Dow Theory: Non-confirmation Warning with Aussie and Transports?

“The game does not change and neither does human nature.”          

-Jesse Livermore

From the classic, Dow Theory, by Robert Rhea, 1932: :  

The movement of both the railroad and industrial stock averages should always be considered together. The movement of one price average must be confirmed by the other before reliable inferences may be drawn. Conclusions based upon the movement of one average, unconfirmed by the other, are almost certain to prove misleading.  

The most useful part of the Dow theory, and the part that must never be forgotten for even a day, is the fact that no price movement is worthy of consideration unless the movement is confirmed by both averages.  

Adding one more risk asset to the picture—Aussie-USD (brown line in chart below); it isn’t confirming either ...

... and the game plays on ...

130 billion bad reasons to think the euro's foundation has changed.

“So what?” he asked. “Things will only get worse. We have reached a point where we’re trying to figure out how to survive just the next day, let alone the next 10 days, the next month, the next year.”  

-Anastasis Chrisopoulos, Athens taxi driver (from Reuters)

 

130-billion-euro here, 130-billion-euro there, and pretty soon you have to start finding some growth!

One adage that seems to work as much as anything else, and why it is an adage I guess, is “buy the rumor and sell the news.”  I won’t bore you with the behavioral aspects of why this works, I think you know.  We are seeing it a bit this morning on display on news a Greek default has been averted: the euro is lower, and ditto for most Eurozone bonds since the announcement of a deal that gives Greece another 130-billion-euro it can pour down the rabbit hole with the rest of the money funneled in by Eurozone taxpayers.   

Of course, sooner or later financial engineering reaches the limits of its public relations effect and there must be some underlying payoff from said engineering besides getting funds to follow banks chasing into periphery debt for a trade.  It’s not that rising periphery bond prices, i.e. lower yields, isn’t helpful; it is.  But even at current rate levels, it will be mighty hard for many countries to maintain austerity pledges; all attempts to do so will likely accentuate the trend we see in the chart below:      

And of course, this chart is the mirror image of the domestic adjustments periphery countries have to make because they do not have a free-floating currency available to help them make these adjustments:      

Thus, periphery economies desperately need some growth.  Rising unemployment and tighter budgets will not produce revenues needed to pay debt; instead it produces a self-feeing vicious spiral downward.  This view seems completely at odds with the Troika program even though the Greek economy provides them with live test case of abject failure stemming directly from the implementation of their own flawed theories.     

And here is why it will likely get worse for Greece and other periphery countries whose growth is heading lower—the real economy will be starved.   

We have already witnessed this economic/money/manipulation phenomenon in the US, from the WSJ this morning:  

“The eight giant European banks that have disclosed their annual results in recent weeks reported holding a total of about $816 billion in cash and deposits at central banks as of Dec. 31.  That is up 50% from a year earlier, when the same banks were holding roughly $543 billion.”  

Does any of this sound familiar?  You can lead a horse to water, in fact you can force-feed said horse with massive amounts of reserves, but you can’t make him lend any of it to the real economy where real people build real businesses and hire other real people who need real jobs.   

Just in case you forgot just how tightly US banks have held on to their Fed sponsored reserves via the massively steep yield curve that impoverishes savers to subsidize bank healing, here is a look.  This chart shows reserves in the US banking system ... hmmm ... three years and counting so far since Bernanke and Company decided this is the only viable strategy for the economy.  Viable for financial assets, but the other side of the economy is still starved ...    

 

The point is, despite the new Greek rescue (I am losing count how many we have had so far), it appears the Eurozone, now clearly a two-track world with Germany bathing in credit and low rates and low unemployment (which adds to more angst and animosity toward Germans amongst the PIIGS), appears collectively heading into deeper recession.  

One wonders if now, finally, EU leaders have run out of rabbits of financial engineering to pull from their hats.  Financial engineering is a lot easier than real growth.  If you don’t believe me, go ask Goldman; after all it is their fun and games that caused much of this Greek problem in the first place.  

     

Hmmm ...

7 reasons why the Chinese yuan can't save us now.

“Be extremely subtle, even to the point of formlessness. Be extremely mysterious, even to the point of soundlessness. Thereby you can be the director of the opponent's fate.”

-Sun Tzu

A theme being discussed more and more is the idea China is going to save us from the monetary mess in which we are now firmly ensconced.  But based on my understanding, it will likely be several decades, if ever, before the Chinese currency seriously challenges the US dollar for global reserve currency status.  

USD- Chinese yuan (CNY) Monthly:    

However, it is not to say there won’t be a different global monetary solution in the years ahead.  It will depend on whether or not there is a repudiation of US debt.  If so, I think some new order will take place, along the lines of what Keynes’ talked about -- the Bancor.  He knew early on the dangers attached to a dominant world reserve currency.  [Mr. Triffin, aka of Triffin’s dilemma fame, warned the US would be facing structural current account deficits as far as the eye could see in its role of world currency reserve supplier.]  Thus, these two were very aware of the danger of global imbalances before it became popular in this cycle. The Great Depression was a valuable teacher for them.  

Of course history tells us global monetary systems are more haphazardly morphing events than they are planned occurrences.  All we have to do is watch the G-20 to see how difficult serious, multi-global planning can be; heck, those guys can hardly decide on what wine to serve and the order of photo ops.   

The handoff from pound Sterling to the US dollar was an unplanned evolving event that accelerated after WWI.  There was no great planning when President Richard Nixon took us off the gold standard and ushered in the error of floating rate currencies.  The gold was draining out of Fort Knox, something had to be done.  Game over.  Dirty float for a couple of years, then no pretense whatsoever of anything backing the currencies of the world’s major powers.  Just faith!  No pretense was justifiable; from that point onward money was a store of value.  Purely a unit of exchange it became.  Case closed.  

