If anyone had any doubt about the enormity of the financial crisis gripping the world, look no further than at the amazing conversion of Canadian Prime Minister Stephan Harper and his Finance Minister Jim Flaherty from small c, small government, fiscal conservatives to big spending, big government, deficit hawks. This is not a comment on the actual merits of the budget; merely a note that Harper and Flaherty have joined the bailout world, even if it seems to be with some reluctance.
Trying to get a handle on the size of the bailouts everywhere The Toronto Star printed a "bailout primer" the day after the budget. While it covers only five nations it is illustrative. We summarize much of it below. All figures are US$ billions.
|Canada||United States||United Kingdom||Japan||Germany|
One thing that stands out in these numbers, other than their sheer size, is the massive deficit/GDP ratios of Britain and the US. Numbers like that put both them in the same league as some third world countries and economic basket cases. Granted, if these deficits last only a year or two the damage may be limited, but the recession now underway may last longer and go deeper than most fiscal and monetary authorities may be willing to admit. We haven't noticed anyone forecasting a return to either balanced budgets or surpluses any time soon. Canada's and Germany's deficit/GDP ratio is reasonable under the circumstances.
It is also going to take an enormous amount of new debt to change the situation around. Given that first financial institutions are reluctant to lend to anyone except the most creditworthy and consumers shocked by the decline in portfolios and losing their homes they are going to shift into a saving mode or pay down debt. It is illustrative that since the Great Depression and the War years ended it has taken increasing amounts of new debt to purchase a dollar of GDP. Throughout the 1950's, 1960's and 1970's it basically only took about $1.50/$1.70 of new debt to purchase a $1 of GDP. With the recessions of the mid 1970's and the early 1980's the 1980's saw a huge jump to requiring almost $3 of debt to purchase a $1 of GDP. It remained that way in the 1990's although it was rising slowly.
This past decade has changed the equation once again and it took $5.40 of new debt in the 2000's to purchase $1 of GDP. Given the severity of the decline it will probably take the kind of increase in debt to buy a $1 of GDP that we saw in the 1980's and this decade to once again increase GDP. That means we might have to rise to over $9 of new debt to purchase a $1 of GDP. We can assure you that is not going to happen and would be mind boggling if it did.
Almost universally the fiscal and monetary authorities are saying that their prescriptions of sharply lowered interest rates and massive stimulus will do the trick, and will limit us to a short sharp recession and a quick recovery. We would hate to remind them that if massive spending and sharply lower interest rates were a panacea, then Japan would have come out of its "lost decade" a lot faster. The spending by Roosevelt during the Great Depression did not resolve the depression. It took WW2 to do that. We do not recommend war, but we can't help but note that during the Kondratieff winters there is always a major war.
Speaking of Kondratieff it is appropriate to show our old table of the Kondratieff cycles. The one below centers on the long cycles of the USA, although these cycles could easily be applied to Europe and elsewhere as well. When the depressions hit they were usually international in nature, at least to the extent of what today we refer to as the West - Europe and North America.
|Spring (expansion)||Summer (recession)||Autumn (plateau)||Winter (depression)|
(War of 1812)
("Era of Good Feelings")
(Mexican American War)
(US Civil War)
|1864-1873 ("Reconstruction")||1873-1896 |
(World War 1)
(World War 2)
("The Information Age")
(War on Terror? Or?)
Each autumn (plateau) period was preceded by a period of war and commodity inflation and ended in a period of speculative fever. Once the speculative fever topped out, the depressions all featured banking panics and collapses.
We found some interesting comments about each of these depressions.
The economist Milton Friedman wrote:
The banking panic of 1837 was followed by exceedingly disturbed economic conditions and a long contraction to 1843 that was interrupted only by a brief recovery from 1838 to 1839. This Great Depression is particularly interesting for our purposes. It is the only depression on record comparable in severity and scope to The Great Depression of the 1930s, and its monetary concomitants largely duplicate those of its later mate. In both, a substantial fraction of the banks in the United States went out of existence through suspension or merger --around one quarter in the earlier and over one-third in the later contraction--and the stock of money fell by about one-third. There is no other contraction that even closely approaches this dismal record. In both cases, erratic or unwise governmental policy with respect to money played an important part.
From Professor Scott Reynolds Nelson, a professor of history at the College of William and Mary, commenting on the depression of 1873:
As continental banks tumbled, British banks held back their capital, unsure of which institutions were most involved in the mortgage crisis. The cost to borrow money from another bank -- the interbank lending rate -- reached impossibly high rates. This banking crisis hit the United States in the fall of 1873. Railroad companies tumbled first. They had crafted complex financial instruments that promised a fixed return, though few understood the underlying object that was guaranteed to investors in case of default. (Answer: nothing). The bonds had sold well at first, but they had tumbled after 1871 as investors began to doubt their value, prices weakened, and many railroads took on short-term bank loans to continue laying track. Then, as short-term lending rates skyrocketed across the Atlantic in 1873, the railroads were in trouble. When the railroad financier Jay Cooke proved unable to pay off his debts, the stock market crashed in September, closing hundreds of banks over the next three years. The panic continued for more than four years in the United States and for nearly six years in Europe.
