Approaching Stagflation

Bill Bonner - Tue 04 Mar, 2008

The trouble we seem to be getting into now is stagflation.

It is snowing this morning…winter is not over; in fact the worst weather of the year may still be ahead.

Yesterday, the Dow held steady, after falling 315 points on Friday. Gold rose again – another $11…to $986. It looks like $1000 gold is only days away, about which, more below…

This is the big month, when mortgage resets peak out – with nearly $120 billion worth of mortgages to be adjusted upwards. Naturally, you’d expect Americans to be feeling pinched… especially with prices of energy and food at record levels.

“Americans start to curb their thirst for gasoline,” says a Wall Street Journal headline.

Car sales fell in February – as you’d expect. Retailers report slower sales. And the economy itself, when last measured, was neither moving ahead…nor retreating, but stock still.

This has prompted a rush to judgment on the part of some critics:

“The Federal Reserve’s Rescue Has Failed,” announces a headline in the English paper, the Telegraph. Ambrose Evans-Pritchard, the paper’s business editor, says “the verdict is in. The Fed's emergency rate cuts in January have failed to halt the downward spiral towards a full-blown debt deflation. Much more drastic action will be needed.

Yields on two-year US Treasuries plummeted to 1.63pc on Friday in a flight to safety, foretelling financial winter. The debt markets are freezing ever deeper, a full eight months into the crunch. Contagion is spreading into the safest pockets of the US credit universe.”

Mr. Evans-Pritchard then brings up New York’s Port Authority, which operates bridges, bus terminals and airports in the New York, New Jersey area. The Port Authority is backed by both state governments. Yet, when it went to borrow money, it was treated like the junkiest of junk credits…forced to pay 20% rates.

"I never thought I would see anything like this in my life," said James Steele, an HSBC economist in New York.

“No sane mortal needs to know what term-auction means, except that it too became a tool of the US credit alchemists,” continues Evans-Pritchard. “Banks briefly used the market as laboratory for conjuring long-term loans at Alan Greenspan's giveaway short-term rates. It has come unstuck. Next in line is the $45 trillion derivatives market for credit default swaps (CDS).

“Sub-prime debt is plumbing new depths. A-rated securities issued in early 2007 fell to a record 12.72pc of face value on Friday. The BBB tier fetched 10.42pc. The "toxic" tranches are worthless.

“Why won't it end? Because US house prices are in free fall. ”

The article goes on to mention that we are only half way through the mortgage reset storm. Expect more bad weather, says Evans-Pritchard.

But here at the Daily Reckoning, we are in no hurry to pronounce judgment on Ben Bernanke’s plan to save the US economy. We don’t have to. We knew it was a mistake from the very beginning. Exactly how the markets would react, we couldn’t say. But the idea of rescuing people from too much debt by lending them more money struck us a bit like serving martinis at an AA meeting; it was bound to lead to trouble.

The trouble we seem to be getting is popularly known as ‘stagflation’. Prices rise, but so does unemployment. It wasn’t supposed to work that way. Inflation was supposed to spur consumers to spend money and businesses to hire people. But people eventually catch on to the trick. They eagerly get rid of money…and prices do rise. But they also come to realise that it’s not a real boom…but a phoney boom… So, businesses do not expand…do not hire…and do not earn more money. They raise prices, but their costs go up too.

Still, the ‘stagflation’ label is reassuring to people. Those over the age of 40 can recall the stagflation of the Nixon years. In retrospect, it didn’t seem so bad. But there, too, we part company with most observers. It wasn’t so bad then because America’s economy was much, much stronger – strong enough to take Paul Volcker’s bitter medicine…and survive.

This time, the financial authorities aren’t even opening the medicine cabinet. They’re afraid the patient couldn’t stand the treatment. Instead, they’re administering the old elixir that got the economy into serious problems in the first place – more cash and credit.

Different circumstances…different treatment…we will surely get a different result. Stay tuned…

*** The costs of the credit crunch are mounting up. Each estimate is bigger than the one than before it. The latest estimate from the Union Bank of Switzerland is $600 billion. Economist Nouriel Roubini goes even higher - at $1 trillion. Of course, those are just the direct losses…the disappearing cash. There are also losses in implied wealth (and subsequent changes in spending and retirement plans) from falling house prices themselves. The residential housing market is worth some $20 trillion. If it goes down 30% from top to bottom, as expected, that’s a loss of more than $6 trillion.

