Screw the periphery, hail the core

The Global Economy Suffers From Hypothermia

By Raul Ilargi

We've used the analogy before, in particular to describe what happened to the Roman Empire during the latter days of its existence. Looking around various economies in the world today, the same analogy once again comes to mind. One might say that what we see these days is analogous to the more advanced stages of hypothermia.

Early hypothermia may show in nothing more than cold feet, in itself an amusing analogy perhaps. But a body that is exposed to extreme cold over longer periods of time will at some point start to exhibit symptoms such as frostbite, which are the result of the core of the body trying to save itself at the cost of the periphery, the extremities. Typically, a human body, for instance, will lose its toes first because the heart can no longer pump enough blood (heat) to them and at the same time keep the body's core above a minimum temperature.

In our economies we see the same pattern. It is not generally looked at or even recognized, however, since 99% of us live in denial of the possibility that such a thing would even be an option. This is a direct consequence of the fact that, first, all major news makers and decision makers reside in the core, and second, that saving that core while letting the extremities die off is somehow seen as a good thing. Post-crisis policies around the globe are directed at saving the financial system, not the people the crisis has pushed into poverty. Since these people are not seen as crucial to the survival of the core, and the system as a whole, they are - almost ritually - sacrificed on the system's economic altar.

In a reason-driven society one would expect a discussion on the viability and the intrinsic value of the system itself, but our global economic system, as I've said many times before, exhibits far more symptoms of a religion than a rational scheme. Our "analysis" of the system and the crises it goes through takes place in the part of our brain that deals with belief rather than rational thought. Therefore, we are bound, nay, certain, to get this wrong. You might think that a body can survive minus a few digits, but that is questionable, not in the least, to stick with the hypothermia analogy, because additional problems and afflictions such as gangrene are a major threat to the body's ultimate survival.

In our economic systems, we see this in Europe, where a few weeks ago it was claimed that the recession was over. And while that may be sort of true according to some specific dataset, and some specific timeframe, recessions don't of course happen in spreadsheets and datasets, they happen to real people in real streets. And if you would ask the people in the countryside in Greece or Portugal whether they feel the recession is over, we all know what the answer would be.

The core part of their nations may be suffering a bit less, but that's only because the peripheries suffer more. This is a general pattern. Money today can only be made by taking it away from other people, who - paradoxically or not - don't have any to begin with. Our economies only managed to "grow" in recent decades, since about the late 1970's, because we borrowed from ourselves to buy products produced by people working for wages only a fraction of our own, and when borrowing from ourselves was no longer a viable option, arguably 10 years ago, though 30 years might ultimately prove a better estimate, we started borrowing from our own futures and those of our children. While the core, the financial and political system, which had accumulated by far the biggest part of the debt, escaped the blame and often even fortified itself by taking more and more away from the periphery.

Which is why it's nonsense to claim Europe's recession is over. Granted, it's a timely claim, given that in Germany, Angela Merkel faces federal elections on September 22, and we never should have expected anything but rosy numbers to come out and support her bid, but it makes no rational sense. Germany's numbers may look sort of alright, even if you have to wonder how much that has to do with that same election, but we've already seen acknowledged pre-election - in a clear sign of how confident Merkel is - that Greece needs another bailout, and there's no way Portugal will not need one; Merkel and the ECB are just waiting for the politically least damaging timing to announce the next phases. And the Italian and Spanish populations have been forced through the austerity wringer so tightly any meaningful definition of the term "growth" won't be applicable for a long time, if ever, to their societies.

We will see advanced stages of the hypothermia analogy play out globally in the remainder of this year and into the next. In Europe, it will initially reach center stage in the usual suspects around the Mediterranean. What's more, a new member of the club, one with - coincidentally or not - a long strip of Mediterranean coastline will come to the fore. France. Ironically, the Eurostat report that tried to make us believe the recession is over also claimed - as a crucial part of the overall claim - that France is recovering, and even showed a positive growth number of 0.5%. We're moving into theater of the absurd territory here again.

What's really going on in France was described quite accurately by John Mauldin over the weekend in an article aptly named - in our hypothermia analogy -: France: On the Edge of the Periphery, so I don't have to do the details on that anymore. The crux is that if and when the Eurozone loses France as a net creditor, and that point is now as close as it is inevitable, the entire picture changes in a radical manner. Germany may look good pre-election, but if France goes under, that doesn't mean a thing.

