Today, in what we hope will be a regular feature, we bring you a post from our very good friend “Hunter at Distressed Debt Investing,” a pen-name for a financial professional who has asked us to keep his or her identity secret. For his very first column, he introduces us to an important analysis about the potential for inflation and deflation.
When I set out to start a distressed debt investing blog, I promised myself I would focus on bottoms-up investing and analysis. Bankruptcy, valuation, and fundamental analysis is where I get my edge.
That being said, sometimes I read articles, blog posts, or emails sent to me from colleagues or friends that need to be shared with a larger audience because they are just that insightful and informative. I bet every single one of us would have liked to hear John Paulson’s thoughts on the U.S. Housing Market and the Securitization Market in 2005 – and then we all would have subsequently made billions of dollars shorting subprime.
Today, I received an email from Sahm Adrangi, who I met at Monish Pabrai’s annual meeting a few years back. Sahm used to work at a large distressed debt hedge fund before striking out on his own and forming his own investment advisory firm. I would recommend everyone that enjoys what follows to email Sahm (sadrangi [at] kerrisdalecap [dot] com) and get on his Bi-Weekly email distribution list. Incredibly inciteful stuff (including A LOT of commentary on distressed debt investing). You will not be disappointed.
I think there are a lot of interesting investment ideas that come out of this commentary (especially with distressed companies that have the ability to raise prices), we will talk about those in a future post. Without further ado…
The Dollar Crisis
* Abandoning the gold standard in 1971 has resulted in large global trade imbalances and a massive buildup of foreign currency reserves
* These trade imbalances and buildup of foreign reserves have resulted in frequent booms and busts since 1971
* The Japanese bust of 1989, the Asian economic crisis of 1997, and the current US credit market collapse have resulted from the post-1971 paper money monetary system
* Abandoning the gold standard has gradually resulted in a very overvalued US dollar, and that the dollar is headed for disaster
* “The dollar standard is inherently flawed and increasingly unstable. Its collapse will be the most important economic event of the 21st century.”
This week, I’m doing another book review, this time on “The Dollar Crisis” by Richard Duncan. Before I begin, I’ll make a prediction, since I’m an investor and my job is to predict. I increasingly believe that the dollar will collapse, and its ramifications could be as violent as when the credit markets cracked in July 2007. Currency collapses are nothing new, just as the bursting of a credit market bubble was nothing new. A dollar collapse could very well lead to carnage in domestic asset markets, whether it be the stock market, bond market, etc. Also, US imports and the overvalued dollar are fueling many of the export-oriented economies abroad, so a dollar collapse could wreak havoc on foreign asset markets as well. And once it happens, we’re going to view the collapse of the dollar as an obvious event that we should have long seen coming. Just as we now view the subprime wreckage and bursting of the real estate bubble as an event we should have easily predicted.
The problem is timing. Does the dollar collapse in 2009, or 2015? And is it a slow depreciation, or a sudden 50% fall? Those are tougher questions. Richard Duncan predicted the dollar’s demise in 2002. His error of timing discredited an otherwise brilliant book.
In a sentence, “The Dollar Crisis” is about how the world changed in 1971. That was when Richard Nixon dropped the gold standard (or its close cousin, the Bretton Woods international monetary system). Here’s the youtube video: Youtube Bretton Woods. The end of the gold standard ushered in a new era of large trade imbalances and the buildup of foreign currency reserves, and these trade imbalances and large foreign currency reserves have had significant impacts on the global economy that many people don’t realise. Huge trade imbalances and large foreign reserves didn’t really exist during the gold standard. During the gold standard, a country’s money supply was determined by the amount of gold it had. Banks’ reserves were either gold or indirectly tied to gold, and so the amount of money they could lend, and that the nation could print, was backed by the nation’s gold reserves. To see the implications of that sort of monetary system on trade imbalances, let’s take a hypothetical United States and China, where the US is buying lots of goods from China. The US gets goods; China gets dollars. China takes its excess dollars, gives them to the US, and gets gold in exchange. The US gold reserves would decline, causing credit contraction in the US. This would lead to recession; prices would adjust downwards; and falling prices would enhance the trade competitiveness of the US. The US would stop exporting so many goods from China as China’s costs of production begin rising relative to the United States’. The US would stop being a net importer; gold would flow back in; and equilibrium on the balance of payments would be re-established.
Under the gold standard, trade imbalances were unsustainable and self-correcting.
Today, in the system of fiat money, that’s no longer the case. The US gets goods; China gets dollars. China takes its excess dollars, and invests them back in the US, whether in the form of treasury bonds, Freddie Mac mortgage-backed securities, or US corporate bonds. The US takes those dollars and buys more Chinese goods. China gets more excess dollars and reinvests in the US. The US buys more Chinese goods. And on and on, until the US credit market debt as a % of GDP goes from 150% in 1970 to 350% in 2008. Just as reference, that number was 130% in 1950. During the gold standard, debt-to-GDP hardly grew. Under fiat money, it has soared. America isn’t awash in debt because we’re inherently greedy, profligate consumers. It’s because money is no longer backed by gold. China and Japan eagerly reinvest their dollars back in the United States so as to keep their currencies low relative to the US dollar. American consumers and companies happily borrow the money foreigners are throwing their way. The party lasted until 2007, when Americans finally began having trouble paying their enormous debts.
