Sunday, September 30, 2018

A Critical Look at the U.S. Economy

The stock market has been soaring, unemployment is low, and there is some improvement in wages and corporate earnings, though significantly less than from other recession recoveries. But there are other issues here that should be of concern. First of all, it should be noted that stocks are at lofty levels that marked the tops of major bull markets preceding the Great Recession, the “dot.com” (tech stock) bubble in 2000, and the crash of 1929. In the third quarter of 2008, U.S. household debt peaked at $12.7 trillion; today it is $13.3 trillion, 20 percent higher than five years ago. Since 2008, Student debt has more than doubled, to $1.5 trillion. Delinquent auto loans have risen 53 percent, to $1.2 trillion, with 6.3 million borrowers being 90 days or more late on auto loan payments. These delinquencies have been increasing steadily since 2011 and are now the highest in 15 years.

Total global debt—sovereign, corporate and household debt—spiked 75 percent in the past decade. During this period total corporate debt rose 78 percent to $66 trillion, and nonfianancial bonds rocketed 172 percent, from $4.3 trillion to $11.7 trillion. A recent report by McKinsey says 40 % of U.S. companies are rated one notch above “junk” or lower. And the Bank for International Settlements says 10 percent of the legacy companies in the developed world are “zombies,” meaning earnings before interest and taxes don't cover interest expenses. That is what zero interest rates and quantitative easing will get you: more debt and lower credit quality.

Because of the recent Great Recession, Ben Bernanke, then chairman of the Federal Reserve, set the Fed on a course that more than quintupled it's 2008 balance sheet by 2018 by buying long term bonds and mortgage-backed securities. He explained this “unconventional” monetary policy of easy money would lead investors to shift out of bonds and into the stock market and real estate. Supposedly, this would raise household wealth, which would increase consumer spending and strengthen the economy. Instead, this Fed policy inflated price bubbles in stocks and residential housing that produced trillions of dollars in losses when those bubbles burst and household wealth nosedived. As Martin Feldstein, former chairman of the Council of Economic Advisers under President Reagan, put it: “In short, an excessively easy monetary policy overvalued equities and a precarious financial situation.” During the Great Recession, the real estate industry lost $7 trillion, the stock market crash added another $11 trillion in losses, and retirement accounts lost $3.4 trillion.

Those gigantic losses stimulated a politically tolerable solution but failed to provide an economic solution, which is why so many economic metrics are now worse than in 2008, setting the stage for another major crash. Every borrowed dollar since 2008 has generated only 44 cents of economic output. The GDP has increased 35% since 2008, but the national debt has increased 122%. Now the national debt is over $21.5 trillion, compared to $9.5 trillion in 2008.

Though there has been no link between gold and the dollar since 1971, gold prices factor into such things as the relative desirability of holding dollars, interest rates on U.S. treasury securities, the price of oil, and political considerations. For example, whether the dollar is strong or weak is likely to influence the prevailing sentiment for buying gold.

Central banks are buying gold for their reserves at the fastest pace in 6 years, adding 264 tonnes to their holdings in the January-to-September 2018 period. That includes 9 tonnes by Poland, the first European Union country to buy gold in the 21st century. The biggest buyers were Russia, Turkey, and Kazakhstan, accounting for 86 percent of central bank buying. “Egypt bought gold for the first time since 1978, while India, Indonesia, Thailand and the Philippines re-entered the market after multi-year absences. The Reserve Bank of India added 8 tonnes of gold, buying for the first time in almost nine years, and then added another 7 tonnes by the end of August,” according to the World Gold Council. The people of India, avid fans of gold, value it for religious and ceremonial purposes as well as aesthetic, sentimental and monetary reasons. They are estimated to own 20,000 tonnes of gold in jewelry, coins and bars.

After President Nixon severed the last link between the dollar and gold in 1971, he sent Secretary of State Henry Kissinger to negotiate a deal for buying Saudi Arabian oil. Saudi Arabia lies in a violent part of the world, where wars, revolutions and assassinations occur more often than in most other parts of the globe. In 1973 the U.S. offered to sell Saudi Arabia, then the world's leading oil exporter, airplanes, tanks, and other weapons and provide U.S. military protection to the ruling family and the government. All the U.S. asked in return was that Saudi Arabia's oil be sold only for dollars and that surplus revenue available for investment by the Saudis from oil sales, after deducting for the needs of government, would be invested in U.S. Treasury securities. Such a deal! By 1975 all of OPEC (Organization of Petroleum Exporting Countries) members agreed to the same deal.

Since every country in the world was either buying or selling oil, they were all dealing in dollars because oil was priced in dollars. These “petrodollars” gave support to the American currency, but that is now all but gone. As a result of fracking, horizontal drilling, deep-water drilling, and the discovery of new oil fields all over the world, neither Saudi Arabia, nor the United States nor any other nation can set the price of oil—and the currency—irrespective of what is happening in the industry all over the globe. Japan is buying oil from Iran priced in Japanese yen. India buys oil from Iran in rupees. Russia agreed to the sale of $400 billion of natural gas to China over the next 30 years with the gas priced in Chinese yuan, not dollars. China also has agreements with at least 23 other countries for bilateral trade agreements in currencies other than the dollar. The BRICs (the large developing nations of Brazil, Russia, India and China) have agreed to trade in each others currencies rather than using the dollar as an intermediary. Australia, South Korea, Turkey and Kazakhstan have agreed to conduct trade in currency swaps of their own respective currencies. Germany has agreed to trade with China in yuan and euros. The importance of the dollar is receding from the position it held since the 1970s. 