And here, an interesting comment from the economist John Kenneth Galbraith from his book The Great Crash:1929
For a long the New York Stock Exchange looked with suspicion on the investment trusts; only in 1929 was listing permitted. Even then the Committee on the Stock List required an investment trust to post with the Exchange the book and market value of the securities held at the time of listing and once a year thereafter to provide an inventory of its holdings. This provision contained the listing of most of the investment trusts to Curb, Boston, Chicago, or other road company exchanges. Apart from its convenience, this refusal to disclose was thought to be a sensible precaution. Confidence in the investment judgment of the managers of the trusts was very high. To reveal the stocks they were selecting might, it was said, set off a dangerous boom in the securities they favoured. Historians have told with wonder of one of the promotions at the time of the South Sea Bubble. It was 'For an Undertaking which shall in due time be revealed'. The stock is said to have sold exceedingly well. As promotions the investment trusts were, on the record, more wonderful. They were undertakings the nature of which was never to be revealed, and their stock also sold exceedingly well.
One should note particularly Galbraith's comments about the investment trusts of the 1920s and Nelson's comment about the crafting of "complex financial instruments that promised a fixed return" from what preceded the banking panic of 1873. Today we might substitute the investment trusts for hedge funds and private equity funds, neither of which have accountability. The complex financial instruments might be today's derivatives and collateralized debt obligations (CDOs), none of which are transparent and which few really understand.
Indeed the complexity of the instruments and the ability for things to go wrong struck home in reading the latest Economist. The section was a special report about "Inside the Banks" - The future of finance.
In the article, Edmund Phelps, who won the Nobel prize for economics in 2006, is highly critical of today's financial services - "Risk assessment and risk-management models were never well founded" he says. "There was a mystique to the idea that market participants knew the price to put on this or that risk. But it is impossible to imagine that such a complex system could be understood in such detail and with such amazing correctness.... the requirements for information.... have gone beyond our abilities to gather it".
What went wrong was very simple. The financial institutions grossly underestimated the risks. The rating agencies who were supposed to be monitoring the banks and dealers did not have anything like the sophistication of the models used by the large financial institutions. Everything was based on normal distribution curves. Somebody either overlooked or forgot those tails on the curves. As the Economist article noted, a BBB tranche in a CDO might pay out in full if the defaults remained below 6%, but not at all if went above 6.5%. In a conversation with a former derivatives dealer colleague of mine, he said it was simple - things were great as long as the default rate was 3% or lower, but if it went up to 3.5% the whole thing blew up. No one expected the so-called rare event at the tail of the normal distribution curve.
Back to the Economist article. Benoit Mandelbrot, the mathematician who invented fractal theory, calculated that if the Dow Jones Industrial Average followed a normal distribution, it should have moved by more than 3.4% on 58 days between 1916 and 2003; in fact it did so on 1,001 days. It should have moved by more than 4.5% on six days; it did so on 366. It should move by more than 7% only once in every 300,000 years; in the 20th century it did so 48 times.
The quants, the mathematical wizards and others who were coming up with all these financial instruments while working at the biggest and best of the financial institutions in our time discovered that the markets, rather than being just "mildly" unstable, were in fact "wildly" unstable.
You put all of this primarily in just a few large organizations - Citigroup, J P Morgan Chase, Goldman Sachs - and suddenly when it goes wrong huge organizations are taken down because the so-called rare event was a lot less rare then they ever conceived. The list of the fallen and the gravely wounded is a Who's Who of our global banking system. A systemic failure, simultaneously, of the entire global financial system.
So now to try and save the system it has become a "bailout world". But just who is getting bailed out? Main Street or Wall Street? Given the amounts of money already spent on banks, auto companies and many others, coupled with huge tax cuts primarily directed at the financial behemoths, it is primarily Wall Street. The question is, will the bailing out of Wall Street save Main Street? (Note: We are using the term "Wall Street" to refer to all the huge corporations that have been recipients of bailout money. This includes the banks in Canada as well). Naturally the fiscal managers are hoping the stimulus packages will save Main Street even though they don't get a bailout.
We doubt the stimulus packages will save Main Street. It didn't save them in the 1930s. It is telling that despite the collapse of Lehman Brothers and the disappearance of Merrill Lynch and other investment banking behemoths, bonuses of some $18.4 billion were paid out in 2008 alone by these insitutions. Now there is talk of creating a "bad bank" so that the same people who brought this crisis will be allowed to go off with the "good bank". The "bad bank" of course will be the responsibility of the taxpayer. Despite all the adulation heaped on President Obama, his major financiers came from Wall Street.
