"One Cannot Operate A Capitalist System If The State Can Borrow At A Negative Cost"

Tyler Durden's picture

The following extract from Charles Gave's (of GaveKal ) latest letter to clients is a must read for all, especially for the central planning members of the FOMC. The punchline is this statement which is so simple and obvious, it is no wonder virtually noone in control has figured it out yet: "One Cannot Operate A Capitalist System If The State Can Borrow At A Negative Cost."

From GaveKal Research: Obsessed by Negative Real Rates

Deflation and crisis

Consumption bubbles fuelled by negative real rates always contain the seeds of their own destruction. Debt levels get too high and force household deleveraging; meanwhile the currency falls, which improves competitiveness in the global marketplace. The combined effect is a narrowing of the current account deficit. When the world’s reservecurrency nation experiences such a narrowing, the supply of dollars outside of the US falls, and inevitably catches some countries out.

The best way to look at global dollar supply is to remove China and oil from the US current account balance; this is because of the incredible competitiveness of China, and the scarcity-value of oil producers. Excluding oil and China, the annualized US current account has moved from a deficit of 3% of GDP in 2003 to a recent surplus of 1% of GDP.

This improvement in the current account position has taken place despite the fact that most of the world is growing well below its potential. In effect, the US economy has exercised an immense deflationary pressure on the margins of companies outside of the US, and in so doing has managed to “recover” roughly 4 % of its GDP.

This turnaround underlines just how low the value of the US dollar fell after years of dilutive monetary policy. Moreover, the pressure of a cheap dollar has been compounded by mercantilist China’s de facto peg to the US dollar. No wonder so many current account crises are percolating around the world—countries from Egypt to Italy to India have had to deal simultaneously with a hypercompetitive dollar, an undervalued renminbi and higher oil prices:

While the oil producers and China may still be sitting on a ton of US dollars—which they are recycling into USTs and thus keeping US government borrowing costs at bargain-basement levels—the dollar supply elsewhere in the world has fallen sharply. The countries which have no access to the US currency have to start using their foreign exchange reserves to meet their payments (very often to oil producers and China), thus amplifying the problem. When a country is forced to sell reserves, then it has to follow restrictive monetary and budget policies to depress domestic demand and recreate a current account surplus. 

The cost of capital rises sharply for the private sector. India today offers a prime example of a country stuck in this corner.

In the chart below , I am showing the 12-month variations of foreign central bank reserves deposited at Fed—this is excluding China (I would also exclude the oil producers, but could not find a way of estimating their forex reserves). Past periods of rundowns in global forex reserves always have been associated with crises.

When the US current account deficit starts closing, the dwindling supply of dollars eventually leads to a panicked rush for dollars. Non-US companies that binged on dollars when the money was cheap and the dollar was forever going down, now find themselves caught out. Every entity with a negative cash flow in dollars scrambles for dollars — even through selling local assets and converting the proceeds — depressing risk assets everywhere.

The US dollar and USTs outperform everything, including industrial metals (see chart overleaf). And of course equities are not spared (see chart overleaf).

Needless to say, if one has to be invested in equities in these periods, stay in the US stock market (as US companies will not have such troubles) and avoid non-US equities except when they become extraordinarily cheap versus the US market (e.g., a ratio below 1.2x).

I could go on and on with other examples, but let’s just get to the point: one cannot operate a capitalist system if the state can borrow at a negative cost. Years of irresponsibly loose monetary policy in the US has led to cheap funding for the US (and other) governments, but difficult credit conditions for the  private sector all around the world. As I underlined in How The World Works, negative real rates leads to misallocation of capital which ends in asset deflation, while simultaneously limiting the capacity for recovery by driving out the private sector.

The Fed has been managed by a bunch of Keynesians who care nothing about the role of the dollar as a reserve currency and who probably believed they were managing the central bank of Belorussia or Zimbabwe!

So what’s an investor to do?

Now at this point, the reader may feel I am about to suggest buying a ranch in Oklahoma, a few guns and some nuggets of gold. This is not my recommendation—at least not yet. In fact, for more than a year now, we have been recommending assets with a positive cash flow in US dollars.
We see no reason to change the portfolio yet. Indeed, because the US bond market has absorbed so much of the world’s “panic liquidity,” a
number of US assets are still reasonably priced (corporate bonds) or even cheap (e.g., platform companies, or good quality residential real estate).

The big question is whether there is scope for more sane central banking, and an improvement in liquidity conditions. In some ways I feel hope:

• Oil prices have come down a lot, and the US dollar is rising (despite the Fed’s frenetic distribution of swaps).