So, it leaves us where we are, as I shared with you yesterday, thanks to the excellent insight from Professor Barry Eichengreen.  Now I think it is time to explode the myth China’s currency will replace the dollar.  Many newsletter writers think that will happen tomorrow.  Proving once again newsletter writers never have to answer for their inflated farcicality. But even some serious people believe within the next decade China’s currency will rule.  I think even some serious people are wrong.  

Rather than turn this into a LONG essay, I will try to breakdown the reasons why I think the Chinese yuan is a very long way from world reserve currency status:

1. It is never as simple as “the world reserve currency goes to the country with the largest global GDP.”  The US surpassed the UK in terms of total GDP back in the 1870s.  Yet pound Sterling remained the reserve currency for another 40 years or so. 

2. Remember, the world reserve currency country is saddled with a consistent current account deficit. Thus, China must push out trillions of renminbi and renminbi-based asssets into the world economy.  Fine if your model is open and based on consumption.  Not so good if it is driven primarily by exports, as China’s is.  So we will need to see a big shift in China’s growth model.  That will be a wrenching long-term process.

3. The reserve currency country must open its market to allow foreign investors to hold local assets.  This means China will have to make a complete change to its current political structure to allow much more freedoms for citizens (not only allow money to flow in, but allow its citizens money to flow out freely).  The system in place is not something that is likely to change anytime soon despite the window dressing.  The communist party still maintains absolute power, despite the comments from visitors that all they saw was free market capitalism during their trip to the Orwellian Hall of Mirrors.  It shows just how well the central committee is doing its job.  If you want a better insight into this issue, I strongly suggest you read, The Party: The Secret World of China’s Communist Rulers, by Richard McGregor.  I think this does a great job of showing us how the West in general is duped by the Chinese leadership.

4. The US is becoming wealthier relative to China.  Say what?  All true.  The fact is since 1991, “the average Chinese citizen is more than $17,000 poorer relative to the average American than he was in 1991.” Per capita income for relatively large states is the best single determinant of competitiveness long term. So, until this trend changes, it is highly unlikely the US will give up the mantle of currency reserve status.  [See “China’s Century?” by Michael Beckley, International Security, Vol. 36, No. 3 (Winter 2011/12), pp. 41-78.   

5. Even optimistic assumptions from those who should know, assuming China’s growth remains on track, suggest by 2035 up to 12% of global reserves may be held in yuan. [See Jong-Wah Lee, Asian Development Bank, “Will the Renminbi Emerge as an International Reserve Currency?”]

6. Officially, all is good.  But unofficially, China may be facing its own debt bomb that could dampen growth for years, not just one or two quarters.  It happened to Japan.  Never say never! “The government’s official debt is only 15 percent of GDP, but it adds up quickly. Ratings agency Fitch estimates a bailout could cost 20 percent of GDP. Add the unpaid cost of the last bailout, debts at state-owned entities, local governments and pension liabilities, and a Breakingviews calculation suggests Beijing’s debt rises to roughly 130 percent of GDP,” according to Reuters Breakingview. 

7. The current attempts at internationalization of the yuan seem backwards.  Normally a country opens its capital account and upgrades its domestic financial system before attempting to internationalize its currency.  Instead China is offering bi-lateral exchange deals with some trade partners, and that gets a lot of press.  But that seems to be mere window dressing as countries are really taking up the credit China is offering.  And the developing offshore yuan deposits in Hong Kong may actually backfire, as the unofficial yuan rate in Hong Kong (CNH) is fluctuatiing around the official rate in China (CNY).  This may force China’s central bank to actually hold more dollars. 

So as much as it might be a good thing for the global economy to have a new reserve currency on the scene, it doesn’t seem as if it will happen soon enough to help in this cycle. 

Current Currency Conundrum: Dollar and Euro dependence is a huge risk.

“History repeats itself, first as tragedy, second as farce.”

-Karl Marx

Current Currency Conundrum: Dollar and Euro dependence is a huge risk. But there is no other choice it seems!

In the last installment of as the world turns towards chaos, aka Currency Currents, I discussed the massive debt problems we face and described why this may lead to below-capacity growth in the global economy for years to come.  And the problem with below-capacity growth: it doesn’t allow countries to garner a margin of safety reserves to help weather an external shock.  Thus, globally, one can argue, with the additional leverage in the system since the credit crunch, the systemic risks have increased.  It is hard to believe.  

Dear Mr. Government and Central Banking “leaders,” what have you done for me lately?  

We are already staring down the barrel of the first shock on the way for the global economy; it is the Eurozone sovereign debt-cum-banking crisis. To diverge for a second, I saw a good comment on the entire single currency common market structure rationale recently: It was Europe’s attempt to be a meaningful player in world affairs after realizing just how powerless the countries of Europe were (highlighted by the events of the Suez canal.)  Just think: how much deeper would the European countries be in the hole if they actually had provided for their own defense?  It would have added to the dismal failure that already haunts them and all countries now, by extension. (I am sure I will receive emails blaming it all on the US in some form or fashion.  But I digress ...) 

Without going into the gory details, I think it suffices to say the euro as a reserve currency will lose favor and the world, unfortunately, will become even more dependent on a single currency for the heavy-lifting of global trade and finance. 

It is quite a scary thing to contemplate, given that US fiscal and monetary authorities seem to work overtime trying to drive confidence away from the US dollar on some pretense this manipulation is a proper substitute for serious policy.   

Here is a summary of the clear and present dangers of depending on the dollar (or any other single currency, for that matter) as a world reserve currency at this point in time.  The 1930’s parallels are palpable given the crisis in Europe.  This comes from Professor Barry Eichengreen, writing in the Jan/Feb 2012 issue of Foreign Affairs magazine, “When Currencies Collapse” [my emphasis]:  

The international monetary system rests on just two currencies: the dollar and the euro. Together, they account for nearly 90 percent of the foreign exchange reserves held by central banks and governments. They make up nearly 80 percent of the value of Special Drawing Rights, the reserve asset used in transactions between the International Monetary Fund (IMF) and its members. Of all debt securities denominated in a foreign currency, more than three-quarters are in dollars and euros. The two currencies together account for nearly two-thirds of all trading in foreign exchange markets worldwide. They are the essential lubricants of global trade and finance. Were they not widely accepted, the global economy could not sustain current levels of international trade and investment. 

