naked capitalism

Nouriel Roubini, who has backed off from what was once his signature bearishiness (he has been calling for an U or perhaps a W shaped recovery) nevertheless thinks the current market rallies are considerably overdone. From Bloomberg:

New York University Professor Nouriel Roubini, who predicted the financial crisis, said stock and commodity markets may drop in coming months as the gradual pace of the economic recovery disappoints investors.

“Markets have gone up too much, too soon, too fast,” Roubini said in an interview in Istanbul on Oct. 3. “I see the risk of a correction, especially when the markets now realize that the recovery is not rapid and V-shaped, but more like U- shaped. That might be in the fourth quarter or the first quarter of next year.”…

“The real economy is barely recovering while markets are going this way,” Roubini said. If growth doesn’t rebound rapidly, “eventually markets are going to flatten out and correct to valuations that are justified. I see a growing gap between what markets are doing and the weaker real economic activities.”…

“In the short run we need monetary and fiscal stimulus to avoid another tipping point and to avoid deflation, but now this easy money has already started to create asset bubbles in equities, commodities, credit and emerging markets,” Roubini said. “For the sake of achieving growth stability again and avoiding deflation, we may be planting the seeds of the next cycle of financial instability.”

By George Washington of Washington’s Blog.

(Rest assured that once Yves is done writing her book, and back posting,  or other guest posters write more, I will post less often! )

This essay rounds up arguments for gold as a reasonable investment.

China

Commentators such as Ambrose Evans-Pritchard and Byron King argue that China’s hunger for gold will put a floor on gold prices.

Specifically, they argue that China will “buy the dips” in gold prices, effectively putting a minimum on how low gold prices can go.

Inflation

It is conventional wisdom that gold is a hedge against inflation.

For example, noted inflationist John Williams advises buying gold.

Axel Merk argues that gold is a better buy than TIPS as an inflation bet.

And Taleb advised buying gold in May, since currencies including the dollar and euro face pressures.

Deflation

If gold does well during times of inflation, it makes sense that it would perform poorly during deflationary periods.

But Examiner.com points out that such an assumption is probably untrue.

Specifically, as Examiner.com writes:

Eric Sprott – who manages $4.5 billion in assets, and correctly predicted in March of 2008 a “systemic financial meltdown” – says:

“I believe no matter what environment you’re in – deflation or inflation – people will run to gold,” Sprott said. “Gold is proving exactly what we all would have expected, that in almost any environment, it’s a go-to asset.”

And investment analyst and financial writer Yves Smith argues that gold does well during both periods of deflation and high inflation. She argues:

Historically, gold does well [in] hyperinflation and deflationary [periods]. Gold does poorly under more normal conditions, and gets hammered in disinflationary conditions, a falling but positive rate of inflation.

Analyst Adrian Ash argues that gold’s value actually increases during periods of deflation even if its price drops:

Does the price of gold rise or fall in a deflation?Hint: It’s a trick question, already tripping up plenty of would-be advisors…

Absent the money-supply limits which the gold standard imposed on the world, people rightly guess that double-digit inflation would prove rocket-fuel for the bull market in gold. Yet the purchasing power of gold nearly doubled during the Great Depression, and it’s risen four-fold during this decade’s low consumer-price inflation as well.Why? Because both those periods of low price-inflation saw the money-issuing authorities devalue the currency, first with explicit reference to gold but now without daring to name it. Roosevelt in the mid-30s slashed the dollar’s gold content by 40%; the Greenspan/Bernanke Fed devalued the Dollar again to sidestep a DotCom Depression, keeping real interest rates at less than zero, between 2002-2005.

The maestro’s apprentice applied the same trick in the back-half of 2008, but so far to no avail. And now even the European Central Bank is pumping out money – a near half-trillion euros today alone – in a bid to revive bank lending, swamp the currency markets, and pull Germany out of its first flirt with deflation since the 1930s.

Just such a devaluation – and again, absent any stated reference to gold – was attempted by the Bank of Japan a little less than a decade ago.

Indeed, Japan is the only developed nation since the end of the gold standard to have suffered an extended deflation in prices. So far, at least. Germany and Switzerland look set to try for a re-wind, and unless the dollar can outpace the euro’s descent, we might yet see truly sub-zero inflation in the United States, too.

But whatever that should mean for gold prices, all other things being equal, just doesn’t matter. Because the gold price will not get a chance. All other things are not equal, and the policy solution – rank devaluation – can only make gold more appealing to investors and savers, whether the “monetarist experiment” of TARP, quantitative easing or a half-trillion euros proves successful or not.

Japan’s slump into deflation coincided with the Bank of Japan’s “zero interest rate policy” (ZIRP) at the start of this decade. It also saw the gold price worldwide hit rock-bottom and turn higher, a move that analysts (including us) have typically linked to US monetary moves and investment cash looking for safety as the Dotcom Bubble exploded.

