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The Daily Reckoning | Tuesday, March 16, 2010 The Emerging Market Shift of Global Economics Where the First World ends and the Third World begins Eric Fry Here in Laguna Beach today, it feels like summer. Gentle ocean breezes struggle to keep the mercury below 80 degrees, as beachgoers of all ages struggle to avoid sunburn while basking in the sun. The conditions on Wall Street are not so different. Freakishly pleasant trading action is luring investors into a stock market that seems inviting and serene. For more than a year, investors have been basking in the comfort of steady capital gains. The trick, of course, is to avoid getting burned. It's never easy to know when enough is enough. It's never easy to know when to close up the beach chair and retreat from the beach or when to close out winning positions and retreat from the stock market. Too often, you stay longer than you should. But in the pleasure of the moment, consequences seem...well...inconsequential. You can always worry about consequences later, like when you're peeling your hotel bed sheets off your blistered skin. But your editor won't be a killjoy today; he can do that tomorrow. Instead, he will turn his attention from the stock market to an unfolding story that might influence share prices...eventually. There's a lot of chitchat these days about parlous government finances and perilous currencies. Greece can't balance its books, for example, and Germany is in no hurry to place twenty billion euros on the asset side of the scale. Neither is France rushing to aid the Greeks. Instead, Europe's leaders chitchat, while Greece's citizens riot. We have no idea if this unstable situation will spiral out of control; but we are skeptical that it will spiral under control. The massive and growing government deficits of the Developed World have an "end of an era" feel to them. Maybe the Greeks can lift themselves out of fiscal disaster by their own sandal straps, but does anyone really believe that? More broadly, does anyone really believe that Greece's difficulties are unique to Greece? One plus one still equals two, last we checked. And, unfortunately, one minus ten trillion and one still equals minus ten trillion...which is the approximate debt load of the US. "The US government announced the biggest budget deficit ever - $221 billion - for the month of February," Bill Bonner observed last week. "In other words, per family, the American government spent approximately $2,000 more than it received in tax revenues. Hmmm....if it continues at this rate, it will spend $24,000 more than it receives per family this year. In round numbers, the typical family will pay about $25,000 in taxes...and receive about $50,000 worth of 'services.' "Is that a great deal...or what? It's an absurdity...it's preposterous...it's weird and unnatural. And it can't last. "As long as people thought they were getting something for nothing," Bill explained, "this economic model enjoyed wide support. But now that they are getting nothing for something, the masses are unhappy. Half the US states are insolvent. Nearly all of them are preparing to increase taxes. In Europe too, taxes are going up. Services are going down. And taxpayers are being asked to pay for the banks' losses...and pay interest on money spent years ago. Until now, they were borrowing money that would have to be repaid sometime in the future. But today is the tomorrow they didn't worry about yesterday. "Several countries are already past the point of no return," Bill concluded. "Even if America taxed 100% of all household wealth, it would not be enough to put its balance sheet in the black. And Professors Rogoff and Reinhart show that when external debt passes 73% of GDP or 239% of exports, the result is default, hyperinflation, or both. IMF data show the US already too far gone on both scores, with external debt at 96% of GDP and 748% of exports." Ironically, as the government finances of the world's Western powers deteriorate, the government finances of several developing nations are improving. The list of countries that are running government surpluses includes some surprising entries like South Africa, Indonesia and the Seychelles. Epitomizing this divergence, America's national balance sheet has become so bad it looks downright Brazilian. But guess what? Brazil's balance sheet has become so exemplary it looks like the American balance sheet of the Eisenhower era. It's hard to say any more where the First World ends and the Third World begins. "We are all Keynesians now"...or something like that. But rather than lament what's gone wrong or what might have been, your editor prefers to anticipate what might go right. And it appears that some things are going very right for countries like India and Brazil. The economic axis of the globe seems to be shifting away from the US and Europe. This shift might occur slowly, but it's not too early to notice the trend...and to prepare accordingly. The Daily Reckoning Presents When Money Supplies Go Wild! James Turk The US money supply is much bigger than the official numbers indicate...