Mauldin - A Most Intricately Balanced Nash Equilibrium

by John Mauldin
19 February, 2017
Mauldin Economics

Excerpted from Thoughts from the Frontline

The global economy is orders of magnitude more intertwined than it was in the 1920s and ’30s. Let me list a few of its challenges for you, things that we have touched on in previous letters and a few new ones:

1. The developed countries are awash in debt that totals around $150 trillion.
   
2. As mentioned above, emerging-market countries have $10 trillion of US dollar-denominated debt that they would be unable to pay back if the dollar were to rise by 20%. We would experience a global banking crisis whose proportions would dwarf anything we’ve seen to date. Think subprime debt on steroids.
   
3. It is going to take at least a trillion euros to solve the Italian banking crisis, which is an amount of money that the Italians simply do not have. The only way they can get it is for the European Central Bank to buy the bonds that the Bank of Italy would have to issue. That means Germany would have to blink and participate in the financing of that debt.  That rescue would raise Italy’s debt-to-GDP ratio well north of 175%. Think Greece writ large. How in the wide, wide world of central banks and monetization do you think the Italians, whose economy is growing at barely 1%, can ever repay that debt? Seriously? You think I’m exaggerating about €1 trillion? Do the math and then factor in that the NPLs on the Italian balance sheets will be double or triple the current stated size in a crisis.  I was told I was crazy when I said in 2006 that we would lose $400 billion to the subprime crisis. That was about the time when Fed Chair Bernanke was telling us the subprime crisis could be contained. I was an optimist by at least a trillion dollars, give or take. Looking ahead, €1 trillion may be a similarly overoptimistic estimate of what it will take to resolve the Italian banking crisis.
4. Brexit? Do you really think the Brexit negotiations are going to be a walk in a park, given the nationalist tendencies that are emerging in Europe?
   
5. Japan is continuing to massively monetize its debt. The Japanese have no choice. Their currency is going to continue to fall. I know that Abe and Trump were playing nice last week, but when the yen hits 140 or 150 because the dollar is rising and you can buy a Lexus cheaper than you can buy a Hyundai, how does that work for the trade protectionists in the Trump administration?
   
6. President Trump has expressed concern about certain currencies being manipulated and thus being too weak. A crisis in Europe and Britain would result in their currencies dropping, along with the yen, forcing China to allow its currency to drift downward, too, since China is exposed to all of those countries through its own trade. China simply does not have enough dollars to support its currency at the current level if the dollar were to rise by 20%. To try to do so would destroy their balance sheet. But to allow the yuan to fall would sabotage their current push toward becoming a consumer society and would create an enormous amount of instability. They would be forced to double down on their mercantilist strategy. In other words, an escalating trade war!
   
7. One thing that nearly all economists agree on is that if we pass the border adjustment tax as currently proposed, the dollar would (eventually if not quickly) rise by about 20%. In fact, the Republicans actually use that as a selling point to show that the BAT wouldn’t really increase the cost of our imports, never mind the fact that our imports are priced in dollars and not in foreign currencies. (Remember Megan’s point about “price stickiness” above.) To say that the transition would be messy is an understatement.
   
8. Global market valuations of all asset classes are about as high as they have been in a long time. When was the last time we had interest rates so low and equity market valuations so high? Does this seem like a bubble do you? Or at least the beginning conditions for one?
   
9. If the dollar does rise too much, does President Trump instruct the Department of the Treasury to monetize our debt in order to weaken our own currency in response? Isn’t that called a currency war?
   
10. If our currency rises, the advantage that our exporters get from having to pay no income tax on their exports disappears at the border.