That Seventies Show

There is a serious situation brewing that few people are talking about. This absolutely required a blog update.



One of the most dramatic features of the economic landscape during the 1970s was the disruption of the Oil Shock. Today, people are misled to believe that this was THE cause of inflation in that disastrous decade but that is a long way from the truth. In reality, it was more of a reaction to inflation. LBJ's creation of the modern welfare state combined with his escalation in Vietnam put the US on the path of permanent debt.



Accelerating inflation rapidly ensued for nearly a decade had already resulted in cumulative dollar inflation of over 50% before the Arab Oil Embargo and overnight tripling of prices. OPEC was using their market power and leverage to compensate for the falling value of the dollar and to get ahead of the galloping inflation our government and central bank had created. They noticed that they were being robbed via currency debasement and were in a position to do something about it because they controlled a large chunk of the oil export trade.



Unfortunately, we may be about to see history rhyme if not repeat in the near future. The effects could be extremely serious, with social consequences much greater than in 1974. And it could all be triggered by one medium-sized Southeast Asian nation that few people focus on when looking at economics. That nation is Thailand and the critical commodity that will be impacted is rice.



The likely result arises from the politics of inflation. Thailand's exports are priced in dollars and the severe erosion in value of the dollars earned has created pressure to increase income to revive living standards damaged by inflation. Because Thailand is the largest rice exporter by far in a tight market, they are in a position to demand higher prices - just as OPEC was in 1973-74. The current ruling party in Thailand is committed to increasing the income of farmers and is pursuing policies to control the rice supply and push up prices. From Bloomberg:

Yingluck has said the government will buy unmilled grain from farmers at 15,000 baht ($502) a ton at harvest in November, above current market rates of 9,900 baht. With Thailand the world’s biggest exporter, that may raise rice prices across a region that accounts for 87 percent of global consumption. The leader presented her economic policies to Cabinet yesterday and is scheduled to announce them publicly by Aug. 24.

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Food makes up more than 30 percent of inflation indexes on average in Asia, according to Rabobank Groep NV. The weighting of rice in consumer-price indexes varies from 9.4 percent in the Philippines, 4.7 percent in Indonesia and 2.9 percent in Thailand, according to Bank of America.

Collateral Damage

The sad irony is that the people most affected by this will be innocent bystanders. The western central banks most responsible for currency debasement will hardly even notice. Few people in the West will be impacted at all. The people who will feel the pain will be Asian city dwellers. Middle and lower class urbanites will be especially hard hit. There will be a partial offsetting benefit in rising incomes for rice farmers but the disruption from shifting so much money from urban consumers is sure to trigger political unrest and likely a great deal of violence as well.



The numbers suggest a 50% increase in rice prices if the official Thai government pricing dictates to the world export market. This seems likely to us since they account for over a third of all rice exports nearly every year. With rice in short supply already, it is doubtful that importers will be able to refuse to buy at the higher price for very long. Because of rice consumption patterns, the effect will be overwhelmingly confined to Asia (85% of world consumption) and North Africa. As if those areas needed more economic pressure place upon them.



Once the Asian nations understand the full consequences of this move, the drive to move their economies away from the dollar should accelerate. With the dollar as the global reserve currency, the Fed is able to inflict widespread damage with its irresponsible policies. It appears the casualties in this round will be overwhelmingly Asian. That will increase the urgency to find alternatives to a dollar that is being sabotaged at the whim of Ben Bernanke.

Catalyst for Jawboning

Over the last several days, the Fed has trotted out multiple spokesmen to suggest there might not be another round of trash credit creation (quantitative easing). The Dallas Fed's Fisher came out on Tuesday and suggested the program should not be extended when it ends in June and that things may already have gone too far. Lockhart of Atlanta stated "it's a high bar" in response to questions about QE3. Minneapolis' Korcherlakota stated the economy would have to "worsen materially" to extend the bond market manipulation. Finally, Plosser of the Philadelphia Fed recommended not merely stopping or even reversing the bond buying but also raising interest rates.

