Oil

The most important thing is this (oil price collapse) is a massive tax cut for the world. This is really good stuff for the world.

Larry Fink

CEO Blackrock

December 11, 2014

Lower oil prices are like a tax cut to the economy, so in terms of macroeconomic impact, it’s a positive.

Jacob Lew

U.S. Treasury Secretary

December 11, 2014

Despite the impressive recent gains in natural gas and crude oil production, the U.S. is still a net importer of energy. As a result, falling energy prices are beneficial for our economy.

Over the near term, this will lead to a significant rise in real income growth for households and should be a strong spur to consumer spending. Since energy expenditures represent a higher proportion of outlays for lower income households, falling energy prices disproportionately raise their real incomes. Also, because such households are more liquidity constrained, with budgets that often bind paycheck to paycheck, they have a higher tendency to spend any additional real income.

As a result, much of the boost to real household income from falling energy prices is likely to be spent, not saved.

Bill Dudley

President New York Federal Reserve Bank

December 1, 2014

Here we have the head of the world’s largest asset manager, the CFO of the U.S. government and the globe’s chief money printer and regulator of the world’s most important banks all telling us that crashing oil prices are a good thing. Consumption will go up and savings will fall as a result of lower oil prices and these are, allegedly, good things.

Personally, I have never seen an issue that more starkly contrasts the Keynesian view of the world, as referenced above, with that of the Austrians.   

Keynesians focus on GDP, aggregate demand and animal spirits. Austrians focus on savings and capital creation, the entrepreneur’s focus on wealth creation and the avoidance of the malinvestment that comes from money and credit creation from thin air.

Keynesians want to boost consumption and penalize savings following a bust by artificially pushing interest rates lower. Austrians want to point to rates being too low during the bubble phase as being the cause of the subsequent crash and economic hangover and they argue that lower rates for longer will only create bigger problems in the future.

Oil’s collapse gives us a perfect perch from which to compare these contrasting economic views.

As we saw above, the typical Keynesian view is that the oil price collapse should increase consumer demand and decrease savings. These are thought to be good things.

Austrians view the oil price collapse with horror. Savings (real capital) was wasted on a truly epic scale as malinvestment ran amok throughout one the world’s biggest and most important industries. This is an industry that has seen annual upstream capital expenditures increase by about 75% to nearly $700 billion in the past five years. Pretty much all of that spending appears to have been wasted.

How could this happen?

Keynesians, it seems, don’t really care about the cause of all of this wasted capital. In the U.S. and Europe the only concern seems to be with whether or not the oil price collapse will lead to increased consumption and decreased savings. Both of these effects are cheered on by the Keynesians.

Austrians point to artificially low interest rates as having impacted the structure of production and consumption. Artificially low rates appear to have been a prime mover in China’s titanic infrastructure build-out of the past five years. This created a nearly insatiable demand for energy on the part of China, the major incremental driver of nearly everything on the planet for much of the recent past. This demand drove oil prices relentlessly higher over the past few years.

Alas, the Chinese real estate miracle appears to have crested and, with real estate prices starting to fall, the infrastructure build-out has stalled. Energy demand is, therefore, falling relative to previous expectations.

Oil production, especially in the U.S., boomed with the rise in capital spending that came from artificially low interest rates and strong, but artificial, oil demand. Despite the overall fall in savings in the U.S. over the past decade, whatever remained of the pool of savings was made available for oil production. In fact, oil production in the U.S. is up about 80% from its low point and the high yield market has come to be dominated by borrowers from the oil patch.

To the Austrians, looking back at the oil boom, it was lots of money and credit from thin air that drove the malinvestment that is now being revealed. They question whether pushing the savings rate lower from the current miniscule levels, a move that the Keynesians cheer, will allow for adequate capital spending in the future to drive any wealth creation in the U.S. They also worry about why anyone would ever want to create and deploy capital (savings) any longer if it always seems to be wasted. Malinvestment is simply a reduction in the already paltry rate of interest that is currently being paid on savings and it does not bode well for future capital creation or future real GDP growth.

Until recently, everyone thought that increased U.S. oil production would lead to American energy independence and that this was a good thing. Now, it seems like the Keynesians are telling us that wasting a few trillion dollars in the oil patch while blowing up the junk bond market was also a good thing. Who knew?

