The Martenson Report: Nowhere To Run - A Monetary Crisis

Nowhere To Run - A Monetary Crisis

Saturday, March 6, 2010

Executive Summary

  • Nations around the world are insolvent and on their way to bankruptcy, a fiscal crisis, a currency crisis, or all three.
  • World markets are currently interlocked to a troubling degree.
  • A falling currency is always a cross-border event.
  • The German DAX, the Dow Jones, and the FTSE 100 charts are nearly indistinguishable.
  • A bigger trigger than Greece will be needed to set off the next round of global trouble.
  • The UK is a highly qualified candidate for that role; Japan is also a likely possibility.
  • Expect the unexpected.  The future is going to change suddenly and rapidly.

A significant issue facing all of us concerns the idea of a large decline in the value of our home currency, whatever currency that may be.  History is full of examples of currencies suddenly, and sometimes permanently, losing value.  Certainly, there is no greater financially traumatic event than having all of your perceived wealth evaporate like water on hot steel simply because your currency fails.

Once upon a time, evaluating the relative risks of various currencies was pretty straightforward, as they were independently run and market forces gave pretty clear signals.  Today, the major currencies are hopelessly intertwined, manipulated by central banks, and are therefore providing relatively poor information to market participants.

The dollar is the worst currency in the world, except for all the rest...

The larger problem, especially for those managing large tracts of money, is that there's really no place to hide.  In the 1920s, if one was concerned about German monetary policy, one could have hopped over the nearest border and found sanctuary for one's money.  In 2000 in Argentina, if one was paying attention, getting one's money to Uruguay was relatively easy.

But where can one hide today?  Should one hold wealth in Euros?  Yen?  Pounds sterling?  Dollars?

Without a border to cross, the idea of protecting oneself against reckless fiscal and monetary policies becomes extremely difficult to conceptualize.  If all currencies are being managed recklessly, then where does one go and what should one do? 

This is not a trivial concern, and it has enormous implications.  In times past, investors with the ability to scurry away from reckless monetary regimes imposed a sort of control on the system.  If a government got carried away, big money would leave, their currency would fall, and austerity would be imposed.  But there is no meaningful way to "vote" anymore.  Now that all the major currencies are being similarly subjected to printing (i.e., "quantitative easing") and/or shoveled in obscene quantities into the coffers of the reckless and imprudent (Goldman Sachs, Greece, etc), the final restraint has been removed from government actions.

At any rate, for our purposes, the central idea is that a falling currency is always a cross-border event.  It has to be falling in relation to something:  outside currencies.  If all of the currencies are mismanaged to roughly the same degree, is it even possible to have a currency crisis?  If so, how would one know?  Is it possible for a currency to "fall" if it's just as bad as the rest?

We happen to live at a time when all of the major currencies are being horribly over-printed and governments are running the most reckless fiscal deficits in living memory.  Our choice, should we choose to play the game, seems to be limited to picking which of the currencies is falling least quickly.

Insolvent Is As Insolvent Does

The bitter truth, lurking right in plain sight, is that various nations around the world are completely and utterly insolvent and on their way to bankruptcy, a fiscal crisis, a currency crisis, or all three.

In a recent report from Societe Generale, the following chart was produced, comparing various Western governmental liabilities.  The red bars represent what is commonly reported as the official debt levels of each nation, but the gray bars show the actual total liabilities of each government, including the so-called "off-balance-sheet" liabilities. 


And it bears noting that these gray bars do not include the debts of either individuals or corporations (especially financial institutions).  Were these debts included, the gray bars would extend by another several hundred percent for most countries.

This view provides further confirmation of the idea that there's nowhere to run, nowhere to hide.  Which of these countries represent a better or worse currency risk relative to the others?  Who knows?  From the looks of the chart, one might guess Spain is the best, but that would be a terrible conclusion, because of the degree to which Spain's financial institutions are exposed to the massive property bubble that is still bursting there.

No More Bulkheads

A long time ago, people learned the hard way that it was a bad idea to build large ships without the benefit of bulkheads, which effectively turn a single large ship into several separate floating chambers.  Prior to this realization, if a metal hulled ship was punctured, it sank, unless enough compartments were walled off from the breach.  The Titanic suffered from a long, scraping insult that breached too many compartments, and so it sank. 

