TEH BIIG PIK-CHUR: U CAN HAZ MACRO SCENARIOZ

Top level - the Global Money supply


Between 2001 and 2008, global money supply grew by $35tn, as demonstrated below (data here). It grew not because the global economy was suddenly so much larger but because loose monetary policies encouraged the financial sector's balance sheets to grow in ever more elaborate ways. Without sound money holding them back, banks became deranged - unable to price risk properly even for things as straightforward as government bonds. Now paper (or digital) money is not worthless as some may claim but it's only worth what counterparties think it is worth. Its value is based on the future income it is redeemable against.

I am using 2001 as a benchmark because this appears to be the consensus regarding when the global money supply became excessive. If you ask an Austrian, they'd probably say I have to benchmark much further back. I am not going to do so because I believe it is possible for fiat money to be sound money if it is seen to be backed up by sufficient future income streams.

Most of this $35tn however was not such 'consensus' money - the financial system had vastly outgrown the global economy. Hence this money will now disappear, one way or another. We won't go back to 2001 levels because the global economy has grown since then and has therefore 'grown into' part of this debt. But we've still got a very long way to fall. Because in the past decade and even in these days of crisis money has moved very easily and quickly, where the additional debt-money appeared is not very relevant - losses must be realised among those who hold the assets, not the ones who originated them.

 

How does money disappear? Nominally, money disappears through asset write-downs, of which there have been many, but not nearly enough. In real terms money can also disappear through inflation. Either of these will cost individuals and institutions. 

Write-downs and new assets to date 

According to the IMF, banks have written down only about $2.2tn. Global household wealth only seems to have fallen by about $10tn, according to Credit Suisse. Corporate balance sheets, on the other hand, are only now beginning to shrink. The assets of Forbes' top 2000 companies globally have grown by $4.6tn since 2008. Of course due to the way the Forbes list is compiled this includes almost all of the $2.2tn banks have written down, and it's probably fair to assume the remaining $6.8tn make up ca. 80% of all corporate assets, so it's probably fair to say corporate assets have grown by ca. $8.5tn. This leaves sovereigns and central banks. Sovereigns' assets have actually grown during the crisis, with G-20 countries taking on an extra $1.8tn (analysis based on this and this). Let's assume that this is a big chunk of the total and round it out to a cool $2tn. Finally central banks. The ECB's balance sheet has grown by ca. $800bn, the Fed's has grown by $1.3 trillion, the BoE's has grown by about $300bn the BoJ's has hardly grown at all (compare this with this) although a $360bn increase has been announced recently. Finally, the PBOC balance sheet has grown by $1.45tn (compare this to this). This adds up to about $3.5tn of essentially new money. I would round that up to $4tn to account for the work of smaller central banks. 

If you're mentally adding this up, you'll find that total assets written down are $12.2tn, while total assets created are $14.5tn. There's a cool $3.3tn of new assets floating around. 

Now, the global economy grew by $6.3btn since 2008 and much of this growth is reasonably sound, so we should subtract it from the total (although at a 1:1 ratio to reflect zero appetite for lending). If we do, then it turns out that about $3tn has been lost in the past three years. That leaves around $32tn for the global economy to either write down, inflate away or grow into. With the global economy growing by about $3.5tn to $4.5tn per year, inflation and growth alone will take the better part of a decade to catch up with the world's inflated balance sheet. This is the amount of time that policymakers are playing for. If we can keep the dams up for another 7-9 years, we'll be scot-free and everyone can keep their once-fake money because it will once again be real.

Keeping the dams up

Because most of the money supply is in fact debt, the entire monetary system is based on a system of implicit and explicit debt guarantees. These work like dams, holding the pressure from markets at bay until their weakest spots are eaten away and the torrent of asset write-downs rushes in, in search of a bigger guarantee dam - a more creditworthy institution. Normally the progression runs from consumers to banks to sovereigns to central banks, but the order is actually decided not by institutional status but by the order of credit-worthiness. Credit-worthiness, in turn is determined by an institution's existing liabilities as well as its future income streams and how fast these are growing. The market will continue to test and eat away at guarantees until all of the write-downs needed have occured: i.e. the original excess money minus any money the global economy has "grown into". At this point, the remaining debt-money is once again sound.   

