Why did GDP show a 1.9% gain in the second quarter? It wasn’t the stimulus package. According to Bill Fleckenstein today, it was a 1.1% deflator (implied inflation rate). Now I’m a deflationist, but that is ridiculous.

The new Economist Big Mac index says the dollar is very cheap on a PPP basis compared to many of the European currencies. The Norwegian kronor is no less than 120% overvalued, the euro 50%. The Canadian dollar is mildly overvalued at 14%. The Japanese yen, on the other hand is 27% undervalued, and the Chinese yuan no less than 43%. Curriences do tend to converge on PPP, but only in the long term.

Investment Letters blog has uploaded Jeremy Grantham’s latest letter. The title is “Meltdown! The Global Competence Crisis.” Jeremy says “I for one am officially scared.” It deserves to be read in its entirety, as usual.

Jimmy Cramer, on the other hand, is calling a bottom. Let me see, who do I think is more than likely correct?

Nozzle Rage

I’m thinking of pulling Bill Gross from my list of truth tellers (along with Ben Stein) because he has become an advocate of bailouts galore. Probably the reason is advice from Paul McCulley, whose recent piece called The Paradox of Deleveraging exposes not only his Keynesian views, but the muddled thinking associated with them. He talks about the paradox of deleveraging:

… when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed. Put differently, not all levered lenders can shed assets and the associated debt at the same time without driving down asset prices, which has the paradoxical impact of increasing leverage by driving down lenders’ net worth.

He then goes on to suggest that the simple fix is for the government to buy up the assets being shed:

What is needed instead is for somebody to lever up and take on the assets being shed by those deleveraging. It really is that simple.

He goes on to suggest that the “somebody” should be the government - taxpayers, collectively. But wait a minute, don’t those assets belong to some group of taxpayers today? Some directly, some indirectly, through corporations, partnerships, trusts, and so forth? So redistributing the assets and liabilities between taxpayers so that Peter has less and Paul has more is somehow going to fix the problem? Nonsense. This chart, from a good article in naked capitalism, shows the problem, which is the extreme expansion of credit market debt relative to GDP since the earl.

This chart makes three important points. First, as of the end of first quarter 2008 - deleveraging had not yet begun. Growth in government debt has accelerated to compensate for slowing growth in private debt. Second, the last extreme, at about 270%, wasn’t seen until GDP had fallen dramatically. So we may well see even higher ratios. Third, this is probably a mean-reverting ratio. It will go back to a sustainable level. Japan in 1990 was about 270%, according to the article, and was about 150% in 2006. This is consistent with the chart, which looks like it wants to hang out in the 140%-180% range.

Of course, we have to ask the question, what does this ratio mean? GDP is the market value of all the goods and services from the U.S., commonly measured as (consumption + investment + government spending + exports - imports). We have seen in the housing market at the micro scale how the Ponzi works - assets (houses) are marked up in price, then borrowed against, and the proceeds go straight into consumption. The anecdotes are legion, but the graph shows the result. The credit market debt is the total of the collection of financial assets that Mr McCauley is talking about, some of which he wants the taxpayer to buy, thus keeping the prices up and preventing that “pernicious asset deflation”.

Now it does happen that Mr McCauley is in the business, along with Mr Gross, of investing people’s money in those self-same assets. And their business will suffer if those assets get to deflating. So it is not without some self-interest that he is advocating this, I suspect. He wants some other group of taxpayers, that is other than the ones paying him to manage their money, to be left holding the bag. Fair enough, if I were paying him I would want him to want that.

But anyway, back to the meaning of GDP and credit market debt. It shows us something important. It shows us that a huge inflation in asset prices has occurred, relative to income. Picking 1984 as the beginning of the inflationary period, we find that the debt/GDP ratio has roughly doubled, independent of underlying consumer price inflation. During the same period, the S&P 500, for example, has increased 250% in real terms. Real house prices have increased 100%. And so forth.

• The asset-rich (the capitalists, using Karl Marx’s terminology) have been favored over the asset-poor (the proletariat), as their assets became more valuable. The second Gilded Age resulted.
• Speculation has been favored over investment. As asset prices increased, asset yields declined. But speculative profits increased and the hedge funds and brokers prospered.
• Capital is formed from savings, not asset appreciation which is driven by debt. Saving is proportional to income, but asset prices relate to debt and so leverage has increased.

Our Mr McCauley regards these outcomes as features, not bugs. He fails to realise that leverage is reduced not by moving the assets around to manipulate their prices, but by increasing income and savings, relative to debt, to form capital. The owners of financial assets believe that they are going to be able to keep the game going, to extract their income from the proletariat. But the proletariat has reached its limit. It is no longer willing to pay. It is welching. The burden of debt is just too heavy, so it is being reneged upon. The proletariat will now begin to save, to build capital. After the 1930s, the proletariat recognized that being indebted to the capitalists was a fools’ game, and it took generations to erase the memory of that learning. The lesson will now be repeated. The pernicious asset deflation may be delayed. It cannot be avoided.