03.11.2011

Do you feel lucky?

By Chan Akya

I know what you're thinking: "Did he fire six shots, or only five?" Well, to tell you the truth, in all this excitement, I've kinda lost track myself. But being as this is a .44 Magnum, the most powerful handgun in the world, and would blow your head clean off, you've got to ask yourself one question: "Do I feel lucky?" Well do ya?

The emblematic dialogue from Dirty Harry

Watching stocks skid even as commodities ramp up to impossible levels as political unrest rears its head across the globe and bond markets start focusing increasingly on credit risks of governments, the average investor should go and ask the world's central banks the key question - did they already fire all

the ammunition they had in their pockets, or do they have any other bright ideas left in their arsenals?

Anyone who has seen the movie Dirty Harry (spoiler alert) knows that Harry turns out to have fired his six bullets but by just being the uber-cool Clint Eastwood, he still makes his thug blink. That happy set of circumstances, though, looks impossibly far-fetched for the world's markets from where things stand today.

A litany of problems has plagued global financial markets ever since the US residential mortgage mess broke into our living rooms some four years ago. In an Asia Times Online article titled Hobson's Choice on March 10, 2007, I wrote the following:

Readers looking at this week's mild recovery in asset prices should be cognizant of this risk. I expect further downturns for US equity markets in coming weeks and months; it is likely that the widely watched Dow Jones average will close this year below the level of 10,000 from about 12,200 currently as investors adjust downward their earnings expectations as well as the multiple of earnings they are willing to pay for owning shares. In turn, this would prompt declines in other stock markets around the world, particularly in South America, whose economy, if not its politicians, depends almost entirely on US economic growth.

There is a trivial point of interest here - namely that the current spike in global stocks reached the same level of 12,200 on the Dow Jones Industrial Average before starting to scale back. In any event, the point of that particular article was elsewhere, namely about the ability of the US government to attract new buyers for its debt. On that point, I noted:

In past crises, such as the 1987 stock-market crash or the recession in the early 1990s that sank the administration of president George H W Bush, the US could depend on the munificence of strangers. In particular, the world's sole superpower attracted enough money from risk-averse investors to refloat its economy.

That time has, however, come and gone as developing countries no longer "need" to buy US government bonds. Indeed, as I argued in a previous article ... they are better served by investing in physical assets such as commodities directly rather than diverting their savings to the low-return US markets. In addition to the economic rationale of protecting their own growth, the world's investors are also not interested in US assets for political reasons. A quick look at the world's largest repositories of savings shows the extent of the problem: Middle Eastern investors will buy anything as long as it is not American, while Asian investors are likely to be scared off by recent losses on mortgage holdings. Other countries such as oil-rich Venezuela and Russia explicitly use their reserves as diplomatic tools.

Walk like an Egyptian

This has indeed come to pass, leaving the US Federal Reserve as the world's biggest purchaser of US government bonds (Treasuries). This week, the Financial Times noted that the world's largest bond fund manager, PIMCO, had cut its holdings of US Treasuries to zero. On March 9, the newspaper noted as follows:

The world's biggest bond fund has cut its holdings of US government-related debt to zero for the first time since early 2008 in the latest sign of increasing investor expectations of rising interest rates.

The move by the $237bn Pimco Total Return fund follows warnings by its fund manager Bill Gross of rising bond yields as the US Federal Reserve nears the end of its massive bond buying programme, known as quantitative easing, or QE2. Such rises would hit the value of holdings of bonds as their price move inversely to their yields.

Mr Gross, one of the most influential figures in bond markets, said in his March investment outlook that Pimco estimated the Fed has been buying 70 per cent of annualized issuance of Treasuries since QE2 began - a programme he last year likened to a Ponzi scheme.

Meanwhile, foreign investors have been buying the remaining 30 per cent. Mr Gross said as a result there was a risk of a temporary void in demand once QE2 is scheduled to end in June. "Yields may have to go higher, maybe even much higher to attract buying interest," he said.

Rising bond yields spell further trouble for the stock markets as the discounting rate of future cash flows will be pushed back, thereby reducing the present value, ie today's prices. Meanwhile, those who fear the collapse of government credibility ("walk like an Egyptian" in the parlance of bond-dealing rooms these days, referring to the recent spate of riots and disturbances in the country that unseated a long-standing government) continue to purchase physical commodities, and in particular, gold.

I am a certified gold buff with a published history of support, therefore no further explanation on that point is needed here.