… The international monetary system of the late 1920s and early 1930s resembled the current system in important ways. It, too, was organized around two currencies: the British pound and the U.S. dollar. With the United Kingdom and the United States making sterling and dollars available -- and other countries accumulating them -- global foreign exchange reserves more than doubled between 1924 and 1930. Trade credit was readily available, allowing deficit countries to finance additional imports. As a result, during the 1920s, global trade rose twice as fast as global output of goods and services. International capital flows similarly expanded more rapidly than global output, peaking in early 1928. 

The boom in trade and in the movement of capital created global imbalances similar to those of recent years. Some surplus countries, notably France, accumulated vast quantities of reserves. Others, such as the United States, recycled their surpluses by lending to the deficit countries of central Europe, mainly Germany. But the deficit countries spent the capital they imported on consumption rather than investment. The world saw the rapid expansion of credit and an alarming run-up in asset prices. As the decade drew to a close, doubts grew about the resilience of this precariously balanced system.

 

… Initially, the international monetary system withstood these pressures. In 1931, however, what had been mainly a crisis of output and employment suddenly acquired an alarming financial overlay. In May, there was a run on Austria's leading bank, the Creditanstalt. If a bank could go down in Vienna, investors concluded, the same could happen in Berlin, given the superficial similarity of the Austrian and German financial systems. As capital fled and foreign credit become unavailable, the German government was forced to respond with exchange controls and an agreement, negotiated with foreign bankers, effectively freezing Germany's international loans. British banks had extended some of those loans. Uncertain about the condition of the British banking system, investors began shifting money out of London, steadily draining reserves from the Bank of England. After a pair of belated interest-rate hikes failed to lure back this fleeing capital, the imminent exhaustion of its gold reserves forced the Bank of England to abandon the gold standard in mid-September. 

This sounds oddly familiar doesn’t it?  The next excerpt seems to be describing a current theme: investors and central banks searching for a safe haven.  They are pouring into currencies such as Canadian, Australian, and New Zealand dollars and in Europe the Norwegian krone et al.  But these markets are small and can’t hold that much capital. And bidding up these currencies relative to euro and US dollar creates seeds of its own destruction with a negative feedback loop of slowing global growth even more. 

Back to Prof. E: 

As international liquidity grew scarce, central banks and private investors searched desperately for other assets, that is, alternatives to the dollar and sterling that were liquid and promised to hold their value. They found them in the currencies of countries still on the gold standard: Belgium, France, the Netherlands, and Switzerland. The share of foreign exchange reserves held in those countries' currencies rose from ten percent of the total in 1931 to 20 percent in 1932 and 30 percent in 1933. 

The problem was that these were not large markets. As their larger trading partners adopted a beggar-thy-neighbor strategy of devaluing their own currencies, these smaller countries experienced more and more trouble competing. Countries still on the gold standard saw their exports stagnate and experienced rapidly rising unemployment. By 1933, these states, once seen as bastions of stability, looked increasingly vulnerable. Capital started flowing out, not in, as central banks moved to liquidate their balances in these countries to avoid further losses. 

Will this be the next shoe to drop?  

...The resulting vacuum was disastrous. The chaotic liquidation of foreign exchange reserves made credit scarce and put upward pressure on interest rates at the worst possible time, making it hard for firms to finance not only international transactions but domestic investment, as well. Disorderly exchange-rate movements disrupted trade flows, making it harder for countries to export their way out of the Depression. 

Guess what?  We are very close to a “1930s redux” according to our purveying Professor of historical doom and gloom:  

If doubts about the stability of these currencies deepen further and central banks curtail their holdings of them, those central banks will have less capacity to intervene in financial markets and buffer the effects of volatile capital flows on their economies. In response, governments are likely to limit those flows via capital controls, as they did following the liquidation of foreign exchange reserves in the 1930s. Trade credit would become more costly, since commercial banks would demand additional compensation for holding dollar and euro investments. This situation would resemble the wake of the failure of Lehman Brothers in late 2008 and early 2009, when dollar credits became scarce and international trade declined precipitously. But what was then a temporary problem would instead be a permanent condition. 

Yikes!  If we overlay the negative global social mood, which leads to exclusion at the sake of inclusion, on top of massive unemployment in many industrialized and emerging countries, how much longer will it be until we see serious trade and capital controls pass through our illustrious legislative bodies?  

And given the US War Machine (aka military industrial complex, aka American hubris gone wild) is itching for another campaign, with Iran as the new target, it is looking more and more like its “stock up on cans and head to the bunker” time.  Let’s hope I have this very wrong – I do have lots of experience in that field. 

Tragic ending: financial welfarism sparks global debt crisis.

“One of these clouds was an American wave of optimism, born of continued progress over the decade, which the Federal Reserve Board transformed into the stock-exchange Mississippi Bubble. Another of the little clouds arose from the fact that the segment of our economy based on catching up with the war lag was coming to its terminal, particularly in the construction industries. Still another, a by-product of our enormous increase in individual productivity, was a need for readjustment of commodity prices between groups.

“Our reconstruction from the war had proceeded with such steady success, and the other impulses to progress were so very great that, with the growing optimism, they gave birth to a foolish idea called the "New Economic Era." That notion spread over the whole country. We were assured that we were in a new period where the old laws of economics no longer applied."

-Herbert Hoover

The last gasp of the welfare state likely ends in a global debt crisis (oops, one is already underway.)

