My Two Cents - "The Malachi Crunch Continues" By Andrew

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My Two Cents - "The Malachi Crunch Continues"

By Andrew Sutton
January 11, 2014

Those of you who have known me any length of time know that I love to say ‘they always tell you what they’re going to do’. I had a really scintillating discussion yesterday with two fellow economists as to why that might be and we’ll shelve that for now, but let’s just say this: ‘they’ are at it again. Last week I referenced an IMF working paper ( http://tinyurl.com/nyzu99q ) penned by Harvard dynamic duo Ken Rogoff and Carmen Reinhart regarding asset confiscation and other ways to wiggle our way our the current economic morass that we find ourselves in. This week I’m going to perform a full dissection because there is material in there that you simply cannot go on without knowing if you expect to salvage even a shred of your financial state as it exists today.

Before I begin, let me make the following preface: what I am dissecting is an IMF working paper. These are basically pre-legislation, pre-policy position papers that are written by various parties associated with the bank. A term that might be familiar with some is ‘trial balloon’. Sometimes these papers disappear into the ether, only to resurface decades later, and sometimes they are implemented in the shorter term. The IMF claims that its working papers ‘don’t necessarily represent the opinions and views of the IMF’. Take that for what it is worth. After all, they printed it on their letterhead. I’ll let you decide the veracity of that claim.

I will also preface this article with the comment that every one of the 5 major suggestions and/or solutions made by Reinhart/Rogoff have already been done in the modern monetary era. By that I mean since the creation of the not-so-USFed and the age of the push away from specie-backed currencies. Given the unsustainability of America’s current economic trajectory and its continued loss of wiggle room in terms of buying time, it would appear that we are closer as opposed to farther from seeing more of the measures detailed in this paper come to pass.

With all that said, let’s get started. I’m going to take many quotes directly from the paper; be not afraid, it is written in fairly plain English. There are no fancy formulas, calculus, or anything to fear. Just words. They’re not trying to hide anything, which is one of the reasons the red flags went up over this particular paper.

From the Abstract:

“Even after one of the most severe crises on record (in its fifth year as of 2012) in the advanced world, the received wisdom in policy circles clings to the notion that advanced, wealthy economies are completely different animals from their emerging market counterparts. Until 2007–08, the presumption was that they were not nearly as vulnerable to financial crises. When events disabused the world of that notion, the idea still persisted that if a financial crisis does occur, advanced countries are much better at managing the aftermath, thanks to their ability to vigorously apply countercyclical policy. Even as the recovery consistently proved to be far weaker than most forecasters were expecting, policymakers continued to underestimate the depth and duration of the downturn.”

You can see right from the word go that they’re admitting what we’ve already known for years, but what the media and government lie like filthy rugs about. There’s no recovery. Certainly not a secular one, based on fundamentals, production, savings, genuine capital creation and allocation, and increased standard of living. But did we really need Messrs. Rogoff and Reinhart to tell us this in a working paper with a bunch of fancy graphs to back it up? Not a chance. All we had to do was a little basic observation. Buckle up my friends; it gets a lot better.

The paper goes on to claim that Europe’s sovereign debt crisis, which is ongoing, was an offshoot of the 2008 blowout. I would take exception to that only because the circumstances that led to the Eurozone crisis were already in place long before Bear Stearns, AIG, and Lehman. Certainly the events of 2008 forward did not help Europe and likely did help the EU along its crash course path. But that path was long cast in stone, going back to when the Union was initially created. If anyone needs a refresher, just go and see how the rules were bent to allow Greece to join. I’ll rest my case there. Let’s move along.

“The claim is that advanced countries do not need to apply the standard toolkit used by emerging markets, including debt restructurings, higher inflation, capital controls, and significant financial repression. Advanced countries do not resort to such gimmicks, policymakers say. To do so would be to give up hard-earned credibility, thereby destabilizing expectations and throwing the economy into a vicious circle.

Although the view that advanced country financial crises are completely different, and therefore should be handled completely differently, has been a recurrent refrain, notably in both the European sovereign debt crises and the U.S. subprime mortgage crisis, this view is at odds with the historical track record. In most advanced economies, debt restructuring or conversions, financial repression, and higher inflation have been integral parts of the resolution of significant debt overhangs.”


