Wednesday, December 19, 2007

Inflation is the solution, not the problem

Fundamentally, inflation must be suppressed: Greenspan wants homeowners helped - BBC

Back in the days when Kings ran the Western World, inflation, or, as it was then, in my view, more accurately termed, clipping coins, was a solution to the problem of over-indebtedness- depreciate the value of the currency sufficiently that debt service becomes easier. The other solution, (leaving aside, as Mr. Greenspan et. al. have done, the notion of avoiding the imbalances altogether) was to liquidate- deflate the amount of debt. Of the two, the Kings learned that inflation tended to be less disruptive to the current power structure as the losses were distributed widely.

The anti-Monarchical early Americans took a dim view of the Kingly prerogative to depreciate the currency on his whim and, with a few temporary exceptions, maintained a stable currency with the US$ fixed at 1/20th of an ounce of Gold. Liquidation was the preferred solution under this view.

Liquidation remained the preferred solution until the Great Depression struck. Power, as it is wont to do, became concentrated and inflation was once again seen as a solution. Under Franklin D. Roosevelt the price of Gold was raised from $20 to $35 in an effort to ease debt service burdens.

During the intervening decades, the US Financial System was reformed into an unrestrained inflation machine. First the citizens of the US lost their ability to demand specie (Gold) from the banks and thus force a liquidation or deflation and then foreign governments too lost their ability to demand specie.

Thus the imbalances which grew during the 60s and early 70s, in part a result of Vietnam War debts, were, in a sense, resolved through $ depreciation. Efforts to maintain a fixed link between the US$ and Gold during that period would have engendered liquidation. Let me repeat that to stress the point, efforts to maintain a fixed link between the US$ and Gold during periods of US financial imbalance engenders liquidation, i.e. deflation.

And, it seems, this maxim still holds true.

Consider the chart below.

As you can see, "stress" in interbank lending markets (measured here as the spread between LIBOR and OIS) peaked earlier this year in late August/early September and declined into early November only to turn up again, setting new highs, in early December.

Coincidentally, the US$ price of Gold, which had traded under $700 for most of 2007, rose significantly from September to early November- the period during which interbank lending stress eased. Interbank lending stress rose once again during the most recent period when the price of Gold did not advance.

It seems to me one could argue (and I am) that a depreciating currency, in this case, the US$, as was the case back when Kings clipped coins, is a solution to the stress caused by financial imbalance, and vice versa, that any strengthening of the US$ increases stress and raises the possibility of liquidation or deflation.

It's good to know some things never change.

Alas, some thing do change- notably, the views of those who run the show. These days, in many instances, faith in the "cure" is stronger than faith in avoiding ill health, as Greenspan's embrace of the virtues of mitigating the effects of a burst bubble, rather than pricking it early on, demonstrates. But, I believe this faith is misplaced. There is no "cure" if one defines "cure" as a return to previous conditions before imbalances had become unmanageable. There are only solutions like inflation or deflation.

Thus I find Greenspan's recent calls for inflation to be suppressed, and for the state to coincidentally forestall the liquidation of mortgage debt most confusing. To truly suppress inflation, one should avoid the imbalances that beg such a solution. Now that the imbalances are there, and given the near universal distaste for a deflationary liquidation, suppressing inflation is akin to trying to stop a process already in progress- kind of like prescribing
diarrhea medication to the constipated.

If the powers that be really want to relieve the stress in interbank lending markets (and the indigestion metaphor seems quite apt here), they might consider letting the US$ fall further. Judging by the graphs above, this does seem to help.

Wednesday, December 12, 2007

I agree with Greenspan, in part

In today's WSJ, former Fed Chairman, Alan Greenspan, argues that the root of the mortgage crisis lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World. I agree with Mr. Greenspan, in part- the fall of communism, in my view, set the stage for our current mess- a stage, managed, for a time, by Mr. Greenspan.

It seems to me no mere coincidence that Darwin's Theory of Evolution emerged during a period when faith in the virtues of capitalism was, at least among the wealthy, strong. Both views are based on faith in the virtues of competition. The idea of natural selection through competition is equally at home in discussions of both evolution and capitalism.

Evolutionary biologists argue that environmental changes which reduce competition, such as the elimination of predators, will lead to increases in population. But this rise in population often sets the stage for a "culling of the herd" as new limiting factors (and there are always limiting factors) come into play. In other words, competition strengthens competitors and the lack thereof weakens them.

In our case, the (in hindsight, obviously, temporary) elimination of competition between the Communist block (now market based Russia and China) and the West reduced pressure on economic policy makers to get it right, i.e. to try to avoid the nasty aftereffects of an investment bubble, by, quoting ex-Fed Chairman William McChesney Martin Jr., taking away the punch bowl just when the party gets going.

Even Mr. Greenspan held this view in the early going as evidenced by his pre-emptive strike against inflation in 1994.

As the 90s progressed, however, western economic policies began to be viewed as unalloyed goods (promoted by, inter alios, Francis Fukuyama in his The End of History), markets, even manipulated ones, were seen as never getting it wrong and the desire to avoid investment bubbles was replaced by the view, notably promoted by Mr. Greenspan himself, that a better policy was simply to clean up the mess resulting from constantly refilling the punch bowl.

I suspect easy Al never threw a party for some of the people I know, who won't leave until all the booze is drunk. Then again, he did throw just such a party which has yet to truly end....and the credit addicts are in dire need of yet another fix.

This lack of fear resulting from reduced competition, was, I suspect, a factor which led the US to unwind some of the depression-era banking regulations, such as Glass-Steagle. Faith in the virtues of competition was replaced by faith in the virtues of concentrations of power, in many regards.

I suspect that, after the full effects of the current crisis manifest, we might once again discover the virtues of removing the punch bowl before the party gets going, and thus keeping our hang-overs small.

Until that time arrives, I'll keep a tight hold on my Gold.

Thursday, December 06, 2007

When the stopped clock is both correct AND right

A full-blown dollar collapse would be disastrous. Thankfully, it need not happen - Economist

The old trading adage - a trend is ending when it makes the cover of Newsweek, came to mind when I saw the cover of the Economist magazine. But that wasn't the first thought that popped into my head. My first thought was, "How did Jim Sinclair get his cartoon on the cover of the Economist?"

