Monday, July 26, 2010

Distortions Galore

I was going to write a post about one data point or another that came out today, but Calculated Risk plus Bloomberg cover them all. The bottom line is that in past years, when one economic datum after another comes out weak--ranging from ECRI's WLI growth rate dropping below 10% (a level not even reached in the severe 1981-2 recession) or the various weak reports out of new home sales (record low sales), the Dallas Fed Manufacturing Index and the like, and the widespread skepticism that the European bank stress tests are useful, the stock market usually drops and Treasuries rally in price.

Not now. Perhaps the prospect of zero interest rates forever has gladdened the hearts of valuation algorithms amongst owners of capital.

The VIX has dropped to around 23. In turbulent economic times I have noticed that it averages roughly 25. In good, stable times it is in the teens. Thus the VIX hit a record low late in the last decade's bubble period.

It appears to me that when record low governmental interest rates are widespread and are dropping, this could only fail to be a bubble in government debt if price deflation were present--and this would be "good" deflation, associated with greater supply of goods and lower real costs of production.

This is how living standards improve rapidly.

The last time the U. S. had this sort of "good" price deflation was in the latter part of the 1800s.
But guess what: there was virtually no Federal debt then. There was no central bank. There was no involuntary unemployment. Gold was not an investment; it was money. Financial paper took the place of money but was recognized as not being money. Living standards soared and immigrants flowed without restriction into this country, the only requirement being passing a medical test for public health reasons.

Now, any deflation we have is the "bad" kind: price-cutting, such as of homes, due to overproduction. But we have "underproduction" of iPads due to component shortages (presumed temporary).

An example of "good" deflation that theoretically might occur would be the simultaneous discovery near New York City and Los Angeles of massive amounts of easily accessible fields of natural gas, sufficient to displace huge amounts of imported oil.

I'm not holding my breath for any such game-changing event, however.

What I do see is rampant overpricing of financial assets all over the place, this being a sign that too much "money" has been "printed". Yet the real economy is far less buoyant. Not only is this disconnect unhealthy, but since the money is circulating in New York and its printing supports the establishment in Washington, the result is that people look around themselves in their localities and see a distorted view of the real economy.

It's sort of like trying to see what the temperature is out on the farm by putting your thermometer inside a hothouse.

But the Federal Government is locked into a Japanese-style model in that its fiscal health waxes and wanes with the economy. When the economy is weak, Federal finances weaken. Normally, the "market" would make the increasingly leveraged borrower--the Feds-- pay an increasingly higher price to borrow. Inexplicably, as default chances rise, prices have been falling on said debt. Is this due to "crowding out", manipulation, or no other good investments being perceived available to typical bond investors?

If, for one reason or another, the U. S. is going Japanese (before perhaps defaulting), then the pattern in Japan provides a good template. That template includes huge undervaluation in stocks; and, gold has moved to a record high in yen terms over the years. If one lives in Japan and thus has had roughly stable consumer prices for years, then gold has quadrupled in yen terms.

Anyone who thinks that money printing/massive deficit spending associated with a zero interest rate policy exempts the pricing of tiny minority fractional ownership of corporations (aka stocks) from traditional valuation measures may want to study the Japanese financial experience.

Of course, the U. S. is not Japan, past need not be prologue, etc. Nonetheless, isn't there a saying or two about learning from history?

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