I’ll stick with the Austrian line: The crash in oil prices is exposing malinvestment that was driven by central bank fostered easy money policies which destroyed wealth, deters future savings and wealth creation and, as a result, destroys future growth opportunities.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Gold

My previous post was on the inevitable failure of fiat currencies. It seems then as if this might be an appropriate moment to spend some time on the subject of gold.

Rarely has there ever been an asset class as hated as the yellow metal. Economists (outside of the Austrians) despise it. After all, its use as money would certainly eliminate any need for us to have them opine on the proper level of interest rates and how much money and credit should be whipped up from thin air. Gold as money would remove economists from the biggest part of the public policy debate, and this is unimaginable in their eyes. How would the free market ever decide on the proper level of interest rates? Chaos would surely ensue without their learned input.

While there are many essays out there dismissing gold as an investment and its use as money, I want to focus on one particular issue that Keynesians have been harping on for years. It seems that many economists do not like it that gold is expensive to mine and expensive to store. Surely this is waste of society’s capital:

Most of all, the barrenness of this proposal (i.e., to use gold) makes it most repugnant to those who think that the international need for liquidity can be put to better use than the financing digging gold from the entrails of the earth and reburying it in the vaults of Fort Knox and other gold graves.

Robert Triffin (1957)

Recently, Citibank economist Willem Buiter made the same argument against gold:

Gold is unlike any other commodity. It is costly to extract from the earth and to refine to a reasonable degree of purity. It is costly to store….The cost and waste involved in getting it out of the ground only to put it back back under ground in secure vaults is considerable.

The argument, as you can see, hasn’t changed much over the past six decades. It even makes a certain amount of intuitive sense.  Unfortunately, for the Keynesians, the argument fails when examined in just a little more detail.

I am not going to claim that gold isn’t costly to mine. At $1200/oz., the value of the gold mined each year is equivalent to about $110 billion, and that isn’t chump change. Better to use unbacked fiat money, which costs nothing to produce, according to most economists.

Well, from the Austrian standpoint, it costs society quite a bit to use unbacked fiat money. ABCT presumes that money and credit creation from thin air creates malinvestment. While the cost is somewhat difficult to calculate precisely, it is easily in the multiple trillions of dollars per year. How much malinvestment was revealed as technology shares crashed in 2000-2001? How much malinvestment came to light in the real estate debacle of 2008? How much malinvestment is now being revealed as emerging market carry trades unwind, Chinese (and London) real estate slumps and as oil prices plunge. Trillions upon trillions of dollars have been wasted. Gold’s burden is fairly light then relative to the costs we are piling up elsewhere due to the use of unbacked fiat money.

Unbacked fiat money also has another problem: It violates the principle that all transactions require a like-for-like exchange. All parties need to believe that they are made better off in a transaction. If you produce apples and I produce oranges, we may both be better off if we exchange some of our output. This betterment principle is violated when money and credit is created from thin air. Someone gets something for nothing. The original parties will undertake the transaction, but only because they believe that they can pass on the burden to someone else before the theft has been revealed. Some Austrians have compared the effects of inflation (the creation of money and credit from thin air) to a train since some cars arrive in the station before others. Often, fixed income investors and pensioners are at the back of the train and bear the bulk of the costs associated with the inflation brought on by the use of unbacked fiat money. Unbacked fiat money violates this like-for-like principle while gold does not.

Unbacked fiat money is nothing but theft. It sets in motion malinvestment and it violates the like-for-like principle. It carries huge, but hidden, costs and it has always, eventually, failed and been rejected by the public. I doubt this time will be any different. Mr. Buiter referred to gold as a 6000 year bubble, and perhaps this true. I am certain, however, that no unbacked fiat currency will ever establish such a record. Yes, gold may not return as money, but something will replace unbacked fiat. Nevertheless, I believe that finding something better than gold as money will be most difficult.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Why Fiat Money and Central Banking Will (Eventually) Fail

With regard to the potential success or failure of any economic, political or social institution one must ask two essential questions:

Does Natural Law exist?

If it does, then: Does the economic, political or social institution violate this law?

Central banking, fiat money and money and credit creation from thin air must be discussed in light of these questions.

ABCT is pretty clear about how and why the creation of money and credit from thin air, a central bank’s ultimate purpose, is likely to result in malinvestment or a system that generates failure. This is reason enough to question the existence of central banking.

But why is it that the tools of central banking, fiat money and money and credit creation from thin air, are doomed to create a system that fails?

The reason is simple; they violate natural law, the nature of man.

Let’s start with a premise: The creation of money and credit from thin air is theft.

