Bill Gross from PIMCO wrote an excellent article recently titled “Credit Supernova!”.  It is a great, but at times a little technical, read.  Bill posits that the current global financial system is fragile due to its structure based on fractional reserve banking.  He explains how the system evolves toward crisis, and he shares some thoughts on what investors potentially could do. 

The global financial system is based on a fractionally reserved credit system.  A “fractional reserve system” refers to monetary policy requiring banks to hold only a fraction (typically 10%) of depositors’ funds as cash reserves.  The remaining 90% of deposits can be loaned out to create new deposits which in turns create new loans, and so forth.  This is known as the multiplier effect.  In other words, what Bill is saying is we are living in a world where money is “created” through credit creation – or a little more precise, the money supply is expanded when more and more credit is created.

Bill compares the global fractional reserve financial system to the force of entropy in the universe.  The universe is expanding so rapidly that everything will end with a “big freeze” (luckily for us a few trillion years from now.)  According to Gross: 

          “…the advancing entropy in the physical universe may in fact portend a similar decline of “energy” and “heat” within the credit markets.”

 Bill references the political economist Hyman Minsky’s financial instability hypothesis (which serves as the theoretical framework of my Master’s thesis examining the 2008 global financial crisis.)  Minsky’s main argument was that our current capitalist system was inherently unstable.  “Good” economic times eventually produce financial crises.

 Bill describes some implications for investors with regard to this fragile financial system.  I cannot agree more that credit is currently funneled increasingly into market speculation as opposed to productive innovation.  Asset price appreciation is now critical to maintain the system’s momentum and longevity.  Again let me quote:

          “…our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic – it is running out of energy and time.”

 Bill has the following suggestions for how savings should be positioned:

1. Position for eventual inflation.
2. Move money to currencies and asset markets in countries with less debt and less hyperbolic credit systems.
3. Consider global equities with stable cash flow.
4. Start transitioning from financial asset to real assets.

Click here to read the entire article: http://www.pimco.com/EN/Insights/Pages/Credit-Supernova.aspx.

Now that the election is over I ask myself What now?  A total of $6 billion was spent on the election (Presidential and Congressional elections combined), and we basically end up with the same result we had yesterday.  A Republican controlled House of Representatives, with an intransigent Tea Party contingent and an equally ideologically naive Progressive wing of the Democratic Party.  We have the same Democrat controlled Senate, which will be dysfunctional by the misuse of the filibuster rule.  And we have Barack.  When I dropped off my ballot yesterday I finished listening to the last sentence of Bob Woodward’s audio book “The Price of Politics” detailing the negotiations around the nation’s debt ceiling increase last year – or should I say the fiasco around the debt ceiling debate.  The book is a brilliant piece of modern political history, and I want to urge everyone to read it. 

The bottom line for me, based on my read of the book, is that neither Obama nor Boehner were particularly good at rising above partisan politics to negotiate a ‘grand bargain’ to address the country’s unsustainable finances.  Many will focus on the intransigence of the Tea Party, and the Republican obsession with not raising taxes; however, it is clear to me that the left wing of the Democratic Party is just as much to blame for their willful ignorance of the reality that America’s demographic trends will crush the current structure of our entitlement system.  There has to be deep structural reforms.  There is just not enough wealthy people to tax to pay for it all!

I am a centrist with a libertarian streak.  I prefer devolution over centralization.  I love this country because it is a free republic – people should be free to pursue their happiness in any way they see fit.  The collective has no place in defining social issues for free citizens.  When it comes to social issues like abortion, gay rights, religion, drug use etc. I am philosophically a staunch libertarian – these issues have nothing to do with governments.  For me freedom necessitates personal responsibility.  Freedom presupposes that some people will make bad choices and should live with the consequences.  This notwithstanding, I believe as a society we have to take care of the poor, the marginalized, and the unfortunate amongst us.  As humans we have a moral obligation to care for one-another.  Although I lean more toward private welfare, there is a role for government.  Don’t get me wrong, I don’t believe in a small government.  I don’t believe in a big government either.  I believe in an efficient government.  I believe in competitive free markets and entrepreneurial capitalism; however, government has a critical role to play in establishing the regulatory framework of the economy.  Lastly, I believe there is a time to spend and a time to save – sometimes we’ll have budget surpluses and sometimes we’ll need deficits. 

