What does it mean to be a Credit Flow Investor?
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Currency
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Behavior
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Minksy Instability and Tides Forces of Deflation/Inflation
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Debt Service Perfect and Felicity Foresight
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Overview
[Before every recession,
fly to safety.]
The worst case is what
matters when engaging in a policy - the worst case is far more consequential
than the forecast itself. The Black Swan p162
The aim of this site is to
list a number of charts indicating investment opportunities and to outline my
investment strategy. I want to be “broadly correct” rather than precisely
wrong. By creating this web site, I enforce a discipline on myself to keep them
updated. It is considered an education only – not intended as investment
advice.
As debts mount and debt to
GDP ratios climb, there is a danger of falling into debt deflation. As Keynes
called it, the people lose their animal spirits and fall into a liquidity trap.
If default rates get high
enough, banks will simply be unwilling to lend which will severely limit money
and credit creation. It's also
followed by hoarding and a shrinking of economic activity over a long period.
The precipitant is always a recession because this event shrinks GDP and
thereby the ability of the borrower to service or take on new debt. The
debt/GDP ratio (debt = credit) shows the relationship of debt to its ability to
service that debt. I liken it to the sand-pile that builds higher and
higher.
Climbing a Mountain ...Updated (End of 2008)
Europe, Canada, UK and
Australia all have similar charts! The US debt/GDP figure in the 1920s showed a
similar run-up with a collapse (at 160% in 1929) starting in the early 1930s as
bankruptcies spiraled upwards (debt/GDP eventually hit 260% in 1933).
Japan showed a similar trend in the 1980s breaking into deflation in the
90s.
See Household Debt Selected
Countries and Scenarios for historical debt
ratio
Imagine a man who makes 50k
per year and has 300k in debts. Now a few years pass and he has 600k in
debt. Wouldn't he be more likely to throw in the towel or at least not
borrow any more? If he simply ceases to borrow
more, the economy will contract. It is so dependent on new credit.
Eras of easy credit are
followed by tight credit and crisis/recession. We become more vulnerable
as the debt to gdp ratio climbs that a crisis of scale
reduces monetary policy to no effect.
Approaching Liquidity Trap. When does it occur?
On every cycle the system convinces people that more and more debt is
acceptable. You gradually creep up your debt and as everyone is doing it,
you feel fine. Like the frog analogy in the boiling pot, if you increase the
temperature by 1 degree every minute, the frog doesn't notice. After 80
minutes, he's boiling.
Before central banks, a
crisis would arise when an individual bank failed due to over-lending,
corruption, stupidity, etc. The central bank was created to 'bail out' these
banks and stem crises. Curiously, the Fed was created in 1913 and the Great
Depression happened anyway in the 1930s.
Monetary policy facilitates
credit. Normally, it doesn't create credit per se except to fund government
deficits. Although the Fed backs its members in a crisis at
its policy rate. The policy rate is used as a signal to the
lending community to accelerate or decelerate their lending.
Most credit is issued by
the private banking sector (out of 40T in credit about 1T is currency or cash
and 8T is owed by government). By facilitating excessive lending, credit can be
diverted away from long term capital and job growth and fall into assets.
The Economist talks of the economy being dependent on asset bubbles and a
"wealth" effect. Unfortunately, asset markets are prone to
sudden meltdowns after long periods of credit expansion.
Because the US is the
source of most credit and the world's net consumer, I believe the event will
start in US and spread from there as in the 1930s. For the US and Europe, I
can't say when this trend breaks down. Will the US break at 350%, 600% or
higher? I can only guard against the bad credit event by flying to
safety before every recession.
So the economy
oscillates between increasing deflationary/inflationary threats until it falls into 1 of 3
situations-
1) Mild deflation fought
with 0% Fed rate over a 10-20 year period. There will be many deceptive
rallies in assets.
[Example here is Japan
1990-on. 'Solution' favoured by modern central
bankers and democracies. Best investment over period is treasury bonds.]
2) Whiff of deflation,
followed by hyperinflation. Examples are Germany 1920s, Russia, Argentina.
[These systems were not
credit driven, so unlikely for US, Europe, etc. Best investment is gold.]
3) Rapid
deflation. Examples are 1930s US/UK and many times in 1800s.
[Unlikely today, the Fed is
highly interventionist and aware of this problem. Best investment is
treasury bonds.]
I believe we are currently
in an increasing oscillation mode eventually falling into situation number 1
(mild deflation). It's very hard to hyper-inflate a credit economy as the
bond market senses it and interest rates rise thereby aggravating the situation
(this is probably why Japan hasn't done it).In addition, high government debt
traps the government into mild deflation.
Any small inflation will cause the debt service to rise to an
unsustainable level. Because I don't
know which recession causes number 1, I guard against it by running to treasury
bonds before a recession. Nobody knows how far these asset bubbles could
fall in a collapse.
From Hoisington:
Japan is replacing private
debt with government debt. But the high debt level still leaves Japan in
mild deflation and a recession every 2-4 years. Japan is spending 17% of tax
revenue just to service the public debt so even Japan is not near a
hyperinflation. The US or Japan would get close to a hyperinflation if the GDP
contracted by 50% for example.