Protectionism is also rearing its ugly head. It has been raised by Treasury Secretary Tim Geithner during his confirmation hearings, calling for China to end its currency manipulation. Naturally the Chinese, who hold roughly $700 billion of US debt, denied they manipulated their currency to help their exports. Still, Chinese exports have plummeted; some 13 per cent in the last quarter, but their trade surplus still rose to a record $457 billion largely because imports fell faster. Japan has openly mused about pushing the value of its currency down in order to encourage exports. The Obama stimulus package has protectionist measures for the US steel industry attached to it. It has caused great consternation in Canada's Conservative government.
While any move towards protectionism is akin to economic suicide that may not stop it from happening. Protectionism has a long history. It was in favour during the depression of 1837-44 and in the US the Whig party was elected on issues of tariffs and protection of industry. Lincoln instituted tariffs to help build the Union-Pacific railroad. During the depression of the 1870s many countries including the USA, France, Germany and Britain abandoned free trade and instituted high tariffs in order to protect domestic industries. The 1930s saw the Smoot-Hawley Act that enacted a huge tariff barrier around the US during the Great Depression. This happened despite the pleas of economists and many others. It happened anyway; world trade plummeted by two-thirds and indirectly led to WW2.
Since the financial crisis broke in 2007 world trade has already fallen and could fall further. One only needs to look at the Baltic Dry Index, a measurement of the price of moving raw materials by sea. The Index is down an incredible 91 per cent from the second quarter of 2008. At the lows seen about six weeks ago it was down 94 per cent. World trade was drying up as the credit crisis froze contracts and the availability of financing. We show a chart of the Baltic Dry Index below. Seems that everyone is following it these days. It used to be that hardly anyone paid any attention to it.
Protectionism is a serious issue and we are seeing more and more signs of it. If they are throwing billions of dollars of stimulus packages at the local economy, they want the jobs to go the locals and not discover that other countries are benefitting from their stimulus. While the arguments against protectionism are sound and have proven over and over again to be economically disastrous, we fully expect that it will happen again. We couldn't help but notice numbers that said international air freight plummeted 22.6 per cent in December from a year earlier. This number was described as shocking by industry people and is suggesting that world trade could be in a free fall.
The situation is as serious as anything we have ever seen. Bailout packages have already totaled hundreds of billions. New York University economist Nouriel Roubini (aka Dr. Doom), who wrote extensively about the coming financial collapse, has predicted that global banking sector losses could go as high as $3.6 trillion, of which $1.1 trillion will be US banks and investment dealers. Even at this stage we remain a long ways away from losses of that magnitude. Mr. Roubini has declared the global banking system borderline insolvent, especially if this estimate is realized. The massive bailout injections that have already occurred will nowhere near cover these losses. Hence the "good bank" and "bad bank" scenario to take the bad toxic loans off of the books of the financial institutions and hand them to the taxpayer.
We suppose the financial institutions might be saved but it will bankrupt the taxpayer or cause hyperinflation because of the printing of huge amounts of money. It is already forecasted that the US will run annual deficits of at least $1.2 trillion and they could reach $2 trillion. It could last for at least two years. The financing needs of the US will be astronomical. It is not clear where the money will come from, especially given that the US receives the majority of its financing from foreign sources. While Japan and Germany might be friendly towards the US, the US is also dependent on unfriendly nations such as Russia, China and mid east oil exporters.
Some may come from increased savings, as the savings rate of the North American consumer is showing recent signs of rising from near zero to around two per cent. But it is a Catch 22, especially if the US consumer returns to previous savings levels of 10 per cent. Increased savings will find their way to purchasing US Treasuries at the expense of expenditures in the economy. Retail sales, already collapsing, will continue to fall.
The Fed has indicated a willingness to buy US Treasuries but this is in the realm of printing money. Couple this with quantitative easing, the bailouts and the stimulus packages, the risks of protectionism, and all of this will lead to massive currency debasement. Currency debasement is a method of defaulting on debt. It also risks an inflationary spiral. There will then be only one thing that will be safe, and that is gold. Our series of charts below show how we are already seeing record highs for gold in Canadian dollars, British pounds, euro and Russian rubles (and a host of other currencies). It is only a matter of time before we see it in US dollars and yen as well. We show charts for those two as well.
It is a bailout world, but who will bail out the countries (the US and Britain in particular) when they go down and almost certainly face downgrades on their debt. Nobody. Investors must take steps to protect themselves. The situation is now turning far more dire.
Despite that assessment we continue to see some positive signs in the market. The combination of bailout packages, stimulus packages quantitative easing and low interest rates should at least in the early stages allow for a rebound rally of some substance to get underway that could take us into at least April and quite possibly into early summer. After that the massive financing requirements should begin to weigh on the market and we could be entering a more dangerous time.
Note: Charts created using Omega TradeStation. Chart data supplied by Dial Data.