After enjoying a chuckle I got back to serious thinking (the reading of which, after all, is why I assume you spend your precious time seeing if I've gotten around to updating my blog).

For the past few years I haven't paid much attention to contrary indicators, not because they don't produce tradable moves, but rather because I find it more relaxing to trade from a long term perspective. As speculation is my only income source these days, comfort in trading is key for me.

Yet, I remembered quite a few times during my career when the US$'s obituary was published in the financial media only to beg Mark Twain's response - rumours of my demise have been greatly exaggerated
. One of the Economist's essays noted this: The dollar's place as a reserve currency always seems to be questioned when it falls. Weakness in 1977-79, 1985-88 and 1993-95 was each time met with predictions that governments were about to switch their reserves into another currency. A burst of high inflation, which undermined the dollar in the late 1970s, made that slide as serious as today's scare is. Between 1978 and 1980 the Treasury sold $6.4 billion of “Carter bonds”, mostly denominated in Deutschmarks, to raise funds to defend the dollar. In January 1980 the gold price reached a record $835 (around $2,250 in today's prices) as investors sought an alternative store of value. And when the dollar fell to ¥81 in 1995, many—including this newspaper—saw it as the beginning of the end of its reserve-currency status.

I wondered if this was to be yet another instance when the US$ is doomed crowd was to be seen, in hindsight, as the stopped clock that was momentarily correct, but not right. Interestingly, the Economist took that view, which seems, to the contrarian in me, more a sign to sell than buy. Perhaps they are gun-shy after forecasting a loss of reserve status for the US$ in 1995.

Drifting further down this stream of thought I began to wonder about the "stopped clock" designation. Should one who only forecasts the inevitable on an issue be seen as a "stopped clock?" I'm sure those who made a habit of fleeing Pompeii every time Vesuvius rumbled were seen as "stopped clocks"- and when the inevitable did occur, these "stopped clocks" were the only ones left to be seen.

Alternatively, I'm sure there were many similarly single minded folk who worried about the levees breaking in New Orleans each time a hurricane came near. Eventually, they too were correct- and, it seems to me worth noting, right as well.

The levee as US$ support metaphor seems particularly apt in that the timing of the too-strong storm was always in doubt until the event, but THAT such storms did manifest in that region from time to time was not. Like the next big quake in California or the next eruption of Anak Karakatau (the "child" of Krakatoa) when is unknown but that it will happen is pretty certain. Equally, given that every other fiat currency man has ever tried has eventually, as Voltaire noted, traded at its intrinsic value of zero, the eventually fate of our fiat currency seems sure, even if the timing is not.

And this storm seems big enough to me. Unlike previous storms, which occurred either before the US' current account became chronically negative, such as in the early 80s, or when potential rivals, like Russia and China were weak, such as in 1995, this storm is hitting the US$ after many years of chronic, large and growing current account deficits and when our rivals are on the ascendancy. Meanwhile, such as was the case during the last great US$ bloodletting, the US is bogged down in another expensive war. Additionally, and importantly, efforts to tighten monetary conditions keep getting unwound once real pain is felt. If interest rates cannot rise, inflation will continue.

This time, it seems to me, the "stopped clock" that says the US$'s days as global reserve currency are over is correct and right. Betting on the inevitable will always, it seems, require a few premature wagers- but that just makes the payday that much sweeter. s obituary was published in the financial media only to beg the response of Mark Twain- rumours of my demise have been greatly exaggerated. One of the Economist's essays noted this: The dollar's place as a reserve currency always seems to be questioned when it falls. Weakness in 1977-79, 1985-88 and 1993-95 was each time met with predictions that governments were about to switch their reserves into another currency. A burst of high inflation, which undermined the dollar in the late 1970s, made that slide as serious as today's scare is. Between 1978 and 1980 the Treasury sold $6.4 billion of “Carter bonds”, mostly denominated in Deutschmarks, to raise funds to defend the dollar. In January 1980 the gold price reached a record $835 (around $2,250 in today's prices) as investors sought an alternative store of value. And when the dollar fell to ¥81 in 1995, many—including this newspaper—saw it as the beginning of the end of its reserve-currency status.

I wondered if this was to be yet another instance when the US$ is doomed crowd was to be seen, in hindsight, as the stopped clock that was momentarily correct, but not right. Interestingly, the Economist took that view, which seems, to the contrarian in me, more a sign to sell than buy. Perhaps they are gun-shy after forecasting a loss of reserve status for the US$ in 1995.

Drifting further down this stream of thought I began to wonder about the "stopped clock" designation. Should one who only forecasts the inevitable on an issue be seen as a "stopped clock?" I'm sure those who made a habit of fleeing Pompeii every time Vesuvius rumbled were seen as "stopped clocks"- and when the inevitable did occur, these "stopped clocks" were the only ones left to be seen.

Alternatively, I'm sure there were many similarly single minded folk who worried about the levees breaking in New Orleans each time a hurricane came near. Eventually, they too were correct- and, it seems to me worth noting, right as well.

The levee as US$ support metaphor seems particularly apt in that the timing of the too-strong storm was always in doubt until the event, but THAT such storms did manifest in that region from time to time was not. Like the next big quake in California or the next eruption of Anak Karakatau (the "child" of Krakatoa) when is unknown but that it will happen is pretty certain. Equally, given that every other fiat currency man has ever tried has eventually, as Voltaire noted, traded at its intrinsic value of zero, the eventually fate of our fiat currency seems sure, even if the timing is not.

And this storm seems big enough to me. Unlike previous storms, which occurred either before the US' current account became chronically negative, such as in the early 80s, or when potential rivals, like Russia and China were weak, such as in 1995, this storm is hitting the US$ after many years of chronic, large and growing current account deficits and when our rivals are on the ascendancy. Meanwhile, such as was the case during the last great US$ bloodletting, the US is bogged down in another expensive war.

This time, it seems to me, the "stopped clock" that says the US$'s days as global reserve currency are over is correct and right. Betting on the inevitable will always, it seems, require a few premature wagers- but that just makes the payday that much sweeter.

Perhaps "George Elliot" captured the sense I'm trying to convey in this passage from her novel Silas Marner: The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened, is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent. A man will tell you that he has worked in a mine for forty years unhurt by an accident as a reason why he should apprehend no danger, though the roof is beginning to sink; and it is often observable, that the older a man gets, the more difficult it is to him to retain a believing conception of his own death.