But zero-rate money from the world’s second-largest economy shouldn’t be ignored. And today, zero-rate money is all the developed world has to offer – a trick that might not beat deflation, but might just spur a whole new rush into gold.

In other words, Ash argues that you can’t take inflation or deflation in a vacuum. During deflationary periods – like we have now – governments always increase the money supply with a flood of new dollars, which is bullish for gold.

And PhD economist Marc Faber wrote in October 2007 that gold will do well even in a deflation:

How would gold perform in a deflationary global recession? Initially gold could come under some pressure as well but once the realization sinks in how messy deflation would be for over-indebted countries and households, its price would likely soar.

Therefore, under both scenarios – stagflation or deflationary recession – gold, gold equities and other precious metals should continue to perform better than financial assets.

Looking At the Charts

Is Faber right?

Well, take a look at the following charts showing gold’s performance as compared to the yen during Japan’s “lost decade” of deflation:

Japan’s deflation didn’t definitively end until 2007 or 2008.

This provides some evidence that gold may tend to hold or increase its value at least in the later part of the deflationary period as compared with the relevant national currency.

Moreover – approximately half the time – gold has risen during recessions in the United States:

(The grey vertical bars show periods of recession; the chart gives gold prices in monthly averages; click here for larger image).

If you study the above chart, you will see that gold seems to often fall during the beginning stages of a recession, then rise in the later stages of the recession (before 1971, the dollar was still backed by gold at a fixed price, and so gold did not fluctuate).

But what about Ash’s theory?

The American Enterprises Institute notes:

After five years in a deflationary economic wilderness, the Bank of Japan switched during the spring of 2001 to a policy of quantitative easing–targeting the growth of the money supply instead of nominal interest rates–in order to engineer a rebound in demand growth.

Look again at the first gold chart for Japan, above. Gold appears to start increasing against the Yen in 2001.

This may provide some evidence for Ash’s thesis that it is an expansion of the money supply which pushes the price of gold up in the later stages of deflationary periods.

Uncertainty

Finally, Chris Martenson argues that – in prolonged periods of deflation – we usually see failures of large and significant banks, institutions, and perhaps even states and countries. Because gold traditionally does well during periods of uncertainty, Martenson likes gold during periods of deflation.

Examiner.com notes in a subsequent article:

Merrill Lynch agrees.

Specifically, PhD economist Nouriel Roubini paraphrases a report from Merill Lynch (not available online) as follows:

Short-term rates of 0% are bullish for gold, which serves as a store of value but is a useful hedge against deflation as well, since deflation is inherently destabilizing for financial assets. In the 2001-03 deflationary period, gold rose more than 30%, not to mention the prospect of a return to a dollar bear market. “Gold is inversely correlated to global short-term interest rates and there is a race right now towards 0%. Production is down 4.0% y/y while fiat currencies globally are being created at a double digit rate by the world’s central banks….As for all the talk of a ‘gold bubble,’ it would take a nearly 625% surge in gold to over US$6,000/oz and a flat stock market to actually get the ratio of the two asset classes back to where it was three decades ago when bullion was in an unsustainable bubble phase.”

Gold tends to be less sensitive to global economic slowdown than industrial metals or energy and works better as a hedge against crisis than inflation.

Global Short Term Interest Rates Are Low

The above-quoted Merrill article states:

Gold is inversely correlated to global short-term interest rates and there is a race right now towards 0%.

This argues for gold.

Polls Show Distrust in Government

Time Magazine writes:

Traditionally, gold has been a store of value when citizens do not trust their government politically or economically.

Given the enormous levels of distrust in the government politically and/or economically (and the fact that some have warned of recession-induced violence), gold might do well.

Greenspan and Exeter

Professor Emeritus of Mathematics Antal Fekete has argued for years that gold is the ultimate – and only – safe haven when things really hit the fan.

For example, in 2007 Fekete wrote:

The grand old man of the New York Federal Reserve bank’s gold department, the last Mohican, John Exter explained the devolution of money (not his term) using the model of an inverted pyramid, delicately balanced on its apex at the bottom consisting of pure gold. The pyramid has many other layers of asset classes graded according to safety, from the safest and least prolific at bottom to the least safe and most prolific asset layer, electronic dollar credits on top. (When Exter developed his model, electronic dollars had not yet existed; he talked about FR deposits.) In between you find, in decreasing order of safety, as you pass from the lower to the higher layer: silver, FR notes, T-bills, T-bonds, agency paper, other loans and liabilities denominated in dollars. In times of financial crisis people scramble downwards in the pyramid trying to get to the next and nearest safer and less prolific layer underneath. But down there the pyramid gets narrower. There is not enough of the safer and less prolific kind of assets to accommodate all who want to “devolve”. Devolution is also called “flight to
safety”.

Darryl Schoon makes the same argument.

Here’s a visual depiction Exeter’s inverted pyramid, courtesy of FOFOA:

(Click here for full image; I am not certain every level of the pyramid is accurately ranked)

Alan Greenspan has just lent some support to the theory. Specifically:

Gold prices that jumped above $1,000 an ounce this week are signaling that investors are buying metals to hedge against declines in currencies, former Federal Reserve Chairman Alan Greenspan said.