So what exactly is this ‘toolkit’ they mention? It is made up of 5 distinct parts according to the working paper:

1) Economic Growth

2) Fiscal Adjustment/Austerity (Think entitlement programs)

3) Explicit (de jure) default and/or restructuring (Think bail-ins)

4) Inflation surprise

5) A steady dose of financial repression followed by a steady dose of inflation.


Of all of these, economic growth is the ONLY one that won’t either immediately or eventually adversely affect the welfare of the economic agents invested in that particular system – namely you and I. We’ve certainly heard plenty about austerity in the EU, and that isn’t working out so well. I’m not going to give a sitrep of the Eurozone crisis spots in this essay, but let’s just ask why the Greek stock market has surged at the beginning of 2014 even as the unemployment rate surges upward along with it? Someone’s expecting another bailout or other sort of financial mischief to keep things from seizing up totally.

Defaults and debt restructuring is an interesting issue for America and this connection goes back to last week’s piece regarding the stance of the China-Russia alliance in Syria. They took us out behind the woodshed and beat us like a rented mule. There’s no other way around it. I cannot stress enough the importance of that event in the grand scheme of things because it tells us that the balance of power has shifted. So, with that said, how likely are we to get cooperation from the China/Russia alliance with regard to debt restructuring? They might be very cooperative, however, if that is the case, it is very likely that terms will be very undesirable for the average American.

America has been implicitly defaulting on its debt for a long time now. How long is up for debate. I’d draw the line at 8/15/1971 when we stopped settling external trade imbalances in gold. Some would say it was when the Petrodollar was created by agreement with the oil-producing nations to buy our debt in exchange for oligopoly pricing power in the US energy markets. In either case, it doesn’t matter all that much. Both of those events occurred coming up on a half century ago. The debt agreements (bonds) were sold under the premise that they would be paid back in dollars. However, nobody bothered to mention that perhaps the dollars that are paid back should have the same purchasing power as the dollars that were borrowed to begin with.

But what Rogoff/Reinhart are talking about is an actual default – you don’t get your money back, China, Russia, pension plan A,B,C, or this or that mutual fund, etc. This has happened before, but NOT in the financial free-for-all era we live in now. America forgave huge debts after the first two World Wars. We’ll get into that in a bit, likely at another time. Those other countries defaulted. The authors are suggesting that this tool, which used to be reserved only for ‘emerging market’ type countries, should now be used by what they term ‘advanced countries’. We’d call them first world countries. Others might say G-20 or G-8 countries. So let’s say Uncle Sam defaults on a portion of its debt. Who will be left holding the bag? Maybe your pension fund has 20% of its assets invested in USGovt bonds. Sorry, folks. Maybe you work for the federal government and are invested in the Thrift Savings Plan or the Civil Service Retirement System and own the ‘guaranteed’ bond fund. How is that going to play out?

The very next sentence after the last direct quote is the one that will blow most folks away:

“It is certainly true that policymakers need to manage public expectations. However, by consistently choosing instruments and calibrating responses based on overly optimistic medium-term scenarios, they risk ultimately losing credibility and destabilizing expectations rather than the reverse. Nowhere is the denial problem more acute than in the collective amnesia about advanced country deleveraging experiences (especially, but not exclusively, before World War II) that involved a variety of sovereign and private restructurings, defaults, debt conversions, and financial repression. This denial has led to policies that in some cases risk exacerbating the final costs of deleveraging.”

Managing expectations, eh? How long have virtually everyone on the Austrian side of the fence been talking about that? No quibbling with what they’re saying here either. By lying and obfuscating policymakers only make it worse in the long run. What is left unsaid, however, is that they don’t care. That is my biggest gripe with this paper; it doesn’t address the real reasons why these events took place and will do so again – evil. True evil at its most visceral level. What we’ve got is a bunch of megalomaniacs behind the scenes who want it all. They’re not happy with what they have. No, they want that, plus what everyone else has too and frankly, they don’t care what they have to do to get it. I don’t expect Messrs. Rogoff and Reinhart to understand this and their analysis proves it. It is a dry, academic analysis, but the motive is unmitigated greed. And there is little to no benevolence in the hearts and minds of those the power is shifting to, either.

Exit Strategies – Past and Future

Rogoff and Reinhart list four lessons of the past regarding debt, financial crises, and the escape methods used to ameliorate the problems and /or reset the systems.