Sunday, December 02, 2007

Rogue Central Banking

Chavez wins referendum; gov't sources - Reuters

It looks like Venezuelan President Chavez has won the chance to put his money where his mouth is. But a few weeks ago Mr. Chavez was hoping for "the fall of the dollar" and assuming the early poll results are indicative, he now controls a fund which can force the issue.


Oops, now I have some sense of how the guys who ran the "Dewey beats Truman" headline must have felt. Mr. Chavez did not win the referendum.

Chavez loses constitutional vote - AP

To his credit, he appears willing to bow to the results of the vote- perhaps he is a "true believer" in Democracy. I'll leave my post as written last night as I doubt Mr. Chavez will be the last leader to wish to bend his Central Bank to his own whims (and we know he ain't the first).

Back in the late 80s when I was trading FX at Chase I was always listening for news of Bank Negara, the Malaysian Central Bank, as they were, in a sense, a rogue Central Bank. In addition to "normal" Central Banking functions (these days who knows what "normal" is, but back then, there was a "normal") Bank Negara speculated in FX.

As they were a Central Bank, they had access to more funds than just about any other fund at the time in those markets. Thus, for a time, they were able to "bully" their way around, until they got in the way of the inevitable- GBP's exit from the ERM in 1992. Interestingly, those losses came with Bank Negara trying to prop up an overvalued exchange rate. Had they bet against the GBP, they might still be "slinging it around." Other than that event, as far as I know, they didn't have any political axes to grind, as Mr. Chavez does. Their goal was to make money.

Mr. Chavez, as noted, has an ax to grind- he wants the US$ lower. With Venezuelan reserves totaling (according to the World Bank, 2006) some US$36B he can certainly move the markets is he so chooses.

This could get interesting.

Meanwhile, over in Russia, Vladimir Putin's United Russia won in a (rigged according to many sources) landslide. I guess now we'll see if he was serious about that "New World Financial Order" on which he opined a few months back.

Tuesday, November 27, 2007

FX: The final front in the war on terror

They [the US] get our oil and give us a worthless piece of paper. Iranian President Mahmoud Ahmadinejad
God willing, with the fall of the dollar, the deviant U.S. imperialism will fall as soon as possible too. Venezuelan President Hugo Chavez
If people would look at the strength of our economy, they'd realize why, you know, I believe that the dollar will be stronger. US President George W. Bush
A friend of mine currently stationed in Iraq kindly sent me this photo. I wish him a safe return

During my absence from posting (for which I apologize, I've been putting the finishing touches on my new house before the snow flies) Gold finally managed to break over $800, initially without much comment. "Whew," I said to myself as the $800 level was breached, "so long as Gold can stay under the media radar, its price can really fly."

But, my relief was short-lived. As $800 quickly led to almost $850 US Treasury Secretary, Henry "The Hammer" Paulson and President Bush began to talk up the US$. This was followed by the twins of terror,
Iranian President, Mahmoud Ahmadinejad and Venezuelan President, Hugo Chavez, gleefully cheering the death of the US$. "Damn," I said to myself, "so much for being under the radar. Now we have a new front in the war on terror- the US$."

This got me a bit nervous as I'd hate to discover that betting against the US$ was considered an act of treason. Fortunately, or so I hope, the fact that a good number of senior US officials, including one former Fed Governor (who shall remain nameless) have heavily bet against the US$ using Gold, should keep such anti-anti-US$ trading sentiments from becoming law.

Further reflection led me to speculate that FX was not just a new front in the war on terror, but its final front.

President Chavez is, I believe, correct, in part, when he links the stability of the US$ with my country's ability to project its military might as it does. It is by virtue of the US$ being the world's reserve currency that the current wars in Iraq and Afghanistan can be financed on such good terms. If the US$ loses its status as the reserve currency financing future military endeavors will not be cheap and will likely require cutbacks in domestic spending- a difficult trick given our looming demographic problems.

If the decline of the US$ was solely a function of the comments from the twins of terror I wouldn't expect further declines. But the US$'s decline has little to do with their views. Rather, as I have been commenting for years, its decline is a function of an over leveraged US economy and our external imbalances.

If I was in President Bush's or Hank Paulson's shoes this is not a fight I would choose, as it is a losing battle. But (thankfully) I am not in their shoes. My sense is that these comments from the twins of terror has and will continue to invigorate the defense of the US$- via intervention, mind you, not via policy changes that might change the underlying fundamentals.

The twins of terror are not, as you might suspect, the only heads of state to link the US$'s status as world reserve currency and the US' ability to project military might. Former Malaysian Prime Minister Tun Dr Mahathir Mohamad said, last year, "When the demand for the dollar falls, America will be weakened and it will lack the ability to act as a bully in the global stage." This suggests to me that $ supportive intervention might be met with $ negative intervention- and the battle at the final front in the war on terror will begin.

To the extent my analysis is more or less accurate, defending the US$ by intervening in the markets sets the stage for: 1) much greater volatility 2) a significant decline (and surge in the price of Gold) when the battle is lost in somewhat similar fashion to the decline of the GBP or ITL when the ERM came apart in 1992.

Sunday, October 28, 2007

Revealing admissions

From a May 01 interview with Eisuke Sakakibara:

INTERVIEWER: It began in Thailand. Do you remember what your sense was at the time? Did you think it was likely to be contained there? Did you think that the baht crisis had serious implications for the whole region? Did your thinking about the crisis change as you watched it move from country to country?

EISUKE SAKAKIBARA: Thailand's prices erupted in May of '97. Of course, there was a sense of a bubble bursting in Thailand in late '96 and early '97, but at the time the Thai crisis erupted, nobody, including ourselves, thought that it would proceed to a crisis in Korea, for example. It was unbelievable that the crisis spread as quickly as it did to Indonesia and Korea within a matter of six months or seven months. We realized that the world was much more globalized than we had thought at that time.

INTERVIEWER: What was your own personal worst moment at that time?

