Tuesday, September 9, 2014

The Tipping Point in Perception of Inflation

‘Inflation often begins imperceptibly, and gains a foothold before it is recognised. This lag in comprehension, important to central banks, is called “money illusion”, a phrase that that refers to a perception that real wealth is being created, so that Keynesian “animal spirts” are aroused. Only later is it discovered that bankers and astute investors captured the wealth, and everyday citizens are left with devalued savings, pensions, and life insurance….

‘Inflation can gain substantial momentum before the general public notices it. It was not until 1974, nine years into an inflationary cycle, that inflation became a potent political issue and a prominent public policy concern. This lag in momentum and perception is the essence of “money illusion”.

‘Once inflation perceptions shift, they are extremely difficult to reset. In the Vietnam era, it took nine years for everyday Americans to focus on inflation, and an additional eleven years to re-anchor expectations. Rolling a rock downhill is much easier than pushing it back up to the top.’

- Jim Rickards, The Death of Money

Saturday, September 6, 2014

Six Major Flaws in the Fed’s Economic Model

The U.S. dollar is the dominant global reserve currency. All markets, including stocks, bonds, commodities, and foreign exchange are affected by the value of the dollar.

The value of the dollar, in effect, its “price” is determined by interest rates. When the Federal Reserve manipulates interest rates, it is manipulating, and therefore distorting, every market in the world.

The Fed may have some legitimate role as an emergency lender of last resort and as a force to use liquidity to maintain price stability. But, the lender of last resort function has morphed into an all-purpose bailout facility, and the liquidity function has morphed into massive manipulation of interest rates.

The original sin with regard to Fed powers was the Humphrey-Hawkins Full Employment Act of 1978 signed by President Carter. This created the “dual mandate” which allowed the Fed to consider employment as well as price stability in setting policy. The dual mandate allows the Fed to manage the U.S. jobs market and, by extension, the economy as a whole, instead of confining itself to straightforward liquidity operations.

Janet Yellen, the Fed chairwoman, is a strong advocate of the dual mandate and has emphasized employment targets in the setting of Fed policy. Through the dual mandate and her embrace of it, and using the dollar’s unique role as leverage, she is a de facto central planner for the world.

Like all central planners, she will fail. Yellen’s greatest deficiency is that she does not use practical rules. Instead she uses esoteric economic models that do not correspond to reality. This approach is highlighted in two Yellen speeches. In June 2012 she described her “optimal control” model and in April 2013 she described her model of “communications policy.”

The theory of optimal control says that conventional monetary rules, such as the Taylor Rule or a commodity price standard, should be abandoned in current conditions in favor of a policy that will keep rates lower, longer than otherwise. Yellen favors use of communications policy to let individuals and markets know the Fed’s intentions under optimal control.

The idea is that over time, individuals will “get the message” and begin to make borrowing, investment and spending decisions based on the promise of lower rates. This will then lead to increased aggregate demand, higher employment and stronger economic growth. At that point, the Fed can begin to withdraw policy support in order to prevent an outbreak of inflation.

The flaws in Yellen’s models are numerous. Here are a few:

1) Under Yellen’s own model, saying she will keep rates “lower, longer” is designed to improve the economy sooner than alternative policies. But if the economy improves sooner under her policy, she will raise rates sooner. So, the entire approach is a lie. Somehow people are supposed to play along with Yellen’s low rate promise even though they intuitively understand that if things get better the promise will be rescinded. This produces confusion.

2) People are not automatons who mindlessly do what Yellen wants. In the face of the embedded contradictions of Yellen’s model, people prefer to hoard cash, stay on the sidelines and not get suckered by the bait-and-switch promise of optimal control theory. The resulting lack of investment and consumption is what is really hurting the economy. Economists call this “regime uncertainty” and it was a leading cause of the length, if not the origin, of the Great Depression of 1929-1941.

3) In order to make money under the Fed’s zero interest rate policy, banks are engaging in hidden off-balance sheet transactions, including asset swaps, which substantially increase systemic risk. In an asset swap, a bank with weak collateral will “swap” that for good collateral with an institutional investor in a transaction that will be reversed at some point. The bank then takes the good collateral and uses it for margin in another swap with another bank. In effect, a two-party deal has been turned into a three-party deal with greater risk and credit exposure all around.