Because loss of earnings and wealth is painful to their stakeholders, Governments have an incentive to intervene in order to stop these from happening. In fact, many of the guarantees I discuss above are Government guarantees. Governments can shape the path of the asset write-downs by transferring wealth to guaranteeing institutions in order to make them more creditworthy, making implicit guarantees to them explicit or creating new guarantees where none existed, in order to protect politically powerful groups. In exchange, they will tend to increase their control over said institutions. Imagine engineers steering a lava flow away from civilians in some blockbuster disaster movie: the key is to keep it moving until it cools, while keeping it from hurting too many people. 

Alternatively, Governments might invest in growth in order to accelerate the rate at which the global economy grows into its debt; if they borrow in order to invest in growth then they are simply taking a slightly riskier bet, trading off their ability to install new guarantees against better growth figures. The slower growth is, the more political government intervention becomes. 

The opposite of  issuing guarantees of course is also possible - Governments can default on their obligations, or announce credible no-bailout policies, thus accelerating the flow of write-downs. It's all part of shaping the flow and Government can and choose default as an option if it steers writedowns away from important constituents.

The strength of Governments' intervention does not reverse the write-down process; it just buys more time for growth to catch up and for political factions to influence where the write-downs will be realised. Government generally regulates how the pain from write-downs is distributed, favouring their own constituents when they can. Inflation is not exempt from these distributional effects - it is a tax which redistributes wealth from those whose assets and earnings are growing more slowly than inflation to those with debt, those with strong wage bargaining ability and the speculative classes whose assets are growing faster than the rate of inflation. The more financially developed a country is, the more the inflation tax tends to hurt poorer people. 

Governments can buy time because markets are ultimately made up of people who hate losing money and and want to believe in guarantees. Thus markets will delude themselves for a while that guarantees are credible until the facts become too clear to be denied. The longer the markets have deluded themselves, the quicker and stronger their reaction when their sanity is restored. 

My feelings about Government interventions meant to prop up the national or global economy stem from my feelings about the effectiveness and benign-ness of what happens during this period of borrowed time. Briefly, I am no fan. I believe that growth under such conditions will be very slow, so most Government interventions are 100% political acts, whose rationale is completely divorced from economic reasoning.

Where we are now - Europe as far I can see.

Where are we currently? The dams are bursting in Europe, with all of the PIIGS either under support mechanisms or under pressure from markets. The core countries are hoping that they can use their quickly recapitalising banks as dams should the peripheral sovereigns fail, but the markets seem to be seeing through this - eventually all banks are assumed to be guaranteed by the state. Germany and the ECB have already been targeted as Europe's prime guarantors, and the Fed is seen, despite reassurances to the contrary, as the ultimate guarantor for both. The IMF, on the other hand, has been dismissed as it doesn't have enough money. 

I will go out on a limb and say that Dagong's list of the most creditworthy sovereigns is probably the best:

Norway, Denmark, Luxembourg, Switzerland, Singapore, Australia, New Zealand, Canada, the Netherlands, China, Germany, Saudi Arabia, United States (here) and also Sweden, Hong Kong, Macao and Austria (here)

If you don't like Dagong's ratings, note how well they correspond to Credit Suisse's ranking.

The dark future of Europe 

Spain I think is already too far gone to be saved and its capitulation will prompt a new massive round of QE led by the ECB and the IMF. The IMF in particular will be ordered to create tons of money out of thin air within the next two years and will quickly become the most politicised of the global institutions - a dream central bank that governments can control explicitly. This will drive the Germans bonkers. At the same time, banks will begin to realise (under pressure from sovereigns) that in the interest of stability they may need to take decisive haircuts in order to draw a line under the sovereign issue. With banks' cost of capital rising under the joint influence of increased risk premia and Basel III, the only other option will be large, cross-border mergers, which will leave Europe with a massively consolidated banking sector.

After Spain gets bailed out, a number of major sovereigns just outside the magic circle will come under massive pressure: Japan, Britain and France are the obvious ones, but Britain and France will probably be more vulnerable due to the sheer weight of political guarantees tied to them. Britain is more active in terms of fiscal self-flagellation and more accepting of speculators' role in the global economy, France will be targeted in a major way around 2012. Again, this is no reflection on the intrinsic solvency of the UK - which is way worse off than France. It's just a matter of the write-downs flowing down the path of least resistance. Once their national pride is stung by a snooty FT headline or Telegraph opinion piece, the French will retaliate by pushing for extremely tough regulation through Brussels - stretching the independence and credibility of the new European bank and CRA watchdogs to breaking point.