In finance, the "beta" of a financial asset is a number describing the returns of that asset to the market as a whole.  A beta of zero means that the asset is perfectly uncorrelated, and a beta of one means it is perfectly correlated.

If we had a whole basket of assets moving perfectly together at the same rate as the market and sporting a beta of "one," then we would have no real diversification of risk and would be perfectly exposed to the market itself.

The idea behind beta is to spread out and control portfolio risk.  Ideally, when some things are moving down, you'd like to see part of your portfolio moving up.  This is a matter of concern to me right now, because world markets are currently interlocked to a troubling degree.

I can't tell the difference between the German DAX, the Dow Jones, and the FTSE 100.  Once you remove the names from charts, they are nearly indistinguishable.  Here's a six-month comparison of the FTSE 100 and the Dow:

If you were looking to diversify your holdings over the past six months by holding both US and European stocks with the intent of spreading out your risk, that would have been a failed strategy.  They are virtually indistinguishable.

Further, over the past six months there have been tight relationships between a lot of other currency, bond, and commodity assets, suggesting, again, that there's really nowhere to hide.  It's a global market now, and it trades with a rhythm that has been tightening up lately.

In some ways, we could see this as good, but in other ways it seems like there are no financial bulkheads left.  When another financial insult sweeps across the globe, it will take down nearly everything in its wake, because everything is, once again, linked together to an incredible degree. 

It's almost as if the lessons of the 2008/2009 crisis went completely unlearned. 

From The Outside In - UK On The Brink?

Well, if everything is interlinked and there's nowhere to hide, we might wonder where we might expect the trouble to begin.  My assessment here is that Greece is simply not the place where the true start will be.  It's too small, and its debts are simply not very large in the scheme of things.  Sure, if you live in Greece, things look pretty awful right now, but as far as the world is concerned, a bigger trigger will be needed to set off the next round of trouble.

After all, if the bankruptcy of GM can be absorbed without a hitch, then Greece is simply not going to create much trouble.  However, there is a highly qualified candidate in the arena.

There has been quite a bit of news flying around about the UK for the past few days.  Perhaps I am more sensitive to it now that I am freshly home from my visit to the UK, but I think these stories would have caught my attention even if I had not just been there.

Like the US, the UK is insolvent and heading for a fiscal and quite probably a monetary crisis.  Unlike the US, the UK does not have reserve currency status, and so their level of shielding is much, much lower than the US.

A couple of days ago, Jim Rogers, who is not really known for his currency expertise (he's a commodity guy), had a pretty dramatic set of quotes in the paper concerning a potentially imminent currency crisis for the UK:

Jim Rogers: British Pound could collapse within weeks

Jim Rogers, co-founder of the Quantum Fund and founder of the Rogers Commodities Index, was quoted in a recent press release that the United Kingdom Pound is on the brink of utter collapse, which could happen within the coming weeks and there is nothing governments can do about it.

Rogers, making statements prior to delivering a keynote speech at next month’s Global Trading Day seminar in Westminster, believes the collapse of the Pound could foreshadow a global economic disintegration before the end of the year. The last few months of increases in the markets have been a “false bounce” and occurred due to government interference in the market and throwing everything at it except for the kitchen sink.

The author of “Hot Commodities” believes the beginning of the collapse of the UK will start with the Pound, adding that the Pound has devalued against all other currencies and is a “basket case,” which will put Great Britain in a bad position when the “shakedown” occurs.

A few days after this pronouncement by Jim Rogers, the New York Times weighed in with their own view of the precarious nature of UK finances:

Britain Grapples With Debt of Greek Proportions

LONDON — As Greece’s debt troubles batter the euro, Britain has done its utmost to stay above the fray.

Until now, that is. Suddenly, investors are asking if Britain may soon face its own sovereign debt crisis if the government fails to slash its growing budget deficits quickly enough to escape the contagious fears of financial markets.

“If you really want a fiscal problem, look at the U.K.,” said Mark Schofield, a fixed-income strategist at Citigroup. “In Europe, the average deficit is about 6 percent of G.D.P. and in the U.K. it’s 12 percent. It is only just beginning.”

The problem here is this:  Not only is the UK government running an absolutely obscene deficit-to-GDP of more than 12%, their consumers have been feasting on the ultra-low interest rates offered up by the Bank of England.  How low are the current rates?  Lower than they've ever been since the BoE opened in 1692.  We're talking that kind of low.  Not once-in-a-generation low.  All-time low.

