Twin Peaks and the macro economic model of debt.

The correlation between the Dow and the Nikkei has been picked up by a number of other authors since the publication of the first Twin Peaks. It is of limited functional use without understanding the fundamental thesis behind its original creation and also the method of comparison.

It is statistically near impossible to have a visible and enduring correlation between the peak of the Nikkei in 1989 in Japan and the peak in the Dow in 2007 in the USA. To marvel at the correlation is to be distracted by a sideshow. The relationship between the peaks must also only be established at the peaks and not rebalanced thereafter. Rebalancing the correlation will facilitate a very close match but will defeat the whole object of the assessment for it will not allow the market drift to break off the correlation.

The thesis behind the twin peaks correlation is that Japan and the USA were and are implementing a similar macro economic model dominated by similar monetary and fiscal policies in two different economies in two different time periods. It therefore opens the probability that the outcomes in the two economies would tend to be similar. What then is the model?

This macro economic model is built upon dominant Central Government and Central Bank policy interventions based on mutually complimentary Monetary and Fiscal policies.

The first phase is dominated by a loose monetary policy whereby liquidity flows to the markets are maximised. These flows are channelled through the use of regulation and institutional design into asset inflations which are described as “wealth effects”. The conduit for the liquidity is mostly private debt formation anchored in asset collateral. Inflation in consumables is actively managed and discouraged. The underlying monetary policy floods the economy with liquidity to the point of debt saturation and follows the inevitable course to zero interest rates. Boom conditions are created during this first phase which boosts Central Government tax flows for “easy” fiscal conditions.

The advent of debt saturation in the private sector causes the collapse of the asset bubbles and the boom conditions disappear. The economic model now enters a second phase where Central Government is starved of taxable income. Monetary policy is shifted to accommodate rapid debt formation for Central Government. Every attempt is made to re-inflate the asset bubbles. Central Government in turn accelerates its spending, usually under the guise of so called “stimulation” ignoring falling tax inflows. Central Government will enjoy a “honeymoon” period within which it accelerates spending while placing no additional tax burden on its citizens. In fact, Central Government may even be using some of the debt to subsidise some or all taxpayers. Examples are tax rebates or “cash-for-clunkers” programmes. Monetary policy continues to maximise liquidity absorption but it manifests predominantly as Government debt. The honeymoon period is accommodated by a widening of the tax gap, the gap between Government spending and Government income from taxation. The “deficit”. The government pledging its future taxes to the money lenders.

The liquidity not destroyed in the collapse of the asset bubbles now teams up with the Central Government supply of liquidity to search out anything that may function as a store of value. Favourites are long life commodities and Stock Exchanges. The market for “stores of value” is soon in “inflation” conditions which will last for the duration of the “honeymoon” period of tax deferment.

The third phase is a long drawn out stage of stagnation and deflation. The unbreakable, undeniable law of taxation will assert itself. Government must tax for its spending. Dollar for dollar, pound for pound, yen for yen, yuan for yuan, euro for euro or whichever currency you wish to work in. The tax may be direct and visible or indirect through redistribution of the value of money away from taxpayers towards Government. A portion of the tax will be deferred to the future through Central Government borrowing but such borrowings are also subject to the laws of diminishing returns. Central Government debt formation is not divorced from the markets even with monetary policy support and will face increased resistance with each dollar increase in borrowing. The third phase is entered at the point where Central Government is forced to start closing the tax gap.

An alternative outcome for the third stage is economic and currency destruction in a hyperinflationary depression. It requires a policy of relentless “quantitative easing” whereby the Central Government ignores markets altogether to process its debt formation via unbridled money creation. I discuss this potential outcome in “War on Savings” which can be found on my blog.

Keynesian lore will propose that the economy will start growing as a result of the “stimulations” but it is simply a wish for rescue and certainly not a forgone conclusion. The irrefutable truth is that debt is not income and government spending can never be “income” for it can only originate as direct taxes (redistribution of someone else’s income), indirect taxes (monetary redistribution of purchasing power), or as debt which is simply deferred tax. There is no way around the law of taxation. Government must eventually tax dollar for dollar for its spending (the only question is who it will be – citizens of the USA or perhaps the savers of China?). That is the stasis trap of the third phase. Government debt formation slows down as it must. The tax gap can no longer be financed or expanded. Government and society now face the consequences of having spent the future.

Central Government must deal with the tax gap and the consequences of its own debt while the private sector must content with the consequences of its debt. Bubble formation is no longer an option as both the private sector and the public sector are soaked to saturation in debt. This is the set-up for the “lost decades” economic model.

The stock exchanges are but one place where we can monitor the development of the phases. We are presently in the tax honeymoon phase where society is growing polarised into “debtors” (often also called optimists, patriots or consumers) who believe that given enough “stimulation” a new boom will defer consequences once again; opposed by “savers” (often also called pessimists, traitors or hoarders) who are desperately trying to preserve the value of their savings. Both groups are looking at stock exchanges to obtain capital appreciation for debt repayment or capital protection against money creation. The Nikkei tells us a part of the story of the outcome for the Japanese participant who had to deal with this economic model. In the Twin Peaks charts I track and compare the outcomes of Japan and the USA as but one facet of the developments in an economic model built upon foundations of debt.

Here are the updated charts to Thursday 17th September 2009.




(Click to enlarge)

The Dow has moved above the Nikkei much like the first phase of the correlation after falling below the lows of the Nikkei in March 09. The correlation will have to reassert in a downward move towards a Dow of 5000 at around the end of May 2010 (Data table points; 5208 on 29 May 2010) to remain valid. It will take longer and go lower if recent history were to repeat. This correlation now runs over 488 data points from 9 October 2007 to 17 September 2009.

That is the near picture. Now for a look at the macro chart.





(Click to enlarge)

The keen observer will note the first bounce peak in the Nikkei (on the October 2008 grid) against the current levels of the Dow. I can give the data points for the 2020 lows or the 2026 lows but it would assume this correlation staying in place until then. For now, observation will do. I would prefer to heed the warning inherent to these charts and hope for outcomes which are not steeped in habitual debt formation, private or public.

I repeat my previous observation. These charts are not for day trading. These are trends within a macroeconomic argument. There is no statistical basis for a correlation of this duration and its continuation will be supportive of the underlying economic thesis. The thesis will have to be re-assessed in time, based on the outcome of this facet as well as all the other dynamics. I see no reason to revise or abandon the thesis at this stage and now am keenly interested to see if or when the correlation in the downswing reasserts.

Happy hunting.

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
18 August 2009

Ps. I will continue to track the peaks and will publish another update should we see an interesting development. Otherwise expect an update in another two months.


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .