What Does the World Do - When Monetary Policy Does NOT Work?

Central banks around the world have driven interest rates to historical lows, and even negative in some cases.

"Imagine a bank that pays negative interest. Depositors are actually charged to keep their money in an account. Crazy as it sounds, several of Europe’s central banks have cut key interest rates below zero."

The problem is that low interest rates are NOT having the stimulative impact we need.  Demand for capital is not triggering lending and consumers seem are uncharacteristically withdrawn.  Corporations are holding their cash, acquiring their competitors, buying back their stock, and only becoming more efficient with technology and improved business processes.  None of this behavior is promoting the spending and demand that the world's economy needs to counter deflation. 

More money has been printed over the last 5 years than all of history.  All in a futile attempt to increase inflation and stimulate demand.  But it's not good enough.  Fears of a rise in anti-competitive behaviors (tariffs, currency manipulation, governments using laws to hurt multinationals, etc.), political upheaval over reforms, and nationalism/imperialism are present, all because monetary policy is not having the desired effects.  What's the answer?

Some believe it's time for the USA to raise rates.  That's makes no sense with our dollar already rising more rapidly than ever and tons of corporations warning about exchange rate headwinds damaging earnings.  Besides, since when do you fight Deflation by raising rates?!  

By the same token, super low and negative interest rates are distorting investor and saver behaviors who are forced to chase yields from more risky investments.   The potential for very negative consequences can not be underestimated.  We need a better way.  And we have it.  

A better way was presented by British economist John Maynard Keynes wrote about in his book, The General Theory of Employment, Interest, and Money published in 1936 during the Great Depression, in contrast to his a previous works on aggregate supply-focused 'classical' economics.  Unfortunately, back then, Keynesian stimulus came in the form of WWII.  

A massive military expansion has its appeal for some.  And given the threats around the world, we are already seeing it in countries like China, Russia, India, Saudia Arabia, and other areas.  Fortunately, thanks to the "Sequester" that went into place here in the USA as a result of unresolved national debt ceiling negotiations, the USA is not going down the same military build up path.  Surely the hungry arms industry, congressional hawks, and warmongers would if they could. 

What we need is some Keynesian stimulus in the form of infrastructure spending.  Heaven knows we have enough need for it!  Time has come for a new approach to monetary stimulus.  Let's stop paying banks interest on reserves and start investing in the USA!

"All In" - What do you have?

The monetary standoff between Greece and Germany, being played out by the ECB, took a turn for the worse yesterday (2/4/15). Battle lines have been drawn. Greece has moved all their chips in with a creative debt restructuring plan, under which for all practical purposes they will never pay most of it back. Give them two points for not using the words - write down.

Who is going to be the winner? It won't be Germany. For some reason, their hardliners have no memory ... because if any country should understand the need to write down debt it is Germany! They received a huge write down after WW2. But all they can think about is the austerity rules they expect Greece to live up to.

Well Germany, you can forget about it. Greece elected a President, Party, and new finance minister because they said they will break the rules. At least the Greek leaders are being polite as they essentially tell the Germans to fuck off. The Greeks may have under estimated the price for that. Or the Germans may be under estimating the price for holding Greece to wall. Or BOTH! The big winner will be France, Italy, and Spain! Here is why I believe so.

Greece holds out. Time is ticking on a big debt payment and they will all go to the bell. Each with the position that they get it their way. Which amounts to either a creative way of getting a giant debt haircut, or Greece defaults. If this were poker, Greece has just gone all in on a losing hand. Germany calls the bluff. Game over. Say goodnight Greece. Have a nice new day, and good luck starting over. So what are they to do?

They can say, "Welcome back" to the drachma. And after some new currency laws, all the Greek citizens who ran the banks, only to find that only the firsts in line got any Euros, will now be proud to accept drachma instead. And for the rest of us, get ready for the best tourism packages we've seen in a long time, after the riots are over in about a year.

Meanwhile, what did Germany win in this poker game. A big fat bad debt write off. Along with France, Italy, Spain, and everyone else with any skin in the Euro. It is starting to look real bad for everyone at Euro party, I mean pact. Coming apart at the seems? Maybe, but I think not. Too much to lose. Funny how it is when you are standing at the edge of a cliff you get a fresh perspective. And what do they see? They realize that Greece was on to something! Default is such a messy thing. There has to be a better way.  Enter ECB, wait, let's just call the debt problem we have, Hmmm, what did Greece call it, we can't use that name, but .... what ever name they can come up with that will make a whole bunch of trillions in debt go away for so long that two generations from now nobody will remember where it came from.

