Welcome to the Weekly Report. Today we look at the long term map that guides readers along the macro-economic highway. Try and stick with this week's article, I am struggling to put into writing how I see the current and future path evolving. It's not a change of stance, more writer's block!

The old:

• bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation.

• Deflation, credit contraction, Conglomerate destruction, nationalisation, mis-placed rejection of sound shares, Bank asset hoarding, historically low base rates, wide spreads to commercial rates, low/no access to credit, sovereign default and bankruptcy, widespread poverty, increase in regional wars, Quantitative Easing in the US/UK, attempted reflations, savings growth, debt repudiation, FX re-pricing, non-governmental intervention from IMF and BIS, co-ordinated protectionism, a new form of capitalism leading to profit sharing through true ownership/part ownership and not based on risk transference...... eventual emergence of new trading and commercial environments.
  Remember these events are not listed in a strict chronological order; they will overlap and in some cases occur more than once.
  

As mentioned in previous Weekly Reports the current rise in commodities and shares is not backed by screamingly good fundamentals, it can't even be put down to a future expectation of a return to pre 2008 growth. The rises are down to an availability of cash and a relaxation of credit tightness to the Institutions and the Banks, allowing the purchase of perceived "good value" assets. This is what we should expect from the reflation experiment by governments, central banks and pan-national bodies.

However up to this point we have only seen losses from the reduction of leverage and credit, we have yet to see losses from the affects of recession coming home to roost. Let us be clear, the conditions for a consumer led expansion are not in place and the Fed agrees.

• At the end of 2008, the 19 BHCs held $1.5 trillion of securities, more than one half of which were Treasury, agencies, or sovereign securities, or high grade municipal debt, and so are subject to no or limited credit risk. Only about $200 billion was in non agency mortgage backed securities (MBS) and only a portion of these were recent vintage or were backed by riskier nonprime mortgages. Remaining material exposures included corporate bonds, mutual funds, and other asset backed securities.

  For securitized assets, supervisors assessed if the security would become impaired during its lifetime. If the current level of credit support was considered insufficient to cover expected losses, the security was written down to fair value with a corresponding "other than temporary impairment" (OTTI) charge, equal to the difference between book and market value. These OTTI charges equaled $35 billion in the more adverse scenario, with almost one half of the estimated losses coming from the non agency MBS.
  

These are not small amounts.

Think about this, after the stress test adverse scenario has run its course, the Fed expects further losses. Now the Fed does say in The Supervisory Capital Assessment Program: Overview of Results that the true losses are not really known, the figures are best guess based on available figures and a deeper and more protracted downturn than the consensus. The report relies on more than half of Tier 1 assets being low/no credit risk consisting of treasuries, agencies, sovereign securities or high grade municipal debt.

Are the Fed relying on the rating of these instruments when they say low or no risk? They must be, because I cannot find any calculations that use a reduction in Tier 1 capital in the event of a dollar rout or some other re-pricing event.

In simple terms the Fed is looking for 1:10 leverage of tier 1 after the damage is complete, considering this to adequate cover for the risky assets.

This is a controlled version of the 2008 credit implosion, were banks et al had to stop lending, deleverage and hoard capital to offset losses in MBS, ABS CDO, LBO etc. With the requirement to raise further capital Banks are still unable to open the consumer credit spigot. Even if Tier 1 capital is adequate the Fed is essentially ruling that leverage should not exceed 1:10. This has the effect of restricting credit by removing the much higher levels of leverage used prior to 2008. By my rough calculations I suspect the availability of credit to consumers and non-bank business will by 50-66% below pre-crunch levels by 2010.

As ever with bank lending the calculation of defaults will show which borrowers are acceptable and which are not. It will take some time before the available market of low risk borrowers is sated and risk is allowed to increase, permitting lending to lower rated borrowers.

It will take years before consumers are able to find EZ credit conditions again, ensuring that any recovery will be weak.

Is it possible that Tier 1 capital could come under threat? In line with my thoughts last week, I am watching this carefully:

Although a falling dollar supports our rising Dow observations, at some point overseas dollar denominated asset holders are going to baulk at further losses, if compensation for dollar weakness falters (Yields and capital appreciation). If foreign holders of Tier 1 type debt decide to sell then Tier 1 assets will be re-priced lower, if not by the Banks themselves then by the shareholders as they revalue their holdings.

On a more personal point I have to pose myself a question:

Am I missing out on a strong rally because I won't turn to a more optimistic outlook?

I am in capital preservation mode where I adjust holdings to ensure my capital remains unaffected. I use a further small pot of capital that I can afford to lose to take positions and attempt to capture gains. I have a few % points of gain but I am not matching the gains of stocks since the March low. As I am effectively hedged on my main holdings I need only examine short dollar positions, a retest and failure to breach above the 200ma would be a good starting point.

What if commodities and shares continue to rise if the dollar stabilises? This would tempt me into small dollar denominated long positions. However I would view this as a "goldilocks" scenario that would eventually destabilise, again not a buy and hold opportunity.

Right now I see the "green shoots" talk as nothing more than over-hyped talk about the slowing of the fall in growth, not a return of growth. We have a long way to go before any genuine, sustained growth becomes apparent.

Finally this week I have a little quiz. Can you identify what this chart is displaying?

Answer in next week's letter.

Welcome to the Weekly Report which this week is shorter than normal as I think we are at a point of conflict in market thinking. So, unusually for me, I want to look at the current situation and a short-termist view into the summer.

For some time we have been looking at the interventionist methods of the Federal Reserve and of late we have focused on the efforts to control the US Treasury yield curve. Firstly let's remind ourselves why the Fed is intent on controlling the yield curve:

• March 18, 2009

  
  The Federal Open Market Committee (FOMC) has announced that the Open Market Trading Desk (the Desk) will begin a Treasury purchase program of up to $300 billion to help improve conditions in private credit markets. The Desk will concentrate purchases in the 2- to 10-year sector of the nominal Treasury curve, although purchases will occur across the nominal Treasury and TIPS yield curves. Consistent with prior outright Treasury purchases, these purchases will be conducted with the Federal Reserve's primary dealers through a series of competitive auctions via the Desk's FedTrade system. On average, the Desk will purchase Treasury securities two to three times per week. Further details will be provided early next week after consultation with the primary dealers and other market participants. The Desk plans to hold the first purchase operation late next week .
  

Courtesy www.stockcharts.com

There is something wrong with the yield picture when compared to the dollar:

As we have identified previously the Dow and yields react to the strength and weakness of the dollar. Yields rise as the dollar weakens and foreign investment (carry trades) into the Dow increases as the price in dollars becomes cheaper.

What worries me is the non-reaction of the 1 year and 1 month UST yields which have remained at or near their lowest levels found around the turn of the year. Even gold isn't reflecting a worry about potential dollar weakness. Now this may be a reflection of continued forex intervention by the Japanese but I cannot sit comfortably with this idea. The Japanese are happy to let it be known when they intervene and the expect markets to react accordingly, we should expect to see bigger flows into the Dow. Those flows seem weak and the rise in the Dow is equivalent to the rise in yields on 5 and 10 yr Treasuries, reflecting the weakening of the dollar since early March.

Buying still seems to be concentrated in the short end of the yield curve to the extent that a clear break down in the yield relationships has occurred. Can we ignore such buying when we see dollar weakness?

The Fed is now in a bind, the dollar looks to be breaking down from longer and short term trend line supports. The Fed targeted part of the curve (5-10 year) is reflecting this by allowing yields to rise in compensation. Does the Fed allow the dollar to fall and attempt to increase purchases in the targeted area and undermine the natural market tendency? Or does the Fed move to support the dollar to control yields which is the message the short end of the yield curve is transmitting?

I cannot see the former idea working, if the dollar begins to fall then Treasury sellers will appear in large numbers, swamping the efforts of the Fed and causing a policy failure with rates rising rapidly. Conversely supporting the dollar will be seen as an anti global measure which will make dollar priced assets more expensive for the rest of the world. It would also reduce dollar availability for world trade, continuing the squeeze on commerce.

We have a Fed induced inability to weight up risk as the central bank distortion of bond markets becomes the major cause of movement. This places the investor in a real hole regardless of whether the investor considers the outlook to be inflationary or deflationary. Therefore we need to look further afield and compare the distortion of the Fed to the expectations of the real economy:

Here we have a comparison of Fed Funds to Moody's AAA and BAA corporate bond yields starting from the initiation of the credit crunch in mid 2007 as Bear Stearns closed/bailed out 2 of it Hedge Funds. Whilst Fed Funds did reflect yield movement in the general market that relationship stopped in late 2008. Again we can see that elevated yields are apparent in corporate bond markets and that corporates are following the lead of the 5-10yr US Treasury yields. Overall conditions show only a circa 100bp improvement from the peak in 2008.

As long as the Fed stays out of the corporate bond market we have a real indicator of investor expectations and the message is saying that conditions remain poor, very poor. Corporates are also in conflict with the stock markets, rising yields and the high spread from Treasuries are compensation for increased risk premium, conflicting with the current rising trend in shares. Noticeable is the movement of BAA corporate yield which, unlike AAA, has remained above 2008 levels.

So we end up with a picture that has been heavily edited by the Fed, a steep yield curve in Treasuries in which the market seems to be calling the Fed's bluff by allowing 5-10 year yields to rise even in the face of Fed intervention. Corporate bond yields remain elevated and are tracking the middle of the Treasury yield curve and conflict with signals from the stock markets. The real economy is still sending the same message as 2008.

The Dow still wants higher:

It hit the area I looked at using the Armstrong dates, support and resistance and the patterns I could see back at the 19th April. 8130 looks to have become support but now becomes vital to any further progression. Again we can see the trend change from the low in March, a large move that should be reflected in a fall of AAA/BAA yields:

Yields continued to rise after the Dow rallied, not backing off until the beginning of April, however since mid-April yields have returned to the levels seen at the start of the Dow rally showing an increased rise in risk premium even after shares have rallied strongly.

My conclusion is that the Dow is not reflecting true economic conditions, either through manipulation or, more likely, mis-placed optimism of share purchasers. All well and good but markets don't react to my thoughts (I really do not like the look of the Dow from a long side perspective); therefore I will continue to exercise patience, not take a stand either way and rely on short term opportunities for trades.

Maybe I am looking too deeply at the current situation and all markets are reflecting a belief that the dollar is starting a new significant downtrend. It is at times like this, when conflicting views are apparent (from our point of view, will this reflation continue for awhile or has it run its course?) that by sitting on my hands I have preserved capital.

In the end I have to watch the direction of the dollar, all else will follow.

Welcome to the 1st anniversary subscribers edition of the Weekly Report. Boy did I pick a good year to start a subscription service! Firstly I would like to thank all the subscribers for their time, patience and thoughtful input. The reward for me has been the emails from those members who have used the long term economic analysis to protect their wealth.

Whilst some might expect a recount of my previous calls I haven't got the time to waste, too much is happening and the future effects are beginning to become clear. This week we saw the first developed economy to get it wrong in a massive way.

This week the UK had what is called the Budget, where the Chancellor of the Exchequer stands up in Parliament and announces the future spending and taxation plans of the current government. Readers will know that I do not believe the fiscal and monetary approach of governments such as the UK and the US will work. However my opinion is a moot point, those in power do not know of my existence or of my work, therefore my personal view is not a plan that will be followed.

Why do I think the current plans will fail? Because the initial attempts to cure the problem, the enormous amount of government debt raised to replace the losses of private debt (i.e. the Banks) means that failure is a certainty. Moral Hazard, discussed in many articles last year isn't a transitory experience, it has long term consequences. Those consequences are beginning to appear and will continue to crop up for many, many years.

Here are 2 charts from the IMF that screams about the global problems (and looks better than my previous attempts):

Still think it'll be different because of China?

Let's get back to what is happening rather than what I think should happen. As I have said before the US is following a plan that is reliant on a credible expectation of future inflation to change the saving and spending habits of business and consumers. The plan, first outlined here, is to discourage savings and non-investment that occurs in a deflationary environment by manipulating consensus to expect inflation to occur and for spending and investment plans to adapt accordingly. The tools used to create that expectation are Quantitative Easing, Zero Interest Rate Policies, an implicit inflation target and an apparently irresponsible approach to government and pan-national organisation debt expansion. Horribly enough it works. When you see the tools written down your initial reaction is to scream "inflation" out loud.

However whilst that may be the initial reaction it does not tell the whole story. When CEO's, CFO's, consumers, service providers, importers, exporters etc actually look at real conditions a sobering pessimism descends. Saving continues even though returns are almost non-existent, investment is put off as prices are seen falling (cheaper tomorrow), the lack of buyers causes a reduction of capacity and production.

What looked like a good plan on paper suddenly seems much harder to achieve in reality. That said the US and the UK were amongst the first to apply the plan and begin the long road to stabilising and eventually re-flating theirs (and the worlds) economy. The hope is that eventually the "borrowed" central government/central bank money will be re-paid as profits rise, the toxic assets will recover to a higher pricing level and tax receipts would rise to service the enormous debt issued to bail out the financially crippled parts of the economy. All of this utterly reliant on a change of expectations and there are signs that an attempt at re-flation, especially in commodities, emerging markets and battered developed country markets is taking place. Whether this spreads, or as I think may happen, becomes known as the first of a number of failed re-flations is still to be decided.

Men are weak, politicians are weak and greedy. The current Labour government in the UK is in trouble, trailing by 12-15% in the polls and in disarray with internal tensions and a leader that actually makes your skin crawl when he smiles. The only topic that has kept the economy off the front pages of the papers is the scandal of Members of Parliament claiming expenses for porn (an error, apparently), sink plugs, furniture and anything else that fattens their bank accounts. Nearly all the culprits have been members of the governing party. The pressure from the public and hints from the Rating Agencies have now made the government change tack in the plan to re-invigorate the UK economy.

The Budget contained elements that would appear inflationary, helping to enhance inflation expectations, such as the headlined increase in debt:

• "UK net debt, which includes the cost of stabilising the banking system, will, as a share of GDP, increase from 59% this year, to 68% next, 74% in 2011-12, and 78% and 79% in 2013-14."

• "We have identified [tax] loopholes and schemes, which, when closed, will result in £1bn of extra revenue over the next three years"

  "I believe that it is fair that those who have gained the most should contribute more"

  "This will allow us to protect frontline public services, while keeping current spending growth, in real terms, at an average of 0.7% a year from 2011-12 onwards"

Darling also pledged to make £15bn in public sector efficiency savings in the current year. This along the tax hikes identified above (including increased duty on fuel, tobacco and alcohol) will ensure that the public and business will expect more of the same in the future.

Far from expecting an increase in inflation both business and consumers will expect a further deflation of their income stream and the will act accordingly. With the UK government expected to borrow £179Billion in the current year and with similar (and larger if the recovery does not appear) amounts for the next 5 years both the availability of private sector cash for investment beyond government debt and the requirement to increase taxation to attempt to pay the debt off will also reduce the flow of cash into the economy. Darling probably hasn't realised that deflation isn't just a reduction of fiat currency in circulation caused by a lack of printing.

As I have said before deflation can occur in an economy even if the printing presses are rolling (heresy for some) because if the future production of fiat currency is already earmarked for the purchase of future debt that will not be used for spending then there is no increase in the amount of cash in circulation.

We already know the UK government has adopted the approach that the banks should be the receivers of funds doled out to help offset losses and attempt to get the credit mechanisms flowing again. Until those banks decide it is safe and profitable to lend then the funds will remain locked away from the economy.

Without fiscal stimulus from government (the local government spending contribution will also be slashed) and the unavailability of bank credit, cash will remain king and a valuable asset. As with all assets it will be coveted and saved whilst it appreciates. Far from an expectation of inflation and an incentive to spend and invest, the expectation will be for a long term reduction in available cash.

From this we can take 2 ongoing lessons.

Firstly we now have an economy that will fare no better (and probably worse) that Japan over the past 19 years.

Secondly we will have an example to watch of how Eggertsson Theory can fail and what to expect if other economies also change or drop the plan.

Subscribers should carefully review any current sterling based investments and/or closely examine the viability of any future investments. Until next week, spend a little time examining your portfolio performance, maybe even a "stress test".......

Late Notice Alert:

Watch the situation in Mexico closely. The outbreak of pig originated influenza that spreads from human to human has the capacity to become pandemic. In normal times this would cause some panic and restrictions on movement but would pass with little impact on the global economy. However if the flu does become pandemic and has a high fatality rate in today's highly stressed environment the impact could be enough to stop global economic flows for a period of time. Be ready to hedge out risk.

I will put this article forward for public viewing toward the end of the week.