The central bank should set a pace for selling its mortgage and Treasury holdings in conjunction with raising interest rates, Plosser said today in a speech in New York. He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.

So why is the Fed so concerned suddenly after abusing their authority in blatant fashion for more than two years? Clearly they don't care about inflation - having inflicted a tripling of oil prices, a doubling of most grains and even worse in some commodities upon the world. It would seem that they are concerned that people are catching on to what they are doing and starting to point the finger in the right direction. So now they need to very publicly posture as "inflation fighters" until people's attention wavers. And the spotlight is definitely turning their way. As the Financial Times reports:

The finger of blame is increasingly pointing toward central banks and the US Federal Reserve in particular. By printing money through quantitative easing, there are supposedly more dollars, yen and pounds chasing the same number of Beefy Crunch Burritos. Fed chairman Ben Bernanke actually was asked during a speaking engagement last month whether the central bank was culpable for the revolution in Egypt.

“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to US monetary policy because emerging markets have all the tools they need to address excess demand in those countries,” said the clearly annoyed banker.

But an increasingly common view is that, with the very best intentions, he is at fault. Critics regularly cite the words of Milton Friedman, who said that “inflation is always and everywhere a monetary phenomenon”.

Essentially, the Bernak is standing over the body with a bloody knife in his hands and the lights have just turned on. He seems determined to brazen it out and has sent out his minions to talk about all of the wonderful things he's done and will do if we just leave him alone with his power. This is all an attempt to distract attention for the Fed's culpability in the destruction of purchasing power worldwide.

It is all about perception. That is why the Fed cares about inflation expectations, even while deliberately inflicting inflation on the economy. They can more effectively steal the value of your savings and income if you don't know what is going on. That job becomes much harder when the population starts to adjust their thinking and behavior to account for the destructive acts of the Fed. It is so important to prevent that change in thought and deed that Paul Volcker once raised short-term interest rates above 15% to prevent it.

With the spotlight now focused firmly on the Fed, this weeks' jawboning is just the first act of their attempt to change the subject. If that doesn't work, they might actually be forced to DO something. In particular they will need to act to stymie commodity speculation - which is the portion of the iceberg that everyone can see, as it affects the daily life of nearly everyone. While they are also likely to attempt to prop up the stock market, it will be tough to do both at the same time since commodity producers and related firms have been a key driver of the new equity bubble.

With private lending in the US essentially dead, the government is the sole source of credit growth right now. If the debt limit interferes with further bubble finance at the same time as the Fed is forced to try and look responsible, the speculative markets could be in for a rough ride indeed.

A Little Credit

That really is all that is available in the debt markets today and the consequences are obvious. At the same time, we'd like to claim a little credit for calling the direction and - to some extent the magnitude of this crisis. We felt that these (then pending) consequences were obvious 18-24 months ago. In fact, one of the first posts on this blog in August 2007 noted:

Today's actions by the European Central Bank and the Federal Reserve confirm that the real threat is DEFLATION - not inflation. Central Banks don't pump $150 billion dollars into the banking system because they are afraid of creating too much money.

Again this June:

That is where we are now. The Fed has failed. The Great Oz has been exposed a just a man behind the curtain. Prepare for severe credit deflation and falling asset prices in markets that traditionally use leverage to purchase or hold positions.

For years massive credit inflation raged unchecked and asset prices soared as the pool of buying power increased far faster than the assets available to absorb it. As the debt machine began to break down and collapse under its own weight, credit creation proved insufficient to continue propping up all asset prices. At this point the Universal Debt Bubble (UDB) began to falter selectively. First housing, then junk bonds, asset-backed securities, commercial real estate, equities, corporate bonds and sovereign debt all fell off the wagon in turn. By early 2008, the one asset class that had not yet been hammered was commodities - though in reality, that was also a fragmented market with the highest profile stuff still going up while nearly everything else was down.