The newly elected Claude Junker of the Economic Union will show up in the picture too, with fresh ideas for brand new debt.  After all, now that they've just freed up so much borrowing power, thanks to the power of the printing press and the fact that they just shoved so much of the old debt out of the way, they can practically start borrowing money all over again.  But this time is different!!  Yeah, right.  Well, at least for a while.  Long enough to stimulate the economy a "new way" with serious infrastructure spending.  (At least that's what I'm hoping for.)

And as the Europeans and the ECB applaud their own brilliance for saving the Euro, will they thank the Greeks for their great idea on how to handle debt that can't possibly be repaid? Of course not!  But the least they can all do in Europe is vacation on the Greek Islands! (But, people from Germany, suggest you find a way to lose the accent. Otherwise don't be surprised if you get very sick from from every Greek meal you eat.)

OR, Plan B, for the 12th time.  GREECE CAVES and swaps a "kick the can offer" for a "stay in the Euro" deal.


UPDATE: 4/27/15:
Since I published my blog post in February, the notion of bankruptcy and an exit have been trending.  It appears to me that the leaders in Europe are foreshadowing the future in an effort to give banks and the markets and finance ministers time to get ready.  At some point the expectation may be so much in the market that the actual announcement can come as welcome news and even has the potential of bringing a relief rally.  Here's an article which posits the position I have had for quite some time.  "We should let Greece to bankrupt." 

New Image Emerging

The sands are shifting.  The status-quot is giving way to market forces.   

Greece is going socialist or Marxist - and the economy is destroyed.  Germany and the ECB will use them to set an example. Venezuela - has imploded, but just needs a bit more time to collapse.  Russia is sinking - while it hopelessly uses its massive reserves to breath.  They're losing their world power status and rebuilding can't begin until Putin takes a long holiday - for good.  Oligarchs will buy his ticket and help him on the plane. 

The debts of both Greece and Venezuela have to be written down, by way of a default or some back door deal.  Either way, capital (money and talent) leaves, their markets are crushed.  Banks are run.  Game over.  But the phoenix will rise.  As it is finally going to do in Cuba.  

Spain, France and Italy look at the carnage and are determined to take a different path.  ECB draws the line and "does whatever it takes" to restructure their debts.  Seeing how turning back from reforms has hurt Greece, the ECB uses this as leverage to force faster progress on reforms but makes the pill more easy to swallow by using the printing press.  Together with Junker and the Economic Union, a new growth strategy is introduced.  It  involves reforms coupled with development funding.  In combination with low interest rates and E-QE, Europe takes a turn and their currency strengthens - at least it stops weakening.  This puts a floor under USA equities whose earnings are to hard to hedge otherwise with such a weak Euro. 

USA firms see the potential in Europe and put their reserve capital to work overseas. Plus, this works as another form of hedge to exchanges. Look at the difference this made for Ford who manufacturers in the region.  Rather than bringing reserves home, USA firms decide it is time to invest in Europe.  The Federal Reserve and Congress encourage USA investment in Europe. 

America's picture is changing.  Exchange rates are hurting earnings.  And, the oil industry is costing jobs faster than they're being created by the stimulus of low energy costs.  In an effort to curb costs, there is further downward pressure on expenses, which doesn't help USA growth. Raising rates is a non-starter until late 2015 at the earliest. More patience becomes the new operative way of thinking.  But we still need a new catalyst for growth in the USA!  Something has to come out of congress that is positive for growth.  Low rates, low energy help, but there needs to be a new picture that emerges for prosperity. I'm convinced it needs to be infrastructure - of all kinds - transportation, energy distribution (electric, natural gas and hydrogen), and a more secure Internet.

Along comes India.  Cuba might have been enough of a boost to our economy, had it not been for all the other negative shots. But new hope for the world economy, including China, is going to have the taste of curry.  I love curry!  Bring it on!!  They can take up some of the slack in materials - just in time to save miners from supply destruction.  Same to be said of shipping!  

I have to say, my compass has been spinning around trying to find North since 3Q 2014.  And, I'm still working this out in my head.  My investing starts with a macro-picture, so I've been having a very hard time lately with my compass spinning around looking for north.   Frankly, if I had just followed the plan that I blogged about months ago and gone to mostly cash, I'd be a lot happier at this moment. Costly lessons, hopefully learned!  At least it might be said that equities are looking more reasonably priced at this point.  That is unless you think we're entering a bear market.  