When a central bank creates money from thin air they are stealing from all of the other holders of that currency. The existing holders of the currency will now have to compete with the holders of the newly created currency. Their currency now buys less.

Premise number two: Theft is a clear violation of natural law.

Premise number three: Political, social and economic institutions that are built on a foundation that violates natural law are doomed to failure as man will attempt to minimize the pain and loss that he experiences from the violation of his nature and the objective reality of the world.

Conclusion: Current central banking practices based on fiat currency and the unlimited creation of money and credit from thin air will, eventually, fail.

That is a pretty simple argument. Not surprisingly, C.S. Lewis devised a simple thought experiment that can help us understand why this should be.

This is an experiment where four objects need to be separated into two boxes. If I give you a baseball, a basketball, a baseball bat and a basketball net and asked you to put two items into two separate boxes based on things that those objects have in common, how would you proceed?

Some would put the baseball and basketball together in one box and the net and the bat in the other box. The things that are balls would be together and the things that are not balls would also be together.

Another approach would be one based on functionality. The baseball and bat would then go together and the net and the basketball would be in the other box.

Lewis used this model to examine the following items: Science, Natural Law, technology and magic.

Most people would place science and technology together and Natural Law and magic together. Science and technology are items that can be verified via empirical evidence while Natural Law and magic have more difficulty on that front.

Lewis offers a different way to categorize the items: He places science and Natural Law together and technology and magic together. Both science and Natural Law attempt to conform our minds to objective truths and realities of the world. Science teaches us about the physical aspects of nature that we need to respect and understand while natural law attempts to teach us about the nature of man, which also must be respected.

On the other hand, technology and magic have more in common than you might think as they both attempt to get the world to conform to the will of man. Of course, technology that is grounded in the physical sciences will work while magic will not.

Everyone understands that the violation of physical laws can end in disaster, imagine an engineer designing an airplane while neglecting the law of gravity or the tensile strength of the materials involved. These errors will be discovered promptly upon a test flight.

Likewise, political, economic and social institutions that do not conform to the nature of man will also fail because they do not conform to the objective realities and truths of the world. The difference is that it is difficult to estimate how long this will take and the exact form of the failure. In the physical world of aeronautics, if a wing does not create enough lift, the craft will never fly. Social dynamics, unfortunately, are a bit messier and those that violate Natural Law may take some time to be revealed, but there will be a revelation.

For example, until this moment in time, all fiat currencies that have ever been attempted have failed. Somehow, we expect the results to be different this time. They won’t be.

The 20^th Century saw a couple of massive efforts aimed at subsuming Natural Law to the will of a few men. One was the horrific Nietzchean experiment of Nazi Germany with their cult of the Superman. A world where might made right. Another saw Stalin and Mao attempt to build societies based on Marxist theory.

Not only did they all fail, they all failed despite the horrible violence that they were willing to inflict on those that did not toe the party line. Rome wasn’t any different.

There just isn’t any way, in the long run, to get man to go along with a political or economic system that violates his nature. I am willing to bet that our recent multi-decade experiment with fiat currencies and central banking will also end in failure as it violates Natural Law. Timing, of course, is the issue. The outcome is not in doubt, however.

ABCT tells us that if central banks artificially drive interest rates too low via the creation of money and credit from thin air, then the savings rate will fall and malinvestment will be created.

Empirically, this has all been happening now for decades.

 Given that I have defined money and credit creation from thin air as theft, we should assume that man would respond to this theft of his wealth in some rational way. He, of course, reduces his savings and the amount that may be stolen from him.

Reduced savings and increased malinvestment should also reduce the real growth rate over time.

It is no surprise then to the Austrian oriented investor that these are all happening in the economy of our time as a reaction to central bank orchestrated theft. What is surprising is that investors have chosen to ignore this, repeatedly, and pay absurdly high prices to participate in this deteriorating economic scenario.

Just as in 2000 and 2008, I expect this current foolishness to eventually reverse itself. As I watch stock and certain bond categories trade at extremely high valuations relative to what our society is willing to produce and save due to central bank money and credit creation from thin air, I am forced to constantly ask myself: Does natural law exist?

My answer is always, yes.

I know then that the outcome for fiat currency and central banking is not a healthy one.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

A Matter of Perspective

This is a quick update on my recent post on corporate accounting and EPS.

The FT ran a rather bullish story the other day proclaiming that corporate America is spending again, a sign of returning confidence they told us.

