The presentation could have been titled, “the unintended consequences of US monetary policy.” Marc Faber, Fed critic and publisher of The Gloom, Boom and & Doom report, roughed-up the usual suspects on March 11th at the Madison Sheraton. The annual dinner event was hosted by CFA Society of Madison and co-promoted by CFA Society of Milwaukee.
The central theme in Faber’s commentary is that recent Federal Reserve policy, while attempting to address prominent domestic concerns, has unwittingly created huge distortions in the global economy, largely to the detriment of the United States. From an investment standpoint, he makes a compelling argument for recognizing the future consequences of high US inflation and uncontrolled debt growth while recognizing the sheer size and potential that the new world of emerging economies now holds.
Don’t you know how the money flow
Faber walks us down a familiar path of Fed Funds rate changes over the past decade, highlighting some of the key motivations and fallout of Fed actions. This groundwork helps Faber construct two main conclusions, summarized below, that cast doubt on the efficacy of Fed policy. First, please bear with some of the detail...
In response to fears of recession and, later, deflation following the collapse of the TMT bubble, the Fed began rapidly slashing the Fed Funds target rate from 6.5% in January, 2001 to 1.75% by year’s end, eventually easing to 1% by July, 2003. This historically low level was held until July, 2004, almost three years after the recession ended in November, 2001. Yet even as the Fed gradually tightened from mid-2004 through mid-2006, Faber claims that monetary policy was still highly expansionary. He offers some statistics below on the continuing credit expansion to support this claim.
By June, 2004, credit growth in the US was running rapidly at a 7% annualized rate. Yet, despite tightening, by August, 2006, credit growth had accelerated to an astounding 18% annualized rate. Between 2000 and 2007, total US credit expanded by $21.3 trillion while GDP grew by $4.2 trillion, indicating that each dollar of economic growth during this period was financed by $5 of credit. From this discussion, Faber aims to illustrate that a complete picture of the neutrality of monetary policy must be construed in the context of its effect on credit growth – a consideration Faber believes is given short shrift in Fed policymaking.
By July, 2006, the Fed stabilized the Fed Funds target rate at 5.25%, citing a cooling housing market and dampening effects of higher energy prices in its rationale. By September 18, 2007, the Fed acknowledged that deteriorating credit conditions (a result of indiscriminate credit expansion) would have the effect of intensifying the housing correction and restraining overall economic growth. Fearing a housing collapse and overall economic contraction, the Fed began a new campaign of monetary easing, citing improving core inflation as part of its rationale.
However, the measure of core inflation excludes some volatile price series, notably food and energy prices. Oil prices, which roughly tracked credit growth this past decade, had steadily escalated to a peak of $80 by May, 2006 (up 8x from 1998 lows). By the eve of September 18, 2007, oil prices had stabilized near $75 and credit growth had slowed. But, as if the renewed easing campaign were a cue, credit growth reaccelerated and oil prices nearly doubled to a new peak of $147 by July, 2008.
To drive home the significance of these price movements, Faber quantifies the additional burden of higher oil prices on the US economy: Annualized US outlays for oil had grown from $75 billion in 1998, to $500 billion by May, 2006, to over $1 trillion by July, 2008. If one accepts the link between interest rates and oil prices, as a net importer of oil, these additional US outlays were clearly an unintended burden on the US economy. Other commodity prices, including agricultural commodities, experienced movements of similar magnitude in this period.
Because the availability of additional credit creates incentives for further investment, or multipliers, asset booms, such as those recently experienced in housing and commodities, are created or intensified by credit. The root problem is that the Fed can control neither the intensity nor the sectors in which future asset booms will occur. Thus, Faber stresses that credit driven asset booms are not innocuous events but, instead, are sources of economic instability that create distortions in markets. As the latest example, he believes that the magnitude of the recent run-up in equity markets (some 70%) is also a direct result of a near zero Fed Funds rate policy.
Faber has two main points to take from the above detail. First, over the past decade, the Fed has unwittingly created a succession of imbalances, cropping up in various sectors, in its attempts to manipulate market adjustments to prior imbalances. Second, this game of whack-a-mole has also had an expansionary bias on the money supply and credit growth over the whole period.