Duncan’s book discusses the implications of the large trade imbalances and buildup of foreign reserves that resulted from the new paper money system introduced in 1971. The book is lengthy and detailed and this email will not do it justice. But I’ll discuss some of my favourite topics from it.
First, the massive Japanese stock market and property bubble in the 1980s, and subsequent decade-long recession in the 1990s, was the product of its large trade surplus and massive buildup of foreign currency reserves. To understand this, we need to see how trade surpluses are analogous to money creation and asset inflation. When a country has a trade surplus, its reserve assets increase, and this essentially leads to credit creation. If a dollar comes into Japan due to a trade surplus, two things can happen. First, it can go into a Japanese bank, increasing the total amount of reserves that bank can lend off of, and thus resulting in credit creation. Or it can be bought by the central bank with newly printed currency, which again is new money entering the Japanese bank, again leading to credit creation. The only way the Japanese central bank can prevent this credit creation is by issuing enough bonds to soak up an equivalent amount of the new money that’s just entered the banking system as a result of the trade surplus. If they don’t, the result will be massive credit creation. And credit creation leads to asset inflation, because the new money has to be invested somewhere. That somewhere is usually stocks, property and debt.
Japan’s total reserves minus gold rose from around $5bn in 1970 to $100bn in 1989. Its money supply (including M2 and CDs) grew from 50 trillion yen to 450 trillion yen by 1989. Without the gold standard, Japan’s trade surplus persisted, leading to massive reserve buildups and huge credit creation. All this newfound credit had to find a home, and it went into the Japanese stock market and property markets. The Japanese stock market went up by more than 12 times from 1970 to 1989, with the Nikkei index trading at more than 60x PE before it crashed (today, it’s under 10x PE). Domestic credit as % of GDP went from 140% to more than 250%. Ultimately, incomes could not rise fast enough to catch up with the tremendous asset inflation that was occurring. In 1989, the Japanese stock market and property bubbles popped as debtors couldn’t pay their creditors; the Japanese banking system became flush with bad loans; and a painfully long recession ensued.
Second, Duncan paints a similar story for the Asian financial crisis that occurred in 1997. He shows how foreign reserves multiplied dramatically from 1988 to 1997 in Indonesia, Korea, Malaysia, and Thailand, rising 3 to 6 times over that period depending on which country you’re looking at. Their reserves buildup was due to Japan relocating its manufacturing capacity to the rest of Asia in response to a sharply appreciating yen. Foreign capital entered the banking system and resulted in excessive credit creation. Like Japan, those economies experienced rapid economic growth and rapid asset price inflation. Overcapacity resulted, and ultimately, the bubble popped, leaving a lot of bad loans in its wake.
Third, he discusses how the original Great Depression in the US was also the result of reserve buildups. During World War I, governments dropped the gold standard in order to print enough money to finance the wars. The result: huge trade imbalances resulted, leading to credit creation in the US. Specifically, the United States was the producing the goods that the Allies were using to fight the war. US gold reserves rose 64% from 1914 to 1917 as Europe exchanged its gold for American goods. The US also began accepting government debt from the Europeans. The Europeans had to drop the gold standard, because Europe couldn’t afford to suffer the recession and credit contraction that would result from their fast-depleting gold reserves. In the US, the increase in reserves led to a doubling of the credit base from 1914 to 1920, which led to a boom in industrial production. When the real economy was no longer able to profitably invest the available liquidity in new plant and equipment due to overcapacity and falling prices, increasing amounts of money were shifted into the stock market. Ultimately, the bubble popped, share prices plunged, credit contracted and a banking crisis developed. Duncan’s thesis: it wasn’t infectious greed that caused the Roaring 20s and subsequent Great Depression. It was excessive credit creation that resulted from trade balances during and after World War I, which in turn resulted from the gold standard being temporarily dropped during World War I.
Duncan also makes an interesting comment about just how much more frequent banking crises have been since 1971. He quotes a Bank of England study in 2001 that referenced a historical study by Bordo, Eichengreen, Klingebiel and Martinez-Peria that said that only 1 major banking crisis occurred in the quarter of a century after 1945, but 19 since. During the Bretton Woods period, systemic banking failures were not common because international reserve assets grew slowly. But when the world’s monetary base began expanding exponentially, they became pandemic.