Welcome to the Weekly Report. I doubt there is a reader out there who by now has not heard of a Collateralised Debt Obligation (CDO), Mortgage Backed Security (MBS) or some such collection of letters that basically involved the use of debt. That debt was mixed up, leveraged, packaged, given a high rating and sold on for its interest stream to various Banks, Institutions, Hedge and Pension Funds etc.

The common theme to all these derivatives is the expectation of future fund flows. You buy a CDO expecting the income to reward you handsomely. Risk was discounted by a dismissing the probability of a credit squeeze or crunch and by structuring the CDO so that the highest yielding parts where the first to face default and relying on the theory that the AAA part of the CDO was bulletproof. The following is from Portfolio.com (click on the link to play the slideshow):

This is one of better demonstrations of how CDO's function and shows the reliance on debt servicing at a street level to enable the flow of funds. Even though some redundancy was built into the CDO (and MBS) it was based on a level of default that did not allow for anything more than the levels of default seen in the past 10-15 years. When the levels of default rose beyond that expected the inevitable failure of the higher risk tranches began. Was the collapse in CDO's et al a reaction to a "Minsky moment" or was it the outcome of a known risk that was excluded from the advertising blurb? Or was it the usual outcome of a Ponzi scheme that used future payments to pay current investors?

In the end it doesn't matter as the results are all around us and the solution, regardless of the cause, remains the same - eventual repudiation of bad debt. Worse, a cursory read of Doug Noland at Prudent Bear this week reveals that despite all the talk of new Bank regulation and stricter oversight we find:

• "Liquidity is returning to asset-backed securities. Year-to-date total US ABS issuance of $25.7bn (tallied by JPMorgan's Christopher Flanagan) is approaching half of the $56.4bn from comparable 2008. U.S. CDO issuance of $21bn compares to last year's y-t-d $13bn."
  

Still, I'll keep shouting in the hope that it helps someone.

I digress. The US of A has decided (not the people, you had your say and it was acknowledged by Congress and then ignored as the smell of pork wafted into the halls of power) to issue debt to pay for the bailouts and Government spending. The Fed and the US Treasury are now issuing "notes" either as cash or bonds (QE) that have a low or no nominal interest rate (almost cash, the result of ZIRP) in an attempt to offset the destruction of privately created credit and re-inflate the mechanisms of credit creation and money flows.

The political justification for such feckless behaviour is that the survival of the US depends on the creation of such debt. This debt will be issued for as long as it is required in the attempt to break out of the liquidity trap as defined by Keynes.

But here I come to one of the biggest fallacies that is being published in the mainstream financial media in an effort to boost "future inflation expectations". The Fed is now being tagged with following a Keynesian solution to reverse the current malaise:

• April 13 (Bloomberg) -- Rich Miller -- Federal Reserve Chairman Ben S. Bernanke is siding with John Maynard Keynes against Milton Friedman by flooding the financial system with money.

  If history is any guide, says Allan Meltzer, the effort will end in tears. Inflation "will get higher than it was in the 1970s," says Meltzer

  Bernanke's gamble that the highest jobless rate in 25 years and the most idle factory capacity on record will hold down inflation is straight out of the late British economist Keynes. Should late Nobel-prize-winner Friedman's dictum that "inflation is always and everywhere a monetary phenomenon" prove right, the $1 trillion or more in liquidity Bernanke has pumped into the financial system by expanding the Fed's balance sheet may leave him to cope with surging consumer prices.

  John Ryding, founder of RDQ Economics LLC in New York and a former Fed economist, agrees that the central bank will be slow to soak up all the cash it has injected into the financial system, in part because policy makers will be fixated on still- high unemployment. The rate rose to 8.5 percent in March, compared with 7.2 percent in December.

  "They pay lip service to inflation being a monetary phenomenon," he says. "But they're too much concerned with the Keynesian explanation of inflation."

  Some Fed policy makers seem more worried about deflation than they do about inflation. A sustained fall in prices can debilitate the economy by causing consumers and businesses to postpone purchases.

  "For some time to come, disinflation, and even deflation, will represent greater risks than inflation," San Francisco Fed President Janet Yellen said in a speech on March 25.

• Although this sounds a rather academic based question, it is central to understanding Bernanke's approach. From G B Eggertsson "The Deflation Bias and Committing to Being Irresponsible" the fundamental question is:
  • Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes , Friedman and the monetarists said no."

  Remember, I do not intend to get into the rights and wrongs of Keynesian/Monetarist approaches here, I am attempting to uncover the path that Bernanke has chosen. If Bernanke was following a Keynesian approach then any attempt to improve liquidity would be doomed to fail:

  As GB Eggertsson put it:

  • Keynes argued that increasing the money supply has no effect at low nominal interest rates . This has been coined as the liquidity trap."
    

  If Bernanke had been following a Keynesian solution then he would have believed that any increase in money supply would have been ineffective. Yet we see constant attempts to increase liquidity flows. It is clear then that the policies evolving to combat the threat of credit and liquidity contraction are monetarist based. This makes Bernanke's apology the first signpost on his intended path.

  Many attribute Bernanke with the nickname "Helicopter Ben" in reference to remarks he made in a speech about how to combat deflation. It is oft used by those who rail against inflation to paint Bernanke as an inflationist. However, this is misplaced. Bernanke was in fact quoting Friedman. What many don't realise is that there is an assumption the Friedman was invoking Keynes in this approach. This isn't true. Keynes did not believe such an approach could work with low nominal interest rates whereas Friedman believed that changes to both fiscal and monetary policy could allow government control of prices .
  

It is clear that Bernanke is not following a Keynesian approach (Keynes effectively refuted QE and ZIRP and was proved correct by Japan) but it suits the Fed that such talk circulates. The monetarist plan requires the populace to have "a credible expectation of future inflation", that was missing from the Japanese attempts to reflate using QE and ZIRP. However it involves a great sacrifice. That sacrifice is yet again the wealth of the public and corporate business as saving is discouraged and spending encouraged by the threat of future higher inflation. However the plan itself will not cause inflation.

What many forget is what inflation means, a continuing increase in supply. Fiat money and credit are and always will be similar; they only differ by the fact that credit has a usury compensation attached to it. When that compensation is removed then cash and credit are nominally the same. The destruction of the ability to increase privately created credit has not been replaced by Government intervention despite the actions of the Fed and Treasury. So far Government intervention has not even replaced the funds destroyed, let alone inflate the supply.

The increase in Government debt relies on the confidence of buyers to accept the debt. Confidence is split between the belief that the issuer can service the debt and that the issuer will redeem the principal borrowed. The level of confidence is reliant on the perception of the issuer to raise the funds required to pay.

It is the ability of the Government to gather taxation that enables the servicing of debt, if tax receipts cannot meet the required level of debt servicing then only 2 options exist, either the Government defaults or it takes on further debt to pay the interest owed, or as its called a re-structuring. If the US attempts to truly monetise the debt then it would be faced with an immediate bout of panic selling of Dollar assets and an inability to raise new debt. Currently the Fed is actively purchasing US and Agency bonds in the secondary market to keep yields within a target range. Whilst this sets a day to day price for the curve it may become extremely difficult for US Treasury new issuance to be offered at the Fed manipulated price if confidence in the US to raise taxation is impaired:

Here is a simplified flow of funds for the US of A. Taxation is used to support Government spending, pay debt and offset the trade deficit. As long as the tax flows into the coffers and the trade deficit remains within reasonable bounds then the owners of US debt can reasonably expect to be paid the interest owned and be able to redeem the principal.

However if the economic situation deteriorates and tax flows are affected by a lack of profits, high unemployment and a contraction of business then the dynamics change. With less tax income, spending is increased to replace private capital and investment. This is financed by increasing Government debt. The drop in the trade deficit reflects the slowdown (crash) in world trade and the lowered requirement for imported energy.

Think back to the CDO scenario, if the income stream (tax) fails to meet the debt obligation then the buyer will be faced with the possibility of default. This leaves the US with a credibility problem, it would have to reassure its creditors that it will take action to ensure taxation continues to flow:

The increased Government spending, financed by higher debt will have to be diverted into the consumer and business in an effort to increase spending and productivity. This, it is hoped, will increase tax flows and ensure that the debt can be serviced. In return the debt holders will re-circulate part of the income from the debt and profit from exports to the US (trade should increase), increasing the deficit but allowing further purchases of US debt. In effect the principal is rolled over continuously and discounted, turning US debt into a derivative of taxation income.

All parties want a return to the status quo of pre-2008. There appears to be little desire to change the flow of credit. The Chinese know they can pressure the US with rhetoric about the reserve status of the dollar and the threat of withdrawing from debt purchases, the US knows that China needs a revitalised export market to rejuvenate employment and allow domestic flows of credit, currently expanding at a high rate, to be re-directed into dollars.

However in times such as these it is natural for consumers to restrain spending, save and pay off debt. Business will contract production to meet lower demand, avoid investment and hoard cash. Therefore any increase in net worth caused by public spending increases (and tax rebates etc) would not be introduced into the general economy unless the Government makes it unattractive to save.

By introducing a credible expectation of future inflation, coupled with a real negative savings rate when compared to price inflation, the Government is attempting to force business and consumers to spend now before an expected increase in prices occurs and savings are devalued.

There has been much talk about Armstrong of late (including myself) however there have been some rather mis-leading articles floating around. Most of the articles are homing in on comparing identified dates with turns in stock or commodity markets. Firstly Armstrong's model that has been talked about is the Economic Confidence Model, it is not directly related to stocks and commodities, although if confidence changes then markets should change too. However as we saw in 2008, that doesn't stop markets making what would appear to be large counter trend moves.

Interestingly as we approach a cluster of dates confidence has changed from the turn of the year. Watching happy-clappy Bloomberg et al, reading mainstream and some blog articles we see a lot of talk that the bottom is in, conditions improving, green shoots and even Pretcher calling this a wave 2 bounce that could go much higher.

Let's look again at the Economic Confidence Model chart:

As we discussed in March I highlighted the 19 March date but mentioned that this date was not a turning point but a warning. It is from another part of Armstrongs work involving the division of the 8.5 year cycle. I had to persuade Bruce at Safehaven.com of the confusion that seemed to exist about the 2009.3 calculation when I sent him the March Occasional Letter to publish:

• Hi Bruce,

  The second diagram is from "Its Just Time" front page. Page 30 (attached) has the dates, the April dates are from lower cycles (8.6 month etc, other source)

  8.6 year = 0.3 x 365 = 109.5 (days) ie April date

  minor mid wave is 2.15 years or a quarter of 8.6 year wave. Armstrong says" the next quarter wave is typically broken into half again creating 2 1.075 year waves. We can see that the current wave, the mid-wave turning points were 1008.25 (march 23 2008) and 2009.3 March 19 2009. Typically these waves do not produce specific turning points to the day as do major turning points"

In fact there is a 2009.3 in the 8.6 month cycle (actually 2009.29) that exists within the 8.6 year cycle:

Courtesy M Armstrong

As you can see the date for 2009.29 is 16th April 2009, however this is a 37.33 week cycle date. We may have reached a minor peak in confidence this weekend. If so then that would point to some bad news in the pipeline. However we have to return to the 8.6 year cycle (stay with me!) but not look at the Quarter or Eighths, rather we look at the turning point dates within the current 8.6 year cycle. Again from Armstrong:

• "Looking at an 8.6 year wave, we also see key dates within the wave based upon both monthly and weekly intervals. If we look at the 72 targets of 8.6 months within the 8.6 year wave we have the following dates to watch:

  2007.15 Wave

  2002.865 - 11/12/02 2007.173 - 03/05/07

  2003.358 - 05/11/03 2007.890 - 11/21/07

  2004.301 - 04/20/04 2008.608 - 08/10/08

  2005.019 - 01/07/05 2009.326 - 04/29/09

  2005.737 - 09/26/05 2010.044 - 01/16/10

  2006.455 - 06/15/06 2010.762 - 10/05/10

  .....................................2011.480 - 04/24/11

These target dates do not always match the overall major wave. It is true that there may be a few days apart from major turning points. At times, it is possible to have a high on one phase and the low a few weeks later on the monthly or weekly target."

Notice the differences in the final date on each calculation: 2011.48 above, 2011.44 in the 8.6 month internal cycle chart and 2011.45 in the Economic Confidence chart. Place a mark against April 2011 in your diaries for a bottom in economic confidence.

More importantly is the 29 April 2009 date, this indicates a turn. I have placed the recent and near future dates onto a daily Dow chart, along with traditional support and resistance lines. I have also added a possible rising wedge:

I will be watching this carefully as I see 2 scenarios occurring into 29 April.

Scenario 1. The rising wedge plays out:

Note the red support/resistance line on the example above.

Scenario 2. It's not a rising wedge but an ascending triangle (a rising support line with horizontal resistance) however with only 2 possible touches on resistance it doesn't look properly developed. However there is time for a scrappy ascending triangle to form but if the lower support on the rising wedge goes we can cancel scenario 2.

As ever, I will not give trading instructions but I thought you might like to see what I am looking at right now. I will want to see some confirmation of scenario 1 before picking a trade, especially if the wedge continues to build into 29 April.

That's it for this week.

Welcome to the Weekly Report. This week we look at conflicting signals and worrying medium term developments. However before we start it is time for a check of the new scenario.

• Deflation, credit contraction, Conglomerate destruction, nationalisation, mis-placed rejection of sound shares, Bank asset hoarding, historically low base rates, wide spreads to commercial rates, low/no access to credit, sovereign default and bankruptcy, widespread poverty, increase in regional wars, Quantative Easing in the US/UK, attempted reflations, savings growth, debt repudiation, FX re-pricing, non-governmental intervention from IMF and BIS, co-ordinated protectionism, a new form of capitalism leading to profit sharing through true ownership/part ownership and not based on risk transference….. eventual emergence of new trading and commercial environments.
  

Credit contraction - For consumers there appears to be little change in the availability of credit. US consumers are finding some relief in lower mortgage rates but it may not be enough. Federal Housing Administration insured mortgage default rates have risen to 7.5% as the FHA market share has grown massively. Fannie Mae saw an increase in Prime Mortgage default rates too. The G20 have allotted funds to allow an expansion of global credit for trade to replace letter of credit withdrawn from the market by Banks.

Conglomerate destruction - Continues to threaten the global Auto industry and supporting services. We have already seen Banks, Insurers and other Financial based parts of conglomerates either failed or being supported by massive write downs or bail outs.

Nationalisation - Is happening in the developing and developed economies, ranging from Banks to Oil companies. It will continue, disguised as preffered share swaps (the UK Govt now own 70% of RBS)

Mis-placed rejection of sound shares - Some bargains are apparent but as we have seen since March the Institutions are in the market and bargain hunting now requires good research.

Bank asset hoarding - Continues and will continue. This is ensured by the call for G20 and others to make Banks hold higher reserve ratios.

Historically low interest rates - The adoption and the pressure to adopt ZIRP continues.

Wide spread to commercial rates - Spreads are decreasing in some mortgage products as QE takes hold and central banks purchase Treasuries from the market. However spreads for corporate debt remains elevated but low enough to allow some issuance in the past 2 months.

Low/no access to credit - Shows tentative signs of easing but it is very early days. See credit contraction. I still think there will be a crisis for unsecured debt and credit cards.

Sovereign default and bankruptcy - Mexico joins the list asking for an IMF bailout, I am particularly worried about Japan in the medium term.

Widespread poverty - Much of the G20 rhetoric was directed toward the relief of poverty in the developing world. The trend from my observations appears to be increasing in both developed and the developing world but is still at an early stage.

Increase in regional wars - Since the Russian adventure into Georgia sabre rattling has increased, especially between China and the US and on the Indian sub-continent.

Quantitative Easing in the US/UK - Is a done deal and we see the expansion of the QE Club which may envelope most of the world. I am watching the ECB closely to signal a switch to QE. Whilst pressure has been placed on closing down "tax havens" attention may switch for the smart money to find countries not willing to adopt QE and ZIRP.

Attempted reflations - Have begun in Europe, Japan, UK, China and US using fiscal policy to replace private pools of liquidity that have been withdrawn by Banks etc. However pressure is appearing from central bankers and some commentators that the limit of fiscal stimulus may be very close or reached.

Savings growth - Continues but may see a fall if CPI continues to show a resurgence:

Debt repudiation - Continues across the board as defaults rise, de-leveraging continues and debt is paid down.

FX re-pricing - Has continued as we discussed recently, a recent development is the rise of major currencies against the Dollar, whilst the Yen loses strength against the Dollar.