• China is internationalizing the RMB and increasingly widening its capital account, to provide another source of liquidity.

• If non-US assets become cheap enough, then more risk capital will start flowing in that direction (a break-down of the euro would be very useful here in so far as it would instantly create a lot of very cheap assets in Italy, Spain, France, etc.)

In an ideal world, central banks would stop manipulating prices and would return to the Wicksellian rule which worked so well from 1983 to 2002—i.e., they would decide to put short rates gradually back at a level consistent with the growth in the local private sector GDP. I know full well that allowing short rates to go up at this time flies against the current Keynesian orthodoxy at the Fed. A few Fed officials have already acknowledged that with the Fed balance sheet as enormously large as it, future QE action will simply have much less bang for the buck. Unfortunately, with Wednesday’s FOMC announcement on additional funds for Operation Twist, it is clear that any voice of reason in that organisation will be drowned out the by Keynesians on board.

I can only take solace from the fact that political winds also do not seem to be blowing in the Fed’s direction. We may have to wait for November—to see if the voters fire the Fed. Such an outcome would be very bullish for global risk assets.

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Frastric's picture

This is why I love ZeroHedge, there are articles -- not necessarily accurate all the time -- that help this layman come closer to understanding what's happening.

AldousHuxley's picture

so if the above claims are true, then ask yourselves what is American operating? surely not the impossible capitalism....

 

State of America are operating a scam at this point. How can you have capitalism when your banks are incolvent?

 

capitalist experiment failed. just like communism, extreme dogma and inflexibility to change upon realities of nature, led to extreme greed, and extreme failures, and now extreme coverups. World rewards balance. man and women, ying and yang, capital and labor....all man island ends in no descendents, all capitalism and no labor ends in destitude.

 

Nels's picture

The capitalist experiment ended in around 1913.  It didn't fail, it was killed.

It's the democracy experiment that is in trouble.  We can't seem to elect anybody who is not on the "Save the Banks, Screw the Rest' bandwagon.

Waffen's picture

And then 4 short years later 117k Americans died so Jews could have their Palestine

balfour declaration Quid pro quo to baron rothschild for Jews getting the USA into ww1

Benjamin h freidman
http://www.youtube.com/watch?v=HhFRGDyX48c&feature=youtube_gdata_player

CH1's picture

It's the democracy experiment that is in trouble.

It was NOT a democracy experiment. Originally (like 1776-1792 and 1800-1830 or so) it was a republican experiment. Since then it has been varying degrees of fascism. And yes, 1913 is when it was seriously institutionalized.

This fascist experiment is sold to some people via socialism (i.e., free crap) and to others, more recently, with a supposed holy word, "democracy."

 

AldousHuxley's picture

democracy is not in trouble.

 

bigger problem is nation is founded on republic ideals with distrust of the masses. it is setup for ruling elites.

 

it is like going to police to report a crime, and learning that police are the ones who perpetulators.

 

HOPEless.....just start robbing the top 0.1% . that's probably why bankers are the way they are. they see that even richer elites are all corrupt, so they become cynical of the world and says " fuck it, I'm going to become a millionare by robbing from billionare drug lords, arab kings, chinese slave owners"

 

what is the level of confidence in America being a meritocracy in the mind of banker handling Paris Hilton's wealth?

well now you all are learning this too.

GernB's picture

The US is not capitalist. 24% of GDP is consumed in taxes. The tax code that consumes that 24% is designed to distort normal free market pressures. Then the government spends that 24% in ways that further subverting free markets. Its simply bogus on the face of it to call what we have in the US capitalist. We can agree its failing nd corrupy, but the markets that are the worst off are those where government has distorted markets the most health care, housing, banking, education, and transportation.

mjk0259's picture

France is 57%. Their health care is better than US and cheaper. Transportation is better too. Their banks are maybe not worse than US despite being nationalized periodically. Just about every country has better education and it's government operated the same as US up to high school and usually college as well.

 

GernB's picture

Better according to organizations that use statistcs to get the gullible to believe thingsvthat are contrary to the facts. Even were that the case all it would prove is smaller governments can control things better. It does not prove we should all surrender our right to control the healcare choices availabke to us through our buying power in a free market so people like you can engineer a utopia we will all like or else.

