Thursday, May 21, 2009

Widen Your Perspectives

As we flail around in the midst of the most troubled US economy in more than seventy years the focal point of most investors is the stock market. Fed by the likes of CNBC, and hourly updates on the Dow Industrial Average and our equity heavy brokerage statements the stock market is everything. If it goes up things are better. Right? Maybe not, as I watch the US debt burgeon to solve problems created by high risk in the financial backbone of the economy my mind wandered to the Weimar Republic.

In the face of global deflation pressure, the German republic created money at a pace never before seen. As in Weimar Germany, money creation in the U.S. is now being undertaken by a privately-owned central bank, the Federal Reserve; and it is largely being done to settle speculative bets on the books of private banks, without producing anything of value to the economy.

The $12.9 billion in bailout funds funneled through AIG to pay Goldman Sachs for its highly speculative credit default swaps is just one egregious example.To the extent that the money generated by “quantitative easing” is being sucked into the black hole of paying off these speculative derivative bets, we could indeed be on the Weimar road. We have been led to believe that we must prop up a zombie Wall Street banking behemoth because without it we would have no credit system.

Insofar as the word Credit comes from the Latin word for trust, I would suggest that the bailout does the precise opposite of create trust. The lack of credit offered by the banking system seem to verify that we have created money, not credo.

During the money creation of the Weimar republic, the stock market soared. Hundreds and thousands of percent gains showed up in portfolios. But obviously inflation made the gains irrelevant and less.

I am not positing that the U.S. is about to enter into hyperinflation. It is a "Black Swan Event." That is, an unpredictable outcome unexpected by historical knowledge.

In January two Morgan Stanley economist first uttered the word in a report.Could it happen to Europe or the US? Morgan Stanley says possibly yes, under certain conditions.

Firstly, the rapid expansion of the monetary base by the Fed, ECB and BoE would have to continue and feed into a more rapid and sustained expansion of money in the hands of the general public. This we currently do not see

Secondly, Morgan Stanley says governments would have to face difficulties financing their bailout packages and funding their debt. Given the actions of treasury auctions which seem to find bids primarily from the Federal Reserve this would be a yes.

Lastly, public confidence in the government’s ability to service debt without resorting to the printing press would have to disappear, as well as the government’s actual ability to withstand the pressure to do so in the first place. This would seem to me to be the tipping point. If analysis inside the government were to come to the same conclusion, it would be no wonder the "green shoots of recovery" would be trumpeted from the ramparts. Two months ago I noted that the positive spin began as if someone had turned the feel good spigot on.

And while all of the above is an extreme scenario, the Morgan Stanley analysts say:

"…given the size of the current and prospective economic and financial problems, and given the size of the monetary and fiscal stimulus that central banks and governments are throwing at these problems, investors would be well advised not to ignore this tail risk, especially as markets are priced for the opposite outcome of lasting deflation in the next several years. Put differently, we believe that buying some insurance against the black swan event of high inflation or even hyperinflation makes sense and is relatively cheap "

Don't just watch the market, watch your wealth.

John Barnyak