Do we need more capitulation before there is a massive turn?  Or is there a lot more pain to come first?  Couldn't tell you.  Only the market can answer that for sure.  Gotta love the intelligence of markets and chaos!  That's one of the things I love most about capitalism.

It appears tensions are building in the bond market for some sort of big turn.  It seems to me that another long super cycle of debt is coming to a head.  The sub-prime and US mortgage debt bust triggered the last financial crisis, and the solutions for that bought some time, while simultaneously contributing to the much greater super cycle of sovereign debt - national debt.  While the last crisis started in the USA, where we had the ability to move quickly and formulate a response, the next and larger crisis begins offshore.  And by the time it arrives here the worldwide damage will already be so enormous that a USA response will be like one plane attacking King Kong or Godzilla.

Of course there must be a response.  Mankind made this problem, so mankind can fix it.  It is in our DNA to try!  Maybe QE becomes QF.  E does follow F.  So maybe easing is followed by forgiveness.   After all, what's the real difference between debt which Greece can't possibly pay back and debt it doesn't have to?  In a word - inflation.  Hmmm, now isn't that the solution everyone is looking for anyway?!!

Now OR Never for Mario Draghi

With European inflation at .3% versus the 2% target, the ECB head Mario Draghi had better start using actions versus words to stimulate growth in Europe.  My belief is that he knows his rhetoric and promises have lost their effect.

But I also believe Drahgi's been looking a better means of delivering financial stimulus than the traditional sovereign debt purchases the the ECB has used thus far.  To this point, QE has just been an enabler for the governments to continue with their old ways.

Draghi has pushed politicians to make the kinds of systemic changes to the conditions that have bogged down Europe - heavy regulation, businesses burdened with workplace rules and limited by Unions to restructure in order to be more competitive.

The strong dollar against the weaker Euro is giving European businesses a strong pricing tailwind, which should help them.  And a dramatic drop in oil is leaving more money for consumers.  But ultimately, more aggressive monitory policy is needed to really get the engine revving.  Especially, now with the drag that a slowing China and Russia's collapsing economy will have on Europe.

The solution Draghi has been waiting for has come in the form of the newly elected European Union President, Juan Claude Junker.  He's got the right ideas if you ask me.  Firstly, Junker's stated number one priority is

"... getting Europe growing again and getting people back to work. "

Those words could have been delivered by any politician, but Junker thinks more like a capitalist than the socialists who have kept Europe in the grips of terrible economy for decades!  Since taking office Dec. 10, 2014, Junker has listed clear objectives including "freeing small and medium-sized businesses from red tape, to promote entrepreneurship and job creation."  He wants the commission to "focus on cutting regulation, making smarter use of existing financial resources, and making flexible use of public funds - to provide up to 300 billion Euro in additional public investment over the next three years."

Here is list of ways Junker wants this investment to be targeted:

• Infrastructure – broadband, energy networks and transport infrastructure
• Education, research and innovation
• Renewable energy and energy efficiency
• Projects to help young people find work (building on the Youth Guarantee scheme).

At a recent December press conference, Mario Drahgi announced that the ECB has just agreed to prepare "for further measures."  The pundits, and even those who initially believed in Draghi seem to have written off Draghi's comments has more of the same "talk."  I'm not so sure.  Draghi, who earned his Doctorate in Economics at MIT, is smart enough to know when time as run out on rhetoric.  Drahgi's been waiting for a man like Junker - and now he has him!  

New Year's Call

One of the things I like about New Year's day is how it causes us to forward think. 

A thesis is forming in my mind. It goes like this. Commodity deflation leads to both producer cost deflation, consumer buying power AND consumer consumption. That leads to both rising corporate profits AND inventory draw down. That leads to increased productivity, hiring, and wage inflation. Which in turn leads to work force expansion, and with that comes greater household formation. The stage is now set for a surge in larger durable orders and new home purchases. Consumer borrowing and spending increase quite a bit. The economy moves into a stronger period of back to back hirer GDP quarters. Finally, the fears of deflation are whipped around and the Fed finds sufficient reason to let interest rates gradually tick up. Stocks enjoy this.

Russia can still spoil the party. The Euro can still unravel. Both would likely happen together. If so, that would be more than markets can handle = big sell off. 

Time will tell ... It always does. As we appreciate especially on New Years.