The gains are “strictly a monetary phenomenon,” Greenspan said today at an investment conference in New York. Rising prices of precious metals and other commodities are “an indication of a very early stage of an endeavor to move away from paper currencies,” he said…

“What is fascinating is the extent to which gold still holds reign over the financial system as the ultimate source of payment,” Greenspan said.

In other words, Greenspan is saying that investors are moving out of the second-to-lowest step on the pyramid (currencies and government bonds) and into the lowest step (gold).

Greenspan is also verifying what goldbugs like Exeter, Fekete and Schoon have been claiming: that “the barbarous relic” still holds an important place in the modern investor’s psyche.

Are Exeter, Fekete and Schoon right? I don’t know. And Greenspan might be wrong, or trying to excuse weakness in the dollar (as opposed to all paper currencies).

Note 1: Zero Hedge alleges that newly-declassified federal documents prove that gold prices have been manipulated for decades. If these documents are authentic (I have no reason to doubt their authenticity, but have no inside knowledge), if the claims of artificial price suppression are true, if this is widely publicized, if such publicity causes someone like Congressmen Alan Grayson, Brad Sherman, Ron Paul, or Dennis Kucinich to raise a ruckus in Congress, and if Congress as a whole votes to ban such a practice, then the price of gold would presumably rise. That’s a lot of ifs.

Note 2: Some of the best recent arguments I’ve heard against gold are written by Vitaliy Katsenelson. Read this, this, this and this.

Note 3: I am not an investment advisor and this should not be taken as investment advice.

By George Washington of Washington’s Blog.

As I have recently pointed out, there are strong arguments for ongoing deflation.

But even deflationists think that – after a period of deflation – we might eventually get inflation. For example, in October, I guessed 1 1/2 to 2 years of deflation, followed by inflation.

Moreover, noted deflationist Martin Weiss – after predicting for 27 years straight that we’ll have deflation – has now changed his mind, and thinks inflation is a greater short-term threat than deflation.

For these two reasons – and to make clear that the inflation versus deflation debate is complicated and includes many factors – this essay will focus on the arguments for inflation.

Faber and the Dollar

PhD economist Marc Faber said in May:

“I am 100% sure that the U.S. will go into hyperinflation.”

Faber said he thinks – in the medium-term – we could have high levels of inflation (and see this and this).

Faber’s argument is that a weakening dollar will lead to inflation (as every dollar will buy less goods and services).

Government Printing

The government has injected trillions of dollars into the economy in the form of TARP bailout funds and other programs. Indeed, the government’s own watchdog over the TARP program – the special inspector general – said that number could be $23 trillion dollars in a worst-case scenario.

The basic argument for inflation is – as everyone knows – that the government has injected so much money into the economy (through bailouts, quantitative easing, purchase of treasuries, etc.) that there will be a lot more dollars chasing the same number of goods and services, which will drive up prices. In other words, the supply is the same, but demand has increased.

Indeed, the U.S. has also provided huge sums of dollars to foreign central banks. Could dollars given abroad cause inflation inside the U.S.? Yes – because some proportion of those dollars will be spent by citizens in those countries to buy stocks, commodities, goods and services within the U.S.

Three well-known advocates of the inflation argument are Rogers, Buffet and Schiff.

Specifically, billionaire investor Jim Rogers said we are facing an “inflationary holocaust”.

Warren Buffett said:

The policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

And Peter Schiff has argued for years that hyperinflation will wipe out the value of the dollar, so people should get all of their money out of dollars and into foreign currencies and assets.

But is all this government printing and quantitative easing really enough to cause inflation?

The back-of-the-envelope figures I’ve seen bandied about say no. Because of the massive destruction of credit (which – as Mish has repeatedly pointed out – must be included in discussions of inflation versus deflation), the government would probably have to print one-and-a-half to two times as much as it already has in order to create inflation.

The government could still do so. Yes, it would be suicidal for the dollar and might cause foreign buyers of U.S. treasuries to stop buying, but the boys in Washington could – if they were crazy enough – increase the money printing and quantitative easing to the point where inflation actually kicks in.

Will they do so? Summers, Geithner and Bernanke have proven themselves willing to do a lot of crazy things over the past year, so I wouldn’t rule the possibility out altogether.

Indeed, when the Option Arm, Alt-A and commercial real estate mortgages start defaulting in earnest, there will be a lot of pressure on Washington to “do something”. But again, doubling the amount of money printing would turn the dollar into monopoly money, and so there will be a lot of pressure not to turn America into Zimbabwe.

Devaluing the Dollar

Many commentators also argue that the U.S. is intentionally devaluing the dollar in order to increase trade.

And – as everyone knows – the dollar might tank even if the boys don’t intentionally devalue it into oblivion. Just look at the amount of printing and easing which has already been done, the tidal wave of debt overhang, and the lack of fundamental soundness in the giant banks, the financial system, and the U.S. economy as a whole.