So what will happen when rates rise?  The problem here is that the UK consumer is up to their eyeballs in debt, and is so exposed via floating-rate debt, that even a one-percent rise in interest rates would cause their debt service costs to double to 13% of income.

I'll say that again:  A one-percent interest-rate rise would cause a doubling of the average debt service.  Wow.  Now that's exposed.  It's a guaranteed recipe for disaster.

For now, the UK government maintains a triple-A credit rating, but, as you should know by now, such ratings are utterly worthless as investment guides, because the ratings agencies are either deeply conflicted, inept, or both.

Non-Linear Behavior

As I recently wrote in Getting The Story Right, the risk in all of this is that nothing will happen in a nice, straight line.  Our economy is a non-linear, open system, meaning that it tends to remain relatively calm for long periods, before suddenly flying apart and settling into a new temporary equilibrium.

Niall Ferguson, the Harvard University professor, recently penned an article entitled Complexity and Collapse - a truly nice bit of writing - in which he details that history looks more or less like a series of hockey-stick charts.  Empires spend long periods of time on a relatively flat portion of the graph, but then experience rather sudden and starling periods of upheavals.  Again and again we find that history is anything but linear.

The relevance to our story here is that we should be doing everything we can to get it into our heads that the world is not linear.  Far more often than not, It behaves non-linearly.

We should expect the unexpected, because that's just how things seem to work.

It is my contention that we are past the elbow on an exponential chart.  The future is going to change suddenly, rapidly, and without asking for permission.  Further, it is my experience that the change will come from a place where almost nobody happens to be looking.

This is why I am not spending much time poring over the situation in Greece - it seems too obvious.

Instead, I think the proximate source of our next interesting financial moment will be located somewhere slightly offstage.  Perhaps the UK is even too obvious.  Perhaps we might want to consider Japan as a likely candidate?

Bank of Japan reportedly to consider more easing

TOKYO (MarketWatch) -- The Bank of Japan will likely consider more monetary easing through April, aimed at pushing down short-term rates, according to a report Friday.

Government officials and some market participants have expressed hopes for further increases in the BOJ's monthly outright purchases of government bonds from the current 1.8 trillion yen ($20.2 billion).

Aimed at pushing down short term rates?  Aren't they already at 0.1%?  Here's my guess - if 0.1% isn't getting the job done, then something less than that isn't going to do the job either.  I think Japan is signaling that its own protracted experience with fighting a debt overhang isn't going too well, and it is further burdened by an uncooperative yen that continues to strengthen, causing even more harm to its exporters.

And don't forget the Toyota brand damage that's been done.  All told, Japan seems to be trying as hard as possible to substantially weaken its currency.  For the life of me, I cannot figure out why the yen hasn't been destroyed completely.  It's not for lack of trying.

Because everybody is looking east to Greece and Europe, I wonder if perhaps the trouble won't start somewhere far to the west, like in Japan.


I wish I could provide the necessary fundamental analysis to assess which currency is the worst and which is the best.  Unfortunately, I cannot, as the governments of Japan, the US, the UK, and Europe are all doing their best to flood the markets with their own debased currencies. 

It's as if each currency is a skydiver, and we are trying to guess which one will fall the slowest.

We know that most governments are running unsustainable deficits and are, over the long-term, fundamentally insolvent.  The only rational response to this situation is to get out of the currencies involved, but this is almost impossible to do.  We are each exposed. 

I have not managed to deduce how it is possible for any one currency to really lose ground relative to the others, given the high degree of correlation among all the markets, the fact that each currency is being similarly abused, and the unfortunate realization that there's really nowhere to run this time.

My sincere hope is that one country will elevate itself above the rest and return to a sane fiscal stance and monetary policy, so that we can at least find some temporary refuge for those wishing to diversify their holdings.

For the small and nimble investor, my personal favorites happen to be Canada and Australia, both because their respective central banks seem to be saner than the rest, and also because their resource-rich economies seem well-positioned for the next few decades. 

(Full disclosure:  I have been invested in Canadian Loonies since 2004, but do not currently hold any Australian dollars.)

While we wait for fiscal and monetary sanity to return, the only response I can reasonably embrace is to remove some of our currency chips from the gaming table, convert them into gold, and wait patiently for more predictable times.