 That may help to explain the world's central banks increased purchases of gold, aligning their assets with what they see as a growing trend. Since the formation of the European Union in the 1990s, there was a concerted political effort to phase out gold in the international monetary system and replace it with a fiat currency, the euro. The euro experience has shown that an unlimited ability to print money with no backing cannot replace the effectiveness of a tangible monetary asset, gold. Central bank buying of gold now may be recognition of that. But it may also reflect the historical importance of gold in four central bank agreements. The first Central Bank Gold Agreement took place in 1999.  At that time, central banks held nearly a quarter of all gold held above ground, about 33,000 tones.  The second gold agreement (CBA2) took place in 2004. CBA3 followed in 2009 and CBA4 followed in 2014. The first clause in each of these four agreements began: “Gold will remain an important element of global monetary reserves.” In one of its first pronouncements, the ECB governing council decided the capital subscriptions of euro-zone members would be paid partially in gold, (with the balance determined by a formula of other currencies and the population and GDP of the countries.) For many years the central banks and the International Monetary Fund sold gold in the belief the future world money would be fiat currency. That policy began to change about a decade ago.

When it became possible to buy oil with something other than dollars, there was less demand for dollars that could go to buying U.S. treasury securities to finance America's deficit spending. What else could foreign governments do with the dollars they acquired for U.S. trade deficits? Since 1971, they couldn't convert them for U.S. Treasury gold—but that was changing with the establishment of the Shanghai Gold Exchange. Unlike the gold markets in New York and London—which deal primarily in paper contracts for future delivery, which seldom occurs—the SGE deals in the physical metal for immediate delivery. Countries which could not exchange their dollars for gold from the U.S. Treasury could now trade those dollars for actual gold on the Shanghai Gold Exchange.

When I wrote my book, I concluded that the two possibilities for the future were severe depression or runaway inflation—or possibly both, with one bringing on the other. But I figured the possibility of runaway inflation would so frighten our monetary managers that they would try to avoid that at all costs. Now, however, I think they are somewhat more likely to do what they have done since 2008: simply print more money. There is also the possibility that they would lose control of interest rates, which in turn could bring about hyperinflation.

There is also the question of what will happen to the $6 trillion that are held by foreigners. Nations' central banks have been holding them as reserve assets because they were needed to buy oil, but they are no longer needed for that. Would the central banks be better off trading them for gold? Or yuan? Or stocks, bonds, ETFs or real estate?

When the Federal Reserve buys bonds from the U.S. Treasury, it creates—out of thin air—a corresponding deposit in one of the large commercial banks where the Treasury has an account. The money from that deposit gets into circulation when the government spends it by buying something with it, for which the seller makes a deposit in his own account. The seller then spends the money from his account to buy something else, and the process of sales and deposits is repeated as the money is circulated in accounts throughout the economy.

The Fed is not the only central bank increasing its money supply in this manner. Other central banks are doing the same thing with their national currencies in the hope of stimulating growth in their economies. Japan is a prime example, having employed this and other “stimulative” policies for more than two decades with poor results. Those decades are called the “lost decades.” From 1991 to 2011 Japan's annual economic growth averaged less than one percent. It now has a debt-to-GDP ratio of 250%, the highest in the world, and more than three times what it was (65 %) in 1990 when the first of its ten stimulus programs began. But that hasn't stopped Japan from trying larger doses of the same failed policies.

Shinzo Abe was elected prime minister of Japan in large measure on his campaign for monetary easing. In 2013 he said, “Countries around the world are printing more money to boost their competitiveness. Japan must do so too.” He called for more aggressive action along the lines of the Fed and the European Central Bank. That was his prescription for a degree of “needed” inflation to bring Japan out of two decades of economic stagnation and avoid the growing fear that deflation was now a greater threat than inflation. Whereas the Fed buys only U.S. Treasury securities, the central bank of Japan would henceforth buy at the market more than twice the amount of new bonds issued by its government, and it would buy not just government bonds but stocks, ETF's (exchange traded funds), and real estate funds. These purchases would increase Japan's money supply just the way the Fed increases the U.S. money supply by buying U.S. treasury securities.

Other central banks were particularly interested in common stocks. Easy money policies made stock prices look cheap, and with near zero interest rates on government securities, buying common stocks at least offered the prospect of higher yield. The five largest central banks raised their financial assets in ten years from less than $4 trillion to $14.6 trillion.

Swiss National Bank purchased a record $17 billion in US equities in just the first quarter 2017, bringing its total U.S. equity holdings to an all time high above $90 billion, about 30% more than at the end of 2016.The Swiss National Bank bought almost 4 million shares of Apple stock in the first three months of 2017. It owned more publicly-owned shares of Facebook than founder Mark Zuckerberg, whose holding was worth almost $24 billion. SNB also has over $1 billion each in Exxon Mobile and Johnson & Johnson stocks. SNB is the world's eighth largest public investor. The bank of Japan is a top-five owner of most of the 81 companies in Japan’s Nikkei Stock Average, and it owns 62 percent of the domestic ETF market. If countries around the world are printing more unbacked money, the potential for runaway inflation increases since there is no limit on the amounts they may print. Perhaps this is the reason the world's central banks have greatly increased their purchases of gold.

The conditions favoring gold as the world's reserve currency have altered significantly, and the dollar will not be the world's reserve currency forever. Petrodollars cannot save the dollar from depreciation as they did in the decades following the agreements with Saudia Arabia and other OPEC countries, and Saudi Arabia is no longer the undisputed leader in the oil industry as it once was. Saudi Arabia now exports more oil to China than it does to the U.S. China is accumulating gold as fast as it can, not only domestically but by investing in foreign gold producers and buying prospective properties. And it is helping finance Saudi production of new oil wells. For example, it financed the giant oil refinery in Saudi Arabia at the port city of Yanbu that processes 400,000 barrels of crude per day.












 

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