4) Yellen’s zero interest rate policy constitutes massive theft from savers. Applying a normalized interest rate of about 2% to the entire savings pool in the U.S. banking system compared to the actual rate of zero, reveals a $400 billion per year wealth transfer from savers to the banks from the zero rates. This has continued for five years, so the cumulative subsidy to the banking system at the expense of everyday Americans is now over $2 trillion. This hurts investment, penalizes savers and forces retirees into inappropriate risk investments such as the stock market. Yellen supports this bank subsidy and theft from savers.

5) The Fed is now insolvent. By buying highly volatile long-term Treasury notes instead of safe short-term treasury bills, the Fed has wiped out its capital on a mark-to-market basis. Of course, the Fed carries these notes on its balance sheet “at cost” and does not mark to market, but if they did they would be broke. This fact will be more difficult to hide as interest rates are allowed to rise. The insolvency of the Fed will become a major political issue in the years ahead and may necessitate a financial bail-out of the Fed by taxpayers. Yellen is a leading advocate of the policies that have resulted in the Fed’s insolvency.

6) Market participants and policymakers rely on market prices to make decisions about economic policy. What happens when the price signals upon which policymakers rely are themselves distorted by prior policy manipulation? First you distort the price signal by market manipulation, then you rely on the “price” to guide your policy going forward. This is the blind leading the blind.

The Fed is trying to tip the psychology of the consumer toward spending through its communication policy and low rates. This is extremely difficult to do in the short run. But once you change the psychology, it is extremely difficult to change it back again.

If the Fed succeeds in raising inflationary expectations, those expectations may quickly get out of control as they did in the 1970’s. This means that instead of inflation leveling off at 3%, inflation may quickly jump to 7% or higher. The Fed believes they can dial-down the thermostat if this happens, but they will discover that the psychology is not easy to reverse and inflation will run out of control.

The solution is for Congress to repeal the dual mandate and return the Fed to its original purpose as lender of last resort and short-term liquidity provider. Central planning failed for Stalin and Mao Zedong and it will fail for Janet Yellen too.


Jim Rickards
for The Daily Reckoning

Wednesday, September 3, 2014

China’s Government Crackdown on Corruption

China’s Communist Party announced a formal investigation last month into one of the party's most senior figures, Zhou Yongkang, and one hedge fund manager says the move will bring broader political and market implications.

Jim Rickards, portfolio manager for the West Shore Real Return Income Fund and the author of “The Death of Money,” has experience doing business in China, and recently told FOX Business’s Deirdre Bolton that the investigation is the Chinese government’s warning shot to corrupt officials.

After 18 months of covert investigation, the Chinese government went public with its official investigation against the ex-security chief on July 29, according to Chinese media. The investigation makes Zhou the highest-ranking official to be placed under formal investigation in over a decade.

“Zhou Yongkang was the head of the secret police, the court administration and the enforcement of party discipline. He is the guy who’s now been arrested and investigated,” Rickards said.

While Zhou is just under investigation, Rickards said his fate might already be sealed.

“You have to understand that there is no rule of law in China. They have a constitution, they have courts and lawyers and trials, but it’s all for show….The Power Bureau, the Central Committee and the Communist Party make all the decisions,” he said.

Rickards described Zhou as part of a group of “financial warlords” in the country that use power and connections to secure multibillion dollar project contracts, such as commercial housing projects.

“If you look at these ghost cities and construction sites… why are they building all these empty things that no one needs? If you are in charge of cement, steel or construction… you scam them and then you take the money buy a place in Vancouver [and] New York.” Rickards said.

Rickards said China’s highly-unregulated legal system makes investing in the country difficult for those without government connections.

“The best way to invest in China, is to find a service business that China needs, where they pay you in hard currencies outside of China, and you don’t have to put a lot of fixed assets inside China,” said Rickards. “That way, if things go badly, you just tear up your contract and walk away.”

- Source, Fox Business

Sunday, August 31, 2014

What can the Chinese government do to keep the wealth gap from widening?

China could rebalance its economy away from wasteful investment, which mainly benefits elites in construction and related industries, toward consumption and services, which provides more opportunities for middle-class workers.

China could also invest more in education so that everyday citizens could participate in more high-value-added labor as a way to earn a larger slice of national income. China could also enforce its laws against corruption, bribery and cronyism more rigorously and clamp down on tax avoidance and capital flight.

- Source, DW

Thursday, August 28, 2014

What is driving China's growing wealth gap?

