, and Communications, for example, incorporates national goals, set by the Federal Council, into a unified infrastructure strategy that accounts for the needs of specific sectors. Likewise, Rwanda’s Ministry of Infrastructure coordinates the activities of other ministries and public agenciesensuring that infrastructure strategies align with the East African Community’s regional integration plans – and monitors downstream delivery and operations.

Governments must recognize that the private sector can provide more than infrastructure financing; it can also offer know-how in the planning, construction, and operation phases. Chile, the Philippines, South Africa, South Korea, and Taiwan are all developing frameworks that expand the role of private players in planning projects.

Infrastructure increases economies’ competitiveness, while providing the physical framework for people’s lives. Policymakers’ goal should be to ensure that infrastructure realizes its full potential, so that the people who depend on it can realize theirs.


Martin Neil Baily, Chairman of the US President’s Council of Economic Advisers under Bill Clinton, is Bernard L. Schwartz Chair in Economic Policy Development at the Brookings Institution.

Robert Palter, a McKinsey director, is the global leader of McKinsey’s Infrastructure Practice.