$1.25 trillion bigger, to be exact. If you care about the value of the dollars in your pocket, this information should matter greatly to you. As the financial crisis has unfolded over the last two years, the Federal Reserve has been responding in a variety of unprecedented ways. Therefore, it is logical to assume that these never-before-used actions have altered long-established ways of measuring the US dollar money supply. The quantity of dollars in circulation is being underreported by relying upon the traditional and now outdated definitions used to calculate M1 and M2. These 'Ms' are calculated and reported by the Federal Reserve based on the following guidelines that identify the several different forms of dollar currency used in commerce: M1: The sum of currency held outside the vaults of depository institutions, Federal Reserve Banks, and the US Treasury; travelers checks; and demand and other checkable deposits issued by financial institutions (except demand deposits due to the Treasury and depository institutions), minus cash items in process of collection and Federal Reserve float. M2: M1 plus savings deposits (including money market deposit accounts) and small-denomination (less than $100,000) time deposits issued by financial institutions; and shares in retail money market mutual funds (funds with initial investments of less than $50,000), net of retirement accounts. These esoteric definitions can be confusing, so let's bring US dollar currency back to basics as the first step to explaining why these definitions are no longer adequate. There are two types of dollar currency comprising the money supply - cash currency and deposit currency. Both are used in commerce to make payments. 1) Cash Currency The cash currency we carry around in our pockets is issued by the Federal Reserve. Take a look at one of those green pieces of paper, and you will see that they are labeled as a "Federal Reserve Note". A note is a debt obligation, and a few decades ago one could take that note to a Federal Reserve Bank and ask them to make good on their debt by redeeming it for silver, or until 1933, gold. These liabilities of the Federal Reserve are no longer redeemable into anything, and are therefore "IOU nothing" currency, a phrase made famous by legendary advocate of sound money, John Exter. Nevertheless, Federal Reserve notes remain a liability of the Federal Reserve. 2) Deposit Currency Deposit currency is comprised - as its name implies - of dollars on deposit in the banking system. These dollars circulate as currency when payments in commerce are made with checks, wire transfers, plastic cards and the like. In contrast to cash currency which circulates from hand-to-hand, deposit currency circulates from bank account to bank account. Bank deposits take three standard forms - checking accounts, savings accounts and time deposits. They have different maturities, or tenor, to use a banking term. Dollars in checking accounts are considered to be the most liquid because they are available on demand. Therefore, they are part of M1 because they are the most likely deposit currency to be used to make a payment in commerce. Dollars in savings accounts are less likely to be used to make a payment, but nonetheless are currency because they are spendable. So they are part of M2, which comprises those dollars less frequently used as currency. The dollars in time deposits are used even less, but are currency and therefore available for use in commerce when they mature, or immediately if the tenor of the deposit is broken. They are - depending on the size of the deposit - included in M2 or M3, which is no longer disclosed by the Federal Reserve. Having provided this background information, we can now get to the heart of the matter by looking at how currency is created 'out of thin air' by the Federal Reserve and banks and the impact of their actions on the monetary balance sheet of the US dollar. Cash currency of course is simply printed, but every note issued is recorded on the Federal Reserve's balance sheet. Basically, the Fed 'monetizes' an asset by turning it into currency. If, for example, a bank sells a $1 million T-bill to the Fed, the Fed 'pays' for it with $1 million of newly printed cash currency. The Fed records the T-bill as an asset and the cash currency it issued as its liability. These Federal Reserve Notes are the "currency" component in the definition of M1 above. In the past, the Federal Reserve only created cash currency. However, as the credit crisis erupted two years ago, the Fed began the unprecedented process of creating vast amounts of deposit currency. So instead of purchasing paper from the banking system solely with cash currency, the Federal Reserve since the start of the financial crisis has increasingly relied upon deposit currency to purchase paper. Regardless how the Federal Reserve pays for the paper it purchases - cash currency or deposit currency - it is creating dollar currency and perforce expanding the money supply. But the traditional definition of M1 does not accurately capture this process when the Fed uses deposit currency to pay for its purchase. In fact, it is totally excluded. Because the Federal Reserve did not create deposit currency in the past, none of the Ms take it into account. Consequently, the traditional definitions of the Ms are outdated because they do not capture the total quantity of dollars in circulation. Because M1 is underreported, so too is M2. There has been an unprecedented amount of deposit