Most of the income inequality in China can be explained by corruption and elitism. In the 1980s and 1990s, under the leadership of Deng Xiaoping, China reformed its system of state-owned enterprises (SOES). Some of these SOES were closed, some were privatized, and some remained SOES, but were designated as national champions in their respective industries and allowed to thrive free of normal competition.

In each case, stock in the privatized companies or senior management roles in the new national champions was given to loyal Communist Party cadres and to so-called "princelings" who were the sons and daughters of leading officials or survivors of the Long March days of Mao Zedong in the 1930s. During the export and investment led boom that followed, these enterprises made enormous profits which went principally to the owners and senior managers and not to the workers.

This boom has continued beyond the bounds of normal expansion through China's over-investment in infrastructure, much of which is wasted. In effect, China is misallocating national wealth in favor of the SOES and private companies favored by government, which enriches a few at the expense of the nation as a whole.

How unequal has the current Chinese economic system become in comparison to capitalist systems in countries such as the United States?

Income inequality is a global problem. It has always existed in traditional oligarchical systems such as those in South America. It was less prevalent in North America and Europe and former Commonwealth nations that had a strong rule of law and offered good economic opportunities to those people who did not necessarily start out from a privileged position.

It was also not much of a problem in Communist nations such as Russia and China because there was relatively little wealth to begin with. Elites may have lived better but they were constrained by the relative poverty of their countries. Since the new age of globalization began in 1989, China and Russia have become much richer, which increases the opportunities for cronyism and theft by elites.

The situation in the US is exacerbated by bank and auto bailouts, other forms of government favoritism, and an opaque and complex tax system. The causes of income inequality in China, Russia and the US are different but the result is the same. China has greater income inequality than the US, but both countries are approaching the point where income inequality is so extreme that it threatens to cause social disorder.

The ruling Communist Party aims to preserve social stability to avoid any challenge to its grasp on power. How big of a concern is this widening wealth gap to China's Communist Party?

Income inequality should be deeply disturbing to the Communist Party leadership because it has historically been a source of social instability in China. The demonstrations and massacre in Tiananmen Square in 1989 were in part attributable to increasing inflation, which is a form of income inequality because it is most damaging to those with fewer investment options to hedge against inflation.

However, the Chinese elites are themselves the main beneficiaries of income inequality in the short run. Capital flight from China is accelerating, which is a sign that at least some elites have adopted a "take the money and run" attitude and no longer care about continued Communist Party dominance provided they can extract enormous wealth from the country before the social disorder become more pronounced. The widening wealth gap is troubling, but it is not clear whether there is much political will to stop it.

- Source, DW

Monday, August 25, 2014

Rickards: Stock market reality check

Listening to mainstream market commentary on television and reading the financial press leaves one with the impression that the economic recovery is gaining strength and that stock market indices, at or near all-time highs, will go higher still.

The litany of market happy talk is impressive. The unemployment rate has dropped to 6.1%, down about 4 percentage points from its peak, and is expected to go lower in the months ahead. The economy created about 230,000 jobs per month in the first half of 2014, which brings the increase in jobs to nine million since the economic recovery began in mid-2009. Interest rates remain low, which supports high asset valuations in stocks and housing. Inflation is tame and expectations about future inflation are well anchored. To hear the stock market bulls tell the story, all is right with the world.

But all is not right. In fact, the fundamentals of the U.S. economy are in awful condition and are getting worse. Almost everything about the happy talk story is superficial, and falls apart under scrutiny. There is an alternative narrative of bad news that is seldom discussed on mainstream business channels but is well known to analysts. When these adverse trends are taken into account one conclusion in inescapable. The stock market and economic fundamentals are on a collision course. One or the other will have to swerve. Either the economy will have to improve rapidly and unexpectedly and reverse its fundamental weakness, or inflated stock values are heading for a precipitous fall. The evidence suggests that the latter is more likely.

The first weak link in the happy talk chain is the nature of job creation. For example, it was reported than 288,000 jobs were created in June. But full-time jobs declined by 523,000 while part time jobs increased by about 800,000. The widely reported increase in net jobs masked a disastrous loss of full-time jobs offset by a huge increase in part-time jobs. The part-time jobs offer fewer hours, lower pay and few benefits. They may be better than no job at all, but they are not the kind of jobs that will support discretionary consumer spending on which the economy relies for growth.

This trend in part-time jobs is not new. There are 7.5 million people working part-time on an involuntary basis compared to about 4.4 million doing so in 2007. This rise in part-time jobs is expected to continue because it is driven in part by Obamacare, which does not require coverage for part-time workers. Employers are aware of this and simply cut full-time jobs and replace them with part-timers to reduce insurance costs.

Nor is there any comfort in the declining unemployment rate. Much of the decline is attributable not to job creation but rather to the decline in the number of people looking for work. Once people stop looking for a job, they are no longer technically “unemployed” and the unemployment rate drops even though no job has been found. As columnist Mort Zuckerman said, “You might as well say that the unemployment rate would be zero if everyone stopped looking for work.” Only 62.8% of Americans participate in the work force today — the lowest level since 1978.

The news gets worse. Not only is labor force participation low, and full-time employment collapsing, but the productivity of those working is now in decline. This decline in productivity is another drag on growth. The reason for it is even more disturbing. Productivity is declining because capital expenditure has slowed. Businesses are keeping up with demand by employing part-time workers instead of investing in the plant and equipment needed to make full-time workers more productive.

Not surprisingly, this triple-whammy of declining full-time jobs, declining productivity and slowing capital investment means that real wages are stagnant. If workers can’t make more, they can’t spend more without borrowing. Borrowing is more difficult because home equity has not recovered from the 2007 housing crash and lending standards are the most stringent in years. Companies won’t invest in equipment if consumers can’t spend.

The result is a death spiral of lower consumption, lower investment, declining productivity, stagnant wages, and underemployment all feeding on each other and making the overall economy weaker. This is the real reason for the shocking 2.9 percent decline in first quarter GDP. It was not the result of “cold weather,” which by the way happens every winter.

There are other signs of ill health in labor markets. In a dynamic labor market, net job gains reflect large numbers of new jobs and lost jobs as employees confidently quit their jobs in the expectation of finding new ones. But evidence reported by Goldman Sachs and James Pethokoukis of the American Enterprise Institute shows that job turnover has declined sharply as employees are extremely reluctant to quit their jobs in an uncertain environment. This tends to lock-out the unemployed who lose job entry opportunities and to weaken wage growth as employees lose leverage to demand raises.

Labor force participation is unlikely to rise significantly partly because of generous benefits that provide an adequate lifestyle for those out of the labor force. The U.S. has over 50 million on food stamps, 11 million on disability, and millions more on extended unemployment benefits. Prospective loss of these benefits creates a high hurdle to motivate a return to the workforce.

The news from abroad is no better. China is slowing precipitously and may be on the brink of a credit collapse. European growth is near zero and even the mighty German economy, the locomotive of Europe, is slowing partly because of weaker demand from Ukraine, Russia and China.

Against this backdrop, mainstream voices are beginning to call U.S. financial markets a bubble. The New York Times recently featured a front page story with the title, Welcome to the Everything Boom, or Maybe the Everything Bubble. The conservative Bank for International Settlements in Switzerland recently warned that stock markets had become “euphoric.” Even Janet Yellen of the Federal Reserve, the institution with the worst record for spotting asset bubbles, said that valuations of some securities “appear stretched.”

So, the conundrum is complete. Stock indices march to all-time highs while economic fundamentals fall apart. The two will be reconciled either with a spectacular turnaround in growth or a spectacular collapse in stock prices. The problem is that a turnaround in growth can only come from structural reform, not money printing. Structural reform is the job of the White House and Congress, not the Federal Reserve. Since the White House and Congress are barely speaking, no help should be expected from that direction. Therefore a stock market collapse is almost inevitable and is probably coming soon.

James Rickards is portfolio manager for the West Shore Real Return Income Fund and the author of “The Death of Money,” a New York Times best seller from Penguin Random House. Follow on twitter @JamesGRickards

Wednesday, August 20, 2014

James Rickards on Alex Jones Infowars

Jim Rickards appears on the very popular, Alex Jones, Infowars radio show. He tells Alex to watch what they do. Not what they say.

Monday, August 18, 2014

Tracking the impact of Argentina's debt default

Jim Rickards, Senior Managing Director at Tangent Capital, discusses whether Argentina's second default on its sovereign debt will have a contagion effect on global financial markets.

Saturday, August 16, 2014

Fireplace of financial instability is stacked with wood

Jim Rickards talks with Paul Buitink about the crisis and his presentation for 20 September in Rotterdam.