AldousHuxley's picture

in a free market only the rich can afford healthcare because it is so god damn expensive.

looks like you dont' realize what a poor shit you are and how much help you are getting from your government:

 

  1. state is what pays for education system for YEARS to figure out who's smart enough to even receive training
  2. tax free (revenue loss) status to medical schools
  3. free training at the cost of residency salaries ($40-55k/year per doctor) as subsidy to hospitals
  4. hospitals run as tax free (revenue loss) organizations
  5. hospitals can simply write off any unpaid bills (subsidy in accounting)
  6. your healtchare expenses are tax deductible for your employer (revenue loss)
  7. your personal healthcare expenses are income tax deductible
  8. many hospital's buildings are built using tax dollars

Ask yourself, what kind of industry has so much tax benefits? Does your government give $10,000 gift certificate to every citizen so they can purchase stuff your company makes and then give $40,000 year training for every employee you hire?

 

less or more control doesn't equal to less or more quality or price.

you want to lower price, create more doctors with slightly less quality.

YOU KNOW THAT SUPPLY OF DOCTORS ARE ARTIFICIALLY RESTRICTED RIGHT?

AldousHuxley's picture

in a free market only the rich can afford healthcare because it is so god damn expensive.

looks like you dont' realize what a poor shit you are and how much help you are getting from your government:

 

  1. state is what pays for education system for YEARS to figure out who's smart enough to even receive training
  2. tax free (revenue loss) status to medical schools
  3. free training at the cost of residency salaries ($40-55k/year per doctor) as subsidy to hospitals
  4. hospitals run as tax free (revenue loss) organizations
  5. hospitals can simply write off any unpaid bills (subsidy in accounting)
  6. your healtchare expenses are tax deductible for your employer (revenue loss)
  7. your personal healthcare expenses are income tax deductible
  8. many hospital's buildings are built using tax dollars

Ask yourself, what kind of industry has so much tax benefits? Does your government give $10,000 gift certificate to every citizen so they can purchase stuff your company makes and then give $40,000 year training for every employee you hire?

 

less or more control doesn't equal to less or more quality or price.

you want to lower price, create more doctors with slightly less quality.

YOU KNOW THAT SUPPLY OF DOCTORS ARE ARTIFICIALLY RESTRICTED RIGHT?

LG_Knight's picture

So why are you still here?

IBelieveInMagic's picture

Now it is all about defending the reserve currency status -- let's face it, the free stuff has been powerful addictive drug.

narnia's picture

The government spending $3 trillion annually to buy bombs that don't keep us safe, a public education system that is worth a fraction of its cost, a bunch of roads and utilities subsidizing suburbia, and to fight the failed war on drugs is a massive misallication of capital. There's nothing in the government's borrowing rate or the international flow of funds that makes these economic morons run counterproductive deficits.

Waffen's picture

This article sucks. Look if you have not already bought some property and are actively trying to disconnect from the just in time system by being more self sufficient you are a risking an early death.

Get your shit in order first, then if you stil have so much etc cash that you want to invest it in equities (ugh) then I suppose you can do it, but you are just picking up pennies in front of a steam roller.

What do you think at the last minute you're gonna move to the country and suddenly grow a huge garden and raise animals, when you have probably never once picked up a hoe or milked a goat? You think you are just going to know how to grow in (insert state/region here) when you have never even lived their before?

Bad advice.

Whatta's picture

Good advice.

Good investors know to be hedged. So, why not be hedged in life as well (like I am) by having property, source of water, food, etc.

At worst you have a cool place to live at, or hang out on the weekends. If TSHTF then you are mcuh ahead of the masses.

And good property is a good store of value...still.

IBelieveInMagic's picture

You are imagining a gentle and orderly decline where the one's who are unprepared will quietly go away. On the contrary, when things fall apart, it will result in kinetic escalation and then everyone chances are about even. So, why bother.

I have come to the conclusion, the fiat system for all it's defects, has enabled growth to support growing populations (probably by pulling forward future demand) -- of course the guys running the system have taken unfair advantage of their closeness to the controls but all said, it has facilitated easy and fast economic transactions that has resulted in employment for the growing masses. I know this is heresy to many on this forum but it had to be said and no, I am not employed in the financial industry.

Seer's picture

Throughout history the overwhelming majority of widespread collapse has seen people die "on the road."  You can see this thing happening today, with large populations of "displaced" people.

Yes, and history also shows there are handfuls of aggressive people looking to pillage.  Such people, however, are low in numbers: when you create lots of flames it tends to draw more attention (and skew the perception).

"and then everyone chances are about even."

"Chance" is gretaly affected by preparation.  You can rationalize all you want about your choice to not prepare, but doing so doesn't alter these realities.