Non-governmental intervention from IMF and BIS - Has begun and was sanctioned at the G20. I have rarely seen or heard so many references to a "New World Order" in the space of a week. Note the predicted expansion of IMF SDR's.

Co-ordinated protectionism - We began to see a shift of various groupings within the G20 that have common aims and ambitions. The US/UK orientated bloc is weakened, Europe and China strengthened.

A new form of capitalism leading to profit sharing through true ownership/part ownership and not based on risk transference....eventual emergence of new trading and commercial environments. - So far all we have seen is an increase in global tax payers liabilities and unspecified talk of re-regulation. The general thrust of the bail out seems directed at a re-emergence of the old system.

The speed of the bailout, the movement through the scenario, is quicker than I envisioned, however this is not necessarily a good thing. Some may remember how the old scenario finished by following a complete copy of the scenario in a very tight timescale, the scenario within the scenario. We may be seeing something similar at the beginning of the new scenario that leads to a failure and a return to a strongly deflationary environment as the re-flation attempt fails. It is too early to say that is happening from current evidence.

I have always enjoyed reading Gary Dorsch's articles and whilst reading his latest I came across this:

• "Copper Climbs above $4,000 /ton in London

  So far, the metal which has outperformed to the upside this year - is copper, and it's attracted the strongest investor portfolio flows in the mining sector of global equity markets. London copper prices are up 35% this year, the biggest quarterly rise in three-years. Shanghai copper's 40% quarterly surge is the biggest on record. The premium for Shanghai copper above the London benchmark, widened to 1,670 yuan per ton, enough to encourage local merchants to start importing the red-metal into the country.

  Traders estimate that Beijing's State Reserves Bureau, which manages the country's strategic stockpiles, is buying 300,000-tons of copper, and speculate that it could buy up to 1.2-miilion tons this year. The flow of copper from the London into the Shanghai Futures Exchange has begun to make a noticeable dent in the unsold supply held in London Metal Exchange's warehouses, whittled down by 10% since mid-February. The SRB has been the big driver behind rising copper prices this year, while industrial demand outside of China has played little part in the copper price rally."
  

• "China's capital markets might be awash with liquidity in the second quarter and excess money could reach 1-trillion yuan ($146 billion), leaving a huge pool of money sloshing in the markets, if the People's Bank of China doesn't drain funds via bill or bond sales in the months ahead. By artificially inflating the Shanghai red-chip index, which is rising despite a 37% collapse in industrial profits, Beijing creates the illusion of a recovery in the Chinese economy, which attracts speculators to copper and other commodities."

I absolutely agree with GD, the current rise in commodities has been initiated by China as it uses reserves to buy cheap resources and the Hedge Funds etc have jumped onto the trend. Whilst this will last for as long as it wants too (i.e. until China quietly slips away from the purchasing table) I see it it as a trading opportunity, rather than a sign that industrial production is increasing in response to new demand.

We maybe seeing a series of mini "oil 2008" scenarios. You may remember in a recent article I suggested that risk maybe concentrated in the wrong direction:

• "Right now I am worried that many investors are looking the wrong way, that they expect gold to rocket and bonds, the dollar and the Dow to collapse. I am not so worried that the call may be right or wrong, just that the risk is concentrated on a set outcome."
  

The Dow is up, bonds are in a range with gold and the dollar falling. Some of the old rules appear under threat.

Have a good week.

Welcome to the Weekly Report. This week we look at the global economy through a report from the World Trade Organisation. As you know from previous Weekly Reports we have been keeping an eye on various regions in the global economy, it has helped to show the extent of the global recession.

Without doubt Obama and Brown are very worried that a global response to the cry for a united policy of Quantitative Easing, Zero Interest Rate Policies, combined with fiscal stimulus (hereafter referred to as the bailout) will not be answered. If the other power sectors of the economy refuse to play in the same sandpit then the attempt to monetise the $Trillions of debt will fail. Those that have already joined the QE Club and adopted the policies are at a disadvantage if others decide not to create debt and remain with strong currencies. The QE Club hope that those nations reliant on exports will follow the fiat currency devaluation to maintain their market share.

However the whole approach for Brown (the G20 host In the UK, cost: £19million) has been torpedoed by his own central banker, Merv King at the BofE, who cautioned against further fiscal stimulus.

There are signs that some, including some of those in the G20, are not attracted to this course of action. Looking at the WTO report shows why this may be so:

• "The collapse in global demand brought on by the biggest economic downturn in decades will drive exports down by roughly 9% in volume terms in 2009, the biggest such contraction since the Second World War, WTO economists forecast today (25 March 2009). "Trade can be a potent tool in lifting the world from these economic doldrums. In London G20 leaders will have a unique opportunity to unite in moving from pledges to action and refrain from any further protectionist measure which will render global recovery efforts less effective," said Director-General Pascal Lamy."

• "A new way to help people on low-incomes clear their debts has been criticised by a leading creditor organisation. Debt Relief Orders are available to people who do not own a home, have less than £300 in assets and an income of no more than £50 a month.

  The government says the orders will offer hope to people in debt and keep them from using loan sharks. But the Civil Court Users Association says the help for debtors is at the expense of creditors. Debt Relief Orders can be applied for from 6 April if the debts owed are no more than £15,000 and there is no foreseeable way the money can be repaid.

  Instead of going through a court, debtors apply to the Insolvency Service through an intermediary like Citizens Advice."

Whilst such measures as those outlined above are adopted in the developed world, those in the emerging or developing markets, orientated toward exports, will be unwilling to expand capacity or increase production. This is not a currency related problem, this is the result of a deflation of credit (and all fiat money is credit) that has destroyed the ability of many to buy anything other than the necessities of life.

So it should come as no surprise that despite stock markets having a good March the signs for global trade do not look so pretty.

• "A notable aspect of the current slowdown in world trade is its synchronized nature. Monthly exports and imports of major developed and developing economies have been falling in unison since September 2008"
  

Worldwide contraction of trade is deep; there are some serious % drops in the charts above. As trade has to be carried out using currency then the amount of currency in circulation, for the exchange of goods, has dropped correspondingly. Although the charts finish in January '09, we have already seen further drops in activity reported by the US and Japan. I doubt any region is showing signs of expanding trade. One thing that maybe a sign of better times ahead is the narrowing of the trade deficits and the reduction in absolute levels of deficit gaps. However that hope is dwarfed by the dramatic slowdown in trade. With the ongoing contraction in the developed (OECD) countries it is unlikely that trade will show improvement for some number of Quarters:

Both imports and exports continue to fall deeply into negative territory with no sign of recovery. Emerging and developing economies have few options when faced with such a reduction of the volumes of trade other than to contract domestic capacity or consider competitive devaluation. However with the export market closed, devaluation against the dollar would result in an increase of import costs, especially energy, which would negate any possible benefit.

This has implications for the Dollar. Right now Dollar and Yen flows are strong, this is usual into the end of March as the Japanese (and US Internationals) repatriate funds for end of year tax breaks and calculations. However that process is near completion and the demand for both currencies should fall. In normal times the continued expansion of trade keeps the demand for Dollars and Yen in place. Not now, the contraction of trade will result in a contraction of demand for these 2 currencies so we may well see a further weakening through natural market processes. Depending on whether we get this possible scenario and how big the trend is it could have a major effect on prices to the upside in the US and Japan. Perversely enough that is exactly what these 2 countries are wishing for (inflation expectations).

The big question remains the reaction of consumers and business, do they accept possible higher dollar denominated prices or do they retrench further from purchases and investment?

According to the St Louis Fed, real disposable personal income has risen from mid 2008 but has dropped slightly in Q4 and CPI appears to have bottomed and risen from the end of 2008, although both are still below the previous highs:

Is an expectation of inflation occurring within the consumer sector? If inflation is seen as a credible threat, savings should fall as "spare" income is used to buy goods that will become more expensive in the future. If the consumer does not expect inflation of their income (due to low/no pay rises or unemployment or the fear of either happening) then savings will rise in anticipation of possible lower future income streams. Again we look at real disposable personal income and now personal savings:

Are we seeing the first signs of a change in the consumer's expectations? It might be too early to tell and the moves are small but the recent slight drop in savings and personal income, combined with the uptick in inflation may show that "spare" income is being used to purchase higher priced goods. We shall monitor this over the coming months. Whether it is enough to turn world trade around is another question, we shall see.

Who's that knocking on the door? Who's that ringing the Bell?

It's time for another visit by your friendly Collection Agency to offer timely advice and to remind you of his previous excellent record. You should all know by now that the Collection Agency doesn't pull any punches and has ensured that subscribers have been well ahead of developments in the global macro economy.

It has been interesting to read current econo-blogging and main stream writing discussing the present situation, something subscribers old and new must read with a feeling of déjà vu as the memory of articles and letters written up to 3 years ago came flooding back to the fore. Prior to starting my subscription only service I had a blog. The blog is still available to view as an archive and whilst I didn't get a 100% predictive score, I think 99% is not a bad hit rate.

You don't believe me? Why would I lie to you about a free archive that had articles from 2006 through to mid 2008? The link above will take you to the last article on the blog, it was a summation of the calls since the blog started, with a running commentary written in July 2008. Advert over.

So here we are living with the fallout of a credit collapse, with deflation looming for some and embedded for others. Yet right now we are getting numerous articles looking for those famed "green shoots of recovery". I see nothing but a parched desert. Central Banks are moving into a global Quantitative Easing (QE), Zero Interest Rate Policy (ZIRP) environment as each individual economy adopts the measures tried by Japan in the lost 20 years (the lost decade is too short to describe what Japan is suffering). Even the original trialist has returned to the experiment with the Bank of Japan purchasing bonds, shares and debt to increase liquidity, this after the original attempt failed. Now China has joined the QE Club, along with the US, UK and Switzerland as it stokes the domestic credit bubble to expand liquidity through loans. We all know how that's going to end. Even the Eurozone has adopted some of the measures of a QE / ZIRP plan, it will become a full member soon enough.

I read a lot, I mean a lot of economic material ranging from papers prepared for Central Banks, IMF, BIS through to bloggers like me. Some of the information I see is too optimistic or just plain wrong, some is insightful and revealing. However there is one chart that I keep close at hand:

The chart was drawn by Martin Armstrong; it does not predict stock market direction but business confidence.

Mr Armstrong is still writing even though he remains imprisoned. A key date passed this week, the 19 march 2009, yet very few will know of it. The predictions of Mr Armstrong, through his work, are truly stunning and make my work look pale in comparison. He has pinpointed the week, the day where we see talk of recovery becoming familiar and the confirmation of massive interference from the State in the bond markets. More importantly Mr Armstrong noted that the 19 March is not in itself "the date" as his work pinpointed another date that will work in conjunction with events that happened last week, that of 19 April. (There is also another lesser cycle date for the 23 April.)

I understand the principles behind Mr A's work and as mentioned I keep it close at hand, it is just too good to ignore. However, if you think I am going "all in" based upon the dates you have missed the point, remember this is not a direct market prediction. Markets reflect the sum of individual responses to outlook, Mr A points out where the inflection points are that affect that outlook. Those of you that have read my work on the Eggertsson Theory written in April 2008 and titled "The future actions of the Federal Reserve and US Govt are known" know how important expectations are in the outcome of the massive re-flation attempt currently under way.

So what happened last week, as if you need me to tell you? The final action needed to turn theory into fact occurred as the Federal Reserve began to put into action the following from The Deflation Bias and Committing to Being Irresponsible:

• "Friedman suggests that the government can always control the price level by increasing the money supply, even in a liquidity trap. According to Friedman's famous reductio ad absurdum argument, if the government wants to increase the price level it can simply "drop money from helicopters." Eventually this should increase the price level-liquidity trap or not. Bernanke (2000) revisits this proposal and suggests that Japanese government should make "money-financed transfers to domestic households-the real-life equivalent of that hoary thought experiment, the "helicopter drop" of newly printed money." This analysis supports Friedman and Bernanke's suggestions. The analysis suggests, however, that it is the increase in government liabilities (money & bonds), rather than the increase in the money supply that has this effect. "

  "Since money and bonds are equivalent in a liquidity trap dropping money from helicopters is exactly equivalent to issuing nominal bonds. If the treasury and the central bank coordinate policy the effect of dropping money from helicopters will have exactly the same effect as deficit spending. Thus this paper's model can be interpreted as establishing a "fiscal theory" of dropping money from helicopters. The model can also be extended to consider the effects of the government buying foreign exchange (or any other private assets)."

  "It is often suggested that the central bank can depreciate the exchange rate and stimulate spending by buying foreign exchange (and similar arguments are sometimes raised about some other private assets and their corresponding price). Due to the interest rate parity (and similar asset pricing equations for other private assets), however, buying foreign exchange should have no effect on the exchange rate unless it changes expectations about future policy (since the interest rate parity says that the exchange rate should depend on current and expected interest rate differentials)."

  "Will such operations have any effect on expectations about future policy? Open market operations in foreign exchange (or any other private asset) would lead to a corresponding increase in public debt defined as money plus government bonds. This gives the government an incentive to create inflation through exactly the same channel as I have explored in this paper and, therefore, leads to a corresponding depreciation in the nominal exchange rate hand-in-hand with the rise in inflation expectations. An advantage of buying private assets, as opposed to cutting taxes, is that it does not worsen the net fiscal position of the government. It only changes the inflation incentive of the government." GB Eggertsson. ( Emphasis mine)

• "The Federal Reserve's third set of tools for supporting the credit markets involves the purchase of longer-term securities for the Fed's portfolio. As we announced this week, we are purchasing up to $300 billion in Treasury debt, $200 billion of the debt of government-sponsored enterprises (GSEs), and up to $1.25 trillion of mortgage-backed securities guaranteed by the GSEs and federal agencies this year. These purchases are intended to improve conditions in private credit markets. In particular, they are helping to reduce the interest rates that the GSEs require on the mortgages that they purchase or securitize, thereby lowering the rate at which lenders, including community banks, can fund new mortgages."
  

However as subscribers know we are looking for those "expectations of inflation" that are vital to change the spending and investment patterns of consumers, business and banks.

Hello, what do we have here?

Courtesy of www.stockcharts.com

If the US Treasury Bond markets are now artificially priced then logically the future expectations of the masses will be reflected elsewhere. At CALetters.com we have been following yields closely to attempt to divine the range the Fed intends to hold rates within (because we knew it would happen):

Courtesy ofwww.stockcharts.com

In last weeks Report, subscribers were reminded to watch these assets, with the $ as the baseline:

Courtesy of www.stockcharts.com

At the risk of repeating myself, go back and re-read the highlighted part of the last paragraph taken from GB Eggertsson's work. We now get some idea of what it takes to inject an expectation of future inflation, around $1.75Trillion. The big question is how long the expectation will last, will it become embedded or will it fade away without further injections of credit and liquidity?

This is an important window for the Chinese, do they decide to wait for the answer posed above or do they move now and sell whilst the price is supported as the dollar loses value? We get some idea as to how worried the Chinese are from this Reuters article, reported on the 19 March :

• "Russia met representatives of China, India and Brazil ahead of the G20 finance ministers meeting last week, as the big emerging powers seek to up their influence on decisionmaking globally. Their first ever joint communique did not mention a new currency but the source said the issue was discussed.

  "They (China) did not formally put forward their position for the G20 summit but unofficially they had distributed their paper regarding the same ideas (the need for the new currency)," the source told Reuters, speaking on condition of anonymity.

  The source said the Chinese paper envisaged the International Monetary Fund's Special Drawing Rights (SDRs) being first assigned a role of a clearing currency on some transactions and then gradually becoming the main global reserve currency. "They said that the role of reserve currency should be given to SDR," the source said.

  A U.N. panel of experts is also looking at using expanded SDRs, originally created by the International Monetary Fund in 1969, but now used mainly as an accounting unit within similar organisations as a new reserve currency instead of the dollar."
  

• "I expect attempts to be made to peg smaller currencies to a $/Y basket. These 2 currencies will remain strong for the foreseeable future as long as demand for a reduced supply exists. Eventually there will a centrally controlled orchestrated move to develop regional currencies linked to a peg that is not a currency, such as the IMF SDR's (special drawing rights). The movement of currency from one region to another will be after a conversion to "SDR" and controlled by the Bank of International Settlements."
  

