24/03/2011: 1973

In a wink of history, the UN resolution which allows its members to “use all means necessary short of foreign occupation to protect civilians” in Libya bears the number 1973. The year 1973 was the one in which subsequent to the Yom Kippur war, the Arab members of OPEC proclaimed an oil embargo. This event led to a surge in the price of oil, which in turn, so goes a common narrative, led to the Great Inflation in the late 1970s and early 1980s.

When looking back in twenty years on the events of 2011, it is likely that many will attribute the second 'Great Inflation,' the one yet to come in the 2010s and early 2020s, to the Arab spring, the war in Libya, a renewed oil shock and other “special” factors. To misconstrue resolution 1973 as the root cause of future inflation is a too reductionist interpretation, like offering the oil embargo of 1973 is, when explaining the surge in inflation some thirty years ago.

In both cases something more fundamental was, or will be, at work: a loss of confidence in money. Back in 1973, the US dollar weakened dramatically against more solid currencies in the wake of the Bretton Woods break-up. This depreciation and the break-up of Bretton Woods were consequences of a very expansive monetary policy, a policy which peeled away the gold backing the US dollar as no longer credible.

This removal of gold backing seriously dented confidence in the US currency. Thus it was only a matter of time before the price of oil, fixed against the US dollar, began to increase. The OPEC boycott merely accelerated a process — in truly catalytic fashion — which would eventually have taken place anyways. The restoration of confidence in the US dollar only came about under Federal Reserve Chairman Paul Volcker in the early 1980s. Throughout the 1970s, the dollar had lost over 30% against the Japanese yen, more than 50% against the Deutschmark and some 60% against the Swiss franc.

Currently, similar forces are at work. We no longer live in a world in which currencies are backed with a thin sheet of gold. What bolsters currencies these days are the confidence and faith we have that central bankers will uphold and defend the value of money. In my view, this confidence has started to crumble.

To my mind, it is a euphemism to say that central banks, which should be responsible for financial stability, did not see the financial crisis of 2007-2009 coming. Foremost the Federal Reserve, with its ultra-expansive monetary policy following the 2001 recession, laid the groundwork for the housing and credit bubble, which then ensued.

Now, with the monetization of government debt under the guise of the second quantitative easing program, the Federal Reserve is even more expansive than it was back in the mid-2000s. Other central banks are hardly far behind. Even the European Central Bank, supposedly virtuous regarding inflation, has monetized Greek, Irish and Portuguese debt over the last nine months for a price of 77 billion euros.

Where does this fast and loose behavior come home to roost? Prices of energy and food have already increased massively. But as in 1973, “special” factors like the turmoil in the Arab World, floods in Australia and droughts in Russia can be propped up explain these surges. Moreover, as the central bank mantra intones: those prices are not part of “core” inflation. But the core will soon get hit.

Over the next couple of months, prices for textiles will take a lofty spin due to record high cotton prices, those for Chinese imports could climb on the back of inflation and wage increases there, and bottlenecks in semi-conductor production left behind by the catastrophe in Japan will raise the prices of electronic products. Each of these price increases can again be attributed to “special” factors. Nevertheless, taken together this circumstantial evidence provides reasonable grounds for suspicion that something else is at work.

As once before in 1973, we shouldn’t fool ourselves today with special factors. Inflation ultimately is always and everywhere a monetary phenomenon.

09/03/2011: Japan prepares for X-day

“X-day” sounds like, but is not the title of a Japanese B movie in which a giant lizard destroys Tokyo suburbs. Godzilla is tame by comparison. The damages inflicted to Japan on X-day, with ripple effects for the rest of the world, could be many times more severe than the monster's wildest rampage.

X-day is the day on which market participants will refuse to buy Japanese government bonds (JGB). I think, this day is approaching fast. While barely discussed elsewhere around the globe, Japanese politicians — in the government and in the opposition — are preparing for it. Before we examine the consequences of such an event and how to react to it, we need to understand why it could occur in the first place.

The year 2012 (1945 + 67) will be first in which members of the postwar baby-boom generation enter mandatory retirement in Japan. Henceforward for roughly two decades, both the overall Japanese population and that in the working age bracket will significantly decline. This will have severe consequences.