Let’s assume for a moment the world’s central bankers and governments were right to throw so much money into the market in order to stave off a global depression.  I of course would say much of the stimulus was simply to save the old order, i.e. the welfare state in Europe, which Mr. Obama seems desperate to emulate on this side of the pond.  But that’s me.  But even someone who supports this “stimulus” must be worried when they look at the numbers. If they aren’t afraid, they should be ... they should be (to paraphrase Yoda, the mini-Jedi Warrior of Star Wars fame).    

Based on the chart below, on a global basis, $0.89 cents for every $1.00 of “stimulus” is disappearing down the rabbit hole instead of going into the economy:  

       

This chart says that since 2008:  

1. Global GDP has grown 4.7% or $2.90 trillion dollars.

2. Global Debt has grown 14% or $25.70 trillion dollars.

Once again, the phrase “The only thing new in the world is the history we don’t know” resonates.  This from Herbert Hoover’s summary of the Great Depression [my emphasis]:  

⁸ An interesting summary of the contribution of Federal Reserve policies to the boom appeared five years later in the magazine Sphere of July, 1935, summarizing public statements by Adolph Miller, a member of the Reserve Board at that time:  

"Mr. Miller, of the Federal Reserve Board, states that the easy credit policy of 1927, which was father and mother to the subsequent 1929 collapse, was originated by Governor Strong, of the New York Federal Reserve Bank, and that it did not represent a policy either developed or imposed by the Board on the Reserve Banks against their will.  

"The policy was the result of a visit to this country of the Governors of foreign central banks, who unequivocally stated in New York that unless the United States did adopt it there would be an economic collapse in Europe. It was a European policy, adopted by the United States.  

". . . Mr. Miller states that after waiting for the individual Reserve Banks to initiate a policy of safety, the Board, in February, 1929, took matters into its own hands, adopted a policy of 'direct pressure' and issued a 'warning' to the public. It did so, says Mr. Miller, because its anxiety over the situation had become very great. That was one month before Mr. Hoover was inaugurated as President.  

"The fact seems to be that the Board, in January, 1928, intended to curb the speculation, but was overridden by President Coolidge, who issued his famous statement from the White House that the speculation was not dangerous and merely reflected the growing wealth and power of the United States.  

"The Board only began issuing warnings when Mr. Hoover was about to take office; and it was safe to do so then because the Board knew that Mr. Hoover, from 1926 on, had been protesting that the money policy of the Reserve System was certain to bring about disaster and calamity. Mr. Hoover, before and after he took office, was struggling desperately to curb credit extravagance. He wanted to deflate the utter extravagance then rampant, and his every influence in the Presidency was in that direction. The record will show that he became the victim of a policy that was anathema to.”  

A few more numbers to view in sheer horror:  

Industrialized Countries Debt/GDP % adding private indebtedness to the equation:  

US                                     350%

Japan                                 490%

Euro currency countries         443%

United Kingdom                     459%

And of course, in case you missed yesterday’s front page of the Financial Times, it said China is being forced to extend out the time for repayment on debts to local governments, in the $1.7 trillion range, because they can’t be repaid now.  Many mistakenly believe, I think, that China’s Debt/GDP is perfectly manageable, and believe the official numbers suggesting it is in the 30% range.  But more savvy estimates out of the guise of Commie Information Officers peg the debt closer to 90%.  No problem you say when compared with the industrialized countries.  Maybe you should rethink that.  

Why?  Because emerging economies have a much lower threshold for debt, according to Rogoff and Reinheart, economists extraordinaire and authors of This Time is Different: Eight Centuries of Financial Folly:      

Not too many seem worried.  Faith in central banks and governments springs eternal despite the lessons of history:  

Dow Jones Industrial Average versus the Fear Index (VIX):  

 

To be continued.  

George Soros doesn’t like the direction in which Europe is heading.

In my Commodities Essential newsletter a few weeks ago I spoke about George Soros. He’s in the thick of it again, and I’m talking about him again. But first, here are a few of my comments from January 27:  

Soros has an ability to put a finger on global capital flow and its catalysts like few others. The Alchemy of Finance is one of Soros’ books that predated the 2008 credit crunch and its fallout, but explains some of the key reasons why capital moved the way it did during that time.  

So when Soros plays dumb in a major media interview, people take notice.

He basically said that he has no real clue where to invest; he is scared of what might transpire in the coming years; he expects riots and violence in the streets (of the US).  

One wonders what provokes such concern from Soros who is a guy that knows everything about economics or at least knows someone who does. Not to mention, Soros has quite the global presence and connections to key policymakers.  

Here are a couple theories one could deduce, considering the above:  

1)      George recognizes the path to rescuing Europe is coming to a dead end and the eurozone’s collapse will be too much for the global financial system to overcome, leading to serious deflation and depression.

2)      George recognizes the path to reelecting Barack Obama is coming to a dead end and warding off a major, imminent great depression through addition fiscal and monetary stimulus will be Obama’s only chance at defeating the somewhat more fiscally austere GOP.

3)      Further on those two points, George recognizes the path to bringing the US into a new world order requires an admission that a collapsing eurozone will bring down the global economy and will require the US to devote resources to help build a global system of governance in order to manage an increasingly global economy.

4)      George is talking his book, setting the bar extremely low and buying in, hoping that when global economic Armageddon is avoided investors will become optimistic on better-than-expected data and bid up asset markets.  

Today read an interview revealing George is at odds with the austerity pressure on Greece, which is very much spear-headed by Germany and Chancellor Merkel. I recommend you read the entire interview at Der Spiegel – it is a good one.  

Der Spiegel seemed to do a good job at pressing Soros to explain the intent and seeming contradictions in his comments. Now let me try to do the same thing:  

SPIEGEL: Are the new austerity guidelines for countries like Spain, Italy or Greece too tough?  