We can see the systemic strains appearing as Central Banks attempt to manipulate multiple markets, we know from history that such manipulation will not work. We have the Fed supporting the Bond market whilst the dollar is allowed to fall, gold holding a range and the Dow showing a correlation to currency fluctuations. These are not markets that are going to react as we "expect". The Fed truly is "committed to being irresponsible" and the Chinese know it. Worse this knowledge is putting real fear into the Chinese strategy, why should they hold assets that yield single digits if the currency they are denominated in is facing possible large double digit % devaluation? For the US there is a further conundrum, how do you make a capped yield asset attractive if the dollar is dropping in value? Simply put, you don't. Therefore to sell the debt to willing buyers you need to protect the dollar and if the US Treasury is unwilling to do so, they may well find the rest of the world does it for them, buying dollars and selling their own currencies to protect $ priced assets. Competitive devaluation becomes the driving force for national survival in the fight against the US self interest.

We cannot discount the possibility that the US decides that the Fed will buy newly issued US Treasuries, rather than the current cash for debt swap with the Banks, ensuring that the depreciation needed to make the Eggertsson Theory work does not become derailed.

Regardless of which way such actions would affect the global economy it could make the Chinese (well my) idea to switch to a regulated currency market look much more attractive. In the end it might not matter which decisions are made because, as Mr Armstrong would say "It's just time".

The new scenario:

• Deflation, credit contraction, Conglomerate destruction, nationalisation, mis-placed rejection of sound shares, Bank asset hoarding, historically low base rates, wide spreads to commercial rates, low/no access to credit, sovereign default and bankruptcy, widespread poverty, increase in regional wars, Quantitative Easing in the US/UK, attempted reflations, savings growth, debt repudiation, FX re-pricing, non-governmental intervention from IMF and BIS, co-ordinated protectionism, a new form of capitalism leading to profit sharing through true ownership/part ownership and not based on risk transference.... eventual emergence of new trading and commercial environments.

However what it does tell us is that politicians are still not getting it. They fail to understand that for many people its too late, the actions and reactions by governments and central banks are failing to protect the individual. Still as long as the banks are "saved" and governments / bureaucracy can still keep their pampered life intact we should all be grateful. I am seeing a change in the demeanour of the public and it ain't pretty.

• Sony bosses held by workers
  Mar 13 - French CEO Serge Foucher and several other executives were detained by workers demanding better redundancy terms. (Reuters)
  

• Monetary policy assessment of 12 March 2009

  Swiss National Bank takes decisive action to forcefully relax monetary conditions

  The economic situation has deteriorated sharply since last December, and there is a risk of negative inflation over the next three years. Decisive action is thus called for, to forcefully relax monetary conditions. Against this background, the Swiss National Bank (SNB) is making another interest rate cut and acting to prevent any further appreciation of the Swiss franc against the euro. To this end, it will increase liquidity substantially by engaging in additional repo operations, buying Swiss franc bonds issued by private sector borrowers and purchasing foreign currency on the foreign exchange markets.

  The SNB is lowering the target range for the three-month Libor by 25 basis points, narrowing it to 0-0.75%, with immediate effect. It will use all means at its disposal to gradually bring the Libor down to the lower end of the new target range, i.e. to approximately 0.25%. Thus, the Libor now has a narrower target range of 75 basis points, compared with 100 previously.

  With these exceptional measures, the SNB is helping to cushion the effects of the economic and financial crisis, with the aim of limiting the risk of deflation. The SNB has a mandate to ensure price stability, while taking economic developments into account. This objective encompasses the prevention of both deflation and inflation. In carrying out its mandate, the National Bank will - as it has in the past - base its decisions on an inflation forecast.

Notice, as we discussed awhile ago, the optimistic "low and go" forecast.

However there is another central bank that is approaching, if not full, then associate membership of the QE Club:

• 5 MARCH 2009

  The Governing Council of the ECB decides to decrease the fixed rate on the main refinancing operations by 50 basis points to 1.50%,starting from the operations to be settled on 11 March 2009. In addition, it decides that the interest rates on the marginal lending and the deposit facility will be 2.50% and 0.50% respectively, with effect from 11 March 2009.

  Moreover, the Governing Council decides to continue the fixed rate tender procedure with full allotment for all main refinancing operations, special-term refinancing operations and supplementary and regular longer-term refinancing operations for as long as needed, and in any case beyond the end of 2009.

  In addition, the Governing Council decides to continue with the current frequency and maturity profile of supplementary longer term refinancing operations and special-term refinancing operations for as long as needed, and in any case beyond the end of 2009.

Competitive devaluation of currency is now firmly on the table and it looks like it's the Dollar that is the benchmark:

Courtesy of StockCharts.com

Here is a comparison of the $, Euro, Yen, £, Swiss Franc and the Dow, using the $ as the benchmark. The Swiss have formally acknowledged currency depreciation whilst others allow their devaluation to occur in a stealthier style.

However the Swiss have introduced a little white lie in their message:

• Swiss National Bank (SNB) is making another interest rate cut and acting to prevent any further appreciation of the Swiss franc against the euro.
  

Courtesy StockCharts.com

The target is the Dollar, specifically the ability to keep the Franc weak to enhance exports to the world's largest economy. The secondary, and only slightly less important objective is to try and stop the implosion of Eastern European debt. Many in East Europe arranged mortgages in Francs and Euros and as these currencies strengthened against local coin debt repayment become onerous, if not impossible.

As an aside a cheaper dollar makes holding shares in the Dow attractive, a strong dollar does not. The rise in the Dow last week had the hallmarks of a carry trade being implemented. I wouldn't place much reliance on the news to find a reason for the Dow bounce.

Interestingly there is obviously enough cash around to allow carry trades to be restarted but not enough to reflate the credit bubble. Banks and the remnants of the Investment/Broker complex are most certainly looking no further than their own interests, lending to the public and business is still viewed as undesirable. Investment behaviour has not changed even though it is the taxpayers who stand behind the bailout of the Financial System; talk of regulation by politicians is a smokescreen to placate the masses.

World trade has collapsed, down 22% at an annual rate, according to Finfacts:

• Monthly trade numbers are volatile and focus on quarters is therefore preferable. In the fourth quarter, world trade was down by 22.0% at an annual rate from the preceding quarter (6,0% non-annualised). In the previous quarter, world trade growth was still growing by 8.8%. The drop in the fourth quarter is without precedent.
  

The World Bank produced a report for the G20 and became the first organisation to declare:

• The sharp global contraction is affecting both advanced and developing countries.

  Global industrial production declined by 20 percent in the fourth quarter of 2008, as high income and developing country activity plunged by 23 and 15 percent, respectively. Particularly hard hit have been countries in Eastern Europe and Central Asia and producers of capital goods. Global GDP will decline this year for the first time since World War II, with growth at least 5 percentage points below potential. World trade is on track to register its largest decline in 80 years, with the sharpest losses in East Asia, reflecting a combination of falling volumes, price declines, and currency depreciation.

• What began as a collapse of the US sub-prime mortgage market quickly spread through the financial system, eroding the value of capital, undermining the creditworthiness of major global financial institutions, and triggering massive de-leveraging. Efforts to restore capital adequacy and uncertainty about the underlying value of assets held in the form of sub-prime mortgage backed securities resulted in capital hoarding, causing liquidity to dry up, ultimately compromising the ability of borrowers to finance transactions in both the real and financial sectors. This in turn reduced demand and employment, undermining consumer and business confidence, and triggering a further contraction in demand. According to the IMF's latest World Economic Outlook Update, output in advanced economies is expected to contract by 2 percent in 2009, a sharp downward revision from expectations just a couple of months ago. Forthcoming forecasts by the World Bank and the OECD will likely show a further deterioration in the outlook.

  Falling demand in advanced economies has had serious implications for global trade, with 2009 expected to experience the first yearly decline in world trade volumes since 1982, the largest decline in 80 years. Advanced country imports are projected by the IMF to contract by 3.1 percent in real terms compared to earlier expectations of no change in volumes, and further downward revision is likely. The counterpart to this is the expectation of a virtually unprecedented decline (of close to 1 percent) in exports from emerging and developing economies.

  Protectionism remains a serious threat in the current environment. Many countries are contemplating, or have already implemented, increased protection, which may be difficult to reverse and will slow the recovery. Since the beginning of the financial crisis, roughly 78 trade measures have been proposed or implemented, of which 66 involved trade restrictions. Of these, 47 measures were actually implemented, including by 17 of the G20. In addition, anti-dumping claims and actions increased 20 percent in 2008 relative to 2007; and 55 percent in the second half of 2008 relative to the first half of 2008.

As I mentioned earlier it's all jawboning and posturing. Any claims that the G20 or any other organisation is anti-protectionist is not borne out by their actions. We are seeing the beginning of the race to the bottom with competitive currency devaluation and a rise in protectionism, as we have done every time the world is faced with such a crisis.

Globalisation may well be dead. If it does expire then the worst aspects of the new scenario will come to the fore, sovereign default, widespread poverty and regional wars. I leave you with this quote:

• "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."

  John Kenneth Galbraith, A Short History of Financial Euphoria
  

Welcome to the Weekly Report, this week we look at the UK and US and explain how Quantitative Easing (QE) works in conjunction with Zero Interest Rate Policy. You need to read this article carefully, it is complex.

A quick reminder of the scenario we followed until recently:

• bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation.
  

• Deflation, credit contraction, Conglomerate destruction, nationalisation, mis-placed rejection of sound shares, Bank asset hoarding, historically low base rates, wide spreads to commercial rates, low/no access to credit, sovereign default and bankruptcy, widespread poverty, increase in regional wars, Quantitative Easing in the US/UK, attempted reflations, savings growth, debt repudiation, FX re-pricing, non-governmental intervention from IMF and BIS, co-ordinated protectionism, a new form of capitalism leading to profit sharing through true ownership/part ownership and not based on risk transference...... eventual emergence of new trading and commercial environments.
  

This week the UK followed the US and Japan into the wonderful world of QE. In this realm very, very few economists or mainstream media talking heads understand how QE and ZIRP will enable a recovery of the banking system and the global economy. It's a bit like the dichotomy between quantum physics and classical physics, both have theories that seem to work yet the existence of the two contradict the possibility of each being right.

Let me state right here and now that I do not believe in the success of a Monetarist or Keynesian based interventionist policy to save the global banking and economic systems. Simply put, you cannot prescribe larger doses of the same medicine to treat an illness that has worsened. However, I am not setting the agenda. Therefore I have to accept that my cure will not be tried and it's pointless to try and ram it down people's throats.

Rather my time is better spent looking at what is happening and what the results will be. So rather than describe what I would do, let's look at what I believe started this mess.

In many respects the opportunity to save the banking system was taken many years ago when Glass-Steagall, aka the Banking Act of 1933 was passed which separated securities from deposits. The repealing of the Banking Act and parts of the Bank Holding Company Act 1956 (which separated commercial banking from insurance business) was the removal of that final safety net, all that has happened since has proven why the repeal was the greatest financial mistake the US ever made. Indeed we see that each bailout of a bank involves securing savers deposits and the separation of the speculative, toxic bets/debts and a failed, overburdened insurance model (e.g. AIG).

Who did this? Gramm, Leach and Bliley, that's who, when their Act was enabled in November 1999.

• "GLBA exempts some bank activities that have a "securities" component from regulation by the Securities and Exchange Commission. Examples include: third-party networking arrangements, trust activities, traditional banking transactions such as commercial paper and exempted securities , employee and shareholder benefit plans, sweep accounts, affiliate transactions, private placements, safekeeping and custody services, asset-backed securities, derivatives , and other identified banking products."

• ".......GLBA permits formation of a new category of holding company, the financial holding company, which is allowed to own banks as subsidiaries and also own other subsidiaries that engage in all other financial activities--including those that the financial subsidiaries of banks cannot enter directly." The Repeal of Glass-Steagall and the Advent of Broad Banking James R. Barth, R. Dan Brumbaugh Jr. and James A. Wilcox

For a while the unregulated system (1999-2007) was able to survive by expansion, debt was used to make new positions through leverage, expanding so called assets at a greater pace than liabilities. That stopped when interbank lending stopped. Now to survive current and future losses and to enable an orderly de-leveraging, Banks are hoarding cash to bolster reserves to meet margin requirements until the processes are complete.

In the face of this hoarding the Bank of England (BoE) slashed rates in an attempt to make borrowing as painless as possible for Banks, hoping it would allow the reflation of credit markets. It didn't work, Banks shut down.

Source: IMF

The centre and right hand side of the flow chart have broken down, risk wasn't spread by the use of derivatives in conduits and SIV's/ SPV's. Instead the risk was concentrated upon the Banks and especially the Insurers.

As an aside, for those who wonder why AIG wasn't allowed to fail, you can now see why. With the market value of insured derivatives collapsing, the Insurers (and AIG was the player) have had to pay out to the Banks. Without that pay out, the Banks would have collapsed under the weight of the losses. AIG today is no more that a conduit through which the Fed is infusing cash into the Banks.

Back to QE and the BoE. With the Banks connection (loan proceeds) to the left side of the flow chart erased, traditional lending is severely curtailed, regardless of what level base rates are. However the loan cash flow from Lenders to the Banks continues, draining the availability of cash, reducing the Lenders ability to pass on credit to Borrowers. Without a resolution to the Bank crisis eventually credit stops.

How then does QE help to repair this connection, allowing a 2 way flow to restart?

• BoE news release 5th March 2009:

  "To that end, and noting the recent exchange of letters between the Governor and the Chancellor of the Exchequer concerning the use of the Asset Purchase Facility for monetary policy purposes, the Committee agreed that the Bank should, in the first instance, finance £75 billion of asset purchases by the issuance of central bank reserves . The Committee recognised that it might take up to three months to carry out this programme of purchases. Part of that sum would finance the Bank of England's programme of private sector asset purchases through the Asset Purchase Facility, intended to improve the functioning of corporate credit markets. But in order to meet the Committee's objective of total purchases of £75 billion, the Bank would also buy medium- and long-maturity conventional gilts in the secondary market . It is likely that the majority of the overall purchases by value over the next three months will be of gilts."

• "John Hardy at Saxo Bank points out: "The most interesting aspect of this is the announcement that the BoE will be purchasing government debt, as this represents outright debt monetisation , which can be considered one of the most desperate forms of money printing by a central bank. Not even the US Fed has taken this step yet, though it has declared that it is considering the effects of doing so."
  

There is no increase in the "assets" available within the Banking system, just redistribution. The liabilities remain the same. The Treasury now pays interest to the BoE, the BoE now holds gilts in reserve and the Banks now have cash. The Banks lose the interest payments and if they do not repurchase the gilts from the BoE by maturity then the Treasury pays the face value to the new owner, the BoE.

The Banks will not see an increase in assets, indeed they can only lose if they fail to repurchase the gilts from the BoE in the event that they lose the BoE cash (in an unprofitable enterprise) they swapped them for. If all goes well the BoE will receive back its cash when the Banks repurchase the secondary market gilts and as long as that cash remains with the BoE (effectively retired) then no increase in monetary supply has happened beyond the interest paid by the Treasury.

So if this is just a swapping of assets how does QE work? Well the idea is that Banks will put the cash received from the sale of gilts to work by allowing "loan proceeds" to flow to the Lenders on the left hand side of the flowchart. Corporate bonds and gilts would be included allowing issuance to be reflated, especially as a space on the Banks books will be made by the BoE swapping Bank held corporate debt and gilts for BoE cash, allowing new corporate debt and gilts to be bought by Banks, without increasing liabilities. The Corporations and the government will then receive the cash as their bonds are purchased, enabling them to spend on expansion or investment.

Again the risk has been transferred to the BoE, if the Corporation (I won't say government) defaults on the newly issued debt, the Banks write it off and are unable to repurchase previously held corporate debt now held by the BoE. The cash is lost, the secondary market purchased debt at the BoE is bought by the original debt issuer at maturity, the BoE retires the cash received and no permanent increase in the money supply happens.

If the Corporation succeeds then on maturity the debt is bought back from the Banks, the Banks repurchase the previously held corporate debt from the BoE and as long as the cash is retired the BoE hasn't increased the money supply.

Some of you may now see how QE can re-capitalise banks.

What happens if the secondary market purchased corporate debt or gilts that the BoE purchased from the Banks mature whilst on the balance sheet of the BoE? Well the issuer of the debt pays the face value to the BoE and redeems the bond. The Banks now have less debt to repurchase back from the BoE and therefore can keep the cash swapped for the now matured debt. The BoE have already been repaid, the Corporation/Treasury have reduced their cash balance making the payment to the BoE and the Banks keep the balance. No increase in the money supply has happened; it has just been redistributed from the Corporation/Treasury to the Bank, with the BoE acting as the enabler.

Finally all this swapping of assets requires a minimal nominal value of the gilts and bonds to make them as near to cash as possible. By adopting ZIRP this eliminates the advantage of holding bonds and gilts over cash and makes the proposition of using cash to make a profit attractive. Don't forget though for this to work there has to be a credible expectation of future inflation, without that expectation cash and cash like assets remain valuable as they appreciate in a deflationary environment.

