Note: The following blog post originally appeared on January 25th, 2010. I have removed the references to then-current market movements and otherwise cut the article down to the interesting bits. In this case, I have also updated the charts and clarified the text for the additional data we have since then. You can read the original post here.
...However, it supports my belief that the slide late last week isn't (yet) the beginning of a slide into oblivion. Also supporting that point, Greece managed to sell €8 billion bonds quite easily today. I don't really understand why it was so easy. I suppose there is a deep reservoir of people who don't want to see a European sovereign go bust - for example, other Europeans - but it isn't as if that 8 billion will carry Greece forever. They are in dire straits, and as I've pointed out here before they can't print money and that fact is what makes a default possible. I do believe this could be the beginning of the end for the Euro, but I don't think that end is imminent. Institutions have selfish memes and tend to protect themselves vigorously. In this case, I suspect that other European central banks, big European investors, European corporate entities...they all have a very strong vested interest in holding the Euro together, and they will do so as long as it is possible. And it will be possible for a while.
An interesting factoid that I saw on CNBC today: of companies announcing Q4 earnings so far, 9% have beaten earnings-per-share (EPS) estimates, but 65% have beaten revenue estimates. What does that mean? I think it means that margins have been lower than analysts expected (although there's a statistical caveat, because the number of misses may or may not correlate to the size of the miss), which means that they're buying business through lower prices or, on the other hand, are holding prices down while input costs rise. One is a disinflationary spin and one is an inflationary spin. The data suggest the latter, as inflation-other-than-housing has been percolating some, but wage growth (a big input) hasn't exactly been robust either. I'll call it a tie on that evidence (with respect to inflation implications), but either way tightening margins are a sign of economic weakness.
But my bigger worry is that some sharper near-term imbalances are brewing. Economic weakness we can work through, if the basic capital markets and economic structures are left in place and government doesn't take too much of the productive capacity of the country (these assumptions are somewhat in doubt these days, but let's look past that). What worries me in the reasonably short-term is that there are some big imbalances that are following on the heels of the imbalances that just blew up...and those just about cracked the edifice of Western civilization.
All of these imbalances are of our own making, but none has been created as fast as this one. I will do my best to explain it, and I hope that somewhere my logic falls down and someone can correct me.
When the government runs a deficit, where does it get the money so that its expenditures can exceed its revenues? It borrows, from essentially two places: domestic savers and foreign savers. In recent years, domestic savings have been low, and the government has financed its deficits more and more with money lured from foreign investors who hold dollars. Because the only reason these folks hold dollars is because we are buying more stuff from them than they are buying from us, we have a trade deficit. If domestic savings is stable, then over time the budget deficit and the trade deficit must equal; but a better way to think of this is that budget deficit = (trade deficit plus domestic savings).
This is why folks talk about the "twin deficits," trade and budget. Large deficits can only be financed entirely from within if there is substantial domestic savings, but we have been discouraging savings for a couple of decades now. The graphic relationship is sloppy, partly because we're not great at measuring these values and partly because domestic savings ebbs and flows, but you can see that the larger trade deficit in recent decades seems to be at least of similar magnitude as the budget deficit (Source: Economagic.com):
The following blog post originally appeared on January 25th, 2010. I have removed the references to then-current market movements and otherwise cut the article down to the interesting bits. In this case, I have also updated the charts and clarified the text for the additional data we have since then. You can read the original post here.
Well zowie...those last few points are interesting, are they not? The government is running an epic deficit, as we all know, but the trade deficit has actually improved since 2008. How is that possible? It is possible because domestic savings has been growing by trillions of dollars over the last few years.
Now, you might say "that's great news!" except that it isn't great news at all. The largest part of that "savings" is the money that the Fed has printed by buying Treasuries, agencies, and other collateral. This is where the rise in the money base (see chart below) is showing up.
To tie these charts together, I will note that the total rise in the balance sheet assets since August 27, 2008 has been $3.0 trillion. And the cumulative difference in the budget deficit, less the trade deficit, has been $3.1 trillion.
That's right: the improvement in the trade deficit, despite the huge budget deficit, comes almost entirely because the Fed has provided the needed savings with its checkbook. But now here's the problem. The Fed declares that they are not going to keep doing that, which means that (a) they're lying, or (b) there is going to be a massive improvement in the budget deficit, soon, or (c) the trade deficit is going to start looking really, really, really bad, pretty soon.
Any guesses for (a), (b), or (c)? [Editor's note: with hindsight, it seems that (a) really was the correct answer. It isn't clear whether that is the correct answer today. I suspect there will be come combination of (a), (b), and (c).]
Assuming that the Fed isn't lying, and assuming that the federal government isn't going to find fiscal Jesus and slash a couple trillion from the deficit (as I've noted though, if they just don't have any emergencies this year the deficit ought to improve a few hundred billion), then the trade deficit is going to start to look ugly. Epic ugly. Medusa-ugly.
And this leads to the worry - if the trade deficit explodes, then two other things are going to happen, although how much of each I can't even guess: (I) protectionist sentiment is going to become very shrill, and fall on the ears of a President who is looking to burnish his populist creds, and (II) the dollar is going to be beaten like a red-headed stepchild (being a red-headed stepchild, I use that simile grudgingly).
Others - Warren Buffet is one - have publicly toted up the numbers and observed that it's hard to figure out how we finance such deficits unless most of it comes from overseas. To entice such largesse, the currency unit will need to be cheaper, and rates will have to be higher.
This is my worry - not a global meltdown, but a U.S.-specific meltdown. Higher rates, higher inflation, lower equities, and a lot of volatility. And it may happen quickly, when it happens. [Editor's note: Thanks to the Fed pursuing the policy in (a) above, it hasn't yet happened!]
When might this happen? Putting dates on nightmare scenarios is ordinarily a useless chore. It is usually far better to merely be alert to possibilities and to move quickly when the rock looks like it's toppling. But in this case, there is a particular time period I am especially concerned about: the end of March (as in, about two months from now).
The Fed is gradually reducing its purchases of MBS, with the intention of ending those purchases...in March. Also, Japanese year-end is in March, and lest we forget the Japanese represent some 20% of the foreign ownership of Treasuries. There is a reason that seasonals for the bond market are weak in the spring. If we can skate past April 1 without something serious happening, then I will breathe a sigh of relief and go back to balanced-rock-watching. But in the meantime, I sleep fitfully.
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