Once France starts running into serious trouble (not default-threatening in the short-term but seriously humiliating), the endgame will come into view and Europe, or at least the Eurozone, will come together to issue the ridiculously misnamed E-Bond and draw up under cover of darkness a Death List of European bank haircuts. This will be e-bonds, rather than European project bonds, as the member states will not want to cede any powers over fiscal policy to the EU Institutions.

Germany's responsibility rhetoric will go out the window the moment France, its no. 1 trading partner and a massive recipient of German bank loans, gets into trouble. This will be a major cultural and political event as well as an economic one - it will prompt a political upheaval unseen for ages and political parties in Europe will be judged for decades in terms of where they stood on the matter. It will also mean an overhaul of the EU institutions as EU member states will no longer be content with their share of power in Europe now that the stakes are so much higher. Without any 'own resources', which it is even now frantically trying to raise, the Commission will be the biggest loser in this titanic power-struggle. The Parliament will win at the expense of national parliaments - and thus an infant European identity will be born amidst incredible pain all around.

In the UK, events in the Continent will continue to be mis-interpreted as derived moslty from the failure of the Euro, and moves towards further integration with Europe will meet with fierce resistance. UK Governments will have to cover the country's back somehow, and will look to the US for implicit guarantees. Austerity measures will work for the most part but Britain will also make use of the EU's haircut drive to get rid of debt as the effects of austerity on growth will begin to threaten social cohesion. 

Finally, a further round of bank consolidation will ensue, with the surviving megabanks prompting angry regulatory responses from their overseas rivals, especially in the States.

Once all of this is done,  sometime after 2015, Europe will finally be at peace. Amazingly, the Euro will live to mess everyone's economies up another day, although some peripheral countries will have the prescience to push for more flexible product and labour markets and thus gain in competitiveness. Others will be caught up in a deflationary spiral, which will have more or less the same effect on their current accounts. Europeans, especially those in the periphery, will by now have lost so much faith in the social safety net that savings ratios will go through the roof and continue to rise for years. The matter of imbalances among European nations will remain officially unresolved - with debt now in freefall and savings on the rise in the periphery no one will feel it is an urgent enough issue to justify the political drama of tackling it.

Although the European Commission will lose power in this showdown, the EU institutions will be strengthened. National governments will continue to hide behind international fora in order to pool funds and deflect the political fallout from austerity policies. However, this will inadvertently create a backlash against international institutions as the peoples of Europe connect the dots and associate all things foreign with massive amounts of pain and humiliation. Note that, at the same time, Europe will for the first time start to see a net outflow of immigrants as origin countries begin to grow - but it will be the most employable immigrants that leave first, leaving behind a very frustrated and miserable melange of human misery which will attract naked hatred from the native population. The combination of these trends will push Europe headlong toward nationalism. Depending on their political cultures and stage of disintegration, some (such as the UK, France and Germany) will head towards national corporatism and others (such as Greece, and much of the periphery) towards national socialism - a bad combination by the way.

The Others

If all of this comes to pass then, amazingly, Europe may not experience a surge of inflation as credit begins to flow once more. However, Europe's new-found frugality will have a massive knock-on effect on China, whose authorities will not have time to rebalance the Chinese economy further towards spending. This will risk serious unrest and prompt the Chinese Government to become much more paranoid and far less tolerant than it has been to date. I really don't know what the Chinese will do, but then again I don't think many people do anyway.

The US is of course a wildcard in all of my thinking. I don't understand the US well enough to say much but I would suggest that the American people have not seen the last of the Tea Party movement, which will morph into something much more influential and deranged as events in Europe continue to play into its hands. I think austerity will take hold in the US and with sub-sovereign failures on the rise the increase in DC's power will begin to seriously challenge some Americans' view of the Constitution. A Tea Party on steroids will also be a challenge to the Fed, which will suddenly find itself under increased scrutiny by an incredibly hostile population. I think the backlash against the Fed has already begun. Ron Paul is now almost certainly the most powerful libertarian in the world and will become an eminently quotable spokesperson for anti-Fed sentiment..

Greece: the endgame.

Let me say from the outset that I think much of the discussion about Greece's economic prospects, at least at home, assumes that the possibility exists of a 'goldilocks' outcome in which most of the shape of the Greek economy will remain as we know it. I do not believe this. As far as I'm concerned, some good outcomes are possible, in the sense that it is possible to salvage a good deal of national sovereignty and achieve fiscal sustainability. Salvaging the current Greek lifestyle and social structure is, I believe, impossible.

[More to come soon]