Their ebullience seems to have been triggered by the fact that, according to a survey by the Association for Financial Professionals, corporations’ cash balances have been falling. The FT assures us that this is an important turning point in our recovery from the Great Recession.  Accordingly, this is a clear sign that animal spirits are returning to the US economy.

If only it were true. The FT starts the story this way:

US corporations are starting to run down their cash for the first time since the recession- a sign of returning confidence- but they remain reluctant to invest in new equipment.

Let me give you my translation of this line:

US corporations are confident in their ability to boost earnings per share so long as they DON’T invest in their businesses by purchasing new equipment.

The story does note that buybacks and acquisitions are what the cash is being used for, but it neglects one small detail that may be important: Cash is going down despite the fact that businesses, in the US anyway, are borrowing money at a faster rate.

According to the Fed’s Z.1 report:

Annual Business Borrowing

($ billions)

Year             Amount

2011               295

2012               532

2013               516

2014*             700

*  Annualized YTD numbers

Here is what we know, annualized borrowings have jumped nearly 40% this year, companies refuse to reinvest to grow their businesses and corporate profits have flattened out:

After Tax Corporate Profits with Inventory Valuation and Capital Consumption Adjustments

(SAAR, $ Billions)

Period             Amount

Q2 2012           1551

Q3 2012           1600

Q4 2012           1594

Q1 2013           1565

Q2 2013           1644

Q3 2013           1673

Q4 2013           1648

Q1 2014           1380

Q2 2014           1498

Source: Economagic, BEA

BEA defined profits differ from what we see in GAAP accounting. The BEA only wants to show the economic impacts from production in a current period. As such, it eliminates inventory profits and losses, adjusts depreciation expense to reflect current, real, depreciation and it strips out capital gains and losses and things like changes in expenses for bad debt.

As we can see from the above table, real economic profit growth is becoming tough to come by as profits have now fallen for three straight quarters.

So, where does this leave the corporate executive? He can no longer seem to grow his business top line. Over the past year, half of the companies listed in the Dow have seen negative real sales growth. Additionally, the Fed’s abusive interest rate policy has crushed any incentive to reinvest since incremental returns on capital must equal incremental costs. These are now set at zero, thanks to the Fed. Growth at the bottom line seems to have peaked, as well.

This leaves the corporate executive who wants to show EPS growth with share buybacks and acquisitions. Corporate capital allocators have been pushed into the equity markets, just like all other investors, as it appears to be the only place where a return in excess of punitively low interest rates can be generated. As stock prices rise, however, it is costing companies more to reduce their share count by a similar amount. This is what explains the need for more borrowing and lower cash balances. In fact, companies are buying shares at dramatically higher prices today than two years ago despite the fact that economic profits have fallen over this time.

As Austrian Business Cycle Theory teaches, central bank interest rate policies can act in a way that fools most capital allocators by sending signals that push these capital allocators to do the wrong thing at the wrong time. This is true of corporate executives today, in my opinion.  

The FT wants to proclaim that the decline in corporate cash balances is a sign of strength for businesses. I see it very differently. My view is that the corporate world is trapped, and their only option at the moment is to buy overvalued shares in businesses that cannot grow any longer. This will end badly.

I will point out that BEA after tax profits peaked well in advance of the peaking of share prices in 2000 and 2007. Those were also periods of time, not coincidentally, that saw a less accommodative Fed.  Will declining economic profits and a less profligate Fed combine, once again, to crush investors?

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

On Corporate Accounting and EPS

There is an old joke about accountants and CFOs:

A company’s chief executive needs to hire a new CFO. He has the field narrowed down to two candidates and he decides to call them in separately for one last interview. The interview will consist of only one question.

The CEO calls in the first candidate and asks, “How much is 2+2.”

The first CFO candidate answers, “Four.”

The CEO thanks him and lets him know that he will be in touch.

The second candidate is then ushered in for his interview and the CEO asks him the same question, “How much is 2+2.”

The second CFO candidate gets up out of his chair, closes the door to the office, looks at the CEO and says in a hushed tone, “How much do you want it to be?”

I tell this story only as a way to emphasize that companies often have a wide degree of latitude when it comes to reporting earnings. What’s more, that latitude generally grows during a bubble.

For example, back in the late 1990s, the technology companies found a way to completely change the way that they paid their employees and expensed their research and development costs.

Technology companies, up until that time, had always expensed their R&D upfront, as it occurred. This was a very conservative stance.