Selected commodities proved to be the final bastion of credit-driven asset inflation - leading many analysts to mistakenly call for inflation when the exact opposite was looming. Credit creation has now fallen to such a low level that asset inflation is now dead virtually everywhere. Grains, metals and oil were the last holdouts of the UDB and they are now being hammered into the ground. The WSJ provides us with evidence and a salutary example of how demand destruction works in Metals Meltdown Burns Scrap Dealers:

Now demand and price are in a freefall. Does the Miami businessman sell his now high-priced inventory at basement prices, or wait for the market to recover?

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But in the last six weeks, scrap steel prices have fallen nearly 60% to about $400 a ton. Prices for aluminum scrap has dropped 33%, copper 25% and nickel about 15%. Peter Marcus, metals analyst for World Steel Dynamics, says, "We aren't near the bottom yet."

For a while, the trend in price seemed to be in favor of commodity inflation. The reality was that the huge amount of "money" (really credit) created during the UDB has been running around looking for someplace, anyplace to hide and commodities were the last asset bubble it ran towards. But the economic function of bubbles is draw in such phantom "capital" and destroy it as if it had never been. The trend-followers and and performance chasers will never understand this as they are always late by definition. One has to take a systems analysis approach to understand how pulling a lever over here can impact things that have no obvious connection to the original stimulus.

The last bubble is over. Oil has collapsed from nearly $150 to less than half that. Grains are down 60% or more. Industrial metals are in worse shape than that. Deflation is now the order of the day. Governments will try to stop it but will fail repeatedly. They do possess the power to stop it before deflation runs its full, natural course but the price will be self-destruction and national suicide via devaluation and hyper-inflation. In this case the cure is much, much worse than the disease.

Global Reversal

It's been a few weeks and there's been a bit of excitement surrounding the Fed. But from an economic and credit standpoint, it's largely "sound and fury, signifying nothing." Risk spreads are still wide, lots of high-grade and few low-grade bonds are being issued, market rates (all but the shortest maturities) are higher not lower. Sure, stock markets are rallying on the promise of inflation but the Fed may not be able to deliver, especially since only the Bank of Japan is using the same playbook.

If you look closely, the recent past is very similar to the 1970s. We have rising inflation everywhere, though masked this time using statistical manipulation in the First World. Inflationary credit excess driving unsustainable demand for all kinds of stuff. This benefits rising industrial exporters (Japan then, China now) and commodities producers (OPEC, Chile, Brazil, Canada, Australia, Texas, Alberta and various African nations). We experienced a co-ordinated global boom then, just as now and for the same reasons. In fact, we are currently experiencing the highest sustained rate of global GDP growth since the early 1970s - not a terribly auspicious precedent.

Even with cuts in the Fed funds target rates, the US economy seems to be well along the road to a severe recession. Housing can only be described as collapsing. To those who argue that prices haven't come down much, you are correct - that comes later. Prices are sticky in housing since the average market participant is poorly informed. Price declines often continue well after a bottom in sales and construction. Just given what's happened already, we can look forward to 18-24 months of falling prices.

Predictably, lending against depreciating collateral isn't terribly popular and the initial effects of less EZ credit are being seen in the first small drops for consumer spending and retail sales. The declines would have been worse without rapid growth of credit card balances.

The Federal Reserve reported that consumer credit rose at an annual rate of 5.9 percent in August, the biggest increase since a 7.9 percent jump in May.

The increase was led by an 8.1 percent leap in revolving credit, the category that includes credit card loans.

This will get much worse for at least a year. With consumer spending now accounting for an unprecedented 72% of the economy, the vulnerability to a consumer spending slowdown is obvious. Of course American consumers have been spending money they don't have for the last 5 years and the engine for excess spending - the housing bubble has been sputtering and has now shut down.

What's fascinating is that similar dynamics are now being seen overseas. Many nations have experienced simultaneous housing bubbles and their associated wealth effects. A number of them are now rolling over in credible imitations of the US housing market of 2006. What ties them all together is credit. Live by the (credit) sword, die by the sword. It hasn't hit the inflation boom economies yet but it very likely will.

UK Builders
UK Lenders
Australia
New Zealand
Ireland
Spain

There's evidence of housing rolling over in such diverse locations as Sri Lanka, the Baltic States and Thailand. Once again, the only common thread is a deflating global credit bubble.