• "The Committee judged that this reduction in Bank Rate would by itself still leave a substantial risk of undershooting the 2% CPI inflation target in the medium term. Accordingly, the Committee also resolved to undertake further monetary actions , with the aim of boosting the supply of money and credit and thus raising the rate of growth of nominal spending to a level consistent with meeting the inflation target in the medium term."
  

Welcome to the Weekly Report. It's a shortened report this week as I have some important work to do on Sunday. Every so often I like to check out charts for various macro-economic indications of the direction of the global economy.

Courtesy BBC

According to the Japanese Ministry of Finance (MoF) the first 10 days of February 2009, compared to the same period in 2008 shows a 47.7% decrease in exports and a 35% decrease in imports. The trend is accelerating.

St Louis FRB. The red line is current, the solid blue the average of the last 6 recessions.

US industrial production is tanking. Note real income remains flat but real sales are down, even though CPI has retraced:

Consumers are saving, the following chart is to December 2008, I expect the rate to continue much higher:

Thailand exports have crashed:

Courtesy Thai Crisis

Here is India's breakdown:

Baltic Dry Index:

Shipping stocks versus BDI:

Courtesy Business Line

Euro area inflation:

Euro area GDP:

Euro area unemployment rate:

Euro area exports:

Euro area imports:

I could go on, the global picture is dire. Although some point to China and its domestic stimulus policy implemented to revive its economy, no one country can stand against a global retrenchment of this size.

Finally this week I leave you with a chart, the S&P500, monthly back to 1987. I have annotated horizontal support and resistance levels and the last modern era trend support line. Will we see an attempt to show support in March? I have added the Nikkei monthly chart from 1988-present as a comparison, note the break of 2003 support.

Welcome to the Weekly Report. I have seen much head-scratching about the methods being employed by the US authorities in the attempt to turn off the road to depression and onto the highway to prosperity. Many have heard President Obama talk of the failure of government spending to turn around both the US '30s and the Japanese '90-current depressionary eras because the actions taken back then were too slow and too small.

My subscribers have to put up with a lot. My website isn't brilliant, it's cheap to run and has little in the way of extras - but it works. I run the website as though it was a business operating according to Austrian Theory, I don't invest borrowed money and expansion will come from savings, from profits. I haven't invested heavily; current market conditions are not conducive to increasing subscriber numbers. The bonus is it's cheap for members; I have small overheads and can leave the subscription rate as it is for as long as I want. Subscribers have to work their way through some pretty complex, long term ideas to understand what I babble on about, my spell checker is erratic and my grammar can be suspect. However what I say now happens in the future and I have been doing this for some time - it works. I know it works because every so often I get an email saying thank you. We don't chat on line, I don't do a running commentary and even worse, I don't tell them what to invest in but - it works, they subscribe because they read my letters and articles and then see the events I describe unfold in the future. In other words they have a credible expectation that I will get the future right, even if they disagree with how I get there.

It's this credible expectation that keeps readers engaged, if I became a contrarian indicator then people wouldn't subscribe.

President Obama and Co need to engender a credible expectation that a deflationary depression can be avoided. This is no easy task and it requires careful planning and almost perfect implementation. I know this because I divined what the plan was and the methods that would be employed and published my thoughts at the beginning of April '08.

Deflation is a funny beast, it doesn't exist just because a Central Bank reduces the amount of currency in circulation, it can happen in other ways too, as we see today. Deflation can be caused by hoarding, by forming a dam in the flow of money. Right now we have 2 dams in place. The first dam belongs to the Banks who are in real trouble and need to horde cash and cash like assets (liquid and low/no yielding bonds deemed safe) to offset current and future losses. The second dam belongs to business who either cannot get credit to expand (good in my view, it's a silly way to expand.) or prefer to save profits and not spend due to current market conditions and future outlook. Both dams have severely restricted the flow of cash to the rest of the economy, resulting in the turmoil we see today.

If you restrict the availability of an asset that has high demand then it becomes intrinsically more valuable, if you can get hold of the asset you keep it, as it should continue to appreciate. The same can happen with cash, if there is less of it available, yet demand increases, then it will be worth more. So even if the production of money increases, as long as demand remains high (because the dams remain in place) then the appreciation will continue. I could include the velocity of money here too but lets keep this simple, we know that if money doesn't circulate then contraction is a given.

Even if the rate of interest is nominally nil on deposits (or yield on bonds) the capital appreciation means it's still profitable to save. This is a major problem for those in debt as the burden, the capital borrowed, increases in real terms even if interest payments fall. The inflationary effect that reduces the worth of the debt in the long term can no longer be counted on to lessen the burden.

So how can a government make it unattractive to save an appreciating asset? It has to change the expectation that the asset is worth keeping, it needs to encourage (all) savers to change their behaviour and conclude it is better to spend than save. To do this the government must be seen as irresponsible but credible.

It is irresponsible to massively increase government debt to buy toxic assets, to bail out broken banks and failed businesses, to make huge tax cuts and bail out defaulting mortgage holders. Why would good money be thrown into a black pit of losses, especially if the money created to do this increases the debt burden and the eventual liability to the tax payers? Even in the face of criticism the government continues to expand its debt obligations through fiscal and monetary policies, happily quoting figures that end in the word trillion, rather than the old fashioned billion.

How on earth does the government expect to pay off this debt in the future? Surely the only way such sums can be paid off is by monetising the debt, lowering the capital burden through the mechanism of deliberate inflation, allowed by low/no Federal Reserve Fund Rates. Did you nod when you read the last sentence? Good, you have a credible expectation that the government will inflate the amount of currency (including bonds) it produces to pay off the increased debt.

By acting irresponsibly, the government actions will make you credibly expect inflation to appear and increase in the future. By you I mean everyone including banks, businesses, consumers and foreign investors.

How does this become entrenched in the psyche of the population? We have seen a close copy of such a policy, or set of policies in action that struggled to succeed because one ingredient was missing. Japan adopted Quantitative Easing (QE) and Zero Interest Rate Policy (ZIRP) to flood the economy with liquidity in an attempt to lower the burden of debt in the Japanese banks. However they refused to create a credible expectation of future inflation. Without that expectation the Japanese hoarded cash and then decided to invest in higher yielding assets in foreign lands. The carry trade was a direct result of the Japanese failure to discourage savings.

The Fed chairman Ben Bernanke has studied both the Japanese Deflation and the US '30's episodes in great depth. Through his own and others work he formulated a plan to combat deflation should it happen in the US. As we can see today both QE and ZIRP have been adopted as the main enabling platforms to allow the massive increase in debt. However in a break from the plan used by the Japanese (and FDR) Ben Bernanke knows he needs to make saving unattractive by ensuring there is a credible inflation expectation.

That's it, that's the plan, the hopes of the world rest on it working. (I should say here that I do not agree with the Fed/US government plan, I think it will fail.)

When everyone decides that saving cash and low/no yield debt is no longer profitable then only one path remains, to spend the cash on assets that have a better rate of return. Ben Bernanke and President Obama are waiting for you to realise this. Ben Bernanke will keep rates artificially low and President Obama will continue to commit funds even when inflation appears and starts to rise, just to make sure everyone gets the message.

Ben Bernanke did something over the past month that put the final touches to the trebuchet that will hurl the buckets of liquidity into the walls of the dams. On 16 January by conference call, he re-opened the discussion about setting an inflation target:

• "Conference Call

  On January 16, 2009, the Committee met by conference call to discuss issues associated with establishing an explicit numerical objective for inflation . The Committee made no decisions on whether to establish such an objective. Most meeting participants expressed the view that an explicit numerical objective for longer-run inflation would be fully consistent with the Federal Reserve's dual mandate of promoting maximum employment and price stability and would not impede fostering the stability of the financial system.......Some indicated that the establishment of a numerical inflation objective could be particularly helpful under present circumstances in forestalling an unwelcome decline in longer-run inflation expectations---and hence in contributing to economic recovery--while also assuring the public that actions taken to counter economic weakness will not lead to high inflation over the longer-run . However, several participants expressed concern that an initiative to clarify the Committee's longer-run inflation objective could be confusing to the public in the current context of economic weakness and financial market strains."
  

In other words, it's going to happen but not right at this moment (back in January). The minutes from the FOMC meeting some 11 days later reveal that the Fed didn't get the expected result from the December release and the adoption of ZIRP:

• "The decisions of the Federal Open Market Committee (FOMC) at its December 15-16 meeting reportedly were more aggressive than investors had been expecting . Market participants reportedly were somewhat surprised both by the size of the reduction in the target federal funds rate, to a range of 0 to 1/4 percent, and by the statements that policy rates would likely remain low for some time and that the FOMC might engage in additional nontraditional policy actions such as the purchase of longer-term Treasury securities. Over the intermeeting period, investors marked down their expectations for the path of the federal funds rate , as measured by money market futures rates."
  

I suspect the reaction referred to above (that would have been known to the Fed by late December / early January) was the initiator for re-opening the discussion about an explicit inflation target. Ben Bernanke was ready to add that extra ingredient missing from the Japanese menu:

• "The deflation bias is closely related, and in some sense, a formalization of, a common objection to Krugman's policy proposal for the BOJ . To battle deflation he suggested that the BOJ should announce an inflation target of 5% for 15 years . Responding to this proposal, Kunio Okina, director of the Institute for Monetary Studies at the BOJ, said in DJN (1999): "Because short-term interest rates are already at zero setting an inflation target of say 2% would not carry much credibility. " Similar objections were raised by economists such as, e.g., Dominiguez (1998), Woodford (1999), and Svensson (2001)" From "An interpretation of The Deflation Bias and Committing to Being Irresponsible" by G B Eggertsson

On the day of the release of the January minutes Ben Bernanke gave a speech that drew attention to the adoption of a long term explicit inflation rate. The detail was not in the minutes but in an addendum, the Summary of Economic Projections:

• "All participants anticipated that unemployment would remain substantially above its longer-run sustainable rate at the end of 2011, even absent further economic shocks; a few indicated that more than five to six years would be needed for the economy to converge to a longer-run path characterized by sustainable rates of output growth and unemployment and by an appropriate rate of inflation ."
  

As can be seen the Fed is placing a credible expectation of inflation into the public arena, rising to 2% and staying at such levels for at least the next 6 years. We can also see that the preferred measure is PCE (Personal Consumption Expenditures) and not core PCE. This explicit target gives the Fed (and US government) 2 new weapons. Until the target is achieved and maintained the QE and ZIRP policies can remain in place, ensuring inflation expectations remain anchored even if (and when) the various Fed liquidity schemes are drawn down. Secondly it allows the Fed to focus on talking about inflation rather than deflationary aspects in their public announcements and encourage a belief that 2% of "gentle" inflation is good (it isn't).

A paper written by GB Eggertsson, adopted as a theory by Ben Bernanke has become the method employed for the greatest monetary experiment the world has ever seen. The result of this experiment will set the scene for the US and the world for the next 50 years. There are already parts of the method that will need to be re-examined as the experiment begins to yield results, especially the implicit level of inflation. More importantly the whole success of the experiment hinges on that most ephemeral of subjects, the expectations of the individual.

There can be no going back now the experiment has begun, this is a one way trip that will either fail or succeed. The Fed/US Government believe success will allow the current financial system to be revitalised, depression avoided and a continuance of a fiat currency, credit based economic system. Failure will result in a severe, prolonged depression that will destroy confidence in any fiat currency system and irreversibly change the balance of power around the globe.

All the constituent parts required to enable recovery are now in place and the battle between Keynesian and Monetarist theory has begun:

• "Can the government lose control over the general price level so that no matter how much money it prints, it's actions have no effect on inflation or output? Economists have debated this question ever since Keynes' General Theory. Keynes answered yes, Friedman and the monetarists said no." (Eggertsson)
  

So far this week I have recapped and updated what I call The Eggertsson Theory. All the components are now in place but as subscribers are about to learn I have discovered a flaw in the plan that will lead to catastrophe.

Central to the approach of the US is that it must be seen that the government will spend whatever it takes and run up deficits with apparent abandon. It is these credible but irresponsible actions that engender the inflationary expectation that the government will monetise the debt. However as with all experiments unexpected actions can cause the result to be changed.

President Obama just unleashed such an action in his Saturday radio/internet address. This was no minor action, it could derail the whole plan. President Obama was talking about the budget, specifically about cutting the deficit by 2/3 over the next 4 years. This looks like a good idea and if times were normal I would agree, I hate debt. However these are not normal times and the Fed has already initiated a recovery plan that requires the people to have little or no expectation that government spending will be reduced. If the people expect spending to be reduced then they will not expect the debt to be monetised and therefore they will not expect inflation in the future. Rather than the public thinking of President Obama as FDR, they may well end up thinking Herbert Hoover.

By Thursday President Obama may well have undone much of the Fed's work:

• "That work begins on Monday, when I will convene a fiscal summit of independent experts and unions, advocacy groups and members of Congress to discuss how we can cut the trillion-dollar deficit that we've inherited. On Tuesday, I will speak to the nation about our urgent national priorities, and on Thursday, I'll release a budget that's sober in its assessments, honest in its accounting, and that lays out in detail my strategy for investing in what we need, cutting what we don't, and restoring fiscal discipline."
  

Many will cheer these ideas, especially those who think it will fight inflation. However, and in this I agree with Eggertsson, you cannot fight deflation by cutting inflation or mechanisms of inflation. Remember this is a game of expectations of the individual. People will look at what's happening now and project the effects into the future. Here is a demonstration:

Real income is holding up (though still down from 14 months ago) because it is calculated using PCE, as price inflation drops, it offsets any loss in actual income worth. So where is that income going if it isn't being spent on shopping or services?

As they always do, the people are saving when they detect hard times and they will continue to save if they fear that income could be reduced in the future. That fear was not allayed by President Obama, this from The New York Times:

• The president will propose to tax the investment income of hedge fund and private equity partners at ordinary income tax rates, which are now as high as 35 percent and could return to 39.6 percent under his plans, instead of at the capital gains rate, which is 15 percent at most.

  Mr. Obama will also call for letting the Bush tax cuts on income, dividends and capital gains lapse after 2010 for individuals who make more than $250,000 a year. But while the top rate for income would rise to 39.6 percent, the top rate for capital gains and dividends would be 20 percent.

This will discourage spending (and business; Hedge Funds and PE did not cause the Banking crisis, Banks did that to themselves) in 2 ways. Faced with increased taxes these affected individuals will save more now to offset the future loss of income. Many however will take their business elsewhere, beyond the increasing tax burden. Whilst the public at large, outside of these groups facing higher taxation, will be told it will not affect them many will view such announcements with a jaundiced eye. Tax increases have a habit of spreading.

President Obama's call for fiscal responsibility and higher taxes was not the only political action that undermined the Fed's plan. Hillary Clinton was in China last week:

• "During their meeting, she said, Mr. Yang told her that Chinese people were spending more on home appliances. "It would also be fair to say that that many Americans have now come to terms with the fact that saving might be a good habit to acquire ," Mrs. Clinton said.

  She thanked Mr. Yang for China's "continuing confidence" in the United States, as the largest foreign buyer of Treasury securities . He offered a noncommittal statement that China would decide where to invest its foreign-exchange reserves on the basis of safety, value and liquidity."(NYT)

To me it's becoming clear that either the President doesn't understand what the Fed are doing or he doesn't agree with it. His messages (along with his Secretary of State) seem correct at face value, saving is good, the US is now reliant on friendly relations with China, cutting debt is sensible and in normal times would and should be applauded. Even in the current environment such moves would be sensible (including staying friendly with China) if a different approach had been taken to instil recovery.

But we don't have the luxury anymore of changing tack, the path is set and we are travelling down it. Everyone involved should be "on message" in a coordinated approach that attains the result required, that people expect saving to become a bad option.

All the steps taken so far by the Fed and the Treasury are aimed at this goal, bailouts, handouts, the schemes, QE, ZIRP, "unlimited" deficit spending to get recovery going and the last piece of the puzzle - setting an explicit inflation target. If the Administration allows doubt to erode the credibility of future inflation through its words and deeds, it will derail the possible recovery and allow a Japanese Deflation scenario to unfold. Without the export potential that kept the Japanese afloat in the '90s-'07 the US would face further contraction.

What happens when the ability to use exports as the driving force of an economy is curtailed? Here is the Bank of Japan monthly report of recent economic and financial developments for February:

• "February 20, 2009

  Bank of Japan

  Japan's economic conditions have deteriorated significantly .

