Comstock Partners, Inc.February 14, 2013
CURRENCY WARS WILL ONLY GET WORSE
Cycle of Deflation
When massive private and public sector debts result in a credit collapse and recession, the efforts to pare down the debt is deflationary. Measures to inflate our way out of the situation are likely to fail as households are attempting to pay down debt and increase savings, rather than start a new round of debt accumulation. In addition, financial institutions are willing to lend to only the strongest borrowers, another factor limiting credit expansion. This is called a "liquidity trap" and is very difficult to generate inflation under this environment. Total U.S. credit market debt (government and private) grew from about $1.5 trillion (tn) in 1970 to over $55 tn. presently.
Presently, the public and private debt peaked at about 385% of GDP in 2008 and is not much better now. Over time it has taken more and more debt to create a given amount of GDP growth, and when debt is declining, as it must, it is difficult to get any growth at all. In fact, Bill Gross put the problem in perspective in his latest newsletter, where he states, "Each additional dollar of credit seems to create less and less heat (referring to GDP). In the 1980s, it took four dollars of new credit to generate $1 of GDP. Over the last decade, it has taken $10, and since 2006, $20 to produce the same result".
Bernanke understands the problems of deflation under the present situation where most people still believe that inflation will be the consequences of the enormous debt we've accumulated over the past two decades. Trying to remedy the significant amounts of debt the global economy built up, could lead to a debt collapse and depression if not dealt with aggressively. Bernanke, being a student of the "Great Depression", warned Japan about this same dilemma in 2003 where he advised Japan to aggressively stimulate both fiscally and monetarily.
We've received numerous feedbacks from our weekly comments regarding the fact that we used the "Cycle of Deflation" (attached) numerous times over the past few years and warned about potential "competitive devaluations", and "beggar-thy-neighbor" policies that are all symptoms of the deflation we expect to take place very soon. Most of the feedback received gave us credit for bringing up these terms years ago, when they never heard of them before. Now they are being used in the financial media every day. Actually, we believe that we are in the "competitive devaluation" stage presently as country after country is printing money in order to lower rates and doing whatever possible to devalue their currency in order to export their goods and services. Remember, deflation is a product of too much debt in the U.S. and we either default on the debt or pay it off. When we get to the dashed line in the "Cycle of Deflation" chart, right after "protectionism and tariffs," is when the deflation sets in and economic pain becomes unbearable.
The main driver of the recent currency movements has been the various monetary policies of the world's major central banks. The U.S. Federal Reserve (Fed), the Bank of England (BOE), the Bank of Japan (BOJ), the Peoples Bank of China (PBOC), and the European Central Bank (ECB), are all attempting to grow their economies with different policies. These are just the major central banks. Actually, there are 38 central bankers around the world either printing money or initiating loose monetary policies. Some, as was the case just a few days ago in Venezuela, just devalue their currency (the Bolivar).
But some have it easier than others. In fact, because the ECB is not able to pinpoint exactly which of the 17 countries in the Euro Zone need the most help they are forced to offer three year loans to banks at the cheap interest rate of 1%. This policy was initiated over a year ago by Mario Draghi right after he became President of the ECB. The Euro vs. the dollar continued rising by almost 10% since then, and was up more than 20% for the last 3 months. This put the Euro Zone under economic pressure as they found it difficult to export goods to their trading partners with an increasing currency. In fact, the latest statistics release today showed the 4th quarter annualized GDP of Germany to be down 2.3%, France down 1.1%, Italy down 3.7%, Spain down 2.8%, and Portugal down 7.2 %. Also, the ECB forecasted zero growth for the Euro Zone this year.
Since all this competitive devaluation is affecting the Euro Zone so negatively, Japan has decided to do whatever is possible to lower the value of the Yen and increase inflation. They realized that they were not aggressive enough with competitive devaluation over the past couple of decades. So far, they have been very successful, but at the expense of being the target of all of their trading partners. It is clear this is not over yet, and the competition to have the fastest currency in the down-slope race to the bottom is not over. The main point we would like to make is that the competitive devaluation will not end well as shown in the cycle of deflation chart. Remember how well it worked for the Greenspan Fed as they lowered rates in 2003 and started the housing bubble. Stay tuned to the "Cycle of Deflation" as we continue to update it.