"I have come to the conclusion, the fiat system for all it's defects, has enabled growth to support growing populations (probably by pulling forward future demand)"

Growth is the strategy of bacteria and cancer cells.  You need only do a SIMPLE study as to where this leads.  Keep in mind that humans survive at the whims of bacteria: if not for all the bacteria in your gut to break down your food, which in turn heats your body, you WOULDN'T exist!  In a way you can say that we ARE bacteria.  These facts inform us that we are not apart/different from bacteria, that the same basic laws apply to humans.  GROWTH in a finite environment is LIMITED!

"probably by pulling forward future demand"

When you wrote this did you even consider what this means, what the ramifications are?  It pretty much wipes out the notion of growth being good.

Back to the "even chance" part... I lose fowl to aerial predators.  What I have come to realize is that this happens is that those that turn into raptor lunch are either weak or are not paying attention to their environment.  The "weak" ones are MY fault: I have failed to correct this either through a failing in culling or a failing in proper animal husbandry.  Your argument would clash with this reality, it would have "strong" animals being as "weak" and as unaware as the "weak" and unaware ones.

Next time there's a big thunderstorm go out into a big field and hold up a long metal rod, while barefoot.  Given your logic you are no more likely to be hit by lightening than a neighbor who is below ground and wearing a rubber suit.

If you believe that there is no purpose in planning then that's YOUR belief.  But do NOT mistake the word "belief" for the word "fact."

They Tried to Steal My Gold's picture

negative inflation.......hmmm

They Tried to Steal My Gold's picture

Yes.....we all should to get laid more often.

PhilB's picture

You are right...that the articles are sometimes not correct. This guys analysis isnt worth the pixels im reading it on. What a bunch of crap stats and assumptions. Anyone with half an econ degree can see the gaping holes in this article.

GernB's picture

How about one example. I tend to dismiss claims of inaccuracy if not backed up by at least something that illustrates why its wrong.

PhilB's picture

Just one example? The whole piece is a bunch of gibberish. The fact that you dont see it so clearly just tells me that indeed you dont understand economics or markets very well. If my assumptions on you is correct, you just saved me doing your homework in critiquing a piece of crap article that is so fallacious that it doesnt merit any serious consideration or refutation.

mjk0259's picture

Well, what's the sense of analyzing US trade without China and oil? Those are the two biggest imports. What the hell is the US increasing exports of with this cheaper dollar? We barely export any manufactured products.

All Risk No Reward's picture

Folks, Keynesians don't run anything anymore than a Randsian ran the Fed under Greenspan.

Pay close attention - the detail is in the detail, not the slick narrative or the thin veneer.

The people running the show are bankster crooks who have criminally blown the world's largest credit bubble (having leveraged to the hilt with full foreknowledge of the bubble and profited immensely) and they use a b*stardized version of what they sell as Keynesianism to the masses who don't really know better.

When the banks got in trouble, did Alan Greenspan wip out Ayn Rand, his alleged hero, and tell the banksters to bury their dead banks as Ayn would have had them do?

H* no, Rand when in the trash "cand" faster than you can spit and the debt money spiggots were turned on as society is saturated with debt (and ultimately bankruptcy - bankster corporate fronts are TBTF&J, not nations) and the criminal insider banksters loaded up on Federal Reserve debt receipts that we now get to pay back to their Federal Reserve front corporation!

IOW, Ayn Rand was nothing more than cover for Greenspan to allow the banks to do whatever they want until her theories were no longer useful to the bankster profits...  then she was kicked to the curb.

The EXACT SAME is true with Keynesianism.  It is cover to allow the banksters to loot the Treasury dry and saturate society with debt...  BUT IT WILL NEVER BE USED TO JUSTIFY BAILING OUT SOCIETY, JUST CRIMINAL BANKSTERS.

Bankruptcy and receivorship (societal asset stripping) awaits society.

And yes, hyperinflation is the end game, but not until these crooks have traded in their debt receipts for the Earth's real, tangible, physical wealth.

That 3.66% mrotgage is an "I dare you to take this mortgage, we're gonna bust you and take the home from you later" loan, not a "Oh my, we'll hyperinflated next year" loan.

Remember, the banksters control the money supply AND make those loans.  They can't hide their true intent IF YOU KNOW WHAT TO LOOK FOR!

I just told ya.

PS - that doesn't make gold bad, I plan on buying some in the Great Deleveraging so long as I have "the necessities of life" fully covered first.

 

 

 

 

 

IBelieveInMagic's picture

From what I hear, the average time for forclosures is 5+ years in most places. This cost free living does not sound like a very onerous deal for home owners. Damn, I regret paying off my mortgage.

toady's picture

I tried to start my own bank to get those negative rates, but they told me I needed to know a guy who knew a guy, and blah blah blah, and unless I knew the secret handshake they wouldn't tell me the password to their good ol' boys club.

Savyindallas's picture

Like Skull N'Bones? where you have to be sodmoized by all the other guys and do it to a few animals before you learn the secret nahdshake?

Pure Evil's picture

What's it, the secret handshake or the sodomizing?

Now, if only Jerry Sandusky knew about the secret handshake.

DaveyJones's picture

...and now he's going to place where neither the handshakes nor the sodomizing are secret. Poetic really

Papasmurf's picture

If you belonged, this wouldn't be a concern.

New_Meat's picture

and it would'nt be here

carbonmutant's picture

"One Cannot Operate A Capitalist System If The State Can Borrow At A Negative Cost."

Bullshit

YHC-FTSE's picture

 

Then try, "A debt cannot pay for itself". 

 

In an extremely stupid world it does. And we're living in one, because the illusory promise of safety in government paper has the whole world beguiled, when in fact taking the blindfold off reveals that it is toilet paper signed by criminals. Low grade toilet paper at that. Debt is not capital. Debt is not wealth. When capital is the false promise of payment, the system cannot operate. Didn't we learn anything from subprimes? I put it to you that the USD (Or any fiat) in all its guises is one giant subprime "asset", backed by nothing but fear, hope, and the false promise of productivity by future generations yet unborn. Would you want that in your pocket?

ebworthen's picture

One cannot have liberty and sound money with a central bank controlling the currency.

derek_vineyard's picture

our policies and laws are so fucked up it will take a dictatorship or revolution to change things

a group of lawmakers cannot fix this mess  (it all starts with bringing jobs home, americans accepting that work and the ruling income class being eliminated)

america can't have 313 million zuckenfuckers

financial apocalyptic contagion's picture

the jobs will flow where labor is cheapest, which wont happen in the US anytime soon

subsidies are a stupid idea, so what we are left with is to make shit that no1 else can make.

which is hard to do nowdays coz within a few months India and china will clone it faster and cheaper, which has become a cyclical process in this economy.

relocate

 

 

John Law Lives's picture

"the jobs will flow where labor is cheapest, which wont happen in the US anytime soon"

Correct.  Jobs flowed out of the US and into countries like China and India for several reasons including (a) relatively inexpensive labor and (b) gaining a foothold in those emerging markets.  No politician in the US was ever going to effectively stand in the way of that process.  No chance.

ebworthen's picture

You forgot:

(c) avoiding environmental laws so you could pollute someone else's back yard

(d) avoiding paying a living wage and health care insurance to domestic workers

(e) maximizing CEO and upper-level management salaries

(f) taking advantage of slave labor and the downtrodden while supporting oppressive governmental and societal regimes

(g) offshoring of profits to avoid taxation

(h) gutting domestic insfrastructure and manufacturing facilities to ensure the above

CH1's picture

You forgot:

Ditch the system and move on without it.

Stuck on Zero's picture

Good points ebworthen.  And something else.  The factories followed the capital.  U.S. bankers exported all the capital to build those factories.

 

DaveyJones's picture

The Jungle in The Heart of Darkness 

 

New_Meat's picture

f a:

"the jobs will flow where labor is cheapest, which wont happen in the US anytime soon..."

Actually, when total cost of product ownership is concerned, the tide is close to its peak.  Why?  Economics from the MBAz have not panned out, there are still lower cost venues to do the manufacturing of low-cost goods, and the data continue to flow in.  Cost cutting is reaching back into computer execution of low-skilled tasks on overseas locations.

So, I do agree with you, the "labor" is becoming cheaper by the silicon v. carbon components of the supply chain.

You recommend to "relocate".  To India?  China?

Please give us your travel-log as you self-execute your own recommendation!

Inquiring minds wish to know about your experiences (from well-afar!) as you eventuate.

Don't cha' know.

- Ned

Seer's picture

"what we are left with is to make shit that no1 else can make."

And then you encounter the little problem of such products being affordable.  Remember: 2/3 of the world's population lives on $3/day or less, and this number is NOT improving (debt pileup and over-saturation).

Kind of hard to build a new boat while you're busy bailing the one that you're in.  In a contractionary environment your debts weigh extra heavy.  Yeah, being contrary sets you apart from competition, "innovation" and "expansion" might sound good during contraction, but it's based on expectations of some sort of "recovery," and at this point it should be clear that That ain't on anyone's radar (other than TPTB's cheer-leading squad).

We have before us a MAJOR paradigm shift.