Moreover, some people argue that the dollar carry trade will drive inflation. Specifically, they argue that we’ll get “spec-flation”, meaning that investors will buy dollars and – in a carry trade – use the dollars to invest abroad. This will devalue the dollar, creating inflation.

And, importantly, the U.S. is quickly losing its status as the world’s reserve currency. Therefore, the “premium” on the value of the dollar for its status as reserve currency will also fade, and the value of the dollar decline.

For these and other reasons, Faber and other inflationists would argue that the dollar will continue to substantially decline and inflation will therefore kick in (Note: Mish is still a dollar bull, and so doesn’t concede this point).

Unemployment

I have previously argued that the rising tide of unemployment will contribute to deflation for some time.

However, Edmond Phelps – who won the Nobel Prize for Economics in 2006 – and PIMCO Chief Executive Officer Mohamed El-Erian both say that the “natural unemployment rate” has risen from 5 to perhaps 7 percent.

What is the natural unemployment rate? It just means that if unemployment falls below that a certain percentage, then inflation will be created.

So if the natural unemployment rate has risen, that may mean that we will get inflation sooner (when unemployment falls to 7%, instead of when it falls all the way back to the previous peg of 5%).

End of Foreign Bond Purchases?

Tiger Management founder and chairman Julian Robertson warns that – if foreign purchasers stop buying U.S. treasury bonds – inflation will strike:

If the Chinese and Japanese stop buying our bonds, we could easily see [inflation] go to 15 to 20 percent,” he said. “It’s not a question of the economy. It’s a question of who will lend us the money if they don’t. Imagine us getting ourselves in a situation where we’re totally dependent on those two countries. It’s crazy.

Bottleneck Inflation

Finally, Andy Xie argues that “bottlenecks” can cause inflation. Specifically, Xie argues that inflation in a single key market – say oil – can cause inflation, even in a weak economy.

Conclusion

As I have argued for a year, we will probably have a period of deflation followed by inflation. I still believe that.

When inflation will kick in is the million dollar question. The inflation camp argues that inflation will kick in any second now without any warning. In the deflation camp, David Rosenberg argues for years of deflation, and Dr. Lacy Hunt argues for decades of deflation.

Bottom line: In my opinion, the question is when, not if.

But in investing, being too early is being wrong. Someone who is positioned for inflation decades too early will get creamed. Likewise, someone who is betting on deflation for 20 years will get hurt if inflation kicks in next month.

Note: Remember that we could also get mixed-flation. In other words, inflation in some asset classes and deflation in others. Indeed, given that speculators drove up the price of oil last year, it is possible that – especially in a stagnant economy – speculators could drive up the prices of some asset classes and drive others down.

It must be lonely being a China bear….particularly for those dubious about its longer term prospects, as opposed to those who might simply think its stock market is a bit ahead of itself even after its recent correction.

Vitaliy Katsenelson, in an article at MorningStar, beings almost sounding a tad persecuted before he warms up to his theme. that there is more in common between Japan in the late 1980s, when it seemed poised to continue its inexorable rise and China today. And the differences for the most part favor Japan. Katsenelson first quotes Jim Grant at length, then offers his own comments.

From Morningstar (hat tip reader Michael):

China today is where Japan was in the late ’80s, except with the greater political instability that comes with a semi-controlled economy and the lack of a social safety net (read: jobless, hungry people don’t write angry letters, they riot)…Today China projects to the world a similar image as Japan did in the 1980s…

Lately, the Chinese economy has been impressing us with its growth…But Chinese economic structure is not is not superior to the West’s; the Chinese can just cook GDP numbers better and control their economy more effectively through forced lending and spending.

However, these short-term advantages come with long-term consequences – there will be a steep price to pay for them; there always is. I’ve written a lot about this (here and here). Instead I’ll quote James Grant, the publisher of Grant’s Interest Rate Observer. Jim is providing the latest issue of his newsletter free…Here are a few quotes …:

“A superb primer on the risks of China’s go-for-broke lending drive was published by Fitch Ratings on May 20. Is it not passing strange, the agency asks, that Chinese lending is accelerating even as Chinese corporate profits are shrinking? ‘Ordinarily, falling corporate earnings are met with tightened lending, but in China, precisely the reverse is evident. . . .’ You would expect—and Fitch does anticipate—that the borrowers of these trillions of renminbi are not so profitable as they were in the boom, and some will therefore struggle to service their debts.”

I think this chart, also excerpted from Grant’s Interest Rate Observer, tells the full story of the quality of China’s latest growth…

“Examining, first, the track of Chinese bank lending and, second, the trend in Chinese nonperforming loans, the seasoned reader will remember … Drexel Burnham Lambert. In the mid-to-late 1980s, the American junk bond market combined breakneck growth with muted default rates. The secret, fully revealed during the subsequent bear market, was that the default rates were a direct product of the issuance rates. Borrowers didn’t default because of—to adapt the Fitch formulation to that earlier time—the ‘pervasive rolling over and maturity extension of bonds as they fell due.’ Drexel failed when the junk market did.