After recounting various examples of how trade imbalances that were not sustainable under the gold standard have created boom-bust cycles post-1971, Duncan discusses the unsustainability of the current dollar standard that has replaced the Bretton Woods system. Over the last 30 years, the United States has been transformed from the world’s largest creditor into the world’s most heavily indebted debtor. The dollar standard has incentivized countries with trade surpluses to reinvest their dollars back into US dollar-denominated assets, because that’ll keep their currencies low and fuel their export-oriented growth economies. The problem is this: at some point, the US will reach a point where it can’t pay its debts. So at some point, surplus countries will be forced to convert their dollar currencies into their own currencies, causing a sharp appreciation in their currencies and a sharp decline in the dollar. That shift will restore equilibrium to the US balance of payments, but it will also throw the major exporting nations into recession (or exacerbate current recessions) as their exports to the United States collapse (or further collapse).
Duncan has a fascinating chapter called “Global Recession: Why, When and How Hard”. When you pick up the book, turn to page 175. Written in 2002, the chapter is stunningly prophetic. When Duncan’s book came out in 2003, it was soon discredited, because the boom from 2004 to 2007 appeared to prove him dead-wrong. But his ability to predict the events of the past two years in gory detail, back in 2002, is somewhat mind-numbing. For instance, he has a subchapter titled “When?”, with the following sentence reading “When the U.S. property bubble pops. In 2002, the global economy is being supported by an American shopping spree that is being financed by a bubble in the U.S. property market…. The housing bubble is the main explanation for the resilience of the American consumer. Sadly, bubbles pop… In August 2002, the 30-year fixed-rate mortgage fell to a record low of 6.13%. Rarely has global prosperity relied so heavily on one number.” Sounds like obvious stuff nowadays. But written back in 2002? Neat. He also discusses the securitization markets, and accurately predicts the implosion of the asset-backed securities markets. And the collapse of Freddie Mac and Fannie Mae. And the massive banking failures currently sweeping across the nation. His problem was an issue of timing – Duncan was too early in his forecast, and didn’t sufficiently account for governments’ abilities to temporarily reflate their economies by lowering interest rates and pumping money into the world. But these sorts of temporary solutions could only last so long – at some point, a country with rapidly expanding debts becomes no longer able to pay those debts.
There’s one final topic I want to address. One of the more complicated ideas of the book, for me, was his discussion of inflation / deflation. Duncan explains how the global credit creation that resulted from abandoning Bretton Woods has led to global overcapacity. This overcapacity has led to disinflation / deflation, since there is too much global supply in the world relative to global demand, resulting in low prices. Overinvestment causes excess capacity, and excess capacity causes deflation. Second, trade imbalances have allowed export-oriented economies to keep their currencies low relative to the dollar (the currency of the world’s largest consumer), which has also been disinflationary / deflationary. It’s an interesting discussion, because it addresses a question I’ve always had: If we’ve had such strong economic growth from 1982 to 2007, why was there so little inflation (at least until 2004 to 2007, when commodities began surging). Duncan’s answer is (i) ‘global overcapacity’ and (ii) ‘trade imbalances + free trade’. When the world goes into recession, these deflationary forces should only accelerate. He also questions fiscal and monetary policies in this deflationary recessionary environment. He writes “Monetary policy works through credit expansion. When the government wishes to expand the money supply, it buys assets (such as government bonds) from the banks, increasing their liquidity. In theory, the banks, in turn, lend more to businesses… thereby eventually stimulating consumption and the economy overall. In a post-bubble economic environment, characterised by excess capacity, bankrupt corporations, and overly indebted consumers, monetary policy does not work… there are neither a sufficient number of creditworthy borrowers to lend to… nor a sufficient number of clients who want to borrow, due to the lack of money-making investment opportunities left in the gutted marketplace. Consequently, the increased money supply never reaches the consumers and personal consumption does not revive.”
So today, we’re in the following situation: (i) global overcapacity and declining demand; (ii) governments printing money; and (iii) potential collapse of the dollar due to the trade imbalance. The question is: are we heading for deflation or inflation? Duncan seems to admit that he doesn’t really know. In the 2005 edition of his book, he appends an additional chapter discussing how the US and Japanese central banks revived the global economy in 2003 to temporarily stretch out the disequilibria several years longer. He ends that final part, and the book, with a chapter titled “Bernankeism: Anticipating the Policy Response to Global Deflation”. He lays out various scenarios by which the temporary boom can end (the ultimate scenario ended up being a combination of scenarios #2 and #3 (#2 was “A US asset price bubble that drives property prices so high they can’t be financed even at very low interest rates” and #3 “A meltdown of the under-regulated US$200 trillion derivatives market”). He discusses how the dollar will collapse under any one of the scenarios.
Then he writes: “the only option left to stimulate aggregate demand would be to drop paper money from helicopters. That too would fail, however, for who would accept paper dropped from helicopters in exchange for real goods and services? Hyperinflation would quickly set in. Economic transactions would then be conducted through barter rather than via the medium of a debased script. Eventually, a gold standard would re-emerge… Exactly how these events will unfold is impossible to forecast; nevertheless, the eventual outcome is within sight. The dollar standard is inherently flawed and increasingly unstable. Its demise is imminent. The only question is, will it be death by fire – hyperinflation – or death by ice – deflation? Fortunes will be made and lost, depending on the answer to that question.”
I look forward to any comments you may have.