The Price of Ponzi

Faking Bank
First let's be clear that prices for the majority of asset classes around the world are unsustainably high. This is an obvious corollary to the very inflated state of the global financial system and economy due to the excessive leverage that we have commented upon many times. It bears repeating that central banks (CBs) have little actual power, they merely serve as rallying points and fetish-totems for optimistic, true-believing speculators. The evidence is quite clear that CBs often fail to accomplish their goals, in recent cases despite extraordinary actions to "inspire confidence" - i.e. reignite speculation.

If the CBs were as powerful as most think, they could not possibly fail to accomplish their goals. Like voodoo, it is the BELIEF of the victim that causes the damage - a negative application of the well-documented placebo effect. While they have succeeded in restarting speculation to some extent in equities and commodities, they have utterly failed to do so in most of the securitization and especially the re-securitization markets. Other than the Fed itself, there is very little demand for MBS and ABS. CDOs have fallen flat on their face and can't get up. The investment bankers' efforts to re-securitize garbage and get it rated as AAA again have largely met with derision. Assets in the real economy are seeing no increase in demand at all to this point. Housing, commercial RE, private businesses, capital equipment and others are all in the doldrums with hardly any positives even in the second derivative.


Flee(t)ing Confidence
Take note of which asset classes are seeing speculation and which are not. It is only those that can be sold instantly with a mouse click that are getting any action - equities and commodities which trade as futures on an exchange. The exceptions are revealing. Iron ore, which requires long-term contracts instead of futures isn't going up and in fact is going down, with users essentially buying at spot by refusing to commit to L-T deals. Assets that are theoretically liquid but actually trade by appointment only are seeing little help. This would include the aforementioned MBS and ABS. Those that require a real commitment and have payback periods measured in years continue to crater. Basically, the only confidence at this time is the confidence of the daytrader.

Yet we now see speculation among economists that there could be a return to growth in the next four quarters and actually, it's hard to disagree that such a thing is technically possible. The key here is the massive amount of deficit spending by governments around the world. Official US Treasury estimates place the FY 2009 deficit at $1.8 trillion but $2 trillion is more likely. The DEFICIT will likely represent 14% of GDP this year. China is in a similar situation, with a "stimulus" package of nearly $600 billion in a $4.4 trillion dollar economy - which works out to just under 14% of GDP. Hmm, that number sounds familiar.

Large segments of both economies are ponzi schemes, though China's most vulnerable sectors are both larger and more leveraged relatively speaking. In the US, the most affected sector is finance; in China, construction and fixed investment. Consider for a moment that both governments are spending enormous sums of money they don't have - effectively borrowing it from the future to spend now. Once again hoping to ignite a chain reaction of speculation and a new bubble.

We actually expect a slight positive print in US GDP in early 2010, with a larger collapse to follow as soon as the government can no longer borrow cheaply. This is the inevitable result of spending twice your income (tax revenue) just to keep the current illusion alive. When the bond market cuts off this foolishness, the portion of the economy that is unsustainable without a bubble dies and all of the capital spent to keep it alive dies with it - a complete waste. Instead of a mere depression, we have a depression compounded with the destruction of capital that should have been preserved to start rebuilding afterwards.


Pricing Ponzi
If you think about it, both the US and China are expending one-seventh of their respective GDPs to support a lie. Another way to think of it is the rate of return the market (in the form of speculators) demands to continue to invest in the ponzi schemes. In effect, the government's best guess at the required RoR is 14%. Antal Fekete has written about the falling marginal productivity of debt. In other words, the debt-based ponzi scheme is becoming less and less effective. As a result the sponsor of the scheme (governments) are having to increase the amount pumped into the bubble to keep the speculators in and prevent a UNIVERSAL recognition of the failure that has already occurred. This is typical of late-stage ponzi schemes where a critical mass of investors become suspicious and demand their money. The sponsor has to come up with it somewhere and in this case they can conveniently pledge their citizens' future income (taxes) as collateral for more loans.

It is impossible to calculate the precise cost but we can look at deficit and "stimulus" spending as a good first approximation of the price to keep the ponzi scheme rolling. If 14% of GDP can be spent and not even produce a single quarter of positive numbers then the decay is even larger and more advanced than we have previously postulated. As an example, the latest Personal Income Report from the BEA showed the scale of government attempts to manipulate the economy. Wages dropped sharply but personal income rose 1.4%. The money quotes:

Private wage and salary disbursements decreased $12.4 billion in May, compared with a decrease of $0.7 billion in April.