Soros: They create a vicious circle. The deficit countries have to improve their competitive position vis-a-vis Germany, so they will have to cut their budget deficits and reduce wages. In a weak economy, profit margins will also be under pressure. This will reduce tax revenues and require further austerity measures, creating a vicious circle. Markets do not correct their own excesses. Either there is too much demand or too little. This is what the economist John Maynard Keynes explained to the world, except that he is not listened to by some people in Germany. But Keynes explained it very well -- when there is a deficiency of demand, you have to use public policy to stimulate the economy.  

I take issue with this – there is no better-known force than markets at correcting excesses; and perhaps no better force than bureaucracies at creating excesses. Plus, the use of public policy very much depends on one’s definition of ‘demand deficiency.’ The deficiency Soros speaks of is simply a necessary market correction of excess and artificial demand, but it goes against his political philosophy to make such an admission. (Only a very limited amount of public policy usage can bring about growth/prosperity.)  

SPIEGEL: But it was the abundance of "cheap money" that was at the core of the last financial crisis. Would we not repeat the same mistake if we pledged billions of fresh money to countries in crisis?  

Soros: I know it sounds as though we are repeating exactly the same mistake. But let's compare the situation on the global financial markets to a car that is skidding. When a car is skidding, you must first turn the wheel in the same direction as the skid. And only when you have regained control can you then correct the direction. We went through a 25-year boom in the global economy. Then came the crash in 2008. The financial markets actually collapsed, and they had to be put on artificial life support through massive state intervention. The euro crisis is a direct continuation or consequence of the 2008 crash. This crisis isn't over yet and we will have to spend more state money in order to stop the skidding. It is only afterward that we can change the direction. Otherwise we will repeat the mistakes that plunged America into the Great Depression in 1929. Angela Merkel simply doesn't understand that.  

What George doesn’t understand, or refuses to admit, is the failed policies that exacerbated the depression and made it so Great. It is suggested that a true, unimpeded cleansing would have been short-lived. But it would have greatly undermined the workings of a shadow banking system which was, to a degree, still in its infancy; but the interests were just as powerful.  

SPIEGEL: But you push for lower interest rates or access to "cheap money," for instance. Both steps would help you as an investor.  

Soros: That is true. But it would also help all other investors and it would help to preserve the global financial system. In that sense, I am concerned with my own interests. But I am also retired and no longer actually managing the fund. Nevertheless, I think that I perhaps understand the financial system better than some of the people who are in charge. So, as a citizen, I feel justified in trying to give advice. I am not arguing for the policies I support to make a profit. I make it a principle in my advocacy to put the public good before my private interests.  

Again, I would imagine George is choosing to leave out just how intimately he knows the financial system. In fact, it is the current distortion of the global financial system that likely drives George’s advice. To wit:  

SPIEGEL: You have repeatedly pushed for the introduction of euro bonds. German Finance Minister Wolfgang Schäuble responded by saying: Euro bonds give the wrong incentives because you "spend money you do not have to pay the bills of others."  

Soros: People like Schäuble don't seem to understand that the heavily indebted countries are now at a severe disadvantage, because they have basically become heavily indebted in a foreign currency, the euro. They do not control it, and so they are in the same position as third world countries in Latin America were in at the beginning of the 1980s, where the countries became indebted in dollars. It was a situation that led to a lost decade there. Europe now faces a lost decade. That is the reason we need euro bonds and a new EU fiscal compact.  

Of course, find ways to create new demand for credit, as that is what greases the financial and public sector growth initiatives. Interesting that George brings up the Latin American crisis of the 1980s ... because that’s when a majority of major US banks were on the ropes, insolvent based upon bad debts and overleveraging. The cure for banks then was to increase the profits made on borrowing cheaply and lending at higher rates, all facilitated by the Federal Reserve. European banks face similar insolvency, bad debts and junky collateral. The problem is that demand for credit does not exist and thus the ECB is trying to nurse banks back to life from said carry transactions i.e. inverted yield curve that ultimately subsidizes the financial system to the expense of consumers. A collapse in Europe’s banking system will be a systemic global event. It may damage much of what  George has worked to accomplish as the serfs lose more confidence in government to solve problems and will likely turn to the private sector.   

SPIEGEL: Do you also support the idea, as demanded by the Occupy movement, that rich people like you should pay higher taxes?

Soros: I do. And I do not support the Republicans who want to save me from paying taxes.

SPIEGEL: What is your tax rate?

Soros: My effective tax rate is relatively low, but only because every year I contribute at least the maximum 50 percent of my income to my foundation.

SPIEGEL: If you support the idea of higher taxes, then why don't you just pay more taxes instead of giving the money to your foundation?

Soros: Because I think that my foundation uses the money better than the government does. In any event, I do pay taxes.

SPIEGEL: You are basically saying that you are smarter than the government.

Soros: Well, I have greater freedom of action than a bureaucracy. I also care more about the causes to which I contribute.

SPIEGEL: So how can you then turn around and tell other rich people that they should pay more taxes?

Soros: If every rich person gave 50 percent of their wealth to charity, I would not say they should pay more taxes.  

The truth shall set you free. Imagine that – letting private citizens allocate their own wealth based upon the causes they support.  

George, I have my own question for you: If you and your foundation can make better decisions than government, why support administrations who want to take more from private citizens?   

Maybe Warren can give us clues into George’s tax dilemma; from reason.com:  

Warren Buffett is very much a political entrepreneur; his best investments are often in political relationships. In recent years, Buffett has used taxpayer money as a vehicle to even greater profit and wealth. Indeed, the success of some of his biggest bets and the profitability of some of his largest investments rely on government largesse and “coddling” with taxpayer money.  

Warren and George – separated at birth?  

So, should we be concerned with the direction Merkel is “steering” Europe? If it sets the stage for another 1930s redo, then yes; we should all be concerned as the probability this path cannot be avoided, regardless of all the good intentions, seems to be creeping higher every day.  