Due to aging, Japanese households will increasingly disperse — spend — their savings. A declining private savings rate has been observed in Japan since the mid-1990s. Without a change in demographic dynamics, something, which is very unlikely, the Japanese household savings rate will continue its downward trend and become negative within the next two to three years. At the same time, with greater numbers of people in retirement, government expenditures will significantly increase. Hence Japanese private savings (both households and private companies), which so far have absorbed the huge Japanese public deficits, will decline below the financing needs of the government.

Current Japanese government debt stands at roughly 230% of GDP, or almost a quadrillion (one thousand trillions or a million billions) Japanese yen. To grasp this number better: Japanese government debt is almost equivalent to the US gross domestic product. Over the years many analysts have been puzzled at how the Japanese government was able to pay extremely low interest rates on a debt of this size. The answer, plain and simply, was that there was a domestic demand for a “safe” asset from Japanese households saving for their retirement. This demand is now significantly declining and the Japanese government will need to find other investors than its own population to purchase its debt.

International investors, however, are unwilling to buy debt bearing a higher credit risk than that of the US, the UK or Germany (Japan was recently downgraded from Standard & Poor’s from AA to AA-), while at the same time offering much lower yields than AAA sovereign debt. Proposing higher interests rates is not an option either.

If Japan today were to pay the same interest rates as Germany, its revenues would not suffice, and Japan would pile up even more debt to meet coupon outflows. We would be in a classic Ponzi- or Madoff-scheme. More explicitly: Japan would be broke.

In my view, on X-day the only solution which could work — there is no guarantee — would be a monetization of the debt, i.e., the Bank of Japan would need to buy the lion’s share of newly emitted JGBs. This would massively fuel Japanese inflation, and the value of the Japanese yen would crumble.

Hence I venture this bold forecast: After two decades of deflation, starting on X-day, Japan could be paradoxically the first developed country where inflation rises out of control.

04/03/2011: Oil price surges on gushing liquidity

One consequence of ongoing turmoil in the Middle East and North Africa, now with the moniker “Arab spring,” is the surge in oil prices since the beginning of the year. In New York, the price of a barrel of West Texas Intermediate (WTI) recently surpassed the 100 US dollar level, and in London the price of a barrel of Brent flirted with 120 US dollars.

Investors and traders are concerned about the Libyan supply, which represents some 2% of world production. This could be absorbed by the spare capacities of other oil producers readily enough, but if the turmoil began threatening Algeria’s oil production (3% of world supply) and spread to some producer of the Arabian Peninsula, then even higher oil prices could become a fact. One broker recently went so far as to project a 220 US dollar oil price. This, in our view, is somewhat far-fetched.

Nevertheless higher oil prices, should they linger longer, will certainly impact growth negatively. A rule of thumb for developed markets suggests that 10 US dollars more per barrel in the oil price shaves 0.3% to 0.5% off of headline growth depending on the country and — sometimes forgotten — the extent to which the oil price rise reflects the weakening of the US dollar. The recent strengthening of the euro and the Swiss franc against the US dollar surely mitigates the surge in oil prices.

“Higher oil prices, weaker growth, risk of stagflation: only bad economic news,” one might be inclined to say. However, for the investor there is also a brighter side to this.

In our view, one of the main risk scenarios at the beginning of 2011 was an earlier-than-anticipated reversal of the ultra-lax US monetary policy. Obviously, with growth at risk due to higher oil prices, an earlier-than-forecasted rate hike by the Federal Reserve becomes less and less likely.

That said, this bright side of the coin has its umbral partner. If the growth outlook becomes too weak, then the voices calling for new quantitative easing measures by the Fed beyond the QE2 program scheduled to run out in June will become louder.

High oil prices are caused not only by the Arabian spring; they also manifest the creation of tremendous liquidity. Hence, should the Fed consider further quantitative easing measures after QE2, then a vicious circle similar to that in the 1970s (high oil prices – lax monetary policy – even higher oil prices) could become reality. Let’s hope that this mistake is not repeated.