Faber then turns to how US monetary policy has affected the global economy and the Unites States’ relative standing in it.
I didn’t mean to turn you on
We have just experienced the first global synchronized boom. Faber spends some time describing why a global synchronized boom had not been possible prior to this latest expansion, but it boils down to two main reasons: higher international trade and capital barriers (due to lack of participation by closed economies), and the relative lack of capacity in industrializing nations (due to small size and lack of infrastructure in relation to Western economies). These barriers had been largely brought down by the turn of the century, a process that had been more than 20+ years in the making, typically marked by the opening of China in the 1970s and reinforced by the subsequent fall of the Soviet empire. Faber illustrates that the pieces were in place, as never before, for industrializing nations and resource producing nations to meaningfully participate in the next expansion.
So far so good, but as you might have guessed, Faber believes that the global expansion, which should have been more gradual and organic over the past decade, was turbo-charged and distorted by US monetary policy.
The credit boom in the United States created extensive current demand at the expense of future demand, leading to domestic overconsumption by the private sector. This is reflected in the growth of the US current account deficit, from $150 billion in 1998 to over $800 billion by 2007. Overconsumption in the US was matched by overproduction in foreign economies. This trade accelerated growth in capital spending, employment and incomes, primarily in emerging Asia and, especially, China.
Historically, the terms of trade had been unfavorable for resource producing nations (Faber cites 1980 to 2001); raw materials/commodities prices had steadily declined while prices of imported goods had increased. Rapid industrialization in emerging Asia created new long-term demand for raw materials and energy as well as a new supply of finished goods to resource producing nations. The magnitude of industrialization in Asia effectively reversed the terms of trade to resource producers, leading to rapidly higher export prices and lower import prices – a positive reversal of fortune.
But the party ended badly. When increasingly dubious credit growth finally buckled under its own weight, the entire global supply chain was affected, resulting in a global synchronized bust. The ensuing unwind has laid bare some distortions created by the boom.
The world is awash in dollars. The US current account deficit has led to an eye-popping increase in international reserves, from $1 trillion in 1996 to over $8 trillion currently, 70% of which is held by Asian central banks. With vast reserves and strengthening currencies, emerging industrial economies are on a sounder financial footing, better able to compete with the West for political, strategic and economic influence. Faber believes the sheer magnitude and speed of industrialization, often driven by competition to be first-mover, contributed to an unintended transfer of technology and know-how from developed to emerging industrial economies. Another positive legacy for emerging economies is gleaming new infrastructure, even if there has been inefficient investment, likely leading to future positive externalities. Faber believes these positive legacies in emerging industrial nations are some of the building blocks that will create future investment opportunities for investors. On the other hand, the turbo-charged industrialization in Asia has accelerated competition for resources, exacerbating global tensions.
The legacy of the bust for Western economies is a bit more challenging. Consumers’ balance sheets are in terrible shape. Having heavily financed bad housing investment and frivolous consumption, consumers are now forced to save and deleverage. Corporations saw pressure on revenues from reduced spending coupled with evaporation of corporate credit, forcing drastic cuts in employment and investment, a further blow to consumers. Meanwhile, the bloated public sector has yet to tighten its belt (Faber offers more on this later).
It would be dishonest to say that there are no painful adjustments that accompany a globalizing economy. Painful adjustments in some sectors are accepted because economists expect they will be outweighed by net gains to the overall standard of living. However, the Fed-fueled credit boom created such huge distortions, and the credit bust created such wrenching pain, that capitalism and free trade have been made scapegoats. This legacy is ironic.
If Faber would like us to remember one thing from his presentation, it is that the Federal Reserve, in its manipulation of the most important price in the global economy – US interest rates – unleashed a credit binge on the world economy. The credit boom and its damaging distortions are the end-result of government intervention in markets, not free markets. Faber believes that, even now, the Fed leadership has not acknowledged the role that credit growth contributed to the crisis. Below, Faber sheds some light on why this may be the case.