Yves here. Hyman Minsky fans will recognize this as his Ponzi unit paradigm. Back to Grant via Morningstar:

“Since 2005, China has generated 73% of the global growth in oil consumption and 77% of the global growth in coal consumption.” [emphasis is mine]

Yves here, I know extended quotes in blog posts can be a bit confusing. We are now done with Jim Grant and are back to Katsenelson in a second of two linked articles:

Today, Chinese economic growth is the force pushing the global economy. The quality of this growth, however, is low as it is predicated on massive (forced) lending and thus unsustainable. As Chinese growth slows, China will turn from a wind into sails of global economy to its anchor. The impact will be felt in many, often unsuspected places.

It will tank the commodity markets, commodity producers and commodity exporting nations. Let’s take oil, for instance. As incremental demand from China collapses, oil prices will follow, taking the Russian economy with it, as Russia is for the most part a one-trick-petrochemical-pony. According to GavKal Research China accounts for 15% of Brazil’s exports (up from 1.5% a decade ago), significantly impacting the economy of that South American nation..

Demand for industrial goods will fall off the cliff. China consumed a lot of those goods – $550 billion worth annually (also according to GaveKal Research). So if Caterpillar expects to sell more of its yellow earthmovers to China, it will have put that thought on hold for awhile…..

Finally, Chinese appetite for our fine currency will diminish, driving the dollar lower against the renminbi and boosting our interest rates higher. No more 5% mortgages and 6% car loans.

Identifying bubbles is a lot easier than timing them. An astute observer could have seen the Japanese bubble developing in 1986, 1987 and 1988, but he would have been “wrong” until 1989….

Yves again. The other reason to take this gloomy appraisal seriously is that in the Great Depression, it was the big exporter (the US) that faced the most difficult adjustment. Overconsuming indebted countries in Europe simply defaulted.

Some investors see the Baltic Dry Index, a proxy for the shipping rates for dry bulk cargoes, as an indicator of international trade activity. BDI is admittedly noisy, and so needs to be interpreted along with other information.

Chinese imports have been a driving factor in commodities demand, which drives the BDI. The price of imported iron ire has dropped below $100 a ton and may fall further. From Cajing.com (hat tip reader Michael):

The slump had sparked panic among iron ore traders, who might now rush to clear their stocks, which could drive prices even lower….

The price for 63 percent grade Indian fine ore was US$95 to US$97 per ton on August 24 on a cost and freight basis, down from US$110 per ton on August 10, according to industry consultancy Mysteel.

“The price drop was caused by an increase in steel and iron ore stocks at mills and sea ports and a decline in steel prices,” Xu Guangjian, analyst with the Umetal Research Institute….

The slump had sparked panic among iron ore traders, who might now rush to clear their stocks, which could drive prices even lower, he said.

Mysteel analyst Xu Xiangchun said iron ore prices were still high compared with revised steel prices.

“The steel price has fallen to its early July level, but iron ore is still US$20 a ton higher than it was in early July,” he said, adding that iron ore will likely fall to about US$80 a ton.

The total stock of iron ore in 19 major Chinese ports was almost 73 million tons as of August 22, up 48 million tons on a week earlier, according to Umetal.

Nouriel Roubini verged on apocalyptic during the course of the crisis, and was proven largely right. Now that he has softened his stance, some have accused him of moderating his tone as a result of his much higher profile.

While that’s possible, a couple of factors seem more likely. First and foremost, much of Roubini is now being filtered through the MSM, which as many readers have commented, has been too often trying to find the happy face in any bit of economic news. A glaring instance in July was when Roubini put out a press release disputing a Bloomberg news report claiming Dr. Doom had said the recession would be over this year. So we are not getting the raw, unedited, long form Roubini of RGE Monitor, which tends to pointed language, but the MSM soundbite. Some of the forcefulness of Roubini’s views comes from his relentless and usually multi-point exposition, and not just colorful turn of phrase.

Second is we are well outside charted bounds, and making any kind of forecast is perilous. As much as I think that the elephant in the room no one wants to talk about is the need to restructure and write down debt, the powers that be are acting as if their efforts to halt the asset price collapse via massive liquidity injections is a solution. It isn’t. It was an effective stop-gap, but no one seems to have an end game. Worse, to the extend the authorities are thinking about next steps, the focus is on when and how to mop up liquidity, when the bigger issue is how to reform the financial system, how to curtail subsidized risk-taking (now that we seem to be giving virtually every form of credit known to man some sort of backstop), and how to renegotiate and restructure bad debts. There are too many contradictions in the current policy mix for this to be healthy in the long run (and it ignores the lessons of past financial crises, which show that tacking the banking system mess and cleaning up the bad debts are top priorities). But we could bump along for quite a while before other shoes start to drop.

