Oh Shit!!! : The Things That Scare Me To Death….



The Dow Jones is near a historical high, even as the DXY Index is at a mid-term high. For a currency almost guaranteed to break up, and/or issue about € 3 trn of new currency, the Euro is just about 7-8% down from its intermediate highs of 1.35.

Declaimer: This article was originally in November 2012, and some data points may be outdated

The Indian markets, knowing what they know about the country they are in, seem to be trending towards the end of the runway; either they will crash into the ramparts, or they will lumber up towards the sky, at least for a while.

All over the place, the all-knowing markets seem to be confident that things will work out, yet…..I don’t know where they get their confidence from!

  • Now that Obama has returned, will we go back into the gridlock we saw in Aug 2011? Will the chastened Republicans just quietly fall in line and wind up their Tea Party?

If that (gridlock) happens, will the US continue to run 9% Fiscal + Current Account Deficits into 2015, taking them well past the 100% Public Debt Ratio? What will then happen to the $ 1.6 trn of balances with the US Fed, which were still lying there at negative real interest rates, when I last checked?

If Obama tries to balance the Budget, what will he cut? And if not, what (taxes) will he raise and how does that affect private enterprise? Maybe he will do a little bit of both, cut defense + raise Cap Gains & Dividend taxes, besides rolling back the payroll tax cuts, even remove the mortgage deductions (why not? The last thing you want now is to get any leverage back into housing)

  • If the Republican die-hards have their say, that itself scares me to death, but anyway, they will if they must…! The point is, thereafter, will they do what they said in the Romney campaign or will they turn out to be politically expedient liars, who spoke (Thank God!!!) with crossed fingers?

If they are sensible, they will cut entitlements, maybe a little too deep; it may have humanitarian implications, and history may not remember Obama well, but the economic damage will be limited. Especially in areas like geriatric care, welfare payments, etc. But a big possibility is that the (compromised solution) might cut taxes, which is the easy part, and leave out the rest.

  • The Fiscal Multiplier measures the impact of changes in Govt spending (or taxation) on broader GDP growth. We all know Consumption+ Investment + Govt Spending – Imports + Exports= GDP. What many of us don’t know, is that a change in any one of these ‘components’ will also affect the other components. The net effect of a change in Govt spending, divided by the change in GDP, is the multiplier.

What makes government spending a little unique, especially during a recession, is that it is mostly funded either by debt or by deficit financing (i.e. printing cash). The latter produces inflation, which affects consumption. It also affects Investment, because that is dependent on Savings, which drop in periods of high inflation, even as capex costs rise with the tide.

During boom periods, tax revenues are buoyant, so there is no need for Govt to pump prime. Theoretically, a utopian Govt would salt away some of this money, by paying down debt. This rarely happens in practice.

In the middle of a bust, a debt-fuelled spending spree by the Govt rarely produces the impact desired, because the increase in debt is disproportionate AND the Govt misallocates that money to its favorite constituencies, who are either poor or political, i.e. not business. This does not have the knock-on effect on Savings and Consumption that it is supposed to have, leading to inflationary pressures. Perversely, this inflationary growth in nominal GDP leads to some buoyancy in tax revenues, which can be used to service the debt incurred to fund the Govt expenditure in the first place.

Rarely, a Govt has already run up huge debts, which have already been misallocated or frittered away. A large number of developed countries have been running up debts to fund welfare entitlements; among many other things, this is what has created, at least in Europe, a sovereign debt crisis. In many countries in Europe, they have got past the tipping point, i.e. if you cut Govt spending by 1%, GDP falls by >1%. So if you cut spending by 1%, and GDP falls by (say) 1.7%, then tax revenues fall by 0.5% (assuming an average tax rate of ~30%), leaving you with a marginal impact on the deficit.

This is how it works, Suppose you have expenses of $ 110, while taxes bring in $100, leaving you with a deficit of -10%. Now, when you cut expenses by $1.1, you are spending 108.9, while taxes are now down to 99.5%, based on the logic recounted above. This now leaves your deficit at 9.4%, only 0.6% down while GDP is down by 1.7%. This is what we are seeing in Greece and to a lesser extent, Spain.

Think of Govt debt as a nicotine addiction. While picking up the chain-smoking habit, you replaced eating with smoking, but at least you were enjoying yourself. Now, as you try to return to eating, the withdrawal symptoms are painful, but the resultant loss of appetite will anyway kill you. So you’re damned if you do and damned if you don’t…

The US is not in such bad shape, but its Fiscal Multiplier has reached 0.5, i.e. a 1% drop in Govt expenditure will reduce GDP by 0.5%. Given the sclerotic 2% growth rate, a combination of inventory de-stocking and some sustained reduction in Govt spending will push them close to recession.

A hike in taxes would hurt Savings & Investments, just what you don’t need. Consumers are anyway too highly leveraged, it is the savers who would have come to your aid, and those, unfortunately, are the rich.

  • If you look closer home, I can’t find anything to celebrate either. Only 215 of the top 1000 companies in India have Free Cash Flow of any size, and if they don’t borrow anymore, they will have to carry the burden of increasing the Investment rate. The Indian household sector, that great big beacon of hope, has seen a fall in the Savings rate. In any case, given high inflation, Savings is a bum’s game in India. We will continue to have red-hot demand from millions of people who shouldn’t have been born in the first place….and their existence will crowd out whatever productive capacity the rest of the country has…
  • Europe is the big one. Adding the pension obligations of the bankrupt Greek Govt adds up to $ 1.2 trn. That is not the kind of money even the Germans can absorb. Combined Europe has the problem that India has….a bankrupt (Greek) Govt that keeps increasing its ability to soak up whatever is produced by everyone else (i.e. Northern Europe).

The only way they will get out of this will be through a massive inflationary shock. Or an implosion that breaks up the currency union; I believe that the former is more acceptable (provided it is in a controlled fashion) than the latter, which could trigger Armageddon.

I don’t understand why Gold is 30% off its highs, Silver 20%, DJIA is right up there, and the Euro is back ‘in range’. Our own Nifty is up 26% off its bottom, and about 10% above the levels of 5th Aug 2011. This, mind you, as we head into another Day of Reckoning. Most Volatility Indices are back at 2007 levels, even as we head into macro headwinds of inflationary shock and bond market revolts. It sounds more like 1973 than 2013; is it because most of the fools in the market were born after that year?!!.



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