EISUKE SAKAKIBARA: Well, I have lots of recollections during that time, but one meeting I remember very clearly was in September 1997. It was the annual meeting of International Monetary Fund, which was held in Hong Kong. That was at the time of the return of Hong Kong to China. I remember meeting with George Soros [the hedge-fund specialist and philanthropist] in Hong Kong. During our meeting Soros said Korean banks owed very heavily to Indonesia, and Indonesia was now entering the crisis, so that the problem will eventually proceed to Korea. So as early as September George Soros was predicting that the crisis would spread to Korea. After that meeting I checked the numbers and realized it was true. The American and European banks had been withdrawing their money from Korea beginning in the middle of 1997, and in September the Japanese bank, they were the last ones to get out of there. It was a very rapid withdrawal of money by European, American, and Japanese banks which resulted in the Korean crisis in December of 1997.

When the Thai Baht began its steep decline in July 97 I was a conference with Joseph Yam, of the HKMA and Dr. Zeti Akhtar Aziz of Bank Negara and they too, like Mr. Sakakibara who, at that time was Vice Minister of Finance for International Affairs for Japan's Ministry of Finance, had no sense that the crisis would spread.

These are not unintelligent, uninformed people and yet, perhaps as a function of a desire to be a part of the machine, they cannot see its flaws until they become too imposing to ignore.

In my next post, I'll explore the issue of lags in thought, perhaps "sticky assumptions" would be more apt, and their effect on policy.

Wednesday, October 24, 2007

Be back Friday

Other duties require my time for the next few days.

Tuesday, October 23, 2007

Dude on Gartman on GATA on Gold

Written,in response to the views (in italics) below with keyboard firmly lodged in cheek.

.... While on the topic of gold, we shall nod in the direction of the folks at GATA who've argued for years -- often seemingly braying in the wilderness -- that the US government was manipulating the gold market via gold-lending operations. The government has denied that vehemently, even as GATA has trumpeted it relentlessly.

Last week Mr. James Turk, one of GATA's leading lights and a gentleman whose work ethic and tenacity we have come to admire over the years, wrote that:

"... the U.S. Treasury quietly made a subtle change to its weekly reports of the U.S. International Reserve Position, which includes the U.S. Gold Reserve. This change was first made May 14. It says the U.S. Gold Reserve is 261.499 million ounces and importantly, that the gold is now reported 'including gold deposits, and, if appropriate, gold swapped.' (Emphasis added.) This description provides clear evidence that the U.S. Gold Reserve is in play. Gold has been removed from U.S. Treasury vaults and placed on deposit, presumably in the couple of bullion banks the Treasury has selected to assist with its gold price-capping efforts. Gold placed on deposit gets loaned out by these bullion banks, and then sold into the spot market to try capping the gold price."

Sadly, even if Mr. Turk is right (and for the moment it appears that he is), gold is weak. This is enormously bullish news of gold; it is having no effect at all, however, making us recall our old aphorism that a market that will not rally on overtly bullish news is not bullish. GATA

.........While on the topic of solipsism, we shall nod in the direction of one Mr. Gartman, who has argued for years -- often seemingly spitting into the wind of a Gold bull market -- that the US government would never intervene in the Gold market, and even if so, would have no effect. GATA has urged him to reconsider his view, and even requested a public debate on the topic, but Mr. Gartman has been relentless in his ridicule of their view.

Recently, Dennis Gartman, the leading light of the Gartman Letter, and a gentleman whose work ethic is such that his views are expressed in the first person plural -- King Dennis, if you will -- noticed that additional research on GATA's thesis of Central Bank Gold price suppression by James Turk seemed to indicate that perhaps GATA had been correct all along.

In like manner to the man in Winston Churchill's well worn adage who stumbles over the truth, picks himself up and hurries off as if nothing had happened, Mr. Gartman declares that even if Mr. Turk's views are accurate, their effect on the Gold market is, obviously, nil.

How, you might be wondering, does the esteemed Mr. Gartman arrive at this view? "Elementary, my Dear Watson," as one Sherlock Holmes never said in any book written by Arthur Conan Doyle. Solipsists, like children, confuse their awareness of a phenomenon with awareness in general. When a solipsist learns something new (an exceedingly rare event, mind you) he or she assumes, as if others' awareness was dependent on his or her own, that others have just become aware. "A ha," says the solipsist, "a new piece of bullish information has just hit the market (i.e. him) and it did not rise, therefore it is immaterial."

That others might have been trading (profitably) on the truth (partial or total as the case may be) of GATA's view for years, thus obviating the solipsistic conclusion that such is new news, seems implicit in Mr. Gartman's statement that GATA has been promoting this view for years, until you realize how deep that solipsistic rabbit hole goes.


To be fair to Mr. Gartman, I too have fallen into (and wallowed for a not short period of time) the perilous trap of solipsism, which, I believe, is one of the dangers of one way discourse, or preaching from the pulpit without also walking amongst the masses.

Disembodied intelligence isn't.

On a less facetious note, the trading strategy of gaming expectations seems to me to have run its course for this cycle. When most speculators are trading fundamentals, profits can be made by gaming their expectations. But when the majority are gaming each other, they become oblivious to the overall fundamental landscape, focusing instead on, as Mr. Gartman does, the immediate reaction to bits of news.

Sunday, October 21, 2007

Valuing Theories of Inflation, as the tide recedes

Pragmatism asks its usual question. "Grant an idea or belief to be true," it says, "what concrete difference will its being true make in anyone's actual life? How will the truth be realized? What experiences will be different from those which would obtain if the belief were false? What, in short, is the truth's cash-value in experiential terms? William James

Only when the tide goes out do you discover who's been swimming naked
Warren Buffett

It's been so long since lasting, cumulative inflation has been a valid concern in the west that pressure to have a useful theory thereof is almost non-existent. In Pragmatic terms, until recently, theories which asserted its death, i.e. new economic paradigm views, were more profitable than those which suggested that it might come again. Like a family that would ride away from Pompeii at the first hint of a rumble, only to be ridiculed by those who stayed on their return; those fearful of inflation have often prepared for the worst, for naught.

In the arena of speculative finance, however, the cost of a false view isn't ridicule but loss of money. Yet how does one discern a true view from a false view, but in the event? An imaginary bond trader who, since 1983 asserted that inflation was a thing of the past and would never happen again has been rewarded for that faith while one who, over the same period, but, having lived through previous periods of inflation, and having read of many others, repeatedly cut and ran at the first hint thereof has been severely punished for his view.