Personal current transfer receipts increased $162.6 billion in May, compared with an increase of $59.1 billion in April. The American Recovery and Reinvestment Act of 2009 provides for one-time payments of $250 to eligible individuals receiving social security, supplemental security income, veterans benefits, and railroad retirement benefits. These benefits boosted the level of personal current transfer receipts by $157.6 billions at an annual rate in May.

Once the long-end of the Treasury yield curve resumes its upward march, the financing will get more difficult. If short-term money ever becomes expensive for the US government then the deception is over. But for right now we may get further upticks in optimism as long as the government can continue to create doubt and obscure the real state of the economy. In the near term, it's all in the hands of the speculators and their mood swings and isn't that a sad commentary on the state of the world.

Trade Grinds to a Halt

Over the last 6-9 months, we have seen many indicators of weakening demand and the impact on trade. For example, the collapse of the Baltic Dry Index - down more than 90%. This reflected lease rates for freighters and indirectly demand for bulk cargo capacity. The initial drops in shipping volume were modest but had a severe impact on commodity prices and shipping rates as the global economy swung from a sellers market to a buyers market. Now we are starting to see the full impact of credit withdrawal. Our thesis has long been that excessive and EZ credit (TM) were the root cause of massive false demand that radically distorted the consumer economies, those who manufactured and exported to them and the raw material suppliers to the manufacturers. The chain of causation has proven out and now we will see just how large that distortion was.

Domestic Strife
Our back of the envelope calculation is that first-order effects in the US will be 10% of GDP, with further ripple effects from there. Our assumptions are fairly simple. Net additions to household debt ranged between $800 billion to $1.2 trillion from 2002 to 2007. That number fell to $77 billion in Q2 and negative $117 billion in Q3. All data come from the Fed Z.1 Flow of Funds release. We merely assume that net consumer credit will go to zero, whereas it could go severely negative as defaults and debt repayment have already caused outstanding credit to fall. We further assume that household savings will rebound from approximately zero to halfway back to the historic 10% range. The cumulative impact would be to reduce personal consumption by $1.3-1.6 trillion or between 9% and 12% of GDP.

Granted not all of this will hit US production. Much of the damage will occur in the export economies as we stop buying from them. We have repeatedly argued as much. Outsourcing which destroyed jobs in the US and made the target nations prosperous is now going in reverse and this should provide a partial circuit-breaker to the US economy which MAY prevent a consumption-employment-income-consumption death spiral like the 1930s. On the other hand, business spending is also falling and that swing is far more difficult to estimate. For modeling purposes, the hit to US output from lower capital spending should be roughly equal in size to the reduced demand for imports so US GDP probably declines 9-12% - straddling the 10% line of the textbook definition of depression.

Unless people dig themselves even deeper into a debt hole, households will not take on further debt - either out of prudence or inability. It would have been extraordinarily difficult to stop this a year and virtually impossible now. Once the (misplaced) confidence evaporated, the conclusion became inevitable.


Globo Stop
I'd like to thank Karl Denninger of Ticker Forum for his inimitable description of the current crisis. The PG version of which runs:

We're screwed, but they're screwed worse.

We are indeed seeing just how bad the rest of the world has it right now. The NY Times did an excellent piece over the weekend that described the rapid decline of world trade. Here's the money quote:

Over all, the total reported exports from those 43 countries peaked in July, at $1.03 trillion. By November, the figure was down 26 percent, to $766 billion. Since the figures are seasonally adjusted, the monthly figures should be comparable.

This is not just a problem for Asia but a global one. German exports fell 21%. Over a quarter of all world trade went away in only FOUR MONTHS. I think this is a pretty good example of just how much credit distorted the US and world economy. At some point, credit goes from a useful organ to a cancer. We have often spoken of the Universal Debt bubble and the breathtaking size and scope of it. It was "fun" while it lasted but the bill for the UDB is about to come due. The check is on its way to the table and we're going to spend a lot of time arguing over who gets to pay for it. George Washington spoke of government but it applies to credit as well and the distinction between the government and the banks grows ever smaller:

... a troublesome servant and a fearful master. Never for a moment should it be left to irresponsible action.