currency created by the Fed over the past two years. The following chart illustrates this point. It shows the quantity of demand and checkable deposits, i.e., the amount of deposit currency, at the Federal Reserve since December 2002. From December 2002 until the collapse of Lehman Brothers in September 2008, the quantity of deposit currency created by the Fed averaged $11.8 billion, an amount that is relatively insignificant compared to total M1. Presently, it stands at a record high of $1,246.2 billion, which of course is highly significant. More to the point, none of this deposit currency is captured in the traditional definition of the Ms. The quantity of dollar currency is therefore significantly underreported, which is illustrated by the following chart. The Federal Reserve reports M1 to be $1,716 billion as of February 15th. When deposit currency created by the Federal Reserve is added to the traditional definition of M1, M1 after adjustment is actually 170% higher at $2,918 billion. Its annual growth increases to 29.5%, nearly 3-times the rate reported by the Fed and more importantly, is an annual rate of growth in the quantity of dollar currency that is approaching hyperinflationary levels. The US dollar is being inflated and worryingly, the rate of new currency creation is approaching hyperinflationary levels. Unless the Federal Reserve changes course, the US is headed for a deposit currency hyperinflation like those that plagued much of Latin America in the 1980s and 1990s. James Turk for The Daily Reckoning Bill Bonner The Great Correction: Awaiting Bailouts that Will Never Come Bill Bonner We're going to rename our theory. This is more than a depression; it's more than a financial and economic phenomenon. It includes a shift of power...a return to normal after 4 centuries of aberration...and the failure of a whole line of Nobel Prizing-winning economic claptrap, including the Efficient Market Hypothesis and Modern Portfolio Theory. Let's call this phase "The Great Correction"...and wait for events to prove we're right. In the meantime...we await clarification... When will this bounce end? What will happen when it does? Yesterday was another inconclusive, information-free day. The Dow rose 17 points. Gold went up $5. Oil fell to $79 a barrel. But the deep trends continue. The government grows...and heads towards bankruptcy. Most developed nations are running huge deficits in their public accounts. The one that has been most in the news is Greece. The Hellenes promised to cut their spending, rioted in the streets, and now hope for some back-up plan from Europe. The rest of the PIGS (peripheral European states, with good food and wine, but bad finances) watch carefully. What Greece gets now they're likely to get later. But the problem is hardly limited to the small states of Europe. Barron's reports that the states face "massive shortfalls" in their pension programs. This is in addition to the other massive shortfalls faced by governments all over the planet. "US ratings threat," is the headline on today's Financial Times: "Moody's Investor Service will warn the US today that unless it gets its public finances into better shape than the Obama administration projects there would be 'downward pressure' on its triple A credit rating." Moody's learned a lesson last year. You take money from the ratee. You give a good rating to junk. Then, people point their fingers at you and sue when the junk goes bad. The raters don't want every Treasury bond holder in the world at their throats. The US is going broke; no doubt about it. Of course, it may take years... What the hell? We can wait... Some Treasury buyers aren't waiting until the last minute. "China continues selling US Debt in January," comes a report from The Wall Street Journal. Japan too, adds Bloomberg. Japan, of course, faces a financial crisis of its own. It already has government debt greater than 200% of GDP...and its aging citizens are saving less money each year. Pretty soon, it will be unable to finance its deficits. Then what? Then, yields will rise and Japan will face a crisis similar to that of Greece. And what about China? Even countries with sound budgets can take huge financial hits. "China may face massive bank bailouts," Bloomberg reports. Yes, dear reader...China has a solid budget...and industries that make money. The trouble is, it has too many of them. And now it's made the mistake of stimulating them to increase production - as well as increasing infrastructure - at the worst possible moment, just as their major customer goes into a funk. So, while China's state finances are in good shape - at least on the surface - its private sector finances are a mess. They are such a huge potential mess that one analyst refers to China as the 'mother of black swans.' Who's going to bail out China's banking sector? Who's going to bail out Greece? Who's going to bail out Japan? Who's going to bail out the US? Day by day, the lumbering, clumbering wheels roll on...towards bigger governments with greater debts... One government looks to another one to help it out. The other looks to yet another. One nation depends on its central bank...and its central bank depends on the US Federal Reserve, the capo di tutti capi of all the world's central banks. Regards, Bill Bonner for The Daily Reckoning