Thus, as my friend, Stephen Plant, is (correctly, in my view) wont to argue, do the movements of capital engender their own belief structures.

It's been so long since
lasting, cumulative inflation has been a valid concern in the US that many people still expect gas (and other) prices to "come back down" in much the same manner that people in the early 70s were sure that prices would fall back to "normal" levels, without understanding that "normalization" requires an anchor that had been cut. Once the price of oil left the $3.00 level, it never returned- an observation we might soon be making about the $50 level.

It's been so long since lasting, cumulative inflation has been a valid concern in the US that I suspect some even of the money managers have forgotten the part that wages play. On the one hand many will cite the ability to out source, i.e. find cheaper labor, as a key feature in the relatively-inflation-free 90s, but few, apparently, seem concerned about rising wage pressures in, say, China.

Of course, to be concerned about the potentially inflationary effect of rising wages in China one would have to believe a theory thereof that included such as cause.

The reason I'm flogging this (inflationary theory) horse to death is because prices of key commodities, notably, but not solely, oil, seem to me to be, unlike much of the 1983-2004 period, moving into permanently higher ground. Ironically enough, to the extent faith in a new economic paradigm where lasting cumulative inflation does not occur is still prevalent, this will, to the extent my forecast proves accurate, seem to some, like a new economic paradigm, although it won't be. That is, it seems to me the tide is going out- a cash value is about to be assigned to certain theories of inflation- the event is now.

So what causes inflation? Quantity theorists will tell you that more money means more inflation, and I believe in the link, although there seem to me to be other necessary factors- one key factor being a closed system.

The integration of the old Soviet sphere of influence into western commercial and financial circles as well as the opening of China played a key role in undercutting faith in the variants of quantity theory, as they are all, to an extent based on the notion of money as entirely endogenous. The end of the cold war and opening of China threw a lot of exogenous shocks, albeit largely of the positive kind, at the West, and especially at the US.

Now, of course, we're globalized, by which I mean, it's all endogenous now, which is why I suspect quantity theorists may well be coming back into vogue as the tide recedes. Money may soon matter again.

Another thing I suspect we might learn is that the US is no longer able to wag the world economy or so I read the tea leaves of recent price changes. In decades past, when the US household sector's balance sheet was impaired world growth slowed, but this time may well be different- the US consumer may no longer be the fulcrum on which the global economy pivots. According to the IMF, China made the largest contribution to world growth of all nations in 2007, and is expected to do the same in 2008.

So how does lasting cumulative inflation become entrenched in an economy? The Austrians will tell you that money moves through different parts of the economy in turn and that a general wage gain will, in a sense, complete the cycle, and set the stage for another round. Thus, one could, and I suspect this has been one aspect of Fed policy, try to keep wages low so as to forestall cumulative inflation.

If the IMF's expectations of Chinese growth prove accurate, the old game of keeping US wage gains low enough to forestall entrenched inflation, which had worked pretty well, may no longer prove effective, because Chinese growth may overwhelm US weakness. Indeed, that tactic seems to me to be risking a disastrous stagflation if goods prices, which have already been rising faster than wages in the US, really jump.

Who knows, maybe it's about time to end the great inflation charade and let wages (and government transfer payments) rise.
For too long, I think, policy has been based on a view that you can get a little bit pregnant...err, have a little bit of inflation and abort each cycle. If (and I'm not advocating the policy just arguing that the policy has consequences) we're going to inflate our way out of the financial mess, wages are going to have to rise, and reasonably quickly. Time, alone, won't heal these wounds.

Thursday, October 18, 2007

Whither the gold volume?

I was poking around LBMA gold clearing statistics and wondering where the Gold volume went?

As other commodity prices rise near to and exceed long time highs, trading volumes in those commodities rise:

CHICAGO, IL, July 2, 2007The Chicago Board of Trade (CBOT®), one of the world’s leading derivatives exchanges, today announced that it set a new record for quarterly trading volume, with 255,947,010 contracts traded during the second quarter of 2007. Total second quarter volume increased by 23 percent compared with the same quarter in 2006. Exchange average daily volume (ADV) reached a record 3,999,172 contracts during the second quarter, up 21 percent over the second quarter of 2006. Volume on the e-cbot® electronic trading platform set quarterly records for both total volume and ADV. Total electronic volume was 200,531,673 contracts, and electronic ADV was 3,133,307 contracts – up 43 percent and 41 percent, respectively, over the second quarter in 2006.

Some volume may have leaked over to the COMEX and some might have leaked into the new ETFs but not 15M OZ. worth per day, and that volume decline is not from some frenzied peak in Gold trading like 1980-81, but from the LTCM/Russian default days when Gold's price was in a contained downtrend from the early '96 peak of just over $400.

I don't have any answers, just speculations at this point, but my curiosity has been whetted.

Wednesday, October 17, 2007

Busy today, be back tomorrow

I should have a new post up by tomorrow (Thursday) afternoon...say 4-ish.

Monday, October 15, 2007

From SIVs to SWFs

Rich Nations dread Sovereign Wealth Funds

Washington: With the annual general meetings of the International Monetary Fund and the World Bank just a week away, treasuries and finance ministries of the rich nations (G7) have accelerated their call for international controls on sovereign wealth funds (SWFs).

In the context of the ever increasing financial clout of these state backed funds, the concerns of the rich states go beyond the normal definitions of economic protectionism and xenophobia. Many in the developed world see these financial leviathans as potential threat to global financial system and ultimately capitalism itself.

If all this alphabet soup is getting you a bit confused, just repeat after me:

SIVs are good- because the biggest financial institutions in the west will use them to hide their poor investments off their balance sheets.

SWFs are bad- because the state managed funds in the Middle East and Orient (which by the way are, in the main, the repository of a good portion of US trade deficit IOUs) will be used to buy up the West and thus endanger our sovereignty.

Both are artifacts of a global monetary system run amok.

In a sense, the fear is that these SWFs are like CNOOC buying Unocal or Dubai Ports buying port operations in the US on steroids, unless, as the French are planning:

To stand up to the ever growing financial power of these funds, France is drawing up a report to protect certain state owned strategic interests from the potential financial clout of these funds.