As the bubble in technology shares grew, things began to change. In order for companies like Cisco and Microsoft to be able to retain their employees, they had to start to pay them more in the form of stock options because everyone knew, at that time, that technology shares only went up.

The only problem with this was that GAAP accounting did not require companies during this period to expense the value of the options granted and run that expense through the income statement. The quality of technology company earnings was, therefore, starting to collapse.

The trend got even more egregious as the most talented coders and developers would walk out the door one day with their best ideas, form a company and turn around and auction it off to their former employer or one of its competitors for billions of dollars. R&D, which at one time had been expensed upfront, was now outsourced at no cost to the company, at least with regard to its income statement. Cisco was issuing so many options to employees and new shares to start-up companies without products or revenues in the form of takeovers that CSCO was soon issuing $25 billion per year in equity securities that would never be expensed.

It was a debacle, and shareholders never cared about the horrific quality of the reported earnings as long as the shares were going up. For anyone that cared to look, however, it was very clear that the economics of the businesses did not justify the share prices.

There is a similar deterioration in the quality of corporate earnings today only it is far more widespread than what we saw during the technology bubble of the late 1990s.

Today, the item that is now significantly starting to crush the quality of corporate earnings is the enormous move to buy back company shares.

The intellectual problem that I have with current accounting standards is that buying back stock is thought of entirely differently than is any other corporate expenditure item.

If Caterpillar spends $100,000 to build a hydraulic excavator and sells it for $150,000, all is well and the resultant income and expenses are run through the income statement and investors can track management’s ability to operate the business.

The same thing is true if they spend $100,000 to build the excavator and sell it for only $90,000. Investors can see the resulting loss in the income statement and judge management accordingly.

None of this is true regarding share buybacks, and this is no small matter. Share buybacks are the new business of America. I have argued before that this tells us much about management’s views of their ability to profitably deploy capital in their main business in the future. They are not positive.

It is, however, boosting earnings per share meaningfully today as companies can borrow at next to no cost, thanks to the Fed’s massive intervention in the securities markets, and buy back shares, thereby reducing the denominator in the earnings per share calculation.

For those of us that believe that share prices, broadly speaking, are near the apex of an incredible bubble, then all of this buying back of company shares represents an incredible waste of capital, though none of it will ever be expensed according to GAAP standards. It does, however, give the appearance of boosting earnings per share today, which is all that seems to matter to investors.

Yesterday, Caterpillar Inc. reported earnings that appeared to be great. The earnings report was seen as so good that CAT shares were up more than $4 and the report was seen as a key reason for the more than 200 point jump in the Dow.

Let’s take a look at these stellar earnings.

Revenue from machinery sales was up just 0.6% Y/Y.

Operating profits were actually down $9 million Y/Y.

Earnings per fully diluted shares outstanding did manage to jump to $1.63 from $1.45 in the year earlier, however.

This prompted noted CNBC commentator Jim Cramer to exclaim, “If Caterpillar can do this kind of number when things are bad, what number can it print when things are good?"

So, how did CAT boost EPS with such poor top and operating line performance?

The answer, of course, was to stop investing in the business, borrow lots of money and buy back shares.

Capital spending is down $800 million YTD vs. last year. Despite borrowing an additional $1.4 billion YTD, interest expense was actually slightly lower in the quarter and the company has bought back a whopping $4.2 billion in stock so far this year, taking the diluted share count down nearly 30 million shares.

As a point of reference, share buybacks this year are running at 178% of capital expenditures compared to just 63% last year. No one believes that we shouldn’t expense capex over time, so why shouldn’t we run gains or losses on share buybacks through the income statement so that investors can get a better sense of management’s ability to deploy capital? After all, we are no longer talking about paltry sums here and we need to account for this activity in a better way.

Now, let’s get back to Jim Cramer. He wants to believe that CAT’s earnings numbers will be spectacular when things improve in the economy.

Given the fact that the savings and investment rate in the U.S. has crashed due to the Fed’s policy of artificially driving interest rates towards zero, just how does Mr. Cramer expect the economy to improve?

Companies are clearly saying that they can no longer earn a return on the capital deployed in running their businesses, so they are clearly deciding to give up and they are returning the capital to shareholders. Corporate America doesn’t believe that things will improve in the economy, not enough to justify increased investment at the expense of reducing share buybacks anyway.

Is it a good idea for companies to return capital through share buybacks?  