Paul Krugman has had a couple of posts on the fact that the normal words like “recovery” don’t adequately characterize our “getting less bad” situation. We may escape a parallel fate, but the US in the early 1930s and Japan in 1992 both featured a roughly year long period of stabilization that were widely seen as the precursor to recovery before the economy took another leg down.

Parsing Roubini’s latest piece at the Financial Times (with his characteristic list), his bottom line is we seem to be on track to an anemic recovery, but also says another drop could be in the works.

From the Financial Times:

There are several arguments for a weak U-shaped recovery . Employment is still falling sharply in the US and elsewhere – in advanced economies, unemployment will be above 10 per cent by 2010…

Second, this is a crisis of solvency, not just liquidity, but true deleveraging has not begun yet …

Third, in countries running current account deficits, consumers need to cut spending and save much more, yet debt-burdened consumers face a wealth shock from falling home prices and stock markets and shrinking incomes and employment.

Fourth, the financial system – despite the policy support – is still severely damaged…

Fifth, weak profitability – owing to high debts and default risks, low growth and persistent deflationary pressures on corporate margins – will constrain companies’ willingness to produce, hire workers and invest.

Sixth, the releveraging of the public sector through its build-up of large fiscal deficits risks crowding out a recovery in private sector spending. The effects of the policy stimulus, moreover, will fizzle out by early next year…

Seventh, the reduction of global imbalances implies that the current account deficits of profligate economies, such as the US, will narrow the surpluses of countries that over-save (China and other emerging markets, Germany and Japan). But if domestic demand does not grow fast enough in surplus countries, this will lead to a weaker recovery in global growth.

Yves here. Roubiini was early on to the U shaped recovery, but he is not calling for a Japan rerun (the L shape, for alphabet fans). But this is his second possibility:

…..there is a rising risk of a double-dip W-shaped recession. For a start, there are risks associated with exit strategies from the massive monetary and fiscal easing…

Another reason to fear a double-dip recession is that oil, energy and food prices are now rising faster than economic fundamentals warrant, and could be driven higher by excessive liquidity chasing assets and by speculative demand. Last year, oil at $145 a barrel was a tipping point for the global economy, as it created negative terms of trade and a disposable income shock for oil importing economies. The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly towards $100 a barrel.

The second possibility is not getting the play it deserves. Some economists, in particular Jim Hamilton, think the commodities run-up of last year played a direct role in the crisis, by pushing consumers at the margin of begin able to service debt over the edge.

Served by Jesse of Le Café Américain

Someone asked why Bernanke seemed so positive about the US recovery, and what he would do if his prediction turned out to be incorrect.

The first answer is rather straightforward. He is ‘jawboning’ or trying to increase confidence in the system to motivate businesses to spend and consumers to buy. The Fed can only set the playing field, but the players have to be confident enough to take the field. We think he is underestimating the neglect that the American consumer has taken over the last twenty years in terms of their overall poor condition (real income), and the disrepair of their equipment (household balance sheets), not to mention the rocks and snares and pitfalls remaining on the field from the gangs of New York and the economic royalists.

But let’s assume Bernanke’s first major gambit does falter. What is he likely to do next?

Beranke’s Fed does have a printing press, and he has been using it as we all know. Here is a chart showing the expansion of the credit side of the Fed’s Balance Sheet. This is from the top line labeled “Reserve Bank Credit” from the weekly H.41 report which is becoming more popularly followed these days. If one adds the Feds gold holdings, currency in circulation, and Special Drawing Rights, we get the Total Factors Supplying Reserve Funds.

http://www.federalreserve.gov/releases/h41/Current/

So what would Ben do for “Plan B?” Would he merely add more programs, expand the Fed’s Credit Items even more aggressively?

There was an important function added to the Fed’s bag of tricks during this crisis that has not received sufficient attention perhaps: their ability to pay interest on reserve funds on deposit with the Fed from the Member Banks.

As can be seen from this next chart, this amount is now substantial running close to a trillion dollars. A portion of this would be characterized as ‘excess reserves.’ The Fed should be able to motivate banks to use these reserve by adjusting the riskless interest rates they pay.

This was a much desired tool by the monetarist Fed because it enabled them to expand their Balance Sheet and add a significant amount of credit to the banks system immediately, but to keep ‘a bit of a leash’ on the downstream effects of this liquidity even after it was deployed.

As the Fed’s interest rate remains sufficiently high, the reserves, especially the excess reserves, remain in the banking system, and are not deployed actively as loans and inflationary additions to the financial system.

The Fed issues an H3 report, Aggregate Reserves of Depository Institutions and the Monetary Base. In their latest report, they characterize $708.5 Billion of these reserves as ‘Excess Reserves.’

So, what we might expect to see is the Fed, as the banking system stabilizes after perhaps some new programs and credit facilities, begin to slowly unleash these excess reserves by reducing the interest to the Member Banks, which would lower the bar and motivate them to engage in more commercial loan activity.

We think one problem is that the banks have more options than merely keeping their excess capital at the Fed or loaning it out to private companies.