How do we cut through the
rhetoric and determine if we are in fact falling into deflation? I believe that
it's imperative to be on the right side of this event. One theory has
this event followed by a currency debasement or hyperinflation. Although thus
far, Japan has bailed out its companies with more government debt and not cash
or money printing - no hyperinflation. Russia, Argentina, and 1920s Germany had
hyperinflation but their systems were not credit driven. You buy
houses in these economies with cash. How do you enforce credit schemes in
these economies?
I believe that we are in an
interim period where we oscillate between rising credit issuance and deflation
threats. As the debt to GDP ratio mounts, the risk of deflation rises.
The fed also knows this and seeks to fight the deflation with more and more
credit facilitation. The fed does fall into 2 strategies, however, of
inflation or deflation fighting. It's important to recognize which mode
they're in and judge the market accordingly. Given the risk of an extreme
deflation, it only makes common sense to err on the side of caution.
As we all know, you can't
grow your debt faster than your income or spending forever. Eventually a
limit or "puke" point is reached. However, we cannot say which
credit event will precipitate the collapse. Gold bugs always say it's just
around the corner but they've been saying that for 20 years! On the other hand,
stock market Pollyanna's say the economy is always just fine and we should
ignore the debt or other negative issues.
Since I can't trust the
"salesmen" of either side, I seek to have an open mind and judge each
recession or slowdown. Since the 1930s, the economy has not experienced
debt deflation or hyperinflation despite the hyperbole of either side's
proponents. I want to develop indicators of the dominant forces in deflation
and inflation. By tracking these charts, the economy can be understood as
having a deflationary or inflationary bias. The correct investments for
each environment can then be purchased or sold.
I think of the problem
facing the Fed as a giant lever. The lever size grows as the debt/GDP
ratio grows. After each cycle/recession, the Fed must respond with more
and more stimulus to get the economy going. Eventually, the lever breaks.
From
Robert Zielinsky, Lehman Brothers Tokyo 1989,
commenting on Japan's economy in the 80s:
"All the growth was
coming from financial gains in the market or lower interest rates...and so it
was a vast circle of money but there was no real basis, no economic reality for
the boom that Japan had."
I'll let Lee Hsein Loong, former Deputy Prime Minister of Singapore,
state the solution to the problem. He is talking to a reporter in regards
to the Asian crisis of the late 90s:
“...So don't let your
banks go lend recklessly. Don't allow bubbles to get out
of hand. Keep prudent measures, sound economic policies which will inspire
confidence and maintain confidence, so in a crisis people will know that you
will stay the course and won't panic and be up and off. It's easier said than
done, but these are the principles you have to follow.”
And another solution (wikipedia), William McChesney
Martin, Jr. was the ninth and longest-serving (1951-1970) Chairman of the
United States Federal Reserve. His most famous quote about his central banking
philosophy was that the job of the Federal Reserve is "to take away the
punch bowl just as the party gets going," referring to the need to raise
interest rates when the economy is at its most active.
I don't believe the Fed or
any other Western government will entertain such measures until the crisis
hits. In fact, Asia has done little to change themselves after the crisis in
the late 90s except to borrow and export more to America and Europe. As
such, investors need to be on-guard and protect their capital as we don't know
the recession that will precipitate the crisis.
I also challenge the
assumption that the government will 'always' bail out investors. At some
point, I suspect the politicians will talk like Roosevelt in the 30's about the
evil money changers, etc. Why issue credit to support a bunch of investors when
I can build highways and bridges? Japan has followed its deflation with lots of 'make-work' jobs and plenty of public works
construction. This will buy a lot more votes with less money than bailing
out investors.
On the other hand, from “the collapse of complex societies” p58,
“Colin Renfrew (1979) argues that under stress complex societies lack the
option to diversify, to become less specialized. By doing more of what may have caused the
problem in the first place, the breakdown of the system is made inevitable.” (more speculation and more debt)
There are five inputs and
two outputs of my investing method.
Inputs
1) Credit
Acceleration/Deceleration
What are the Credit Growth Rates?
Credit
Acceleration/Deceleration
What are the Credit
Growth Rates?
US credit growth has been
falling since Q1'06. A recession is pending. Europe. Gee...no hyperinflation here.
Total Credit Growth...Updated 2009
Q1
Household credit, the
largest component, is now in deflation. Notice below how households kept
borrowing faster and faster from 2000-2005. This cushioned the last
recession, 2001. Now federal government is stepping up its credit growth
to compensate.
To recognize the relative
importance of the credit sectors, GDP components 2006-
Households: Personal
Consumption (70%), Residential Construction (5%)
Business: 11%
Government: Federal (7%),
State and local (12%)
Trade: -5%
US Credit Components...Updated 2009
Q1
The favored investment for the
moment is US long bonds.
They are of value (negatively correlated to recent market movements), people are apathetic to them, show wonderful long term
dependence, and an up-trend since 1982 but first let’s see Japan’s experience
with the 10yr government bond yield as reported by ECB:
The
cold statistics have hardly been encouraging for the traditional [buy and hold]
view. On a total return basis, the Ibbotson data show that the S&P 500 has
underperformed long-term Treasury bonds for the last five-year, 10-year, and
25-year periods, and by substantial amounts. - Peter
Bernstein Feb, 2009
For current
charts….
Always formulate a “sell” rule. Short-term sell signs are:
1) After economic
and credit recovery, a rise in CPI
2) Stocks Rising
over 45 weeks
Interesting Reading:
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on information contained herein.
As I do not charge for my web site,
it provides information "as is" for informational purposes only, not
intended for trading purposes or advice.