That, of course depends on whether the shares are cheap or expensive. Sadly, as John Hussman reminds us with the following graph, companies are generally extremely poor market timers. As for me, I am taking 50 cents out of a company’s earnings report for every dollar of stock that they buyback given my view that the market is extremely overvalued. If you believe that stocks are cheap, then you should add a few cents to net income for every dollar of stock they buyback.

Those undertaking the latter action should give some serious thought to the Mr. Hussman’s graph, however:

 

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

The Economist Stumbles Over the Truth

The Economist magazine recently ran an article detailing some surprising results of a paper published by three finance researchers from MIT, Dartmouth and the University of Rochester.

From the Economist:

IT IS Economics 101. If central bankers want to spur economic activity, they cut interest rates. If they want to dampen it, they raise them. The assumption is that, as it becomes cheaper or more expensive for businesses and households to borrow, they will adjust their spending accordingly. But for businesses in America, at least, a new study* suggests that the accepted wisdom on monetary policy is broadly (but not entirely) wrong.

What surprised the Economist was that a decrease in interest rates actually caused a decline in capital spending:

While this was counterintuitive to Keynesian trained analysts, it is not for those versed in Austrian economics.

Occasionally, we all may have a burst of real insight into a situation that doesn’t jibe with conventional wisdom.  With regard to Austrian Business Cycle Theory, mine came while reading the Roger Garrison summary of The AustrianTheory of the Trade Cycle:

On page 114 Garrison drew a simple supply and demand graph of loanable funds (savings). He showed that as you dropped interest rates artificially, via Fed money printing, the level of loanable funds would fall.

It was a simple and elegant insight, yet it was extremely radical in terms of traditional economic thought. The Keynesians were, I realized then and there, entirely wrong. Money creation from thin air was not neutral to the capital structure of the economy, but had profound impacts. It changed everything for me.

So, now that some traditional economic platforms are starting to understand that the real world doesn’t act in a way that Keynesian economics would predict, what should we expect to see happen? I am going to go along with Winston Churchill on this one:

Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing ever happened.

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Be Careful What You Wish For

In what I found to be a most interesting article, Jared Bernstein, a former Obama and Joe Biden economic adviser, wrote an op-ed in the New York Times advocating the removal of the U.S. dollar as the world’s reserve currency.

He claims that the balance of payment deficit engendered by the dollar’s reserve status is costing the U.S. jobs. These job losses are the result of foreign demand to hold the reserve currency, pushing the dollar too high relative to other currencies making production in the U.S. too costly. He reckons that the downside of losing reserve status for the dollar would be an increase of just 1% in the CPI rate of inflation.  This, he thought, would be an acceptable, low cost, trade off.

As someone who thinks that the U.S. would experience acute pain from seeing the dollar lose its reserve status, I thought that I should attempt to explain why I feel this way.

Let me start by referencing another article that I found to be most fascinating over at Mises.org.

Dante Bayona referenced an old tale about Salvador Dali:

There is a story about the great Catalan surrealist painter Salvador Dali. It is said that in the last years of his life, when he was already famous, he signed checks knowing that they would not be submitted to the bank for payment. Rather, after partying with his friends and consuming the most expensive items the restaurants had to offer, he would ask for the bill, pull out one of his checks, write the amount, and sign it. Before handing over the check, he quickly turned it around, made a drawing on the back and autographed it. Dali knew the owner of the restaurant would not cash the check but keep it,put it in a frame, and display it in the most prominent place in the restaurant: “An original Dali.”

It was a good deal for Dali: his checks never came back to the bank to be cashed, and he still enjoyed great banquets with all of his friends. Dali had a magic checkbook.

But what would have happened if one day art collectors concluded that Dali’s work really did not capture the essence of surrealism, and therefore that his art was not of great value? If that had happened, every autographed check would have come back to the bank (at least in theory), and Dali would have had to pay up. If Dali had not saved enough money, he would have had to find a job painting houses.

Bayona, in using this story, is  warning that the U.S. has been writing an excessive number of checks that it clearly believes will never be cashed. As long as the dollar remains the world’s reserve currency those dollar-based IOUs held overseas will remain there, uncashed.

But just what would happen if the dollar lost its reserve status and those checks had to be honored? I propose that we look at a similar situation that played out for the U.S. between the end of WW II and, roughly, 1980.