  Exports have decreased substantially. Corporate profits have deteriorated at a faster pace, and business fixed investment has declined substantially. Private consumption has weakened, as the employment and income situation has become increasingly severe. As for housing investment, the number of housing starts has begun decreasing again. Public investment, meanwhile, has been sluggish. Reflecting these developments in demand both at home and abroad, production has decreased at a much faster pace.

  Japan's economic conditions are likely to continue deteriorating for the time being.

  Exports are expected to continue to decrease due to the slowdown in overseas economies and the appreciation of the yen. Domestic private demand is also likely to weaken further as corporate profits and firms' funding conditions deteriorate and the employment and income situation becomes increasingly severe. Public investment, meanwhile, is projected to be sluggish. Reflecting these developments in demand and growing adjustment pressures on inventories, production is expected to continue to decrease.

  On the price front, the three-month rate of decrease in domestic corporate goods prices has been large, mainly due to the drop in international commodity prices. The year-on-year rate of increase in consumer prices (excluding fresh food) has moderated to around 0 percent, mainly reflecting the declines in the prices of petroleum products and the stabilization of food prices.

  Domestic corporate goods prices are likely to continue decreasing for the time being , mainly due to the drop in international commodity prices and the easing of supply-demand conditions for products. The year-on-year rate of increase in consumer prices is expected to become negative, mainly due to the declines in the prices of petroleum products and the stabilization of food prices and also to increasing slackness in supply and demand conditions in the overall economy.

  In money markets, the weighted average of the overnight call rate has been at around 0.1 percent. JGB repo market rates, however, have tended to fluctuate, and interbank rates on term instruments have remained at high levels. Meanwhile, the yen's exchange rate against the U.S. dollar has depreciated and stock prices have fallen compared with last month. Yields on long-term government bonds have been around the same level as last month.

  Financial conditions in Japan have remained tight.

  The overnight call rate has been at an extremely low level , but the stimulative effects from this have become increasingly limited given the significant deterioration in economic activity. It seems that funding costs have declined compared to the levels at around the end of last year, mainly reflecting the reductions in the policy interest rate, although credit spreads on corporate debt have generally remained wide. In response to various policy measures, some firms have increased issuance of CP, and the amount outstanding of bank lending, especially to large firms, has continued to increase rapidly. However, the amount outstanding of CP and corporate bonds issued by firms with low credit ratings has been below the previous year's level, and an increasing number of firms, especially small firms , have reported that their financial positions are weak and lending attitudes of financial institutions are severe. Meanwhile, the year-on-year rate of change in the money stock has been around 2 percent."

This is the result of the Japanese failing to engender inflation expectations back in the early 2000's. Whilst the global economy was expanding the Japanese could supplant weak domestic demand by devaluing the Yen and exporting goods. Now that crutch has been removed, exposing the weakness that was never combated.

The Japanese like to save, regardless of economic outlook but they did not dismiss Krugman's remarks that we looked at earlier. The proposition was studied:

• "In conclusion, Professor Krugman's proposition that stimulating consumption by making the real interest rate decline makes sense in the USA and UK. Statistical evidence, however, shows that is not the case in Japan, because of the reluctance to use consumer credit in general and the likelihood that Japanese households will accumulate safety assets under any circumstances."
  

The Japanese thought the idea would work in the US/UK because of the use of credit by consumers. However we know that credit for US/UK consumers has all but dried up, to spend they need to use income.
Here we get to an essential truth.
Many have derided Ex-US Tsy Sec Paulson's call (He is not alone, amongst others calling for this is President Obama) for the credit system to be repaired and revitalised to allow consumer spending to increase.

Now you can see why these calls are being made. Krugman's idea was central to the paper that Eggertsson wrote and that Ben Bernanke adopted as the blueprint for recovery. Without credit the US consumer begins to resemble the Japanese consumer, especially as the saving bug begins to take hold. If President Obama's administration continues to take actions that encourage consumers to save then the US (and the UK) will enter a Japanese scenario. Unfortunately for the US/UK they will not have the ability to supplant weak domestic demand by increasing exports.

I am now firmly of the opinion that unless credit conditions ease dramatically and almost immediately then the US and UK will enter a catastrophic deflationary depression that will resemble the current Japanese situation, not the early 2000's.

Welcome to the Weekly Report. We have to face facts; the financial system is utterly broken. Worse, we are led by individuals who either do not understand the problem or are intent on restoring the status quo that existed 18 months ago, prior to the Bear Stearns hedge funds collapse. Those that do not understand what the problem is and how to fix it are now beginning to feel the pressure of enquiry; the questions are becoming more searching and are pointing out the contradictions inherent in bailing out conglomerates and banks yet ignoring the public. Those that wish for a return to pre-2007 have to face the increasing anger of those suffering the effects of the credit crash and the financial systemic failure of the developed world.

These individuals do not possess the answer to the problems, they do not have the wit or foresight to see what is required. The automatic State protection given to any firm considered "too big to fail" is not the answer, instead it is compounding the effects and will lead to a deeper, longer and more viscous depression than most can imagine.

Is it too late to fix the system? Yes, it is but it is the wrong question, the system does not require fixing, it requires replacing.

We have seen numerous attempts to fix an inherently broken banking system, the fixes are applied by the State, usually by giving money to the banks so that they can increase the capital reserves, allowing losing positions to be held until the power of inflation allows the debt to be written off or sold without damaging reserves. However, every so often the crisis becomes so great that the bail out requires the permanent transfer of wealth from the public without any compensation. This has the inevitable consequence that consumption contracts ensuring there is excess capacity which has to be removed before expansion or investment becomes a profitable enterprise.

This cyclical rise and fall of banking causes an inherent instability in long term investment, making short term gains more attractive. This short term view leads to crowded markets, chasing rising trends, fuelled by cheap credit allowed by excess liquidity. The eventual outcome is the always the same with a final parabolic surge into a peak that then turns into a crash.

So how do we change the system?

Firstly we need to separate banks and financial institutions from the politicians. Lobbying must stop, government positions must not be filled by bankers or ex-bankers. Ex-politicians (and high ranking government officials) must be barred from taking board positions with banks and FI's, there is plenty of other work out there.

Secondly we set up a system that allows all bad debt to be ring fenced and held so that any returns contribute to the national finances. In return taxes are cut in proportion to the return made on the ring fenced debt.

To ensure that new debt issued by banks is recoverable, banks will have to hold higher capital ratios to debt (in this case bank debt is the deposits of savers), some of which must be gold, leverage is banned. Banks will require long term deposits to enable lending. The expiry date of the lending must match the maturity date of the deposits. The more perceived strength in the banks balance sheet, the higher the attraction rate for depositors. The debt cannot be issued unsecured, it must be tied to an asset that has intrinsic, tangible worth. The borrower can only borrow 50% of the required amount needed for an investment. In the event of default, the depositor has first call, the bank has to take the hit. The ability of banks to create money through leverage and lending is stopped. If a bank cannot attract deposits, then it cannot lend. The amount of depositor's savings, the result of profit, will dictate the availability of credit.

This encourages the use of savings and profit for expansion and investment outside the banking system. Companies following such an approach will automatically examine the risk of such investment with much tighter criteria, reducing mal-investment. In other words expansion will be a function of greater demand, rather than an attempt to increase returns through scaling up.

Banks must be re-directed away from speculation and toward risk management. If a company is encouraged to use its own savings for expansion to reduce risk, then banks will have to follow the same route. Banks as they exist now must be destroyed.

That means banks cannot be run by people who have no personal risk to their own capital if the banking model fails. Currently the risk is transferred to share and bond holders who cannot control the day to day business. If you are running a business without personal risk then decisions that could ruin the company are easily made. Worse, if you pay large bonuses in return for short term "profits" then risk is ignored in the chase for personal wealth.

Therefore any bank that cannot function without bailout money should be placed into protected bankruptcy. The government should take the debt and the functioning parts of the bank, such as deposits, should be sold to the highest bidder. However the bidder must not be another bank. Only individuals, or groups of individuals, who use personal capital can buy the assets. This would then ensure that the new owners are risk adverse, if the model fails then the owners are wiped out. Banks will not be allowed to become public companies. If you want to be a banker, you must risk personal capital and create your own bank.

Of course this new banking system will be initially deflationary, the reduction in credit would see to that. However in the medium term expansion would be a function of savings, controlled by tight risk management. This reduces the ability for banks (but not individuals, you can spend your savings any way you wish) to speculate. Banks would have to use their own capital to speculate, reducing the ability to lend because they could not accept further deposits from savers. Such a bank would become unattractive and therefore depositors would avoid it, placing their savings elsewhere. Speculation by a bank would effectively lead to contraction, reducing profits and viability and thus would make speculation an unattractive proposition.

The fallout from such a change would be great and lead to the loss of some inefficient businesses that rely on credit to function. The social cost would also be great. Many have bought property at high prices and would be caught within a negative equity trap as prices are reduced to meet buyer's ability to spend. Current property owners would also be saddled with servicing a large debt with a restricted or shrinking income. Without support, these mortgage holders will fail, either through an inability to service the debt or because they simply walk away.

Therefore the State should do what it is meant to do, protect the public. Funds currently earmarked to bailout failed and bankrupt banks should be re-directed and those in negative equity should be offered a deal that allows the government to take a part ownership in the property, in exchange for a reduction in the mortgage. That part ownership would entitle the state to part of the future profit, or a rental payment from the mortgage holder, depending on the income stream of the debt holder. This would be a transitional system, designed to help current mortgage holders. It should be made clear to potential future mortgage holders that they will have to save before they can enter the market. Mortgages will be restricted to 50% of the independently valued worth of the property.

After reading this far, you can see why I do not believe we can fix the system. The hazards to the public with or without adopting a new type of banking and financial probity are large and real, pain is already being felt and will continue to intensify. Therefore we should move forward, use the pain to allow the creation of a new way to prosper. We need a system that rewards long term saving and investment and discourages risk taking, not through regulation but through the forces of capitalism that destroys bad business models.

However, before such radical moves are even considered we have to get some sort or reality into our Central Banks. This past week the Bank of England produced its Inflation Report, which includes projections for future growth, output etc. Remember we discussed about the overly optimistic Bank of Japan projections back in the early '00's? Have a look at this:

• INFLATION REPORT PRESS CONFERENCE

  Wednesday 11 February 2009

  Opening Remarks by the Governor

  "The UK economy is in a deep recession. Monetary, fiscal and financial policy have all responded vigorously to that prospect. But the length and depth of the recession will depend to a significant extent on developments in the rest of the world, where a severe economic downturn has taken hold. Growth in the advanced and emerging market economies fell sharply towards the end of last year. And world trade is contracting rapidly.

  As in the UK, the scale and synchronised nature of the downturn around the world has been driven by two factors - a further tightening of credit conditions following failures in the international banking system, which means that lending, especially to companies, is still slowing, and a collapse of confidence, or "animal spirits" in Keynes' description, that is leading to falls in spending and production. Restoring both lending and confidence will not be easy and will take time."

Read it carefully, the central, darkest line has a 1:10 chance of occurring, exactly the same odds of GDP hitting a number outside of the fan projection. It's next to useless. It's a nice chart for politicians to use, showing that the bottom is in. The Bank of England is projecting an 8% move higher in GDP from right now over the next 2 years. I cannot find, in history, reliable stats that say the UK has ever grown at that pace.

The same method is used for CPI (Consumer Price Inflation), bear with me there is a pattern to show you:

Someone please explain to me how you can have an 8% swing in GDP with such CPI? Remember CPI is a function of increasing GDP, higher consumption leads to higher demand leads to higher prices. Is there a possibility of higher consumption occurring in the near (like now!) future?

Any liquidity produced by the BofE schemes is going straight into the coffers of the Banks, it is not going into the economy. This lack of credit is having a serious knock on effect:

Just when households should be saving and depositing those savings at Banks, we see the opposite happening. In other words Households are spending more of their capital to stay afloat. If we are lucky that spending is to reduce debt, paying off credit cards and the like. I somehow doubt it. Notice this is a chart showing the 3 month % change, not the absolute amount. Household deposits are shrinking from a 10% growth down to 1%, the PNFC savings rate is below zero but the contraction is slowing. I see no spare capacity to increase spending.

Is there any sign that lending might increase?

In a word, no. Any lending to the corporate sector is most certainly not for expansion (back to GDP again):

This is survivalist lending, no capital investment, no buying of property and no mergers. The only ray of hope is that balance sheet restructuring means that Corporates are swapping debt obligations and locking in lower interest rates. More worryingly is the increase in requirement to fund inventory by increased borrowing, if sales don't pick up this will be a double whammy.

Is there any sign of an increase in demand?

Ugly, ugly chart.

Finally we finish with a chart that shows what non BofE forecasters think of GDP growth, the blue forecast was from November 2008, showing what was expected in Q4 '09, the orange is the February 2009 forecast for Q1 '10:

A major shift in expectations to the downside with 60% of forecasts showing a continued decrease in GDP a year out from here.

The Bank of England appears to be bending to political pressure to try and show an overly optimistic outlook in its headline charts. Dig a little deeper and the picture is very different. The problem of course is that the policies of the UK Government will be dictated by the overly optimistic presentation, there will be no admitting to deterioration until after the event. By then it will be too late, post event reaction has not worked so far and will not work in the future and such policies will further entrench a bunker mentality amongst consumers and business. In all our discussions about Quantitative Easing, we have recognised that for it to work there has to be a credible expectation of future inflation, the policy footing of the UK government and the BofE, based on twisted statistics will not achieve this aim. QE may well have already failed.

This week's article is shorter than normal. As some of you know, I am involved in trying to help better the fortunes of a Council in the UK and I have had to spend most of the weekend working. As the jobs of workers are involved, I'm sure you will understand.

Davos.

This past week the focus of the political/economic world centred on the Swiss ski resort of Davos, where various commentators, business leaders and politicians attempted to try and find a way forward to combat the Global Financial Crisis (GFC). Of course many who would traditionally travel to the resort didn't make the trip this year, maybe the lack of private jets dissuaded them.

Let's see what some of the guest speakers had to say, it will give us an idea of what may be heading our way in the future.

Vladimir Putin:

• "Unfortunately, excessive expectations were not only typical of the business community. They set the pace for rapidly growing personal consumption standards, primarily in the industrial world. We must openly admit that such growth was not backed by a real potential. This amounted to unearned wealth, a loan that will have to be repaid by future generations.

  This pyramid of expectations would have collapsed sooner or later. In fact, this is happening right before our eyes."

• "Although additional protectionism will prove inevitable during the crisis, all of us must display a sense of proportion. Excessive intervention in economic activity and blind faith in the state's omnipotence is another possible mistake. True, the state's increased role in times of crisis is a natural reaction to market setbacks. Instead of streamlining market mechanisms, some are tempted to expand state economic intervention to the greatest possible extent. The concentration of surplus assets in the hands of the state is a negative aspect of anti-crisis measures in virtually every nation. In the 20th century, the Soviet Union made the state's role absolute. In the long run, this made the Soviet economy totally uncompetitive. This lesson cost us dearly. I am sure nobody wants to see it repeated."
  

• "anti-crisis measures should not escalate into financial populism and a refusal to implement responsible macroeconomic policies. The unjustified swelling of the budgetary deficit and the accumulation of public debts are just as destructive as adventurous stock-jobbing."
  

Gordon Brown.

Brown is beginning to realise he is in over his head. Therefore he is doing what everyone does when they cannot think creatively about a problem, he blames the lack of a historical comparison to draw inspiration from:

• "This is the first financial crisis of the global age. And there is no clear map that has been set out from past experience to deal with it."
  "I'm reminded of the story of Titian, who's the great painter, who reached the age of 90, finished the last of his nearly 100 brilliant paintings......'I'm finally beginning to learn how to paint', and that is where we are."

  "We're learning all the time about how to deal with what are real problems for which we have no historical analogies to fall back on, because when the 1930s problems hit them, they did not have the global financial markets that we have today."

Instead Brown meanders along, trying to keep his "prudence" moniker intact yet failing to demonstrate any innovation in thought or process. Now he attempts to pin his legacy upon saving the global economy and stating that protectionism cannot be allowed to take hold. Unfortunately for Brown, protectionism has reared its head amongst domestic UK voters. Unofficial, wild cat strikes are happening throughout the country in response to the use of EU workers by a contractor at an oil refinery. Brown is now trying to extricate himself from a phrase he used last year: "British jobs for British workers". It has become the rallying call for those protesting, causing Brown to have to explain that he is being "misunderstood". I am extremely worried about the medium term prospects for the UK economy. I can't even bring myself to comment on Brown's call for a return to the "Dunkirk spirit"; I can smell the desperation in these words:

• "While admitting that Britain is "in the eye of the storm", the Prime Minister said in an interview with The Daily Telegraph that the country will see off the worst of the slowdown if the public can harness the "British spirit" and remain resolute and upbeat."