“Lesson 1: On prevention versus crisis management. We have done better at the latter than the former. It is doubtful that this will change as memories of the crisis fade and financial market participants and their regulators become complacent.”

You can give whatever grade you like to the policymakers, etc. for managing the crisis as it relates to American debt and financial crisis, but I’ll rely on an old adage that an ounce of prevention is worth a pound of cure. These clowns knew exactly what was going to happen when they pulled down Glass-Steagall. They knew exactly what was going to happen when they ran interest rates to nothing and fired up the inflation machine. They knew exactly what was going to happen when the decision was made that the Anglo-American syndicate would deal in paper and bombs while the rest of the world prepared to deal in tangible goods, production, and a lack of national excess and ignorance. There is no pass given here for ‘we didn’t know’. They knew. And they know what is going to happen moving forward as they prepare to gut our retirement system to square away the mess they made in the first place. Here’s where the not-so-subtle advocacy of a return to ‘financial repression’ begins:

"Although economists’ understanding of financial crises has deepened in recent years, periods of huge financial sector growth and development (often accompanied by steeply rising private indebtedness) will probably always generate waves of financial crises. As the late Diaz-Alejandro famously titled his 1985 paper “Good-bye Financial Repression, Hello Financial Crash,” many crises are the result of financial liberalization gone amok. Diaz-Alejandro was writing about an emerging market (Chile in the early 1980s), but he could have said very much the same thing for advanced countries today.

Figure 1 presents a composite index of banking, currency, sovereign default, andinflation crises (BCDI Index), and stock market crashes. Countries are weighted by their share of world income, so advanced countries carry proportionately higher weights. The figure, and the longer analysis of crises in Reinhart and Rogoff (2009), show that the “financial repression” period, 1945–1979 in particular, has markedly fewer crises than earlier or subsequently."




So what exactly is this ‘financial repression’? It certainly doesn’t sound good, does it? This ties in with lesson 4, and since this is the crux of the matter, we’ll get straight to it. There is much, much more here and I’ll probably use the next episode of ‘Beat the Street’ to hash it out in further detail, but let’s get to brass tacks.

“Financial repression” includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and generally a tighter connection between government and banks.”

Did you catch that? ‘Directed lending to government by captive domestic audiences’. What exactly is a captive domestic audience? The $18+ trillion in retirement savings in America is exactly what they’re referring to here. It is captive in that it cannot easily be extracted from the system, especially pension and 401k type arrangements where one would have to quit their job to even have any chance of getting access to their savings. Next on the list are IRAs of various flavors because unless you meet the age requirements, you’re going to take a huge hit. And the authors are saying that during the periods when these sorts of draconian economic measures are taken is when crises tend to be less likely, at least according to their own model, however, the methodologies behind that model remain undisclosed.

In Summary

To sum all this up, what we have is two Harvard heavy-hitters for the IMF writing a working paper that suggests that your currency should be further devalued, you should be bailed-in to save your government or some bank, that your pension should be swiped, your capital controlled, and that you should have a GoverBank – a term coined by yours truly in January of 2009 – an incestuous relationship between big money and government. And what has happened so far? We’ve certainly seen the inflation via QE. We’ve seen the emergence of the bail-in first in Cyprus, and now developing in Detroit. If you’ve tried to move some money offshore you already know all about the subtle capital controls that continue to keep popping up.

Like I said, there is quite a bit more in this paper, but I think we’ve made the point – at least for now. And for the record, this is nowhere near the first working paper released on these topics, however, it is one that advocates not only a continuation of the current path (not a surprise considering Rogoff and Reinhart are dyed in the wool Keynesians), but an extension of what they’ve overtly labeled ‘financial repression’. I’ll close merely by saying I would be seriously shocked if we didn’t see at least several events following the course prescribed in Rogoff and Reinhart’s paper in 2014. They may not receive coverage from the lapdog media, but just because no one is in the forest to hear a tree fall doesn’t mean it falls quietly; or that it doesn’t land on someone.

Until Next Time,
Andy

Andrew W. Sutton, MBA received international honors in the field of Economics in graduate school and is the Chief Market Strategist for Sutton & Associates, LLC, a Registered Investment Adviser in the Commonwealth of Pennsylvania. For more information about the company, its products and services, or contact information, please visit our website. Please feel free to distribute, copy or otherwise disseminate this information.

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