Sunday, October 14, 2007

The "inflate or die" fund...under the placid surface

Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks -- call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it. Paul Volcker, Apr. 10, 2005

Paul Volcker's sense that something was rotten "under the placid surface" came to mind while reading news of the letter begging for inflation which inspired Friday's post or today's news that those same financial institutions were thinking of setting up a new fund.

Leading U.S. banks have reportedly been meeting with U.S. Treasury officials about creating an up-to-$100-billion fund to stave off the danger that there could be a fire sale of shaky mortgage-backed securities, collateralized debt obligations and other distressed assets following the recent global credit crunch.

I'll go further and put 2 and 2 together. On the one hand many of the largest financial institutions in the world are asking financial authorities to, expand the range of acceptable collateral and increase the availability of “cross-border collateralisation” so banks can trade in a wider variety of risky assets in return for short-term loans to finance their activities and clients. On the other hand these same institutions are thinking about setting up a new fund (and what's a new fund without a nice new jargon-rich name like
Structured Investment Vehicle) into which they will "park" their non-performing mortgage (et. al.) debt.

If you're wondering how such a "placid surface" is maintained, consider this. If you knew that you could hide your bad investments in some drawer and they wouldn't come back to bite, you wouldn't need to worry about stop loss selling, or anything of that sort. In that event you could just keep buying.

According to Reuters, taxpayer money is not expected to be used. Of course, if the Fed and other CBs are willing to accept the "assets" in these new funds as collateral then, ultimately, it doesn't much matter if the Treasury funds the endeavor (which the Fed would eventually monetize) or if the Fed monetizes it directly. If one thinks of the US$ as the stock of the United States, this is dilution, no matter how you slice it.

On Monday I'm going to explore these Structured Investment Vehicles (SIVs), mainly because I too want to be able to make a bunch of really stupid investments and then push them off my balance sheet, at the expense of the Fed, mind you. Inquiring minds want to know how to do it.

Friday, October 12, 2007

The "inflate or die" letter

Central bankers and finance ministers need to take “essential actions” to help financial markets “regain their footing in the aftermath of serious dislocations” in credit markets, according to the world’s leading financial institutions.

In a letter to policymakers gathering next week in Washington for a meeting of the International Monetary and Finance Committee (IMFC), the leading institutions called for central bankers to take fresh steps to improve liquidity. FT

So the world's leading financial institutions are asking financial authorities to:
  • take actions to help restore confidence among consumers, businesses and investors
  • provide greater clarity about... their role as lenders of last resort in time of crisis
  • expand the range of acceptable collateral and increase the availability of “cross-border collateralisation” so banks can trade in a wider variety of risky assets in return for short-term loans to finance their activities and clients
But, they warned against “possible over-reaction” by regulators.

In financial markets, the appropriate approach is not necessarily more regulation but better supervision in certain areas.” -lol

My translation is that the big guns in finance are in over their heads and they can't go forward unless the financial authorities shout from the rooftops that they will inflate in all ways possible, no more even hinting of being tight with money, requiring reasonable collateral, or expecting to be repaid in the near future.

That certainly leaves me with a warm fuzzy feeling about the state of international finance, how about you?

Got Gold?

Is the Nobel Institute serious? or is this a bait and switch

The Nobel Peace Prize for 2007

The Norwegian Nobel Committee has decided that the Nobel Peace Prize for 2007 is to be shared, in two equal parts, between the Intergovernmental Panel on Climate Change (IPCC) and Albert Arnold (Al) Gore Jr. for their efforts to build up and disseminate greater knowledge about man-made climate change, and to lay the foundations for the measures that are needed to counteract such change.

Indications of changes in the earth's future climate must be treated with the utmost seriousness, and with the precautionary principle uppermost in our minds. Extensive climate changes may alter and threaten the living conditions of much of mankind. They may induce large-scale migration and lead to greater competition for the earth's resources. Such changes will place particularly heavy burdens on the world's most vulnerable countries. There may be increased danger of violent conflicts and wars, within and between states. Nobel Institute

The bait and switch has been a political tool for millennia- the earliest example that springs to my mind is Themistocles' use of a potential conflict with Aegina as public rationale for building a fleet of Triremes that were actually intended to be used against the Persians in the 5th Century BC. And who knows, perhaps the idea of preparing for another battle with the Persians would have been too ominous a shadow under which to work.

As I consider the reasons given for awarding the 2007 Nobel Peace Prize to Al Gore and the IPCC, I wonder if this too is a bait and switch- a means to induce a behavioral change with repect to petroleum. Before you judge me crazier than you had already assumed, (if that is possible), consider that the award wasn't given for raising awareness about climate change per se, but rather man made climate change, and by man made they mean made by the burning of fossil fuels. So, the thinking behind closed doors might be going, if people won't believe Peak Oil, or minimally that conflict for oil is becoming a serious problem for man, BUT they seem to believe in Global Warming, let's use that faith as fulcrum for changing behavior on petroleum.

Hmmm, you might be thinking, does he think Global Warming is a total scam? No, I'm not in that camp. The research I have read leads me to the view that the Arctic ice cap has been melting year on year for some decades now, lately at an apparently accelerating rate, which suggests that in general the atmosphere is warming.

Of course, a read of the few thousand years of recorded human history informs me that climate change, both local and global, is part of life on earth. Floods, earthquakes, volcanoes, tsunamis, ice ages and warm periods are all a part of recorded human history, long before, mind you, we started extracting the potential energy stored in petroleum and other fossil fuels. Going further, to the extent we can extrapolate backwards through time using the geologic record, climate change has been going on for billions of years, long before man is assumed to have evolved.

It seems to me to fly in the face of the scientific method to assume that a regularly occurring phenomenon is caused by something which was only evident in the current cycle. At best I could entertain an argument that human actions are accelerating a regularly occurring phenomenon. Of course, when phrased that way, the impetus to stop burning fossil fuels to stop global warming diminishes appreciably, which is not meant in any way to argue that there aren't other valid reasons to adjust our behavior on petroleum.

As I noted above, perhaps this is the most effective means to get people to change. In my limited experience of trying to warn people of impending, but regularly occurring danger, say from an overvalued equity market, few are willing to change behavior until its too late based solely on a read (or listen) of economic theory and history. Perhaps I should have warned of an eternity burning in hell, or some other nasty hyperbole if the person in question didn't dump his CMGI. Of course, this path creates all sorts of new tangles down the road so I'll stick to my less effective but less tangled approach.