There is some good that comes with the necessary pain of deleveraging and deflation, eventual benefits from a market cleansing process elites and bureaucrats ignore in order to scare the populous and perpetuate a system that slowly corrodes the health of an economy while it enriches the power interests.  

The problem is indeed the common currency, as George alluded in the interview. But the solution is not to micro-manage a recovery in a flawed currency system, but rather to reform or remove the flaws. But that, of course, changes the structure dramatically in a way the micro-managers don’t want changed.  

Eurozone and Greece: another round of Greek-Card Monti ...

“It is always so pleasant to be generous, though very vexatious to pay debts.”

-Ralph Waldo Emerson

Each morning we wake to another round of Greek-Card Monti, a con game played on the streets of New York which almost always ends badly for those risking their money.  Thing is, everyone that knows anything about the con understands the outcome before the game begins.  Is the Greek situation any different? 

Well, the difference between the real game and the Greek inspired Troika version is the fact the players are using taxpayers’ money; otherwise the outcome is the same.  We all know it will end badly.  The only questions: How much longer can this con by the Troika go on, and will it lead to contagion?

This is what a death spiral looks like.

It is what can happen if you join a fixed exchange system, then take out very large debts in what amounts to a foreign currency, and then have simultaneous monetary and fiscal contraction imposed upon you.

Germany discovered this on the Gold Standard when it racked up external debt from 1925 to 1929 (owed to American bankers) in much the same way as Greece has done.

When the music stopped – i.e. when the Fed raised rates from 1928 onwards – Germany blew apart in much the same way as Greece is blowing apart. This is not a cultural or anthropological issue. It is the mechanical consequence of capital flows into a country that cannot handle it, as Germany could not handle it in the late 1920s.

By the way, Greeks work an average 42 hours a week, one of the highest in Europe. Just want to put the record straight on that.

Interestingly, there are not many players picking at those Greek certificates of death after the first round of long-term re-financing from the ECB. But there are those who decided Portugal is a good bet, despite the fact they are travelling down the same road as Greece and are the likely contagion candidate should the Troika not get what it needs—more time in order to prepare for an “orderly” default of Greece which has likely been the game plan for many moons now (a full one today in fact; how fitting if Greece were to howl, “We are better off outside the Euro ... at least we go down with some dignity intact instead of under the whip of Brussels wine and croissants crowd.”) 

Greek versus Portuguese 10-year “Sovereign” Bond Yield:

For now the bet is the charade continues ... long euro, long periphery debt, and small short in bunds.  But in the end, all cons end badly for someone.  This public relations process is once again a way for the big boys to reduce exposure and come out of this more whole before the Troika began shuffling the cards. 

 

Loop of confusion; and 4 euro-related reasons to be bullish now ...

“Most attempts to find out what nations really are have suffered from an intrinsic defect: they have been attempts to define the general concept of nationality. People have said that the nation is this or that, apparently believing that all that mattered was to find the right definition; once found, this would be applicable to all nations equally. They have adduced language or territory, written literature, history, form of government or so-called national feeling; and in every case the exceptions have been more important than the rule. It is been like clutching at some adventitious garment, in the belief that the living creature within could be thus grasped.”

-Elias Canetti, Crowds and Power

I think by most conventional measures, used by most professional investors, European Central Bank Chief Mario Draghi has been a success.  He has bolstered the returns for equity funds considerably since his decision to utilize a three-year term, instead of one year, in the ECB recent liquidity injection to European banks.   

The fact is I missed the trees for the forest on this, and it has hurt.  Failing to understand this lending—which reduced stigma associated with 1-year terms and better matched the funding needs of banks, led to more participation than expected.  This in turn created a classic self-reinforcing positive feedback loop for asset prices:

1. Increased demand for ECB funds stemmed liquidity risk

2. Reduction of liquidity risk reduced bond risk premiums

3. Liquidity helped banks buy local sovereign debt

4. Demand for debt by banks was followed by funds

5. This demand for European paper increased demand for euros (pushing up its value)

6. Increased prices (lower interest rates) on sovereign debt increased the value of existing bank collateral

7. Rising European banking stock prices reduce their cost of capital

8. Rising European financial stocks begets more money flow from funds

9. Bolstered European bank collateral reduces the need to de-lever from Eastern & Central Europe and Asian trade finance (which Europe banking represents and inordinately large impact).

Extending the loop to positive impact on global risk assets, as the core of systemic risk concern was laser-like focus on Eurozone bank liquidity problems, US stocks started rocketing on the ECB three-year term announcement back in mid-December.  And yes, our friend Ben played a strong supporting role with his announcement US short rates likely remain in the cellar through 2014 if he is still the boss.

Mea culpa squared!!!

Of course the multi-billion dollar questions:

• Is this a new paradigm? 

• Is the Eurozone crisis behind us for a while now?

• Should we care at all about Greece? 

• Does leverage on central bank balance sheets matter (ECB is lowering collateral standards yet again by passing the decision on what is adequate collateral to individual country central banks; not perfect to say the least but expedient)? 

• Is the nasty fall in German exports reported today something to worry about, or is it rearview mirror stuff? 

I guess the yes or no question to summarize all above is: Is this positive feedback loop we’ve witnessed since mid-December already imbedded in price?

Consider:

1. The ECB plans to offer another round of three-year funding at month end and expects the participation to be larger than last time.  Shouldn’t that be bullish given the impact just reviewed?

2. The Fed seems quite happy supplying more cash to the market and seems to be committed to doing just that on any signs of weakness.  Shouldn’t that be bullish?

3. China is being pushed by the IMF and some policy makers inside the country to initiate another big blast of stimulus (flame thrower switched on, in other words). Shouldn’t that be bullish?

4. And Clint Eastwood tells us its only half-time in America.  Shouldn’t that be bullish?

I guess the yes or no question to summarize all four considerations above is: If I can spout those four seemingly bullish items, is it already imbedded in the price? 

