World is Out-of-Kilter: Global Financial Adjustment in Progress

Over the last two days, my column has been relatively devoid of opinion, but rather, managed to describe the situation with the US Fed (Friday), and with Ireland, (yesterday). 


It also seems as if I have stopped making suggestions as to what I would do if I could pull the puppet strings. Writing about how to fix the system is a lost cause, since the global balance of economies, trade and finances, is so out of kilter, that there will have to be an adjustment process as these imbalances sort themselves out. On the one hand, you have over-indebted western (developed) economies, which have fueled their growth over the last 10-15 years by a persistent pattern of debt expansion. The emerging economies, which have been best characterized by the 4 headed BRIC consortium, has grown on the back of out-sourcing western jobs, and manufacturing facilities which operate with cheaper labor and lower environmental and operational expenses. The BRIC, as well as other peripheral developing countries, such as Korea, Thailand and Vietnam, to name a few, have had their own issues going back to the 1990s and before. Yet, it all seems as if these developing countries have acquired a fair bit of economic momentum in the new millennium, and can boast growing economies while the developed countries are struggling to gain escape velocity out of their economic doldrums. Along the way, the developing countries have acquired massive stock-piles of foreign exchange currencies, while ignoring the idea that the currencies they are accumulating, and needed when their economies were fledgling, is now becoming an obstacle to global growth. 


In short, the system has many “things” which are out of kilter, and ultimately those “things” will be reconciled. At this stage of progression, government officials are in full combat mode, and in high alert as they seek to right the wrongs of the current system, and grope for a better path out of the current malaise. While I strongly feel that the developed countries have a price to pay in terms of modifying their standards of living, and pay down debt, there are many paths to that solution. Creating inflation is a convenient way to spread the cost of this adjustment across the economy, without explicitly taking money away from any one constituency. Call it a cowardly way out of this mess, but it is politically viable. No one wants to envision what happens if the Fed can create enough inflation which is in opposition to the flow of demand for overseas products. It is also very likely that instead of the US (and other developed countries), absorbing the complete cost of down-sizing, it is also likely that trade surplus countries will help subsidize our adjustment process, via a devaluation of their foreign exchange holdings, (the dollar). How governments respond to the cascading crises, will determine what sort of investment strategies will succeed, and how to navigate your way through shifting (financial and economic) sands.


My mission is to keep our collective heads above water. I am not going to be able to change the system, nor should I view my own opinions in such a way as to create change. It is with this mission statement that I approach this challenge. And so it is with Friday’s piece about the Fed. I have pretty much tried to ignore calls to eliminate the Fed, as that is not likely to happen. I am also giving less credence to the idea amongst some Republican members of Congress, who want to cut the Fed’s mandate to just controlling inflation, without regard to the second mandate, which is to insure economic growth. I doubt this will happen, but even if it did, there is nothing about current Fed actions, which would go against their mandate for low and predictable inflation. In fact, the Fed has sold us on the idea that 2% inflation is OK, and no one seems to question that. Even without the mandate to support economic growth, the Fed could make the case, that with inflation running at a 1.2% rate (last 12 months), or 0.6% when food and energy are taken out, that they will ease further by virtue of their decided goal of a 2% inflation rate target.


The point I want to add to Friday’s blog is that the Fed, led by Big Ben, has taken a rather activist role. My gut instinct is that the Fed understands that the current configuration of trade and flows of funds is very unbalanced between the developing and developed countries, and that much will need to be done to right the excesses/imbalances of the current system. Where I differ from the Fed and their tactics is the notion that the Fed is running out of options, and that it would almost be better off for the Fed to save these policy responses for a time when they are really needed. What I would do is meaningless, since that is just a hypothetical. What is important to take away is that Fed is in an activist mode, and for the near and intermediate future, they will continue to stoke inflation, or at the very least, try to avoid deflation.


To that end, I will repeat a concept I have made many times in the past: with housing comprising 42% of CPI, and that part of CPI running at a -0.2% rate (last 12 months), then the other 58% of CPI is actually running at a pace of 2.2% (over the last 12 months). In other words, a weak housing sector will keep CPI muted, and the Fed will feel as if their 2% inflation target is elusive. This will ikely results in more QE’s, or as I suggested last week, a possibleinterest rate cap on the entire yield curve.


As for my comments about Ireland, this is the latest sign that the developed economies are over-leveraged and have to go along with the effects of de-leveraging. While Ireland might be the most visible patient amongst the developed countries, Spain’s size and problems are casting a shadow, and will eventually need to be dealt with. And when the Spanish problems come home to roost, this will be big enough to overwhelm the system, with very bad consequences for the banking system of the developed countries. Politicians will do what they can to sweep the lesser problems ofGreece and Ireland under the rug, yet the smaller problems will not go away, and how they handle the small problems will determine what they will do when the EU has to deal with a default by Spain, with its hundreds of billion euros of debt. Expect to see much more from me about Spain over the next month, as I want to get ahead of that situation before Spain derails the EU’s delicate balancing act, as I think it will.


* A reader writes in with this comment:


“I had a long talk with someone who I think is extremely bright and worth just under a billion, yet hisdiversification strategy is not into metals, (precious or otherwise), but into Timber and Water Rights – believing these will be scarce and appreciating assets.  He is worried that the problems in the Euro will eventually cause the wall of money to flow back to the US, with commodities taking it on the chin.  What are your thoughts?”


I do agree that real assets will hold value as the fiat monies of the world proliferate. The deflationists view is that, as debts default or are extinguished, then that will reduce the amount of money in the economies, and as such, money (cash), becomes that which is in short supply and in demand, to the detriment of real assets. Whether or not the Fed can create inflation, it is obvious that they are doing whatever they can to prevent money from becoming scarce. On top of that, government policies still supports the extension of credit to homeowners who do not have good credit, and in some cases, do not deserve an extension of credit. This is where the battle lines between deflation, dis-inflation and inflation are being drawn. Based on current proclivities by the Fed to keep printing money, I will go along with the inflationary investing strategy. To that end, I do agree with the strategy of owning real assets. It is hard for the average, or even wealthy person, to own water rights or large tracts of timber properties. It is possible for the average person to own shares in companies which have such assets in their portfolios. This is an endeavor which I support, but I do not have the band width to make recommendations to that end. Lastly, when I have looked at some resource stocks, it occurs to me that these have come a long way since March of 2009. To that end, I feel better buying into these properties with some sort of market correction.


As for your acquaintances opinion that money coming to the US, at the expense of Europe, I do not think that will have much of an impact on commodity prices. Although, if we rewind what happened last May/June, when Greece was in the news, gold and silver did pretty well, while commodities suffered, as did stocks. Commodities seem to correlate with the general stock market, while precious metals will do well when fiat currencies are in trouble. After Europe goes, and we are onto QE4, the proliferation of dollars will help bring back commodities and precious metals, altogether.