By way of quick background, in 1944 the world agreed to adopt the Bretton-Woods monetary system. Everyone agreed that both dollars and gold would be counted as reserves. The U.S., at the time possessing something on the order of 70% of the world’s monetary gold, would see its currency and IOUs held by foreigners, counted as official reserves. The U.S. also promised to honor a gold exchange ratio for foreigners of $35/oz. and currency ratios would all be fixed.

The one thing that no one counted on at Bretton-Woods was the idea that the U.S. could start to run balance of payment deficits. After all, the U.S. was going to emerge from WW II as the economic colossus of the globe. It was impossible to imagine the U.S. as an emerging debtor, but that is exactly what happened.

                          U.S.                                        U.S.

            Short Term Liabilities              Gold Stock

Year           to Foreigners            @$35/Oz.        Tonnes

1955             $11,895                    $21,753           19,331

1960             $18,701                    $17,804           15,822

1965             $25,551                    $13,806           12,268

1968             $31,717                    $10,892             9,679

1971 *          $55,417                    $10,206             9,069

1974 *          $95,000                    $11,803            10,489

($ in millions)

*      Bretton-Woods gold conversion was abandoned in 1968 and gold was then no longer fixed at $35/oz.

Source: The War on Gold, Anthony Sutton, 1977

As we can see above, the U.S. had managed to accumulate debts to foreigners of $18.7 billion by 1960, and this was after settling a further $3.5 billion in foreign claims by shipping 3,500 tonnes of gold overseas. That is, dollars were starting to flow back towards the U.S. The checks that the U.S. had written, never expecting them to be cashed, were being presented for payment.

The problem was that by 1960, the U.S. no longer had enough gold, if valued at $35/oz., to settle its debts to foreigners. The U.S. either had to revalue gold higher (a default), continue to ship gold overseas or adjust its economy so that is ceased allowing excessive money and credit growth so that the gold outflow was stemmed.

For a time, until 1968, the U.S. chose to stay the course, to continue to allow excessive money and credit growth and to cap the gold price at $35.

Foreigners during this period continued to send dollars back to the U.S. in exchange for gold even as dollar claims to foreigners continued to explode due to easy money policies in the U.S.

By 1968 it was clear to the U.S. that they were about to lose all of their gold and they defaulted on their obligations, refusing to honor the $35/oz. pledge of Bretton-Woods. By 1971, the fixed currency portion of Bretton-Woods was also ended, burying the Bretton-Woods system forever.

In 1960, the first year where U.S. obligations to foreigners exceeded its gold holdings, the U.S. GDP figure was $543 billion. The foreign obligations of the U.S. then amounted to just 3.4% of GDP. This was enough to destroy the monetary system of the day.

By 1974, with inflation picking up, U.S. GDP had nearly tripled to $1,548 billion and foreign liabilities had jumped to 6.1% of GDP.

Between 1955 and the end of the U.S. honoring its $35/oz. gold obligation, foreigners sent back well over $11 billion dollars to the U.S., and this clearly intensified inflationary pressures in the U.S.

In the following graph we can see that post WW II the velocity of money in the economy started to accelerate, particularly after 1955:

Part of the increase was initially driven by a normalization of the economy following the war, but the acceleration in velocity was increasingly driven, in my opinion, by the loss of confidence in the dollar's reserve status.

 As the dollar started to lose its reserve currency status and dollars that were expected to remain overseas permanently flowed back to the U.S., CPI inflation picked up dramatically as a consequence of the increase in velocity. From a sub 2% rate in the late 1950s, CPI inflation was over 6% by 1969 before completely exploding in the 1970s.

My point is that foreign obligations of somewhere between 3-6% of GDP created, in the end, massive CPI inflationary problems as many of the dollars flowed back to the U.S. Faith, of course, wasn’t just lost by foreigners, it merely kick started the process of a loss of confidence in the dollar inside the U.S. as well, forcing velocity and CPI inflation much higher.

I would stress that the imbalances of the Bretton-Woods period pale in comparison to the imbalances created by the reckless monetary policies of the Fed and other central banks of the past couple of decades.

The IMF’s Composition of Foreign Exchange report (COFER) alone details nearly  $12 trillion of foreign exchange reserves held by global monetary authorities. Perhaps 60% of this is held in U.S. dollars, roughly $7 trillion. This amounts to 40% of current GDP for the U.S. The Fed’s balance sheet now stands at 26% of GDP. These numbers dwarf the imbalances that kicked off a flow of overseas dollars back to the U.S. under Bretton-Woods, resulting in the start of CPI inflation in the 1960s.