To the extent this award is part of some sort of bait and switch, the thing I find disturbing, even though I'm in favor of the aimed effect, is that I can't see much difference between this and the WMD rationale for going into Iraq. Neither rationale creates conditions for an honest debate of the issues but rather inspires impetuous action, recalling a scene from the film Waterworld, when, after regaling his men with tales of dry land, The Deacon (played by Dennis Hopper) privately remarks, they'll row for a month before they figure out I'm fakin' it.

Maybe longer than a month.

p.s. another worry I have is that a focus on stopping global warming may well stop people from preparing for its eventuality. People in NYC will be a bit miffed if the city goes green but still ends up underwater. I wonder if a large percentage of the Minoans tried to stop Santorini from erupting, rather than moving. I'd like to think I would have been one of those who moved.

Thursday, October 11, 2007

Knee slapper du jour

NEW YORK - A business news channel being launched by Rupert Murdoch’s News Corp. will debut Oct. 15, the company said Wednesday, presenting a head-on challenge to General Electric Co.’s CNBC.

Murdoch has said the new network, which has been in the works for years, will be more “business-friendly” than rival CNBC. MSNBC

There's a market niche that obviously needed to be filled, a network for viewers who thought CNBC wasn't friendly enough towards business.

Wednesday, October 10, 2007

The (authoritarian) Dogs of War

There is a saying of which I'm fond- Great men talk about ideas, average people talk about things, and small people talk about people - which touches on the essence of this short post. I believe the great advances of mankind occur when ideas are the driving force- the enlightenment period in Western Civilization, or even the founding of the United States come to mind- and the great declines occur when people are the driving force- cults of personality come to mind.

John Dean of Watergate fame released Conservatives without Conscience last year and has recently written 3 essays summarizing the views contained therein:

Understanding the Contemporary Republican Party: Authoritarians Have Taken Control

Why Authoritarians Now Control the Republican Party: The Rise of Authoritarian Conservatism

The Impact of Authoritarian Conservatism On American Government

The sense I got when reading Theodor Adorno's The Authoritarian Personality, a book written, in part, as a response to the question of how Hitler came to power, returned while reading Mr. Dean's essays. That sense is that the personalities described seemed more fitting for dogs than men.

Dogs in the wild, or wolves, if you prefer, run in packs led by alpha males. Obedience to the leader is strictly and brutally enforced and a change at the top involves violent revolution from within. Returning to that saying of which I'm fond, one key aspect of these wolf packs and these authoritarian groups is that they are led by wolves or people respectively, not ideas.

Consider this sentence from Mr. Dean: Most conservatives today do not believe that conservatism can or should be defined. They claim that it not an ideology, but rather merely an attitude. That about sums it up, doesn't it? These people don't need ideas to drive them, they have leaders and what their leaders do defines the movement. To wit, If Bush or Cheney do something it must be conservative.

This lack of ideology (a phrase Bill O'Reilly uses in a pejorative sense) is what strips them of conscience. Morality is an ideological standard, after all. The New Testament scene wherein a stoning is averted when Jesus says, Let he who has not sinned cast the first stone, comes to mind. It continues, And they which heard it, being convicted by their own conscience, went out one by one, beginning at the eldest, even unto the last.

Thus the phrase, let loose the dogs of war has acquired a new meaning for me.

Tuesday, October 09, 2007

When "just the facts" aren't enough

Facts are stupid until brought into connection with some general law. Louis Agassiz

The FT's Tony Jackson recently published an essay- Commodities bull story relies heavily on guesswork - which epitomized, for me, the current problems of mass media affected public discourse in general and its economic subset specifically. The problem, it seems to me, is that much of the public discourse is baseless- indeed, so baseless that the idea of a theoretical base upon which to build an argument is ridiculed.

In my last post I opened with a digression I'll return to now- back when Adam Smith wrote the Wealth of Nations the preferred phrase was "under that head", meaning belief structure, but these days "belief" itself has a negative we "know" things...which is to write, are immersed in the metaphysics, or in the patois of the Grateful Dead, have drunk the Kool Aid. Back when Adam Smith was writing, one of his Scottish fellows, David Hume, wrote a polemic on reason which has yet, in my view, to be successfully challenged. His argument was that knowledge, properly defined, is really justified, true belief, and reason, the analysis of cause and effect, is based more on faith than fact. In essence he took the post hoc, ergo propter hoc fallacy to its ultimate conclusion.

This argument flowed from Descartes' imagined descent into a world of manufactured perceptions so ably displayed in the film, The Matrix. How, Descartes asked, can we be sure that the world we see, hear, sell, feel and taste really exists? How can we know we aren't, as portrayed in The Matrix, just pods plugged into a virtual reality machine?

The Newtonian God- the God who made a clock-like universe, wound it, and withdrew- died a long time ago. This is what Nietzsche meant and this is the God who is being observed. Marshall McLuhan

Hume's response was that we can't ever be sure. We are, by virtue of language based consciousness, creatures of faith, or so I see things. Natural scientists must believe in a shared material universe with unchanging laws of reaction in order to try and discern them in communicable form. The Newtonian revolution shattered the world view wherein God could alter the universe at a whim and left us with the stable law universe-view upon which modern science was built.

Lately, though, the notion that man can change the laws on his whim is, more and more, beginning to creep into public scientific meditations- Baudrillard's hyper-reality- the origins of baseless thought.

Promoters of baseless thinking waste no time laying out theoretical underpinnings. They merely grab a few anecdotal facts and craft a new world view which comports with the argument du jour (a world view, mind you, with a lifespan of a fruit fly, or at least until a contrary world view is needed to write the next article), all the while being ignorant of their fickle philosophical grounding.

Consider the article from Tony Jackson which contains this collections of facts:

1) The Aden sisters correctly forecasted a rise in the Gold price to $850 and a subsequent fall to $300 in the early 80s.

2) their next forecast for a rise to $4000 did not pan out

3) Since the start of this year, the gold price has risen 15 per cent, while the TIPS spread has not risen at all.

