Pick a Side or Stand Aside
The world sits at a critical crossroads.
-- Will Henry
The market has been dealt a historic hand and the global stakes have never been higher.
For the last decade, the ace up the Federal Reserve's sleeve has been the U.S. dollar. They let the greenback devalue with hopes that a legitimate economic recovery would supplant the credit expansion that dominated this decade.
Since 2002, the world's reserve currency declined 34% while everything measured in dollars traded in kind. While that snuck by stateside players largely unnoticed, it's been a constant source of stress for foreign holders of dollar-denominated assets.
We call this "asset class deflation versus dollar devaluation" in Minyanville, which is to say we'll toggle between the two as policy makers pull fiscal and monetary strings. While both sides of the equation can potentially falter, the deck is stacked against the dollar and asset classes rallying in sync. (See: Thunder & Lightning)
While near-term headline-dominated nuances are difficult to digest, the big picture has come down to a simple question: Given the uncertainty in Europe, will the dollar be allowed to devalue further, paving a path toward hyperinflation, or will capital drain from the system and induce a prolonged period of deflation?
What's clear is that the world itself has experienced a seismic shift. Central banks have been increasingly proactive in what they do and how they do it. This has transpired for years but the efforts have visibly increased since the shvitz hit the fan in 2007. We opined at the time that something was afoot and the pieces have fallen into place. (See: The Credit Card)
The credit contagion brought this conundrum to bear; what remains to be seen is where the bears will domicile. I'm an optimist by nature but a realist when it comes to the current financial condition. In my humble view, two potential scenarios exist as we continue to edge down this prickly path, with a potential stage being set for the back-half of this decade. (See: Handicapping a Global Economic Recovery)
The first is the continued socialization of markets, nationalization of troubled institutions, and the specter of hyperinflation. A significantly lower dollar is a necessary precursor to-but no guarantor of-this dynamic, as that could "jack" anything denominated by this measuring stick. If that occurs, it would paradoxically punish savers who preserved capital, much like it did in March 2009.
This scenario is presumably preferred by the powers that be as an alternative to watershed deflation. The "haves" would fare better than "have nots" (as the costs of goods and services skyrocket) and they would be able to spur the velocity of money, which is paramount in a finance-based economy and has been noticeably absent since the demise of Fannie Mae and Freddie Mac.
The other option is the destruction of debt, deflationary pressures and an eventual "outside-in" recovery that paves to the way toward true globalization. This would trigger a higher dollar and lower asset classes in the intermediate term but a sustainable foundation for economic expansion thereafter.
Deflation in a fractional reserve banking system means policy makers have, for all intents and purposes, lost control of the economy. It would also impact the top-tier of the societal structure tied to the marketplace, which would be problematic for politicians and the constituencies that bankroll them.
No Easy Answers
The banking system, stymied with credit dependency, is not operating normally. Hidden behind bailouts, stimulus packages, super-conduits, term auction financing, mortgage rate freezes, foreclosure freezes, working groups and Public-Private Investment Programs are politicians attempting to engineer a business cycle that long ago lost its way. (See: Anatomy of a Recession)
The qualifier of this discussion is the elasticity of debt, which is stretched by historical standards as it continues to bump up against the debt ceiling. Factor in the Internet, which I consider the most deflationary invention of all time, and I would place back-of-the-envelope odds at 3-1 that deflationary forces will dictate the end game.
This deleveraging process will take years to unwind but will ultimately yield positive results. The destruction of debt will allow world economies to rebuild a solid foundation for future expansion that is entirely more secure than what is currently in place.
While it would cause paper wealth to evaporate, rich nations will be forced to pour real money-as opposed to cheap debt-into developing economies as a redistribution mechanism. While the path might be painful, the destination will be entirely more palatable for future generations.
There is a marked difference between taking our medicine as a function of time and price and injecting the system with drugs with hopes that the symptoms will pass. The latter continues to be the diagnosis of choice but the economic patient would be well served to understand both sides the prognosis.
Follow Todd and over 30 professional traders as they share their ideas in real-time with a FREE 14 day trial to Buzz & Banter.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter