Agora Financial’s Rude Awakening

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Paris, France

• Deflation takes root from Fareast Asia to Western Europe,
• The pitfalls of trying to defy the laws of nature,
• Lost in translation in Japan, “Q.E. kindling” and plenty more…

Joel Bowman, lost in translation and ruminating from Fukuoka, Japan…

In at least one alternate universe, the U.S. Federal Reserve raised rates last week and your editor arrived on time to board his flight back home to Taipei. In the known universe, however, neither of these things came to pass.

The Fed, for one, is staying put at near free money and leaving intact its $1.75 trillion purchasing plan, including up to $1.45 trillion in the MBS sludge and $300 billion in treasuries (so called, “quantitative easing”). For how long the people who didn’t understand the risk in the first place will be able to manage it, we couldn’t say. We only know that the physical world doesn’t support any ex nihilo activities. In other words, something never comes from nothing; neither in money nor in anything else confined to the laws of nature.

The rules here are incontrovertible, like the rule that you can’t have your cake and eat it too, or catch a plane that has already left. Which brings us to our second “alternate universe” point.

Without the aid of his hyper-organized girlfriend, your editor has the tendency to get “lost” in foreign cities. “Lost” in this context may refer both to geographical position as well as in the time it might take him to get from one point in the city to another, particularly if that second point is a train, plane or bus station. Ergo, our planned two-day skip has turned into a weeklong trip.

We came to Japan last week for a first hand look at what one possible version of America’s future might look like. We wanted to see what a “staying the course” policy of zero interest rates might do to an economy and to the people living, eating and trying to invest in it.

The Land of the Rising Sun began to set, aided in no small part by the implosion of its gargantuan asset bubble, in the early nineties. Over the previous decade, speculators frantically bid up prices, particularly in real estate, to unheard of heights. At the peak of the euphoria, space in Tokyo’s Ginza district had reached the magical “million a meter” apex (about US$95,000 per square foot). The stock market too had run quite the temperature with the benchmark Nikkei 225 peaking at just below 39,000 points in 1989, roughly four times where it sits today.

Then came the crash and the ensuing “lost decades,” referred to in Japan as “ushinawareta jnen” or “the end of the century.” Mired in a deflationary spiral, the Japanese Central Bank cut rates to about where Bernanke has them right now. Similarly, policy wonks stepped in to save collapsing banks and financial institutions whose main specialty, it seemed, was in making loans to as many people who might never pay them back as possible. It all sounds very familiar.

So what about now? What does the place look like today? Has the market picked up? Do the Japanese kids skip to school, knowing they will inherit a better tomorrow?

Anecdotally, things are very quiet on the far-eastern front. Despite consumer prices falling at an astonishing pace (down 1.1% in May, the fastest annualized pace on record), Japanese consumers themselves are still terribly cautious at the counter. The venerable Itawaya and Mitsukoshi department complexes, multistory labyrinths of high end retail space, still draws the crowds…but far fewer customers leave with designer bags than with designer coffees from the courtyard Starbucks. It’s a place to be seen, in other words, not a place one can afford to shop.

As for the chic restaurants along the streets in the fashionable Nakasu area, no reservations need be made. Your editor ducked into a stylish eatery near his temporary residence for lunch today and, to his amusement, had the place all to himself. The bill for a three course lunch in superlative surroundings came to under ¥1,500 (about $15). Two waitresses tended to our every hand gesture (most of which were misinterpreted, we suspect) and even brought us a small ceramic vessel of local sake, gratis, when we tried to leave our conspicuous window seat.

Analysts blame “sluggish” wages as one reason for consumers’ tepidity. Perhaps they might also consider the “bull who cried bottom” syndrome. Japanese investors hoping for a turnaround in their economic fortunes have been told too many times that “this time is different.” As we’ve pointed out in these pages before, the Nikkei 225 actually rallied more than 30% on ten separate occasions during the last two decades, including three rallies of more than 60%.

For frame of reference, it is worth noting that the Japanese stock market did not find its post crash “bottom” until October of last year, when it reached a 26-year low of 6994.90. That’s a long decent…with plenty of time to stockpile a healthy supply of skepticism. Then, in the first quarter of 2009, the enervated economy suffered its worst contraction on record, shrinking at an annualized pace of 14.2% as exports – especially those to the U.S. – fell off a cliff.

So, where to from here?

We’ll have more on our lost in translation experience in Japan later in the week but, from Fareast Asia to Western Europe, we cross to Bill Bonner investigating hyper-deflation in France. Please enjoy…

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Hyper-Deflation on the Streets of Paris
By Bill Bonner

Scarcely a block from our office in Paris is a monetary phenomenon that has escaped the financial press. In one of the highest-cost economies in the world, you can buy a woman’s shirt for 2 euros. A dress? Four euros. A man’s jacket can be had for the price of a cup of coffee.

The shop is tended by Chinese merchants…apparently dodging France’s employment laws by only hiring family members. The merchandise, too, dodges high rents by squatting the sidewalk, under improvised blue awnings.

How come such cheap duds in such a dear city? The latest figures show negative consumer price inflation in 14 countries. In Ireland prices are collapsing at a 4.7% rate. In the United States, they are falling at 1.3% annually – their biggest drop in 59 years. In Britain, consumer price inflation is still positive…but falling. But clothing on the Boulevard de la Villette seems to have been thrown out of an airplane. It is not in deflation; it is in hyper- deflation.

What could cause it? A guess: excess capacity, inspired by excesses of credit, consumption and claptrap during the Bubble Epoque. Spurred by what seemed like insatiable demand from the United States and Britain, Asians built superfluous factories…Greeks bought superfluous ships…and Americans built superfluous malls. Now, the feet are in the other shoes – the cheap ones. The action of the bubble years produces an equal and opposite reaction: excess supply bedevils the market. Unable to sell superfluous brand name clothing, the rag trade strips off the alligators and polo sticks and dumps clothes on discount racks.

Last week, we warned about the extremely destabilizing effects of hyperinflation. One day middle class men are saving money for their daughters’ dowries. The next, they are putting knives between their teeth and swimming across the Rhine.

Today, we deny hyperinflation thrice before the cock crows…and then deny we denied it. First, Professor Alan Blinder in The New York Times: “the clear and present danger, both now and for the next year or two, is not inflation but deflation.”

Second, BusinessWeek elaborates:

“…the inflationary effects of the new money are being fully offset, or more than offset, by the far-reaching and long-lasting impact of household debt repayments. Whether it’s voluntary frugality or under the coercion of creditors, Americans have abruptly switched from living beyond their means to saving more and working down the debts they incurred during the bubble years.”

Third, as Ambrose Evans Pritchard puts it in the Telegraph: “the Fed’s efforts to boost the money supply are barely keeping pace with the deflation shock. Stimulus is not gaining traction. The credit system is broken.”

Professor Blinder explains why:

“In normal times, banks don’t want excess reserves, which yield them no profit. So they quickly lend out any idle funds they receive. Under such conditions, Fed expansions of bank reserves lead to expansions of credit and the money supply and, if there is too much of that, to higher inflation. In abnormal times like these, however, providing frightened banks with the reserves they demand will fuel neither money nor credit growth – and is therefore not inflationary.”

Reserves are what nobody wanted in the bubble years; now we live in a world of squirrels. Bankers add to their reserves; so do individuals and businesses. Americans saved an average of 7% of disposable income since the ’30s. In the 2002-2007 bubble, that rate fell to zero. Now, it’s back to nearly 5% and rising. Thrift is making a comeback. People are changing their own automobile oil. They are cutting their own hair and planting their own gardens.

When consumers cease consuming, producers cease producing. And shippers have nothing to ship. World trade has collapsed by more than it did at this stage of the Great Depression. And at 65% of capacity, there are more idle factories in America than at any time since they stopped making tanks and airplanes after WWII. Business earnings are falling, with no pricing power in sight. In this respect, this downturn is much more deflationary than Japan’s recession of the ’90s. When Japan went into a slump, the rest of the world continued to grow. Japan could continue to manufacture and export products – at a profit. Still, with so much excess capacity, producer prices in Japan fell in nine of 10 years in the ’90s.

And now the denial: These commentators are right; deflation is the immediate problem. Our guess is that it will be deeper and more vexing than even they believe. The feds’ money machine is broken. They can add reserves. But they can’t turn the reserves into price inflation at the consumer level. Result: deflation…maybe hyper- deflation. But far from eliminating the danger of hyperinflation, falling prices practically guarantees it. In other words, it’s not inflation we worry about; it’s the lack of it. Unable to stimulate inflation in the usual way, the feds are forced to resort to extraordinary measures.

Only central banks with their backs against the wall – like Germany in the ’20s…Argentina in the ’80s…and Zimbabwe in the ’00s…would dare to risk hyperinflation. But if its efforts to produce mild inflation don’t work, the United States will eventually be in the same desperate position.

Joel’s Note: Our annual Agora Financial Investment Symposium in Vancouver, British Columbia is rapidly approaching…and this year marks the 10th anniversary of The Daily Reckoning. So, this July, the Symposium will be focused around a “Decade of Reckoning”…four days that will help you to gain greater insight on how to turn investment ideas into the profit opportunities of the next decade.

So, will we be seeing you there? This event is already 70% sold out, so you’ll want to be nimble. Click here for all the info: The Agora Financial Investment Symposium: July 21-24

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[Rude Endnote: And finally, here’s the “noise,” as Nassim Taleb likes to call it.

Asian stocks mostly moved lower today with Japan’s Nikkei 225 leading the way, down just shy of 1%. Hong Kong’s Hang Seng and the Aussie All Ordinaries finished some half a percent lower each while China’s CSI 300 measure bucked the trend to post a gain of 1.65%.

Last we checked, most European indexes were higher. London’s FTSE was up a relatively sluggish 0.6% while France’s CAC and Germany’s DAX had dashed away, up 1.2 and 1.3% respectively.

Not much worth mentioning over in the commodity pits. Oil and gold are up, but only slightly. A barrel and an ounce, respectively, fetch $69 and $942.

We’ll be back with more on the morrow.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com