Fiscal Austerity ~ Collateral Requirements

We sent the following email to friends and clients earlier today:

It’s a sea of red again on stock exchanges, and from a technical (charting) standpoint, things look scary – this could be more than the usual summer lull. Even gold appears to be losing some of its momentum. This makes perfect sense to us, as a deflationary environment in a world of fiat currencies is always bad news for precious metals prices (under metallic monetary standards, precious metals could cause deflation when they were in short supply, but that’s a story for another time). 

There’s only one thing capable of turning things around before downside momentum takes us back to, e.g., the 800-900 neighborhood on the S&P 500, and that’s a change of heart at the ECB and in the eurozone, as in swapping a sufficient amount of distressed interest bearing sovereign debt for newly minted euros. That’s it. Until such time, the current fiscal and monetary directions of the continent are a surefire, double barreled recipe for D-E-F-L-A-T-I-O-N. China’s internal austerity measures, compounded by misallocation of earlier stimulus measures, are contributing to global deflationary pressures as well. We suspect that Secretary Geithner might have been hinting as much in comments he made last night, as we noted on our website today: http://654advisors.com/index.php/blog/2010/05/follow-through-meaning/ 

Also on our blog today — if you can carve out an hour at some point, this presentation by John Geanakoplos on leverage and credit cycles is worth watching: http://654advisors.com/index.php/blog/2010/05/geanakoplos-on-the-leverage-cycle/.  Europe’s leaders should note that in Geanakoplos’ leverage framework, imposing heavy austerity measures is analogous to raising collateral requirements – and it’s about the dumbest thing you can do when the leverage cycle is turning down.  They still have time to set things right, but putting their focus on credit default swaps (http://www.marketwatch.com/story/euro-zone-cds-spreads-tighten-in-wake-of-short-ban-2010-05-19), especially in an autonomous way, amounts to yet more dithering.

 Yes, the CDS market needs to be brought to heel, as do investments banks in general (Geanakoplos’ leverage or margin targeting idea would go a long way towards accomplishing this), but a forceful monetization of some amount of distressed sovereign debt – perhaps some equitable proportions of all EMU nations’ debts – would (1) stem a rapidly unfolding deflation and (2) burn speculators badly. This recommendation will cause inflation and central bank phobes to hyperventilate, but it’s already been done in the U.S. to a significant extent, without causing inflation.

We don’t think this point can be overstated:  imposing heavy austerity measures is analogous to raising collateral requirements, which is the dumbest thing you can do in a crisis. Combined with a relatively tight central bank, i.e., with high real interest rates, and systemic balance sheet strains, ”getting one’s house in order” is far more likely to do the opposite — as it did in the early 1930s and the 1937 double dip, and as it did in Japan in recent decades.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Some clients of the firm hold positions that are expected to move inversely to gold prices.