- German business confidence unexpectedly fell for the first time in 11 months in February. (Bloomberg)
- Confidence among U.S. consumers fell more than anticipated in February to the lowest level since April 2009. (Bloomberg)
“It’s tempting to think that the US can inflate its way out of its fiscal problems. A faster, sustained increase in prices would erode the real value of past debt, and higher future inflation would – other things equal – reduce the real resources needed to service and pay back the promises we are making today. And there is no mistaking the staggering value of those promises. On our projections, federal marketable debt held by the public, which we estimate will be 60.7% of GDP at the end of F2010, will jump to 87% of GDP in the next decade – a level not seen since the post-WW II period (1947). In absolute terms, such debt will more than double over that period from its January level of US$7.2 trillion.
Adding fuel to the fire, a growing chorus of household-name economists from both sides of the political aisle appears to be advocating higher inflation as the remedy for our fiscal maladies. Indeed, many believe that higher inflation will cure multiple ills, and that central banks should raise their inflation targets to as high as 4% from the current ones (some implicit) that cluster near 2%. From a policy perspective, we couldn’t disagree more. As we see it, central bank responses to this financial crisis underscore the fact that inflation targets are medium-term goals to be met flexibly; they have not limited central banks from responding aggressively to the shock. Specifically, we believe that the Fed’s ‘credit easing’ programs have restored the functioning of many financial markets and enabled policymakers to offset the constraint of interest rates at the ‘zero bound’. But the push for allowing more inflation to lubricate the economy is gaining adherents, so it’s time for sober analysis.
FX Trading – Center to periphery relationship is still in play…
This from the International Monetary Fund—morphing views on the “free flow” of capital (our emphasis):
With the global economy beginning to emerge from the financial crisis, capital is flowing back to emerging market economies (EMEs). These flows, and capital mobility more generally, allow countries with limited savings to attract financing for productive investment projects, foster the diversification of investment risk, promote intertemporal trade, and contribute to the development of financial markets. In this sense, the benefits from a free flow of capital across borders are similar to the benefits from free trade, and imposing restrictions on capital mobility means foregoing, at least in part, these benefits, owing to the distortions and resource
misallocation that controls give rise to.
Notwithstanding these benefits, many EMEs are concerned that the recent surge in capital
inflows could cause problems for their economies. Many of the flows are perceived to be
temporary, reflecting interest rate differentials, which may be at least partially reversed when
policy interest rates in advanced economies return to more normal levels. Against this backdrop,
capital controls are again in the news. A concern has been that massive inflows can lead to
exchange rate overshooting (or merely strong appreciations that significantly complicate
economic management) or inflate asset price bubbles, which can amplify financial fragility and
crisis risk. More broadly, following the crisis, policymakers are again reconsidering the view
that unfettered capital flows are a fundamentally benign phenomenon and that all financial
flows are the result of rational investing/borrowing/lending decisions. Concerns that foreign
investors may be subject to herd behavior, and suffer from excessive optimism, have grown
stronger; and even when flows are fundamentally sound, it is recognized that they may
contribute to collateral damage, including bubbles and asset booms and busts.
Why is this important? It is important because the IMF’s morphing views on this imply emerging markets as a group are still highly dependent on capital flow from the
developed world—center to the periphery capital flow (I saw this terminology first utilized by Georges Soros; not sure if he coined this phrase, however.) We have put
together a pictorial of the Emerging market money flow model as we perceive it now:
EM’s are dependent because they do not have internal funding sources i.e. bond markets. Thus, they are highly dependent on Western bank funding (and other institutional and retail forms of speculative capital flows). This will change; the change should likely come in the form of side-by-side domestic demand and capital market development. Aren’t they sick and tired of depending on the Western consumer? The short answer is likely yes. But it has been easier to depend on a flush Western consumer than to make the real grinding changes to their domestic market—and bestowing the related “freedoms” that go with it.
For now, this center-periphery dependence is critical to understanding why we will likely have another major bout of risk aversion i.e. money running for the hills from risky asset classes and into safe havens like deep Western capital markets. The short answer is contagion!
Three primary sources from which we think the potential for contagion flow is rising:
- China – Potential credit bubble pop-age
- Europe – A crisis at the center of Eurozone will be felt by periphery states i.e. Eastern and Central Europe
- Dubai – Lower potential, but still a contender when you add some troubles also brewing in Kuwait.
Taking together, there is plenty of risk out there. Plus, if consider the primary source of global liquidity has flowed from our governments use of our tax payments, which have created some ugly public balance sheets, will said funding continue to flow?
If risk again rears its ugly head, triggered by any of the catalysts we noted above, or from a potential host of other potentials we didn’t, Western banks and institutions will do what they need to do to survive—run from risky assets and pull in credit lines.
Concern about credit to the periphery is secondary. US Treasuries are the beneficiary. The US dollar wins by default. An ugly truth in a still very unbalanced world.
This might help explain why Harvard Professor Rogoff is so concerned about a “bunch” of sovereign defaults in the future.