Certainly Goldman Sachs has shown that it can defy all the odds and make millions each day by aggressively playing the equity, bond and credit markets. It is also more likely that banks would be inclined to invest their excess capital through acquisitions of other banks, which might represent a moral hazard in creating fewer, and more “too large to fail” institutions.

Therefore we might see the first serious moves towards financial reform before the Fed begins to really unleash the liquidity which they have created in the banking system.

There is of course also their monetization of Treasury Debt, to support the stimulus programs being run from the fiscal side of the US financial apparatus. That would be included in the expansion of their Balance Sheet, and we would expect that to continue on at the very least indirectly, if not overtly on the Fed’s balance sheet.

An Aside on the Gold Stock of the Fed

By the way, one method the Fed might use to immediately expand its Balance Sheet would be to recognize that their gold stock is significantly undervalued.

In the H.41 Report, the Fed shows a credit of $11 billion dollars in Gold Stock held primarily in New York, Chicago, Atlanta, and San Francisco, with lesser amounts at each of the Regional Banks. This gold is part of the collateral against the Federal Reserve Notes in circulation, and has been valued at an official rate of $42.22 per troy ounce for many years.

1. Gold held “under earmark” at Federal Reserve Banks for foreign and international accounts is not included in the gold stock of the United States; see table 3.13, line 3. Gold stock is valued at $42.22 per fine troy ounce

By calculation the Fed has 261,511,132 fine troy ounces on its books. If the Fed revalued their gold stock at a more reasonable market price of let’s say $1000 per ounce, then this would immediately add $261 billion to the Fed’s Balance Sheet IF the gold is really held by the Fed without encumbrances.

One has to wonder why the Fed has never taken the revaluation on its Balance Sheet for gold since the value of $42.22 is so clearly an historic artifact. They perform much more market based calculations for the Special Drawing Rights and their Foreign Exchange holdings. One certainly does not need to sell the gold in order to monetize it, since that has already been accomplished, albeit at a much lower rate.

One can only wonder.

Federal Reserve H3.1.2 US Reserve Assets

This story on Bloomberg, about stockpiling of base metals by Chinese farmers and housewives, highlights a type of speculation that observers in the West haven’t considered deeply. Since these were purchases by individuals, sometimes in the form of scrap, it’s hard to ascertain how significant a factor this activity has been. If nothing else, the expectation they will reduce holdings is a sign of a change in sentiment.

From Bloomberg hat tip reader Michael)::

Copper, nickel and other base metals stockpiled by speculative Chinese investors including pig farmers may be sold when “market sentiment turns,” said Scotia Capital Inc.

A price surge and easy bank credit this year encouraged pig farmers, stock brokers and businessmen to buy copper and nickel for speculation, Liu Na, an analyst with Scotia Capital, wrote in a note dated Aug. 17,….

“These stockpiles are in ‘weak hands’ as speculators have no real use for base metals,” Liu wrote. “When the market sentiment turns, they are very likely to turn into quick sellers, especially when the bank’s money is involved.”…

China, the world’s largest metal consumer, uses around 5 million tons of copper and 400,000 tons of nickel a year. Shanghai exchange-monitored copper stockpiles expanded to 76,107 tons last week, the highest in two years.

“The scale of the speculative investment is hard to quantify, although some local observers put the number at some 200,000 tons for copper, and at 50,000 tons for nickel,” Scotia’s Liu wrote. “We regard these speculative behaviors as natural, and they will inevitably occur in a bull market, so we do not want to exaggerate the impact they have.”

Pig farmers in Guangzhou province were buying copper or nickel, Liu wrote, citing CCTV. Residents in Wenzhou city of Zhejiang province, “famously investment savvy,” are reportedly using bank loans to stockpile copper scrap, with one merchant saying he has stored 20,000 tons, Liu wrote.

Housewives in Wenzhou may have stockpiled metals as “they just have too much cash on hand,” Eramet’s Deng said…

Metal traders have reported incidents when “a rich man walked into our office and asked us what had been the lowest and highest prices of nickel,” Scotia’s Liu wrote. “After telling him those prices, he said the current price was low and he placed an order.”

Even though China keeps putting out cheery official numbers, its purchases of commodities are down, suggesting there is less to its stabilization than meets the eye. It’s early to say that this is conclusive, but there is a good bit of other anecdotal information and some firmer information raising questions about the true state of affairs in China.

From Bloomberg:

The Baltic Dry Index, a measure of shipping costs for commodities, had its worst week since October as Chinese demand for shipments of coal and iron ore slowed.

The index tracking transportation costs on international trade routes today slid 135 points, or 4.6 percent, to 2,772 points, according to the Baltic Exchange. That took its weekly drop to 17 percent, the most since the end of October.

“The Chinese have backed off and it’s starting to show in the number of shipments this month,” Gavin Durrell, a Cape Town-based official at Island View Shipping SA, Africa’s biggest commodities shipping line, said by phone today. “Iron ore and coal seem to be slowing down.”