In sharing these views on society and politics it should be clear that I am neither a Republican nor a Democrat.  My beliefs though are guideposts to the things I hope the newly elected Congress and President will do.  I also believe my views represent the center of American politics (well most of them anyway).  Back to Woodward’s book and the failure of Obama and Boehner to reach a deal.  For the record, I blame both.  Also, for the record, I like both, and it is obvious to me they both had the best intentions, and really wanted a workable deal.  They both had integrity.  And they both were prepared to make compromises to reach a deal.  What they lacked were leadership and courage, and in Obama’s case experience.  Read the rest of this entry »

I pledge allegiance to the flag of
the fragmented state of America,
and to the plutocracy for which now it stands,
a red and blue nation,
under financial gods
indistinguishable,
with liberty and justice for the 1(%).

The International Monetary Fund released its global economic outlook report entitled:  “Coping with High Debt and Sluggish Growth” on October 12th (http://www.imf.org/external/pubs/ft/weo/2012/02/index.htm).  According to the report global economic growth is faltering.  The report predicts that the economies of most developed countries will shrink this year or grow at rates of 2% or lower.  Although the report predicts developing countries’ economies (the so-called ‘emerging markets’) will do better, the forecast for them is falling as well. 

It is only the United States and Japan among the large industrialized developed economies who are forecasted to grow at above 2% (the forecast is 2.2% growth for each – nothing to write home about!)  Quoting from the report:  “In advanced economies, growth is now too low to make a substantial dent in unemployment, and in major emerging markets, growth, which had been strong earlier, has also decreased.”

In April, the IMF forecast that the global economy would grow at a 3.5% pace, and would rise to 4.1% in 2013.  This forecast is trimmed to just 3.3% this year, and 3.6% in 2013. 

Of course, one of the most reported statistics from the report was the estimate that there is a 17% chance of a global recession.  I’m not sure how they calculated this probability.  Although I haven’t looked at the methodology used, I am suspicious of the model’s efficacy as a predictive measure.  My bias against the over “modelfication” of economic theory notwithstanding, it is obvious from most of the data I look at that there is an increased likelihood of a global recession with dire consequences for global equity markets.  At this point I should take responsibility for the fact that almost a year ago I had the audacity to predict a recession in the US!  I was wrong, and reminded that I tend to be negatively inclined toward the global economy’s health prospects.  I’m also reminded of the impact of recency bias which is the psychological phenomenon that events closer in time to the present have a bigger impact on our expectations.  In my own case, the occurrences of the financial crisis of 2008 and the European debt crisis sometimes lead me to emphasize those elements of current reality that point to the occurrence of another crisis. 

Having an understanding of my own recency bias, however, does not invalidate some alarming developments in the global economy pointing to an increased probability of further global slowdown and recession.

This leads me to another IMF report released last week, the “Global Financial Stability Report” (http://www.imf.org/external/pubs/ft/gfsr/2012/02/).  The report finds increased risks to the global financial system, with the euro area crisis the principal source of concern.  The report urges policymakers to act now to restore confidence, reverse capital flight, and reintegrate the euro zone.  According to the report both the US and Japan need to take steps toward medium-term fiscal adjustment, in other words decreasing budget deficits over the medium-term. 

Both reports make me nervous about the short-term stability of the global political economy.  In this deteriorating environment it won’t take much to shock the system into recession or crisis.  Imagine if Israel attacked Iranian nuclear facilities at the same time the US fails to avoid the ‘fiscal cliff’ of January 2013.  I think a “risk-off” period is in order for the time being when it comes to investing.

The website www.EconomicsDegree.net named www.World-Political-Economy.com as one of the top 100 economics sites in the country!  This, of course, is a great honor for our site, and as the founder and editor I am humbled by the endorsement. 

For those interested in entering the field, Economicsdegree.net is a great reference for students, career changers, and anyone with an interest in the subject. Here you’ll find information related to degree programs, courses, colleges and universities, and possible career options in the field.  Their list of accredited schools will help prospective students find the right program that meets their educational and professional needs.

Here is their announcement of the top 100 sites they’ve selected:

Economics has been defined as the “social science that analyzes the production, distribution, and consumption of goods and services.” Truthfully, though, economics is much more than that – it’s the backbone of the entire modern world and drives everything from business to technology, from healthcare to education.

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Naturally, World Political Economy examines issues of politics and economics around the world, though its home base is clearly the United States. It presents quick analysis on varied political and economic issues and attempts to maintain some level of political objectivity despite injecting the posts with the writers’ opinions.