*** Remember the Golden Rule: He who has the gold makes the rules.

As nations get rich, typically, they buy gold - or steal it. What else can they do? How else can they protect their wealth?

When Britain was the world’s dominant empire, it loaded up so much gold in the Bank of England that the floor collapsed. Then, power shifted to America. The US collected its war debts and the gold went back to the USA with the doughboys. In a few years, until the US had the world’s largest stockpile, in Fort Knox, Kentucky.

In 1971, Nixon announced that the US would no longer honour foreign claims on its gold – after Charles de Gaulle insisted on turning in dollars for the metal in the 1960s. Since then, the world has operated on a dollar standard. Foreign governments stockpiled dollars, rather than gold, and trusted the US Treasury to make sure their dollars didn’t lose too much value.

Alas, lose value is just what the dollar did. It went from about $1 down to 5 cents during the 20 th century. But the drop was fairly gradual…and other currencies fell along with it - more or less. And the US economy was so strong and so far ahead of the rest of the world, people felt safe holding the greenback, even though it was losing value steadily.

But now, two things have changed.

First, wealth is shifting away from the US. America is no longer a growing power, but a fading one. The real money is being made in other places. The energy exporters, for example, are piling up money – especially dollars – at breakneck speed. And the Asian exporters too are making trillions.

Second, the world is losing confidence in the dollar as never before. Everyone knows the Bernanke Fed can’t defend the buck. There are too many of them. Instead, Bernanke has to try to fight the economic slump – with more cash and credit…further inflating the world’s supply of dollars.

That’s why the dollar index is at its lowest level in 35 years.

“Dollar: it will only get worse,” says CNNMoney.

This leaves the foreigners in a tight spot. They’ve got trillions worth of dollars…and the buck is falling. What are they going to do?

The answer is: what rising powers always do – buy gold. The price of the yellow metal has been in a bull market for nearly 10 years – a bull market that began almost precisely on the day, in 1999, when Gordon Brown sold English gold at a 20-year low in the gold price. Since 2001, gold has risen 240%. Since Sept. 18 th, when Ben Bernanke began with his five rate cuts, it has risen 36%. Like individuals, nations want to preserve their wealth; for the past decade gold has been the best way to do so; even central bankers are catching on.

Russia and Qatar are buying heavily. Qatar is using its oil revenues to buy a tonne of gold per month. Russia is buying three or four times as much, and now has more gold in stock than the Bank of England.

China is said to be buying too – but very cautiously. China has so many dollars, if it wanted, it could buy almost half of all the gold ever mined.

Looking ahead, it is hard to see what would stop gold now – except a worldwide financial meltdown. Some commentators insist that Western governments will sell their gold to take advantage of the high price. The IMF has already been cleared to sell nearly $100 million worth – to cover its budget shortfalls. But with the price rising…and the inflation pumps working round the clock…what central banker or treasury secretary is going to want to be the one who sells the family’s silver now?

*** Talk about bad weather!

“Many trees have fallen…and the electric lines are down. It is as if we had suffered an aerial attack or lost a battle. This is a terrible disaster. We’re hungry and cold.”

This message comes from China, via our Buenos Aires correspondent, Horacio Pozzo. He goes on to tell us that:

“China has suffered in the last few weeks, a severe crisis, with temperatures at their lowest levels in 50 years and record snowfalls. Energy shut-offs, water shortages, supplies of food running out, millions of people trapped, unable to produce or buy…creating an unimaginable paralysis…exposing to the world China’s extreme fragility…

“Unshakable and powerful China has succumbed not to recession, nor to economic slowdown…but to Nature. Something much more powerful…and against which there is no Bernanke, no lower rates, no more liquidity, no Buffett, no credit insurance…nothing to save us.”

China runs on coal. And coal runs on rail lines. And rail lines in China have been covered with snow and ice. When the coal stopped getting where it was supposed to go practically the whole country came to a halt. Economic losses were on the order of $15 billion, with 350,000 houses destroyed and (according to the public reports) 100 people dead.