China’s record coal and iron ore imports in the first half helped the index to advance as much as fivefold this year, reversing some of the record 92 percent collapse in 2008. Demand rose after the country’s government announced a 4 trillion yuan ($586 billion) stimulus package….

Rates are declining as Chinese steelmakers delay imports while they negotiate annual iron ore prices with producers such as Rio Tinto Group, BHP Billiton Ltd. and Vale SA, Durrell said. “I don’t think they will come back until they agree,” he said.

The drop reflects a wider slide in demand for raw materials that will likely push prices for metals, commodities and energy lower, Eugen Weinberg, a senior commodity analyst at Commerzbank AG in Frankfurt, said

On the surface, the particulars of this case seem simple. A Citigroup commodities trader who says he has a contract that could yield him a $100 million payment this year is crossing swords with the new Treasury pay czar, Kenneth Feinberg.

The Wall Street Journal story portrays the pay deal for the trader, Andrew Hall, as a problem for Citi, The bank, maybe. The bank’s top brass, quite the reverse. This is like throwing Bre’er Rabbit in the briar patch. The rich contract established a high pay ceiling. If you know anything about the cognitive bias, anchoring, this is very powerful (if you don’t know the literature, be sure to read on the studies used to test for it. It’s very insidious). Win or lose, that number is now a legitimate. Second, independent of anchoring, Citi is not likely to fight Hall unless pushed by Treasury. A big payout for him provides an umbrella for everyone else.

Before the “sanctity of contracts” crowd tunes up, why don’t you folks wrap your minds around a few other legal obligations of a public company, such as the duty of care that its officers have? Deals like Hall’s are close to a firm within a firm, always a bad idea. Arrangements like that led directly or through knock-on effects to the end of Drexel, the mess at AIG, and the Treasury bond scandal at Salomon. For instance:

Mr. Hall is contractually obligated to receive pay based on Phibro’s profits, and some observers on Wall Street believe Citigroup has a better chance at repaying the U.S. money with its Phibro unit humming.

Critics, however, argue that pay agreements like these need to be redrawn in light of Citigroup’s taxpayer-funded bailout. Soon the U.S. government will be a 34% owner of Citigroup…

Mr. Hall has long operated with remarkable independence. In late 2007 he shot down Citigroup executives who wanted to merge Phibro with the bank’s asset-management arm, which could have clipped his ability to make big investment bets….

Mr. Hall’s pay contract has multiple parts. He has long had a profit-sharing contract with Citigroup and its predecessor banks entitling him to a large percentage of Phibro’s gains. The percentage he and his small team of traders get under the contract terms currently stands below 30%.

Mr. Hall’s pay and independence from Citigroup’s home office reflects a track record of making sizable, successful investment bets. A few years ago, for instance, Mr. Hall, 58 years old, anticipated an important shift in the way the world valued oil, and correctly bet that long-term and short-term energy prices would abandon their historical relationship with each other. In making that investment, Citigroup gave Mr. Hall more leeway to take on risk than it usually gives entire teams, according to traders….

Citigroup doesn’t report Phibro’s detailed financial results, but a footnote in the company’s annual report says that $667 million in 2008 revenue from “principal transactions” related to commodities “primarily includes” Phibro’s results.

Latitude like that is inappropriate in a large organization. Men like Hall hold their employers hostage with the threat that they will go start a hedge fund. But that entails additional duties, like dealing with peaky investors and needing to worry about end-of-month results. While some star traders go on to be very successful hedge fund operators, others fade surprisingly quickly. Those irritating organizational constraints might actually be to their benefit.

Consider John Whitehead, former co-CEO of Goldman, who was incensed that the pay levels in 2006:

“I’m appalled at the salaries,” the retired co-chairman of the securities industry’s most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are “shocking,” Whitehead said. “They’re the leaders in this outrageous increase….

Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.

“I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends,” Whitehead, 85, said….

If the Citi executives really wanted to, they could go over Hall’s conduct with a fine toothed comb and find violations of bank policy (most big honchos break expense rules). And the formalities here do not matter much. Hall is a big producer, perceived to have the upper hand.

No where is the asymmetry of this arrangement mentioned: that Hall and his team get the upside (30%, more than a hedge fund success fee, more than even LTCM in its glory days, which got a 25% upside fee), but the taxpayer gets stuck with the losses. Hall and his bunch have the richest option deal going. Nor does it bother to point out that Hall would find it hard to get access to as much capital as Citi provides him on such rich terms from the outside. Citi not only provides him with more equity than he is likely to be able to raise (certainly for a 30% upside fee) and his cost of funding is sure to be considerably lower than if he were to operate on his own.

Citi is already too big to fail. The Phibro team is a stand-alone unit that takes a lot of risk that is not appropriate for a government-supported entity. The government safety net should extend only to crucial financial infrastructure. This is a great opportunity for Citi to shed a risky, non-core activity, which is exactly what it should be doing.