Sorry, this Currency Currents issues seems to have turned out to be nothing more than a self-feeding loop of questions and confusion.  But then again, is this game anything more than that?

The trend is your friend until it’s not.  Something we can count on indeed.

4 reasons why China's capital waste is about to hit the fan.

“Soon after awarding the contract in December, the city subway operator indefinitely delayed the equipment purchase and shelved plans to expand the underground's rolling stock by seven trains in 2012.

"’The subway project has been completely postponed,’ the executive told Caixin, clutching the contract that won't be fulfilled. ‘For now, we have no new orders, and old orders are being deferred. This has affected us greatly.’

“It was not an isolated letdown. A golden but brief era for urban railway suppliers, builders and related companies across China appears to have ended in recent months.

“Local governments nationwide have slashed infrastructure spending since last summer, and the urban rail business has slowed to a crawl after several years of rapid growth. Spending for subways was cut as central government economic planners put the brakes on rail projects and indirectly reduced local government spending power by maintaining real estate market controls designed to prevent housing price inflation.

“The property market controls, which began in 2010, diminished demand for the valuable land that local governments typically sell to raise fiscal revenue. As a result, cities have less money to spend on railways and other infrastructure.”

-Caixin online

I have a lot of questions when it comes to China.  There is much I don’t know and maybe will never understand about the Chinese economy.  But I do understand the silly notion espoused by China bulls that the Chinese leadership has fashioned together some new and improved quasi-commie-capitalistic economic model is total claptrap!  It is ironic that what is perceived as a great achievement (and to a large degree much of it is and no denying that), the massive infrastructure build across China, could be the very thing that comes back to haunt them and drive GDP growth deeply into the proverbial toilet.

The Austrian School types would call it malinvestment.  Force-fed infrastructure as state initiatives, laced with corruption along the way (like New York City mob-led union payoffs but think of it on a massively larger scale) that, lacking market incentives, have to be paid for sooner or later and one way or the other.  It all comes out in the wash no matter the economic model.

Our vicious treadmill representation, which we created a couple years ago, and shared with you many times before, nailed it again as a framework to follow China’s terminally ill economic model.  I have added one new component today – hot money now flowing out of China.  The idea of a big appreciation in the yuan has faded. 

Stay with me ...

 

CAPITAL MISALLOCATION  ==>  PAID FOR BY HOUSEHOLD SECTOR   ==>   HITS GDP HARD

 Aka Wasteful Projects                     Aka consumption tanks                         

 

Most of us now understand China’s exports are being hit thanks to current slow demand from the industrialized world now ... and expected muted demand for years to come because of under capacity growth across the US, Europe, UK, and Japan.  So what is the saving grace for Chinese growth? — a transition to consumption.

However, those China bulls that are optimistic on this front are missing a major problem with this view—the household sector in all countries pays for the mistakes of the state’s misallocation of capital; this is not just a China thing.  But here is the danger for China – there is no other growth engine left if the consumer doesn’t start contributing.

1. Export demand muted and may fall more if the Eurozone heads into deeper recession.

2. Overcapacity in many industries and massive capital waste – not only real estate but many other state infrastructure projects – is starting to hit the fan.

3. China’s consumer [household sector] will take the hit for the misallocations and wasted capital. In other words: Consumption in China represents an incredibly low 35% contribution to GDP; how can this ever grow when they are about to pay for all the wasted capital for infrastructure build across China?  The infrastructure build enriches the ruling party elites, their relatives, and others connected to the system—it is part of a model that has worked well for them.  They are not about to rock this boat with rapid transition to some new model.  Chinese power elites are no different than elsewhere.  Many policymakers inside Chine see this slow-motion train wreck in the making, but they can do nothing about it.

4. Therefore, there is no other area that can pick up the slack of GDP growth.  Time to pay the piper!

It sets the stage this year for a massive growth disappointment.

Here are the payoff paragraphs from Prof. Michael Pettis in his recent piece on the topic of wasted capital inside China:

The debt will be serviced. One way or the other it will be assumed by the central government through the banking system.

But this is not the important issue. The important issue is that it is clearly proving impossible to keep GDP growth levels high without explosive debt growth, and there are serious debt capacity limits to this kind of debt growth. I have no idea where the debt will next show up, or what the next debt panic will be (I suspect this year it will be SOE debt), but I have no doubt that there will be more of these debt panics. This is not an accident. It is intrinsic to the way the development model works.

The problem, then, is not that there will be defaults. The problem is that the only alternative to default is to service the debt, and this is what will cause the real damage to the economy. If the economic benefits generated by the investment are less than the correctly-valued debt-servicing costs, as they almost certainly are, the difference has to be made up in the form of a transfer of resources from some sector of the economy.

...The problem with this solution is in what it implies about future growth in demand. If investment is being wasted, it must be reduced or it will create a debt crisis eventually. If the external environment is tough, the demand impact of a sharp drop in investment cannot be made up for by a surge in the trade surplus – in fact the trade surplus may actually contribute negative demand. So where will the demand come from needed to pull the Chinese economy? The only possibility is a surge in domestic consumption.

Can consumption possibly surge? No, not if the household sector is going to be forced to clean up the banking mess again. This is the same problem that caused household consumption to drop after the last banking crisis from a very low 46% of GDP in 2000 to an astonishing 34% in 2010.

...The only way to boost household consumption is either to redistribute income from the low-consuming rich to the high consuming poor, or, better yet, to redistribute wealth from the state to households. Both of these have serious political implications that have to be resolved and are unlikely even to be addressed with consumption subsidies. After five years of this argument, during which time consumption has plummeted relative to total savings, you would think they would start to abandon the idea that all we need to do to get consumption to surge is to reduce household savings a little.

The 1% inside China controls a staggering estimated $2-$5trillion dollars in wealth; they are starting to move money out of China, seeking a safe haven.  That should be a good enough signal as they know a lot more about their economy than I do. 

