Is The Collapse In FX Reserves Even More Dangerous Than The Plunge In Money Supply?
By now everyone has read Ambrose Evans-Pritchard's article discussing the historic plunge in the M3, which speculates that due to the failure of attempts so far to reflate the economy, Obama is likely considering a renewed stimulus. To validate his point, Evans-Pritchard quotes Tim Congdon of International Monetary Research": "The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly. Fiscal policy does not work. The US has just tried the biggest fiscal experiment in history and it has failed. What matters is the quantity of money and in extremis that can be increased easily by quantitative easing. If the Fed doesn’t act, a double-dip recession is a virtual certainty." SocGen's Albert Edwards chimes in with an observation from a slightly different angle, namely that the collapse of global FX reserves, whose explosion until 2007 "fuelled both global GDP growth and the credit bubble," which are simply indicative of global imbalances and are a very useful measure of total liquidity, are now plunging. This merely reinforces the deflationary pressures of the plunge in money supply, and forces the Fed into a corner from which there is no escape except by activating another multi-trillion QE program. Yet away from the US, Edwards argues that the huge imbalances within the Eurozone will serve as the seeds of its own destruction.
To quote Edwards:
One of the key drivers - some say THE key driver - of the great credit bubble was global imbalances. Large external imbalances fuel global economic growth when the surplus country intervenes to stop currency appreciation. Growth in global foreign exchange is one common measure of global liquidity. Many believe the explosion in FX reserves seen until the end of 2007 fuelled both global GDP growth and the credit bubble. The recovery in liquidity over the last year is unravelling and this may explain why risk assets are now suffering so badly.
The SocGen analyst chimes in on AE-P's earlier piece...
Monetarists have been jumping up and down about the continued weakness in global money supply measures. The well known market commentator, Ambrose Evans-Pritchard, for example notes in the UK?s Daily Telegraph today that “money supply in the United States is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history” - ?link. Looking around the globe, the US is not an isolated experience.
Now I?m not a monetarist myself, but you don?'t need to be to know that money does indeed matter. And in a post bubble world where the private sector is still de-leveraging and now the public sector is trying to as well, a contraction in the money supply of this order of magnitude spells big, big deflationary trouble. Incidently Bernanke apologised on behalf of the Fed at Milton Friedman?s 90th birthday celebration for causing the Great Depression by allowing monetary growth to implode. To quote ?"I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.” ?- link. Monetarists say they are doing it again!
M3 is just the beginning. For a true picture of global liquidity, one has to look at global imbalances. And they don't paint a pretty picture.
Another key measure of liquidity we watch closely is also in rapid retreat ? namely the growth in global foreign exchange reserves (see chart below). This traditionally has a close correlation to both emerging equity market performance and commodity prices. Its retreat might help explain recent weakness in these asset classes and has broader implications.
If I have learnt one key lesson, it is that extreme imbalances have a funny habit of correcting at some point, bringing the existing consensus crashing down. For example, I remember in the mid-1990s being repeatedly savaged by clients for pointing out that Asia?s extreme current account deficits in the mid 1990s were unsustainable ?Noddynomics?. And using this analysis it was clear to me even back in early 1998 that much of Europe would suffer bubbles with strong parallels to the mid 1990s Asian crisis ? (see The Independent newspaper - link).
How have global imbalances played out in the world to date?
Many believe that the mega-external imbalances (predominately between China and the US) were in very large part responsible for inflating the global economic and market bubble. One measure of the liquidity these imbalances produce is represented by the change in foreign exchange reserves as emerging economies (generally) and China (in particular), print money to stop their exchange rates rising against the US dollar (see chart below).
After recovering last year, this key measure of global liquidity is back in rapid retreat and is closely associated with the current downturn in commodity prices and other risk assets. This might explain why the current ?correction? may be about to turn into something far bigger. One key driver in the reduction in global liquidity is the disappearance of the huge Chinese trade imbalance (see chart below).
While most commentators (including this one) focused on the vendor financing scheme that dominated economic relations between the US and China, few really focused on the huge imbalances that existed within the eurozone, mainly because they netted out to close to zero. But the current crisis in the eurozone has thrown these imbalances into sharp focus.
Make no mistake, the fiscal crisis we are seeing in the periphery is a direct result of the correction in the massive private sector deficits in these counties. The fiscal bust is directly proportional to the depth of the private sector retrenchment, which in turn is a function of the one-size-fits-all inappropriate monetary policy inflicted on them by the ECB. And these huge private sector deficits in the periphery were mirror images of similarly sized surpluses ? mainly in Germany. Germany is to the periphery what China is to the US.
To be sure, the transference of private sector excesses built up during the bubble directly onto the public sector is not unique to the eurozone periphery ? it is equally observable elsewhere (see below chart for the US for example). But unlike the periphery, the US and UK had control of their own monetary policy ? i.e. it was excess of their own moronic choosing.
But one thing is clear in every nation. National income accounting identities require that the public and private sector balances must sum to equal the current account balance (again see chart above). We have articulated previously the dangers of fiscal retrenchment at a time when the private sector is still de-leveraging.
Edwards closes off by quoting Rob Parenteau:
?Rapidly cutting fiscal deficits without considering the impact of such moves on private sector financial balances is a shortsighted, if not dangerous policy direction. Sector financial balances…cannot be treated in isolation. It is an elementary fact of accounting that the private sector as a whole can only spend less than it earns if some other sector spends more than it earns. That sector has tended to be the government… Pursuing fiscal retrenchment in order to reduce government debt default risk will merely raise the odds of private sector debt defaults…The only way to avoid this outcome is if the nations undertaking fiscal retrenchment can swing their trade deficits around in a fully offsetting fashion. Otherwise, domestic income deflation is the likely result ? A return to debt deflation dynamics like those engaged after the Lehman debacle is not out of the question.?
The bottom line is that in attempting to fix one problem in a suddenly broken system, another one develops, as everything is interrelated and interconnected in the global economic system, linked up through channels of liquidity, or lack thereof. M3, global imbalances, declining wages, all these are indications that the Fed is certain to lose the war. But not the the next battle, which will be fierce: expect a massive, unprecedented, and record reflation attempt yet by the Fed and the global central banks, that will make all stimulus to date pale in contrast. At that point, once the Fed's actions become obvious for all to see, watch for the gold "bubble" to go exponentially parabolic.