There is the normal refuge of those who do not wish to own the bonds of a major government issuer - to simply purchase those of another. That option though has been rather dented by what happened recently in Europe:

a. Downgrades of countries such as Greece and Spain.

b. Change of government in Ireland that would likely lead to significant efforts to change or restructure the debt load, with predictable side effects on the rest of the sectors.

c. Weakening economic performance in the continent, which accentuates credit worries.

d. Inflationary fears raised by the European Central Bank that may cause a rise in rates as early as next month.

The markets have already "walked like an Egyptian" in the case of European government bonds; the US is merely the next on the list.

Military Keynesianism

The followers of John Maynard Keynes in today's public policy debates have extolled the virtues of governments intervening in the economy over and over again in order to "kick-start" growth, whatever that means. This policy has failed, as I noted in October 2009 (see Double or quits, Asia Times Online, October 6, 2009), so the Keynesians have merely redoubled efforts to have more spending. With the idea backfiring spectacularly, as noted in the previous section, the interesting question is - what next?

Governments are unlikely to pull back on their spending habits especially as economic data gets worse and regime change beckons ever so seductively (or not, if you actually happen to be in government).

Some countries, like Saudi Arabia, are attempting a bit of Keynesianism at home by expanding state subsidies. Bloomberg reported on February 23, 2011:

Saudi Arabia's King Abdullah boosted spending on housing by 40 billion riyals ($10.7 billion), and earmarked more funds for education and social welfare amid popular uprisings sweeping the Arab world. The social security budget was raised by 1 billion riyals, according to a statement read on state-run television. King Abdullah also ordered the creation of 1,200 jobs in supervision programs and made permanent a 15 percent cost-of-living allowance for government employees, according to the statement.

Saudi Arabia, the world's largest oil supplier, is spending more on social programs as political unrest roils the region. Governments in Bahrain, Yemen and Libya have cracked down on activists calling for greater job opportunities and political openness after uprisings toppled leaders in Tunisia and Egypt.

Unfortunately, opening the financial purse-strings doesn't appear to have worked. News of a violent crackdown in Saudi Arabia on March 10 sent oil prices soaring on the day. As the Financial Times reported:

Eyewitnesses in Qatif said that police tried to disperse about 300 protesters in the city late Thursday afternoon. When the demonstrators refused to leave eyewitnesses said the police fired on them with rubber bullets and percussion bombs.

Three demonstrators were injured and were later taken to Qatif general hospital, according to a protester.

There have been smattering of protests in Saudi Arabia's Eastern province, where most of the kingdom's Shi'ites live, since February 17. Protesters have been calling for the release of nine prisoners that they said have been held without trial since 1996. A delegation from Qatif held a meeting with King Abdullah on Wednesday to ask for their release but the outcome of the meeting was unclear.

However, Thursday's demonstrations are thought to have been calling for their release. A "Day of Rage" has been called for across Saudi Arabia on Friday.

On Tuesday the government sought to ease tensions by releasing 25 Shi'ites arrested during recent demonstrations. Sheikh Tawfiq al-Amir, a prominent Shi'ite cleric detained after a sermon in which he called for reforms, was also released earlier this week.

As seen in the case of Bahrain earlier, and Libya in a much more bloody fashion, the Saudi establishment has resorted to a combination of welfare and militarism to stay in power. This is an internal version of the "military Keynesianism" that many (Keynesian) economists credit with saving the world from the Great Depression after 1929. Other historians count the millions killed in World War II.

The arguments though aren't purely being staged on matters involving (national) domestic security. Chillingly, there are an increasing number of arguments being made in Europe and the US for greater military intervention – witness the French activism on Libya declared on March 10 that effectively puts Europe on a collision/intervention course in Libya. As the Financial Times reported:

France is talking to its allies about targeted air strikes on Libyan airfields and has recognized a leading opposition group in a bid to rally the international community against Muammar Gaddafi's regime.

In an attempt to stiffen the resolve of other European Union leaders ahead of a summit on the Libyan crisis in Brussels on Friday, the French government on Wednesday suggested its international partners should consider more flexible and rapid military responses to the escalating violence.

Being a natural cynic, I cannot help but feel that much of the new-found activism is rooted in nothing more than a cold calculation of economic benefits that arise from greater government spending on the military. This is the likely new form of Keynesianism as governments attempt to keep their spending habits intact while operating under a veneer of moral respectability.

The question is - is this the fifth or the sixth bullet that's being fired?