Reader Mailbag: "Two words for delusional China bulls: PER CAPITA"

"A system of capitalism presumes sound money, not fiat money manipulated by a central bank. Capitalism cherishes voluntary contracts and interest rates that are determined by savings, not credit creation by a central bank."

-Ron Paul

We got some good feedback from our article on Friday. Below are a few reader comments and our responses. Enjoy. (And keep the comments coming.)

Reader Mailbag

Comment:

Per capita income, per se, as a gross economic factor, may mask important on-the-ground factors that influence the quality of daily life: access to cheap local food, access to low-cost medical care, low cost of public education that enables, perhaps, future economic opportunity.   
  
Having a higher per-capita income that is "eaten up" by high taxation, high medical care costs for both basic and advanced services, high fees for quality education, and high costs for the basics of living: shelter, food, etc., raises the question of what is true "personal income."  
  
So, a hundred million or so Americans can buy the latest iWhatever: but all the factories, and all the jobs, and all the manufacturers of all the components for the iWhatever are located in ... China.  
  
And China "sits on" a hoard of great national surplus wealth created by export vs. import trade earnings: how that wealth will be "spent:" that, for this writer, is ... the question.

Response:

There are a couple good points here; I’ll hit them as them come ...

Per capita income is not a perfect indication of “on-the-ground factors that influence the quality of daily life.” But it certainly is an indication of the wealth of a country (and to a large degree the ability of individuals to perpetuate wealth); perhaps better than the total GDP and comparison of GDP growth rates.

Plus, the figures in the article and chart are based on PPP (purchasing power parity) which seeks to account for some of the “on-the-ground” factors.

To the point about the manufacturing of technology components, China does assemble and export a very large portion of high-level goods; but China has a much smaller role in the actual design and production of the components it assembles. A majority of the components found in China’s high-level exports originated in other countries, very much so in neighboring Asia. While this suggests that China is not the growing technological and R&D powerhouse many claim it to be, there is no denying the point you made about the jobs being in China.

Jobs assembling high-level goods in China may not be at risk of implosion, but a generally smaller appetite for consumption is going to hit jobs in other areas of China. That also likely means the “hoard of great national surplus wealth” will not be accumulating as quickly. China's FX reserves declined in the fourth quarter of 2011 for the first time in more than ten years.  And it does beg the question you asked: How will that wealth be spent?

If China fails to make this transition, how can China expect to rebalance their dangerously lopsided economy? The powers-that-be inside China understand this problem; many would like to see progress in this transition, as ultimately it will reduce China’s dependence on the West, which has to be a primary goal of China.  But there is major pushback from those inside China – from the princelings and other well-placed individuals benefitting from the current model at the expense of the average citizen, so this will be a wrenching transition.  The transition can flow from voluntary measures or Mr. Market will force it upon them.   Which brings me to ...

Comment:

It is the low per capita numbers that makes China powerful! That means the govt is still in the driving seat, and it can still leverage the low human capital cost.  
  
If China has higher per capita numbers and become more democratic, China will slow down.

Response:

The low per capita numbers and China’s growth are common patterns in emerging markets; on a relative scale they begin from a lower base.   Granted, China has broken the EM mold a bit, given the dramatic breadth and speed of its growth.  However, the bulk of that dramatic growth started around 2000 area, when the US Fed decided it was time to create free credit for all (Greenspan emergency interest rates) and the US encouraged the symbiotic relationship of US dollars, for Chinese stuff, leading to recycled dollars back into the US financial system to continue the game of free credit.  That has ended—it was called the Credit Crunch.

China during the past cycle has also benefited from labor arbitrage i.e. becoming a massive global manufacturing platform through leveraging the low human capital costs.. I’d argue that the foundation is shifting and making this dynamic less feasible on two counts: 1) Wages are rising in China, making production there less attractive; we are seeing reports that global manufacturers are increasingly finding it makes sense to stay at home, or shift some manufacturing elsewhere;  and 2)  It is why we started this dialogue, as we think growing social unrest is pressuring Chinese officials and elites in such a way that they will need to give ground to these demands and begin to enrich Chinese citizens in ways they so far have been able to avoid. 

This we think will be a good thing for China in the long run, but the blowback from those in power who stand to lose from a new economic arrangement could make this period extremely difficult and will lead to slower overall economic growth than is now anticipated. That is the point. Continuing on the current trajectory may mean avoiding a slowdown; but it will also mean delaying the inevitable by propping up an unsustainable system. We’ve made a similar point when discussing the US; only it is the other side of the coin. As US policymakers continue to focus on building an economy dependent on consumption/demand, they promote a system that is overly reliant on debt and deficit spending and not enough on savings and investment.

Surely the Communist Party leaders and princelings who have been getting wealthy on the current system don’t want to let go; but as time passes, we don’t believe they will have a choice.  The only question in our mind is how long they can delay the inevitable.  So far, they have done a very good job of that and hints of possible easing again we think show a rising degree of desperation (very similar to Bernanke’s desperation as he manipulates money and credit to a degree even we didn’t expect).

Comment:

In the US, 1% of the population own 38.3% Wealth 20% of the population own 85% Wealth.  That I suggest would be China under the Mongol Emperors.

Response

Indeed, the US is not without its own form of princelings. Those heavily connected to the shadow and fractional reserve banking system that thrives on credit creation in the financial economy, while the average Joe in the real economy suffers and those so-called “businessman” who tout their brilliant strategy, while raking in massive favors from their cronies in government would be an example of US princelings.   The byproduct of current fiscal and monetary policy in the US is an enriched upper class and a propped up lower class at the expense of a strapped middle class. Consider the fact that increasing numbers of US citizens are on welfare highlights this problem. 

While central planners and their brethren in the US pull the strings of the financial system so they may line their own pockets, the central planners in China call the shots so that its citizens do not become empowered and threaten their power or control over the so-called “capitalism with Chinese characteristics”—what a bunch of nonsense.