Here's what going to happen in Europe: the Cyprus bail-in model will be extended first to Greece, then Portugal, and after that to all other countries that elect to stay inside the monetary torture dungeon model. The too big to fail banks - I think Europe prefers the moniker "systemically important", will be spared (they're what the system sees as its core), and any other investor, bondholder, and "normal" client will be made to pay. French banks Société Générale, BNP and Crédit Agricole will survive a first round, but since their debts are still gigantic, albeit hidden behind accounting standards and free ECB and Federal Reserve funds, their survival chances through subsequent rounds will diminish. This is just as true for other banks in peripheral countries, but that should be obvious.

Countries will fight to maintain control of their own largest banks, but they will find that they can't when the pressure keeps increasing. One price the banks have been made to pay for their TBTF status is increasing their stock of the various sovereign bonds of the countries they reside in. Bonds that will now start dragging them down.

In hypothermia terminology, the core of the global financial system is located in the US. It will therefore be the last to be hit by the ongoing deterioration of the "body" as a whole. And that will lead to lots of mistaken assumptions. We see this happening as we speak in the dynamics of the emerging markets. Most stories about rapid growth and increasing political power for them have been based largely on the amount of money invested by the West in their economies. That money is already being withdrawn in substantial quantities, and that process is due to accelerate.

Sovereign bonds all over the globe are plummeting in value, and as a consequence their yields are rising fast. Over the past half year or so, yields on US Treasuries have almost doubled. And since investors - rightly - see Treasuries as much less risky than most other bonds, which they only moved into because Treasury yields fell through a bottom, they are moving back from India, Brazil, Turkey, Indonesia etc., into the US. This provides a noteworthy sideshow to the Bernanke tapering story: if and when the Fed gets its timing right, the disadvantages of slowing down its $85 billion per month purchasing scheme may well be offset to a large extent by money flowing back into US markets. Which would, again, save the core at the cost of the periphery.

But it will not save the US economy; just the core part of it. Inside the US, the hypothermia model is evident in unemployment stats: the official U3 number stands at 7.4% right now, better than a few years ago, while U6 is still at 14%. But those are arguably no longer the main statistics anymore. You need to look at the very definition of a "job". And then find that many things once taken for granted, let's call them benefits, have been gutted to the bone, if not completely vanished. While the difference between U3 and U6 numbers already represents millions of "potential" American workers, even many more Americans have seen the quality of their jobs, and the compensation below the bottom line, shrink like a handful of frostbitten fingers. And since 70% of US GDP consists of consumer spending, this means that any growth will have to come from increased borrowing instead of from increasing wages.

Still, for the next little while, the American media, and the political and financial system they serve, will manage to convince people in the US that things are looking up. In hypothermia there's a phase this can perhaps best be compared to, one we all know and recognize: shivering. A body that gets cold involuntarily starts to shiver because that increases heat production: it is an attempt to maintain a certain temperature level (it's basically a muscle contraction just like most forms of physical exercise).

Be that as it may, the trend is clear: like Germany is the core of the European "body", and New York the core of the American one, Wall Street, the London City, Tokyo and Frankfurt form the core of the global economy. And in order to save themselves, they will all increasingly bleed their respective peripheries to - near - death. In practical terms, what this means for Brazil, Turkey, Indonesia and a whole string of countries like them outside of the core is that their sovereign bonds will plunge in value, and they will need to pay a whole lot more interest to borrow in international markets, while ever fewer potential buyers will be available. Interest on the bonds will rise, interest in the bonds will plummet.

An interesting - outlier - case study comes from India, the world's largest democracy, which just, hot off the press, voted in a proposal it had been talking about for a while, to - heavily - subsidize food for an additional 400 million of its people, bringing the total to 800 million, or 2/3 of its population. While this is really nothing else than the US foodstamp program writ large, you can bet the IMF-World Bank-Shock Doctrine (screw the periphery, hail the core) model already has measures in place to punish the country for deviating from the party line this way.

Personally, I would suggest India tell them to go screw themselves, like Italy and Greece should tell Brussels and Berlin to take a hike where the sun never shines, but in every country so far, the core is the core and it behaves that way. It'll be interesting to see where Delhi stands in a year, if the program hasn't been abandoned before then.

I've had this - admittedly fully irrational, so I never talked about it - idea for a while that if and when Italian and Spanish 10-year yields turn the same, things will start to take off. And sure enough, as I was writing this article, they are creeping eerily close together. But that's just sort of a fun idea. Economic hypothermia is not. That's closer to pattern recognition.