Do that to me one more time
While the private sector has acted rationally by deleveraging, government credit growth has gone “through the roof” via fiscal deficits and monetization by the Fed in attempts to offset private sector retrenchment. While Faber didn’t offer statistics on the Fed monetization, I looked it up just for curiosity’s sake. The Fed balance sheet has grown from just under $900 billion in early Sepember, 2008 to over $2.2 trillion at the time of Faber’s presentation (source). As a result of public sector debt growth, total credit as a percentage of the economy is still expanding at present. Below, Faber puts the magnitude of debt growth into historical context and then offers some frightening projections.
In 1929, total debt as a percentage of GDP was 186%, up from 120% in 1921. Following the deleveraging during the Depression, the US went into WWII with a ratio of 140%, and the ratio fluctuated but remained fairly stable until after the Volcker tightening in the early 1980s. Since then, the the debt to GDP ratio has grown rapidly and steadily to its current level of 375%. However, this measure does not include unfunded liabilities from Medicare, Medicaid and Social Security, all entitlement programs that didn’t exist before the Depression. Adding in these liabilities gives a debt to GDP ratio of 800% (which would also exclude any forthcoming entitlements). While Faber didn’t offer sources or methodology on his projections, he believes deficits under the current administration extend as far as the eye can see. He cites unnamed third party projections at over $1trillion, but Faber believes deficits may reach $2 trillion annually. There may be debate about debt levels and future deficit projections, but Faber makes a compelling case that the trend is leading to uncharted waters. But here’s the gratuitous double-whammy.
Interest rates peaked on September 21, 1981, with the 30yr Treasury yielding 15.84%. Yields declined steadily and achieved a generational, secular low on December 18, 2008; 2.08% on the 10yr, 2.53% on the 30yr. Rates have since risen from these levels and Faber believes they will continue to rise while total debt increases. In 10 years, some research services (Faber didn’t elaborate) believe that 35% of tax revenues will be used for debt service – Faber projects 50%. In such a scenario, Faber believes you can’t raise taxes, cut spending or grow enough to get out – the only option is to default, likely by rolling the printing presses.
Faber segues into a discussion of inflation vs. deflation. He cautions against notions that a weak economy with deficiency in demand necessarily leads to deflation. There are hundreds of cases where a weak economy with a high output gap (GDP below potential) and high inflation coexist. For example, Faber offered Zimbabwe which has a 90% output gap and hyperinflation.
Faber offers the 1980s petrodollar crisis as a more realistic cautionary tale. In the 1970s, OPEC countries had huge dollar surpluses which were deposited with American banks and recycled into loans to Latin America, creating a boom in Latin America financed by foreign lending. Early in the '80s, oil prices declined, OPEC surpluses declined and petrodollar loans dried up, threatening a meltdown in Latin American economies that had thrived on a supply of foreign credit. Faber said that, in response, Latin American governments at that time did exactly what the current administration and the Federal Reserve are doing now; create large fiscal deficits and print money, which had the effect of decimating local currency. For example, the value of the Mexican Peso declined 98% from 1979 to 1987.
What do you do for money
From the above discussion, Faber hopes to make clear that Treasury debt is a bad investment. He recommends shorting it if you’re aggressive.
Referencing the petrodollar crisis again, Mexican equities held up reasonably well as a store of value. The Mexican index ended the measurement period up 139x in local currency, up about 29% in dollars. Extending on this, Faber believes that the Fed can make US equities reach any level, depending how much money they intend to print. As such, investors probably won’t be as damaged in US equities as they will in US bonds. Still, Faber believes gold will outperform equities. Agricultural commodities are at 200 year lows in real terms, particularly wheat. Continuing the agricultural theme, Faber suggests that farmland would be particularly valuable if global tensions escalate to apocalyptic scenarios.
Faber believes 50% of assets should be allocated to emerging markets. Offering some sector ideas, only 2% of Chinese leave the country on tourism every year compared to over 100% of English. Asian banks are relatively sound due to deleveraging from the Asian crisis, intensity of city traffic and few toxic assets on their books. Infrastructure in Cambodia, Laos and Mongolia (which Faber calls the Saudi Arabia of Asia), is neglected. India will eclipse China in population and will have favorable demographics. Urbanization in China in 1995 was still 29%, now standing at 44%. Urbanization in India is still 30%.