Finally.

A number of charts that may interest you, showing support and resistance on a weekly timescale:

Russia (RTSI):

FTSE:

Gold:

DOW:

Have a good week.

Welcome to the Weekly Report.

Are the markets in chaos or is there a flow of money that can be followed? Let's have a look at some currencies and indeces to see if there is a pattern. We have 6 charts to look at using each comparison as a baseline. That way we can see if there is a connection. I have gone back to July 2007 to cover the different de-leveraging events that began as Bear Stearns folded 2 hedge funds. Here are the components I have included: Dow, Nikkei, Dollar, Euro, Sterling and Yen.

The following charts are courtesy of StockCharts.com:

Dow as Baseline:

Only the Nikkei has underperformed the Dow, even Sterling has managed to keep ahead relative to the Dow 30.

Dollar as baseline:

It is interesting that the same reaction happened in August 2008 as that which happened in July/August 2007, albeit on a smaller scale in 2007. The pattern though is the same, only the Yen outperformed; everything else took a drop relative to the Dollar.

Did the actions of the Fed back in 2007 do anything other than extend the timeline of the de-leveraging? Readers of the Weekly Report and the Occasional Letter may remember that was the hypothesis put forward back in '07 and that the final result would not be changed, just delayed. The danger of allowing a delay to the resolution, the purging of bad debt and inefficiency, has resulted in a change in the confidence of market participants. We swapped a 1987 scenario for a 1929/32 scenario.

Sterling as baseline:

Sterling shows the effect of de-leveraging and is being viewed with a very high risk component. The markets have voted and decided that Sterling is barely better than holding US stocks. I cannot see how the UK is able to expand its debt without suffering further Sterling devaluation. This has the makings of a financial disaster and despite what the UK government and the pre-briefed mainstream media might say, Jim Rogers is absolutely right.

The UK government has 2 choices. If it attempts to sell debt (Gilts.....or maybe they will become known as Tarnished) at a low interest rate I suspect it will see multiple auction failures. Therefore it will have to raise rates to make the debt more attractive. Remember there is a shortage of global capital, if the UK wishes to attract inward investment it will have to be prepared to buy at the sellers price.

The second option is not to increase UK debt. Can a recovery be enabled without increasing UK debt? We shall discuss this in the near future.

Euro as baseline:

Again we see the repeat of the '07 action in '08 with the increase in scale. Whilst the Eurozone has some deep economic problems which may well result in the fracturing of the membership it has yet to enter the fray in the way Sterling has. However political pressure is being exerted upon the ECB to loosen monetary policy and allow the same solutions to be applied as those in the US. However as a recent auction failure for German Bunds showed, the ability to attract capital is now dependant upon the returns offered. The ECB are probably quite nervous at the moment with more than a few glances at the UK situation.

Nikkei as baseline:

Quite simply, the Japanese are going to cash or cash like assets. The Nikkei should be ringing a bell as it wanders alone through the global marketplace. It would not surprise me to see Japan formally re-adopting QE and ZIRP in the very near future. I am not leading the way with this call but I do agree with the sentiments of this article at Bloomberg by William Pesek. For Japanese savers to invest overseas they will require the lure of an attractive and safe return, a set of circumstances that are lacking anywhere you look. With a y-o-y to December drop of 35% in exports and with China, Europe and the US slowing further, I expect to see some famous Japanese exporters go under.

Yen as baseline:

Here is the final chart reinforcing the message about the flight to cash and cash like assets by Yen holders. Yes, the Nikkei has underperformed its own currency by 95%.

The Yen carry trade underwrote the ability to leverage, it supplied the raw materials that allowed Investment Houses, Banks, Hedge Funds and Private Venture to take advantage of the de-regulation and lax standards of enforcement engineered by governments around the world. It should come as no surprise that a reversal of the carry trade has caused an intensification of leveraged losses and the destruction of capital.

We cannot expect a return to pre 2008 market conditions where credit was widely available. The destruction of the various loan derivative tools, such as CDO's MBS etc (was it only 2 years ago when people used to ask me what these initials stood for?) means that the mechanism that allowed banks to revolve debt from borrowers to buyers has broken down. Now lending can only be enabled when secured against their reserves. If a Bank takes on a commitment to lend it is stuck with that commitment, it cannot lay it off by selling the commitment to other parties.

So in an effort to allow credit to flow (which, we should note, is the worldwide justification for bailing out Banks et al, regardless that it was the expansion of credit beyond the ability of capital reserves to cover losses that caused the current crisis.) governments have stepped in to fill the void. This approach does not sort out the problem; it just replaces the losses caused by the value of debt falling. It does not remove debt from the system.

One way or another, be it by massive centralised nationalisation of debt or by market forces, debt will have to be re-priced until it achieves a level acceptable to buyers. Governments, especially their Central Banks, know this but cannot express such views without causing massive political backlash. Instead they talk about re-capitalising Banks and supporting (allowing bad debt to continue to exist) the financial system.

Taking "toxic" debt into a government shelter merely moves the risk from the financial system to the taxpayer unless it is written off. The debt will continue to underperform or fail but the taxpayer is on the hook for the losses through higher taxation. Would the removal of the debt from the financial system have a beneficial effect for taxpayers by enabling credit?

In the current environment the call for tougher regulation and a safer financial system is foremost in all politicians' utterances. Indeed politicians now feel safe enough to become "angry" with Banks and (ex) board members, moving the blame squarely onto how they conducted business. This deflects attention from the responsibility government has to ensure that regulation is sufficient to stop excess risk taking.

Governments will find little or no opposition to passing new laws to regulate and restrict Bank activity and the speculative use of funds. However these restrictions will ensure that lending will also be restricted; the innovative financial instruments have had their day and will not return soon. That will curtail the ability to lend, reducing the amount of credit available to the public and business (tax payers). Nationalisation of debt will not be sufficient to remove the burden of underperforming debt, it merely shifts the losses from Banks to the public.

For governments there are only 2 options, either write off the debt as a complete loss and try to recover what they can, using a ring-fenced long term Investment Vehicle or reduce the liability of the debt. How can the liability be reduced? By buying part of the debt exposure, supporting the price of the underlying asset the debt is related to. This should be done instead of replacing the capital of banks.

Banks have no right to survive, if they have a bad business model they should collapse. Governments have already let it be known that liabilities will be underwritten but the bond and shareholders should be wiped out along with the business. The government does not increase its current liability, in these times that is already implicit. The funds used to re-capitalise banks and businesses that cannot function without credit (i.e. a failed business model) should instead be used to reduce the debt liability, effectively buying part of or the entire asset the debt is secured on.

Would this be a bailout of the taxpayer? In some ways yes but the taxpayer holding a mortgage would have to swap some of the asset for a reduction in the debt owed. The asset would be owned by the government, the tax payer could have an option to buy it back at a later date or the government would receive a share of the profits equal to the percentage of the part ownership. With such a deal the government stabilises the market, not the derivative. This would then allow derivatives to find equilibrium.

What about unsecured debt? Tough, if banks lent out money that was not secured on assets then they will have to try and recover what they can. That is the downside that cannot be avoided.

This is no short term fix and it will change the way economic life will continue. However it would allow a change and remove the nexus that has caused this and prior "busts". It is time to recognise that the current financial system does not work. Expansion using credit is not sustainable in the long term, we have seen example after example of the results of such attempts. The enabling of credit can only occur if government regulation allows it and Banks etc are willing to extend it to borrowers.

Credit should be purged from the system; its only function is to allow Banks to profit on the future earnings of borrowers. If a Company has a successful business model and wishes to expand it should use its profits to enable such expansion. If profits are not large enough to allow expansion then the results of the business model are sending the Company a message. Why should a car manufacturer be allowed to continually borrow to roll over debt to support a business that does not make a profit? The business should fail and allow new competitors to try and fill the void.

Similarly if a consumer wishes to buy a house then it should be done from the profits (savings) that they achieve. No one has a right to own a house and ownership should mean just that, ownership. Your first thought is how can I save $200k or $400k needed to buy the house I want?

You only need such sums because the financial system allows such inflated prices to exist. We can see the effects already when the ability to buy houses at such prices is restricted or stopped. The asset price falls. That price will continue to fall until buyers consider the purchase of the asset to be beneficial. Wages too will fall, rebalancing the difference in the worth of the asset and the cost of labour. If you cannot save enough to buy a house, then you don't do it.

The current attempts to allow credit to continue to drive expansion are not a cure, just a delaying tactic to put off the inevitable day when the re-pricing of assets must occur to match the level of real capital reserves. To do this by allowing the markets to operate without fetter would succeed but the social cost would be truly enormous.

There has to be a control on the deflation of prices to offset the social cost. That should be the role of government. The time of greed, chasing profit through leverage and credit is over and government needs to act as the taxpayer's guarantor. This will take a generation to work through and although we wish it had happened to another generation, the responsibility rests with us.

Bailing out failed Banks and Businesses will not change anything; we will just incur a higher debt burden in the hope that we can delay the inevitable. If a taxpayer (consumer) cannot afford the mortgage then we should allow partial or whole nationalisation of that debt, not the losses in the derivative based on the debt. The occupier can pay a lower level of "rent" allowing them to remain a useful contributor to the economy. Taxes should be cut but the payment for services supplied by the government should be increased and competition for those services should be opened up.

Many may think such an approach smacks of socialism and is unrealistic. However the alternative, allowing all markets to re-price without interference, would eventually yield the same result but via a different path. The human cost of using the alternative is too great and would place real risks of a failure of the fabric of society.

Government exists to help the people. Whilst the public have become resigned to watching government ignore the needs of people the need itself has not been removed. Government must listen to the voice of the voters, not those who use influence through position or wealth. Right now the government should be looking at how to reduce the burden borne by the public, not business. The cost would not be much different, except for the Banks, of course.

Welcome to the Weekly Report. Here are some economic indicators that need to be watched:

World trade

The movement of goods and money is sending a message out that cannot be ignored. With both imports and exports to/from China dropping, along with exports from Japan and Germany falling by double digit percentage points month on month it is no wonder that the cost of moving containers from Asia to Europe has fallen to near zero.

Nobody can expect an uplift in the world economy unless the trade of goods, especially finished industrial goods reverses from the current contraction. This from liveMINT.com (WSJ) shows the problems faced by shipping in India:

• "On Wednesday, the index climbed 9 points to 920 points from 911 points on Tuesday.

  The index, which measures costs for shipping dry bulk commodities such as coal, iron ore, steel and grains, had plunged to 663 points in December from a record level on 20 May, pushed down by a credit squeeze and waning demand for global trade.

  Frozen credit lines have paralyzed the shipping trade since mid-September, drastically reducing shipments and, in turn, the use of dry bulk carriers.

  A lack of access to letters of credit, in which banks guarantee payment for merchandise, added to the problem.

  As for the recent rally in the BDI, experts are hesitant to read it as an indicator that the market has turned. "It is not a sustained rally as of now," said T.V. Shanbhag, group adviser to India's biggest ship-broking firm, Mumbai-based Trans Ocean Agency Pvt. Ltd. "It is momentary. The problems with letters of credit persist."

  He added that given the extent of the fall over the past few months, a minor improvement of even 5% or 10% will not make a difference."

We can see that the contraction of credit is dealing a double blow, constraining consumer purchasing and business investment and at the same time causing the trade of goods to be curtailed. Since the article referred to above was published the BDI has dropped back to 881.

Credit card / Mortgage default rates

Here is the US credit card default map from the Fed, showing the data up to mid 2008. The map is showing the change of conditions over the previous 4 quarters. Red is an increase in defaults, green a decrease:

Here is the same map for mortgages that are 90+ days into delinquency:

Whilst the Fed has yet to update the maps to reflect the 3rd quarter, the providers of the statistics, Transunion LLC have published the information:

Credit Standards

Conditions conducive to expansion means that credit tightening needs fall below zero. These are the important tables from the Feds Senior Loan Officer Survey, October edition. It is due again this month:

Industrial Production and Capacity Utilisation

There is too much excess capacity in the economy. Will the fiscal stimulus cause an increase in production and a higher utilisation of capacity? This is central to the recovery of the US. The gap between production and capacity has to close but how this happens will dictate the economic landscape.

If capacity is lost so that it aligns with production levels then we will see an increase in unemployment and the destruction of businesses that cannot compete in an environment that demands tight margins.

The hope of the US government is that the infusion of cash into the financial system encourages lending. This would allow (mal) investment that expands production which is used to meet the demand created by the government "make work" schemes.

The second approach seems to be "friendlier" to the workforce and the economy. However it does not allow the proper cleansing of debt and inefficiency from the system, it perpetuates the problem. If the recovery is enabled by the increase of government debt it poses 2 problems. Who will buy the ever increasing amount of debt required to infuse the system and what happens if/when those buyers walk away?

Ahhhh, I'm Sorry Ben, its not Quantitative Easing

Ben Bernanke was in the UK this week (no, he didn't give me a call) speaking at the London School of Economics. As is usual with his speeches of late he spent most of his time re-capping what caused the problems in the financial system and how those problems spilled over into the general global economy.
However later in the speech Ben did something rather strange:

• "Credit Easing versus Quantitative Easing

  The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach--which could be described as "credit easing"--resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet.

  However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental. Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes. In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing.

  To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally."

Ben goes on to explain why QE US style should be referred to Credit Easing (CE):

• "Because various types of lending have heterogeneous effects, the stance of Fed policy in the current regime--in contrast to a QE regime--is not easily summarized by a single number, such as the quantity of excess reserves or the size of the monetary base. In addition, the usage of Federal Reserve credit is determined in large part by borrower needs and thus will tend to increase when market conditions worsen and decline when market conditions improve. Setting a target for the size of the Federal Reserve's balance sheet, as in a QE regime, could thus have the perverse effect of forcing the Fed to tighten the terms and availability of its lending at times when market conditions were worsening, and vice versa."

This is a deliberate attempt to blur the boundaries, treating QE as if it was an accepted and successful approach to re-inflating an economy. He is not so much worried about any perverse effects of target setting but more about having to set a limit to the Feds ability to continually expand, without restraint. These are extraordinary times in which we have seen a plethora of "targets" either changed or dismissed.

It is another attempt to overcome the fear that is endemic within the banking sector. Ben knows that unless banks lend out the money that the Fed is willing to give them then the recovery will not happen. By implicitly denying a limit to Fed lending (we are at the last resort) then he is hoping that banks loosen standards and increase borrowing, in the knowledge that if the lending to customers go awry banks can always rely on new credit lines from the Fed.

However, Ben has also made a huge mistake in this speech. He has spelled out the conditions that would cause the Fed to withdraw the monetary stimulus. This blunder flies directly in the face of raising the expectations of a continued, credible attempt to ignite inflation. Those expectations will only be raised if it is seen that the Fed intends to go "too far" and allow the inflationary policy to continue well after the signs of recovery and inflation levels hit expected targets.

• "Exit Strategy

  Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed's lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed's balance sheet has expanded. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate.

  However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize. In addition, some programs--those authorized under the Federal Reserve's so-called 13(3) authority, which requires a finding that conditions in financial markets are "unusual and exigent"--will by law have to be eliminated once credit market conditions substantially normalize. However, as the unwinding of the Fed's various programs effectively constitutes a tightening of policy , the principal factor determining the timing and pace of that process will be the Committee's assessment of the condition of credit markets and the prospects for the economy.

  As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline, implying a reduction in excess reserves and the monetary base . A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds--including loans to financial institutions, currency swaps, and purchases of commercial paper--are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate."
  

If the economy at large is led to expect that any stimulus will be withdrawn at the first signs of recovery or normalisation of credit markets then the actions of banks, business and the public will reflect this. Those actions will not be based on an inflationary basis, any communication from the Fed trying to imply such an environment would be undone by its own actions. Banks will continue to hoard reserves, business will not invest and consumers will save, not spend.

Whether you call the current policy QE or CE doesn't matter. If the Fed does not commit to a credible policy of future inflation then the current policy will fail. It doesn't matter if you have or do not have a target for the Fed balance sheet if the future expectation is one of tightening and a reduction in the monetary base.

I am surprised that Ben Bernanke has not realised the mistake he has made. It was the implementation of similar measures he discusses above that caused the deep recession in 1937. Only when those policies were reversed (by the politicians applying massive pressure to the Fed) did the consensus return to an expectation of future inflation, causing spending and investment plans to be changed accordingly.

