Sep

5

my birthdayThe more I think about it, I don't believe credit and debt are likely to be our biggest issues in the next couple of decades. The credit crisis was really all about the valuation of illiquid assets, and the death-spiral of marking to market assets that stopped trading outright, because no-one knew what to mark them to, and therefore couldn't assess counter-party risk. It struck me early on in the crisis that trying to mark these "assets" to market was stupid. The most obvious solution was to take troubled debt, garbage or otherwise, and refinance it over longer maturities to gain some breathing room. And that's kind of what happened, and here we are today with LIBOR nicely back to normal. If things get really bad again, central banks will just lead re-financings like the Europeans did earlier this year - and keep interest rates low, because sizeable tranches of new money will likely have to be created from time to time.

Interest rates have to stay low now because governments are running large deficits and adding to their already big piles of debt, and can't really afford to pay much higher interest. The cost of credit appears to have shifted toward a subsidy regime much like agriculture, and could very well become as politicized. Credit needs to be cheap and affordable, and kept there as everyone - governments, business, and consumers - get used to paying so little for money. Because the U.S., Europe and Japan are all in the same boat (Japan saved us seats) and represent the currencies where most reserves are parked, I think we're going to see low interest rates for a long time - even if economic growth comes back, which it should as everyone continues to refinance longer-term debts to lower rates. They'll be able to keep rates low because there really won't be any other game in town currency-wise.

This is my assessment, and who knows if it really will play out that way, but if it does, I think the current financial system and major economies can remain intact for a long, long, time, deferring the day when debt really comes home to roost. I foresee a more robust form of what Japan has gone through in the last couple of decades. Not as much growth as before, a lot of bad debt in the attic that no-one wants to write down in a big hurry, but generally better economic performance than Japan in the aggregate. The analogy I would make is the stretched family that just keeps paying off one credit card with another indefinitely. I think this will be our macro fiscal situation for a while.

Most things in the world will still function, so commodity and equity markets should return to business as usual– they pretty-much have already. With such low interest rates, not sure what's going to go on in the bond markets. When confidence increases, a lot of that money may actually shift to equities and commodities for higher returns, and with that appetite, it might soon again be a good environment for IPO's to absorb some of that capital, and the innovation that goes with that. Industries that depend on, or prosper from low interest rates should do well. Real estate and utilities might boom. Deflationary pressures may still hover near, especially if consumers remain strapped for an extended period of time in the major economies.

Inflation? Don't see it here unless low rates set off another major boom. Future crises? Probably currency, in places like Russia and Brazil. Because other economies/currencies don't have the same low-interest luxury and will be more sensitive to inflation (interest rates in Brazil look to be about 11% these days), we may get some currency devaluations. War and geo-politics are always wild cards. Dollar, Euro and Yen could stay relatively strong from the influence of carry trades (borrowing cheaply in these currencies to get higher returns elsewhere).

Any thoughts out there on this and other scenarios?

Jeff Rollert writes: 

I differ… the crisis began as a liquidity crisis, and has morphed into a problem of insufficient systematic equity. Low rates are a prayer that hopefully buys enough time for debt amortization to effect a re-equitization.

Problem is it assumes stable GDP here and abroad.

Ralph Vince writes:

The villains in the story are the quants– those whose maladroit ir math  mispriced the CDOs and CMOs grotesquely– then ducked back into their dusky shadows.

Not a one of them has been called to account. 


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6 Comments so far

  1. Gary Rogan on September 6, 2010 4:46 pm

    I marvel at how stable the situation looks to George. With the dependency of the population on government help at all time high, with half of the government spending financed by borrowing, with government debt service outlays rising even in the unprecedented low interest rate environment and now exceeding 10% of gross receipts, and with no credible path to any reduction of the dependency of the population on the government outlays, the ability of the system to withstand either an interest rate shock or any kind of shock that requires an increase in outlays seems in question. Just because “credit needs to be cheap and affordable” doesn’t mean it will be. Just because the interest rates need to be low doesn’t mean they will be. SOMETHING will happen to change the course of this slowly developing disaster, but some sort of a goldielocks normalcy it ain’t.

  2. Warren on September 6, 2010 7:47 pm

    @Ralph Vince, actually Paul Wilmott has called out quants repeatedly in his books and columns for using dodgy math.

  3. vic on September 7, 2010 8:32 am

    would Mr. Rogan kindly call linda at 203 840 xxxx so she can send him $ 500 for winning contest on horse whispering and possibly give her email so he can join spec list at same time. he could write to her at linda@xxx vic

  4. George Parkanyi on September 7, 2010 8:01 pm

    Gary, I didn’t use the word Goldie-locks. I’m just comparing the situation to Japan, who had a massive real-estate bubble burst two decades ago, and they’re still hanging around - with a lower standard of living than in the 80’s, but still in the game. And ironically the strongest currency in the world, go figure.

    I’m not saying it’s necessarily going to be pleasant. What I am saying is that the economic system in its current form will probably survive. The typical outcome in a completely untenable economic situation is that the currency is revalued/re-issued, and everyone takes some kind of a haircut on that, and it all starts over. Based on Japan’s experience, I don’t think this will happen for a while yet. And even with all these problems, there will still be bull and bear markets. The innate urge to make money with money (and the thrill of the game) will still always be there, whether it is gambling in Vegas or high-frequency trading in New York.

    But our system still needs fiat currency to function. It’s just not practical to be carrying around and paying with rocks (gold) in our modern electronic age. The currency may change, but the people, roads, bridges, farms, and buildings will all still be there to continue producing under a different regime, assuming we can muddle through without ruinous wars and civil unrest (an assumption yet to be tested).

    You just have to figure out how to navigate all that without over-contributing to the haircut that eventually will come. I’m just saying I don’t think it all breaks overnight.

  5. Gary Rogan on September 8, 2010 10:51 am

    Victor, thank you so much, what a treat! I’ve spoken with Linda and also sent her an e-mail about joining the spec list.

    Best Regards,
    Gary

  6. Gary Rogan on September 8, 2010 11:03 am

    George, the situation in Japan is traditionally differentiated from our current situation by who holds their debt. Over there it’s overwhelmingly the Japanese, and they are so thrifty and all that, so supposedly they are not likely to suffer the same sudden outflows. It’s also a somewhat more coherent political system even with all of heir deficiencies.

    Our system may very well survive in spite of my prediction of collapse from now almost two years ago (the one that really irritated Rocky). It’s just hard for me to see a gradual dollar devaluation that goes on for very long. In reality it depends on how confident the entire world remains about the survival of the dollar while it’s being slowly devalued and treasuries are being steadily purchased by the Fed. If the entire world does remain confident for a long time, there may not even be much devaluation because of all the credit and thus money supply destruction. Things like trouble in Europe and Japan actually work both way, shoring up the dollar for an indefinite period of time while damaging the world economy and thus hurting the US. While people still like the dollar, everything will be intact, trading will go on just like you said. It’s just that any serious shock could result in a sudden loss of confidence and thus collapse. It’s really hard to know in advance, same as in when any bubble reaches it’s peak.

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