More importantly, Russia and China appear to have been forced by U.S. actions in the form of inconsequential returns on their dollar based holdings and interference in their historical spheres of influence to push for a removal of the dollar from center of the global economy. This just may give Mr. Bernstein his wish, the removal of the dollar as the world’s reserve currency.

Unfortunately, unlike Salvador Dali’s experience, the checks that the U.S. has written over the years, checks they expected to never see cashed due to the dollar’s reserve status, will come home again. The result should be massively higher CPI inflation. Dali actually provided those who took his checks with something of great value in the form of his art. The U.S. cannot say the same as its current rate of savings and growth in output cannot hope to cover the number of checks it has been writing.

It won’t be pleasant as it happens, but such an outcome is a necessary precursor to returning to sustainable growth.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Tiger by the Tail

Ben Hunt of Salient Partners recently wrote:

I spent the past week in Switzerland, meeting with old friends and making some new ones, and just like my recent travels in the US there was one overwhelming sentiment. No one doubts the omnipotence of central banks. No one doubts that market outcomes are fully determined by central bank policy. No one doubts that central banks are large and in charge. No one doubts that central banks can and will inflate financial asset prices. And everyone hates it.

Among those investors and allocators with the freedom to flee public markets, the interest in private market opportunities has never been greater. Among those investors and allocators trapped by mandate diktat in the Alice in Wonderland world of public markets, the resigned desperation has never been worse. It’s a quiet desperation in Zurich – a Teutonic stare at the floor and a wrinkling of the mouth – more obvious in Geneva with a Gallic shrug and a full-faced grimace. But’s it’s all the same emotional response to the Bizarro markets in this, the Golden Age of the Central Banker.

At this point in time, the dominant investment belief of our time is that central bankers are omnipotent and no one wants to fight them. The direction of markets is up, as ridiculous as this seems to every sentient being. Portfolio managers may not be happy about all of this as Mr. Hunt points out, but they will not fight it.  They will play the game and be fully invested.

I am quite sure that fund managers don’t understand the true implications of the omnipotent central banker meme, both for society and for themselves.

As far as society is concerned, central bankers have been able to pin interest rates at ridiculously low levels causing a collapse in the savings rate. Below, we can see that net savings in the U.S. has collapsed over the decades following the end of the Bretton-Woods monetary system and a move to pure fiat that central banks can create from thin air:

As we can see, net savings has averaged about 1% of gross national income for a decade. This is a negative savings rate in real terms. There is no way for a society to grow and become wealthier without savings and investment.
This lack of savings is certainly impacting capital spending. We can see from the following graph of industrial and construction capital spending from Goldman Sachs (via Zerohedge) that capital spending is going nowhere fast and is certainly declining in real terms in the U.S., Europe and 
Japan:



   
In short, corporate capital allocators have given up trying to grow their businesses. They are now starting to liquidate their firms because interest rates near zero limit their returns on investment to zero as well. Better to return the capital to shareholders and be done with it. Corporate America is now returning about 4% of the current equity market capitalization to shareholders in the form of share buybacks and dividends each year, and borrowing very heavily to do so.

If I were a professional fund manager I might look at this situation and assume that this is very bad for my profession. It is, after all, tough to be a professional capital allocator if the corporate world is giving up on capital allocation and returning the money to shareholders so that it can be consumed.

Nevertheless, I see some pretty stupid commentary from professional fund managers extolling the wonderful opportunity that we have to buy shares at these levels.  Morgan Stanley strategist Adam Parker even posits that the S&P 5oo could rally another 50% by 2020. All that this requires is a 6% year growth rate in earnings and a 17x P/E multiple in that year to make it so. Well, these companies are telling you that they are going to shrink in real terms if their capital spending plans are any indication. Additionally, if they continue to grow earnings it will be below the operating line and solely a function of financial arbitrage. No one should be dumb enough to pay 17x earnings for shrinking companies in liquidation mode. I wish Mr. Posen’s clients luck in their share buying endeavor. They will certainly need it.

Yes, the primary investment meme of our day is one of central bank omnipotence and that nothing can stop the march of rising asset prices. The cynicism drips heavily from my keyboard now as I am convinced that not only are the world’s central bankers not omnipotent, but they are nothing but a bumbling group of fools who have a tiger by the tail.

Central bank interest rate decisions of the past 15 years have created a situation where societal capital is liquidating itself while asset prices have been forced to levels that predict growth as far as they eye can see. They have created an environment ripe for a disaster.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.