Whilst I am not a Keynesian or Friedman follower, I have studied their methodology because it is those approaches that are being used to form policy. It is pointless trying to use the Austrian School of thought to try and divine what Ben and the Fed are thinking. However it is apparent that the correct processes required to purge bad debt, mal-investment and excess capacity are not going to have a place in the portfolio of solutions put forward to overcome the current environment. As long as this situation exists we will continue to suffer the ups and downs of a flawed economic system.

Welcome to the Weekly Report. I have been reading the mainstream media of late to get a feel for the level of understanding writers (and therefore the vast majority of their readers) have for the new economic situation that faces the global economy.

I have to report that the situation is not good, many writers are behind the drag curve, talk only of the present and fail to understand what the US and UK Governments and Central banks are trying to achieve. Most writers believe the UK is going to follow the US in its policies and actions. I have disturbing evidence that such assumptions may well be mis-placed, evidence that shall present later in this article.

Most of my subscribers and those that read the "free" content (it's not really free to produce, it takes time and resources to write and the free content is used as a form of advertising) probably do not read as much of the mainstream financial media as do those others who have not discovered the financial blogging and website part of the internet. I was "created" via the internet and continue to occupy a small part of the web, my readership comes from such an environment where not only do they read my macro-economic thoughts but also those of other bloggers and writers who follow a similar existence as I do. We are ignored by a huge part of the public, not because we are irrelevant but because they do not know we exist. So this weeks article is aimed at those who rely on the mainstream financial media or government spokespersons for their information.

It would surprise the global public if they knew just how long I and others had been predicting, with evidence, that not only would there be a credit crash but that the global governmental response would follow what we see today. Many of us throw our collective eyes to the ceiling when we read the uttering's of the mainstream media and politicians, saying that the "crisis could not have been foreseen". It was foreseen by more than a few individuals but we were ignored, treated as a small freak show because we disagreed with those saying the goldilocks era would last forever. To give you some idea of the timescales involved I have been laying out the steps that would lead to our current position for over 5 years, other writers/bloggers have been warning for even longer.

It is not in the interest of the Investment Banks (RIP), Stockbrokers, Banks, Hedge funds, Governments etc to allow warnings about the consequences of the expansion of various bubbles to become widespread public knowledge. With such knowledge the public would drastically change the way it invests, saves and spends. It would go against the requirement that a fiat (banknotes backed by confidence) monetary regime requires constant expansion of money supply (at around 2% to be optimal) to allow a credit driven expansion of an economy. Money supply is expanded, given to Banks who lend it out or use it to leverage (create) larger pools of money to be lent out, in the form of credit, to those who think they can gain a return on this borrowed money that will be greater than the cost of borrowing it. Many businesses (and eventually the public too) became reliant on rolling credit, expanding the amount borrowed to repay old debt and use the extra debt to fund purchases for expansion. With a 2% expansion guaranteed by the increase in money, the increase in prices charged would expand the profit (be it gains in house prices or higher prices for services and goods) and allow for an increase in higher levels of borrowing.

However when that ability to increase the amount of credit is curtailed, when Banks decide that it is too risky or their own precarious balance sheets need repairing, the game of rolling old debt for new is over.

We are living this right now; you and I are going to be part of history, a period of time that will be labelled, akin to the '30's and the Great Depression. I don't want to scare or depress you but readers must realise that the current financial climate is unlike anything any currently living person has seen.

So back to this weeks topic of how the mainstream media are forming the discussion about the financial crisis. Nearly all economists and financial writers look at the problems of today from a Keynesian or Monetarist viewpoint. If you are unsure of what these schools of thought are click on the links. These methods are being used to shape your life, it is in your interests to understand what the thinking is behind the Government current actions.

I have decided to look at Anatole Kaletsky, who writes for the Times newspaper in the UK. Last week he published an article entitled "Punish savers and make them spend money" which I urge you to read as it will be central to the counter points and explanations I intend to lay before you. Let me state that I do not intend to "de-construct" Mr Kaletsky, rather I want to show that those writing from a conventional economic stance, taught in Universities and based on Keynes are at a major disadvantage and struggle to understand the dichotomy presented to them. We should also keep in mind that Central Bankers and politicians invariably come from the same school of thought, regardless of their political beliefs.

In Mr Kaletsky's article he begins with:

• "The question, of course, is what to do about the recession. Specifically whether the way out is "to spend, spend, spend or to save, save, save" - as David Cameron has so clearly put it.

  I believe, in line with the vast majority of non-socialist economists, that Mr Cameron's campaign for savings is completely wrong; that "borrowing our way out of debt", paradoxical as it sounds, is exactly the right prescription for our present problems"

He believes that if new debtors replace those that are no longer capable of borrowing then the financial system will be stabilised. However he then dismisses what he believes would work (although he doesn't recognise that indeed the idea is fatally flawed, whom do the new debtors borrow from?) as he makes a statement that is central to what is to come for us all:

• "But what I think is of little importance.......Only two opinions matter: on one side, that of the Obama Administration and the Brown Government; on the other, US and British consumers."

Japan used a Zero Interest Rate Policy (ZIRP) combined with Quantitative Easing (QE) to attempt to reflate their economy. To some extent it worked but it left a fragile financial framework in place that has weakened considerably in the current crisis. Follow the links to read about both of these phenomena, again you need to know if you wish to make the right choices and understand what will happen in the future.

Ben Bernanke, the Chairman of the Federal Reserve has studied both the '30's and the Japanese deflationary periods in depth. Fortunately he published papers and books on the subject along with other like minded economists, including GB Eggertsson. Eggertsson looked at the Keynesian and Monetarist approach to deflation and attempted to show that the Monetarists are right when they say monetary and fiscal policy can be combined to engender credible future inflationary expectations in the minds of the public and business owners. It was these expectations that the Japanese failed to ignite, thus the public and business continued to act as though the appreciation of money and falling prices would continue. This caused spending to be delayed as buyers waited for even lower prices in the future.

Eggertsson believes inflationary expectations could be achieved by ensuring that the increase in money would be combined with a policy that kept interest rates across the whole spectrum of government bonds, not just Central Bank base rates, at an artificially low level which in normal economic conditions would be an extremely inflationary policy to follow. Couple this with fiscal stimulus, such as tax rebates and increasing public (and therefore Government) debt to spend on large scale infrastructure or other "back to work" schemes it is hoped that this would encourage investment and spending to happen in the present to avoid higher costs in the future. The irresponsible but credible inflationary path taken by the Government would raise future inflation expectations because it would be expected that the Government would eventually monetize the increased debt.

This is a huge and untested application of a theory in Monetary Policy that is already struggling to have an effect. What the theory hasn't allowed for is the real term impact of a reduction in productivity, investment and expansion that has led to a crisis of confidence. The public see massive and rapid increases in unemployment and housing foreclosures and rapid and powerful decreases in the returns on investments and savings and the loss of the ability to borrow. Business sees an environment where investment is impossible due to the restriction of credit, falling revenues and the destruction of profits. A cash rich company will not risk using its own cash to invest in such an environment, the returns from holding cash are greater than the risks of using cash to invest.

As this crisis of confidence takes an ever firmer grip on the public's economic outlook they no longer worry about whether policies are inflationary or not. They worry about the survival of the system and more importantly their place in that system.

As you can see Mr Kaletsky is correct in his assumption that the fight about ideals is now firmly entrenched between the US Government and the US public. The US government has acknowledged this will be a long term recovery process that will probably begin at a lower economic base than we presently see, the bottom for the US is not yet "in". The US will increase and make permanent tax rebates, Government spending schemes, ZIRP and QE until inflation returns and holds steady. That could be some years into the future and it will only occur if the mind of the public is turned from fear of deflation and its effects to a fear of inflation. There is no guarantee that the last requirement is going to happen and without it the US faces a Japanese scenario of long term (15 years) deflation and a weak recession prone economy even after that period has elapsed.

It should be remembered that deflation is not necessarily bad for growth and in times before the Second World War it was not unusual for economies to swing between inflation and deflation. Only after the creation of the Federal Reserve in the 1900's do we see the gradual elimination of deflationary periods in the US:

No one can deny the massive expansion of the US economy from its beginnings to the 1900's which occurred with deflationary periods throughout its history. So what makes the current situation so much worse?

The use of leverage to create massive positions increased the destructiveness of losses when those positions went "bad". This coupled with enormous amounts of debt (made possible by Banks selling debt packages to other Institutions and thus freeing up the capital to repeat the procedure) caused capital to be used up at a frighteningly quick rate to cover losses. Soon Banks et al had gone below their capital reserve holdings and had to look to others and eventually the Federal Reserve for more capital to shore up those losing positions. These positions are not covered, just the amount required to allow the leveraging has been replaced. That's because losses are not deducted from the borrowed cash, the loss is borne by the money or assets put up to secure the loan. If those losses exceed the amount of collateral put up, it has to be replaced.

Therefore if the collateral is equal to 10% of the amount borrowed, a 10% loss on the whole position wipes out the collateral. To keep the position open you need to replenish the collateral or you have to close the position, return the borrowings and take the loss. This loss of capital is why banks have stopped lending across the board, even to credit worthy individuals and businesses. They need to hoard capital and revenues to prepare for any future losses. The Banks are not acting as if they have expectations of future inflation.

Until this changes participants in the economy, reliant on credit to continue, (let alone expand) will be under severe strain. To survive they will cut spending, costs and investment. The ability of money, regardless of the amount it is increased by, will not be able to cause an expansionary wave as it will become an asset in its own right, hoarded and saved by all. When assets are in demand and the return is greater (deflation makes money worth more, it has a higher purchasing power) than other "non-money"assets there is no requirement to spend. Why swap the highly priced asset for one of lower value?

Without the need to invest or to expand in the search for higher returns to beat inflation the current financial system cannot function because it is based on leveraged credit. Remove the need for credit and the use of leverage becomes redundant. This has a natural effect on prices, they fall. If business previously carried out was driven by a use of 90% of borrowed money, the removal of that 90% means business is restricted to the 10% left, the original collateral. Prices of assets will have to fall to meet the shortfall of cash. The other alternative is for the asset suppliers to remove themselves from the market place, making the assets unavailable until the price they want is met.

All of the above, from the quote from Mr Kaletsky's article to the paragraph you last read was to explain what his quote referred to. The US Government will do everything it can to engender a credible expectation of future inflation amongst the public and business. As you can see the forces the US Government has to overcome to make this happen are formidable.

This is why Mr Kaletsky then made the following remarks in his article:

• "The next logical step, although it may be politically controversial, would be to do the opposite of what the Tories suggest. Instead of reducing taxes on interest payments, the Government could tax all bank deposits and other risk-free savings. This would create a negative risk-free interest rate, encouraging savers either to invest in property, shares and other productive assets - or simply to save less and consume more. In either case, the result would be more consumption and physical investment, less unemployment and faster recovery from the slump."

In other words such taxation would be viewed as a form of inflation acting on savings. It would actually cost savers to hold cash, negating any increase in the worth of the currency the savings are held in during a deflationary period. This would force savers to spend their savings on assets in a search for a return.

However, this thinking is flawed as it would be counter productive to the domestic economy.

Savings do not have to be held in an account, cash is available in large denominations and can be held in secure vaults. Cash can also be transferred to another tax regime that is friendlier; it would also allow some countries to attract capital. In Japan the outflow of savings caused the carry trade as domestic savers sought higher returns elsewhere in the global economy. The increase in the supply of Yen without the expectations of inflation allowed Japanese savers to become foreign investors in the US, UK, Europe and the emerging markets. Finally Banks need deposits, savings, to allow fractional lending. Without a deposit base Banks do not have the collateral, the reserves, to allow lending. Any government bailout money would only replace the lost deposits, it would not increase the lending power of Banks.

Therefore the next logical step would involve higher income surveillance by Government to see if cash was being hoarded outside of the banking structure. The outflow of cash to foreign investments can be expediently stopped by the adoption of capital transfer restrictions and the control of foreign cash holdings. That would ignite a protectionist economic war that would destroy globalisation.

At the end of his article Mr Kaletsky puts forward the notion that even Mr Obama would balk at implementing a savings tax and that the current ZIRP and QE policies would probably boost consumption and investment. However, as I have shown above even the US Government and especially the Federal Reserve do not believe such policies will work unless the expectations of the public and business are changed.
Mr Kaletsky has caused quite a stir amongst his readers with his tax on savings idea, unfortunately he is missing the point and has not thought about the future effects of such a policy. His "non-socialist" approach would be undone if such a policy was implemented, the very actions of the savers would force heavier centralist government control of the individual.

You may have noticed I have not included the UK in the discussion so far. Its economic situation is extremely similar to that of the US and you would have thought that the UK Government would have eagerly moved to a ZIRP and QE policy adoption before you could say "Prudence". However there is a problem.

Whilst Mr King at the bank of England has overseen a cut in the base rate to 1.5% and indications are that the rate will go lower, the Government has been dragging its heels and seems reticent to make the move toward QE.

The moves made by Mr Darling (well, Mr Brown really), have been lacklustre in comparison to the US. He announced a cut in VAT but rather than make it permanent he allowed the public and business to know he intended it to be a short term measure. Indeed the level of VAT may well be increased in December 2009. Not exactly a credible expectation of future inflation as such a move will remove cash from the economy. Whilst the nationalisation of some Banks and the bailout of others continues the Government has been shown to be powerless in its attempts to revive the increase of credit available in the market place. As in the US, Banks continue to hoard cash to offset future expected losses.

At this stage the US decided to follow ZIRP and QE to replace the devastated credit mechanisms. However Mr Darling seems to be somewhat shy and retiring on the matter. Early in the week he was quoted as saying:

• "Frankly, if you were to do anything further (than set interest rates close to zero) this is something that could only be done with the Treasury and the Bank of England working hand in hand, because the two responsibilities just become so close you have to operate together."
  

This was widely interpreted as a first acknowledgement that QE was on the table. However within a very short space of time (probably after a phone call from Mr Brown) Mr Darling had this to say:

• 'Nobody is talking about printing money,' Darling told reporters. 'There's a debate to be had about what you do to support the economy as interest rates approach zero as they are in the United States. But for us that is an entirely hypothetical debate.'
  

Mr Darling has missed the point entirely. Driving base rates down has had no effect on the availability of credit and further reductions are futile. Without a concerted and convincing policy that the Government will fight deflationary forces then the public and business will act accordingly and save. Spending and investment will be deferred as an expectation of lower prices caused by a lack of demand takes hold. With capital hoarded not only by Banks but by business and the public a deflationary spiral will result that reinforces and strengthens deflationary perceptions.

In other words by not adopting unconventional means to fight the deflationary forces that abound Mr Darling will ensure that the wishes of the political opposition to "save, save and save" will occur.

This weekend it has been leaked that Mr Brown has held talks with the UK's top banks to discuss the latest plan put together by the UK Treasury in an attempt to revive lending. The plan involves guaranteeing loans through a government insurance plan and setting up a toxic bank (the Paulson MLEC or Toxic SIV idea) to allow banks to off-load poorly performing debt. The Times quotes that a 30% default rate has been built into the calculations for this debt. This will not be a profitable enterprise for the tax-payer. The government guarantee on loans will also be enlarged to cover businesses.

The UK seems to be stuck; Mr Brown is still fixated on the idea of bailing banks and jawboning them into increasing lending. Banks have no intention of increasing liabilities in the current economic climate and will take the argument to the brink to gain more time to allow reserves to be rebuilt. Mr Brown cannot threaten the Banks with a withdrawal of support, the fall out from such a move would make last year look like a picnic. He can however start to make noises about nationalisation of the banking sector, a move I believe he would enjoy enacting.

The fallout from the current inaction, the refusal to openly discuss unconventional monetary and fiscal policies including QE, is not conducive to credible inflation expectations. The public and business watch the wrangling, the attempts to implement half hearted measures with a jaundiced eye. They will do what they always have done in such times, they will save, cut costs and pay off debt.

This week I want to look at some charts and share them with you. There are some interesting dynamics at play:

Moscow:

US:

UK:

Dollar/Yen:

Gold:

To my eye I see consolidation patterns abounding on these weekly charts, markets seem to be in a waiting mode. It maybe worthwhile watching these support and resistance levels, something seems to holding the markets back and if I had to make a call, I would be watching for a downside move. I will not be trying to pre-empt such a move from current levels but a fall below 8400 on the Dow (not marked) would get my "short side" interested.

Quite a large portion of this weeks report will be in the public domain, a necessary evil when discussing another writer. However we shall return to the normal, smaller sized public articles next week.

I have reviewed the subscription rate; it will remain as it is for the foreseeable future. Have a good week.