4) Since the start of last year gold is up some 40 per cent, and the TIPS spread has actually fallen

5) the base metals industry is crucially exposed to time-lags. Both supply and demand are inelastic and lead times are long

6) It [China] also consumes about three times as much base metals per unit of GDP as an advanced economy – for the meantime, anyway

I agree with his facts, and taking my cue from Daniel Patrick Moynihan- Everyone is entitled to their own opinion, but not to their own facts, I'll focus on the opinions he crafts from them.

He takes facts 1 and 2 and opines that such thinking was weird. Further he argues that today, unlike the early 80s, people go by logic and fundamentals.

The word "logic" these days has taken on the connotation of truth. Yet, in its classical sense, the word suggests no such thing. It is possible to construct a logical argument that is entirely untrue if the assumptions on which the argument is based are false. The study of logic and the study of truth are two different fields of research.

On his point of fundamentals I defy my 3 (now 4 that I got posted on Itulip) readers to show me a fundamental economic theory in Jackson's article. The article has facts, but the fundamental theory, as best I can surmise, is that thinking the price of commodities will rise further is weird and based on guesswork, as opposed to his views, I suspect- lol.

Facts 3 and 4 are ones I have cited in the past, but in support of a very different conclusion, which he glosses over with the following, if we take the yield on TIPS to be real. If one assumes that the yield on TIPS is "real" by which I suspect he means, along the lines of the "efficient market theory" of Eugene Fama, that the price reflects all known information, then the rising price of Gold seems anomalous. If one, and I'm in this camp, doesn't believe Fama's theory, then the price of TIPS could be what's wrong, in much the same way that the price of Tech stocks was very wrong, for a long time.

Facts 5 and 6 seem to me to refute his argument. If, in the base metals industry, both supply and demand are inelastic and lead times are long, and if China currently consumes 3 times the volume of base metals per $ of GDP and given the unmentioned fact that China's GDP shows no signs of slowing, then the current period of rising commodity prices may well be with us for a while longer.

He gets around this potential problem by suggesting, without basis, that this time, the cycle could prove more acute. This out of the blue comment was presaged by the, oft-used during the Tech Boom, comment, we are in new economic territory.

This last comment is the ultimate end of baseless arguments- we are in a new world, about which we know nothing. Or, as I see it, since we don't like the ends to which current theories suggest we are heading, we will throw out that theory.

My own theory is that the Aden sisters didn't account for the effects of a shift from a fairly autarkic model to a very open capital and trade account model which provided an outlet for all the $s we were creating. But with the world no longer in debt to the US and needing $s, and no longer worried about having insufficient $ reserves to stave off a currency crisis, this game has run its course. If the CBs hadn't done some heavy lifting over the past few years, $ based inflation in commodity prices would be, I suspect, higher than it has been.

In my view, the current rise is $ based commodity prices is far from over for a few main reasons:

1) War tends to drive economies towards greater autarky, which, due to the creation of redundancies, tends to be inflationary
2) The great engine of Capitalism has been unleashed in the most populous region in the world, Asia, and the most populous country, China. Once opened this box can only be caused with great distress. We have about as much chance of stopping China's growth as Great Britain would have had, if they had wished to stop US growth while we industrialized and urbanized.
3) with financial leverage at extremes rarely seen, the political will to remove the punch bowl of monetization will be difficult if not impossible to find.

This view itself is based on the belief that there is something to the quantity theory of money, which is not to argue that there are qualitative aspects worth noting.

But, as William James would have put it, we'll just have to wait and see whose view, in the event, has a cash value. In the modern era, Warren Buffet summed it up well, it's only when the tide goes out that you find out who's been swimming naked.

We'll see who needs a towel.

Saturday, October 06, 2007

A new head: Imagine there's no social security fund

The language of the Social Security Trust Fund gives the illusion that it is an investment fund with tradable economic assets that can be held until needed to pay the benefits of future employees. But it is a fund in name only. It holds no real assets. Consequently it does not generate funds to pay future benefits. These so-called trust fund “assets” (essentially US Treasury IOUs) simply reflect the accumulated sum of funds transferred from Social Security over the years to finance other government operations. Former Congressional Budget Office Director June O’Neill

Imagine there's no SS Fund
It's easy if you try
No savings below us
Above us only sky
Imagine all the people
Living for today
John Lennon (adapted by Dude)

Apologies for my almost week long absence from the screen...the final stages of my new house are taking more time than I expected.

My previous post was written under the assumption (back when Adam Smith wrote the Wealth of Nations the preferred phrase was "under that head", meaning belief structure, but these days "belief" itself has a negative we "know" things...which is to write, are immersed in the metaphysics, or in the patois of the Grateful Dead, have drunk the Kool Aid...but I digress) that Social Security was actually a Fund whose investments included nearly $2T worth of Treasury Securities, albeit of the non-marketable variety, kind of like Savings Bonds.

Yet, as the June O'Neill quote, above, states, this just ain't true.

The Social Security Trust Fund is about as real as Santa Claus. To put it in bond market terms, there ain't no CUSIP numbers on 'dem non-marketable Treasury Securities in the SS Trust Fund.

Of course, just because something isn't real, by which is meant, fills no space in the material plane or as Descartes would have put it, has no "extension," doesn't mean it won't have an effect on our lives. The idea of Santa Claus in the minds of children significantly effects not only their behavior but also that of their parents as they seek to maintain the illusion- an idea to keep in mind as we explore this issue.

In a sense, the 2005 effort by President Bush to use the political capital he earned in the 2004 election to "privatize," "reform," or "fix" Social Security, was really a debate over whether to tell the kids that there really isn't any Santa Claus (perhaps reverse Tooth Fairy would be more apt, i.e. a Tooth Fairy you pay, instead of one from whom you receive). In the event, his effort failed in Congress. The parents decided not to tell the kids there isn't any Santa Claus. If you have children you know what that means....hiding presents, sneaking them under the tree after they go to sleep, and acting surprised in the morning (and paying the credit card bills in January...or whenever, as seems more likely these days).

What's the problem?

According to the White House site from 2005 when the issue was in play:

1. What is the problem?

The Social Security system operates on a "pay-as-you-go" basis, where the payroll taxes of current workers are used to pay for the benefits of current retirees. The system is 70 years old. It was designed at a time when most people didn't live long enough to receive benefits.

We had far more workers per retiree paying into the system than we do now. In 1950, this worker-to-beneficiary ratio was 16 to 1. Today, it is about 3 to 1. By the time today's young workers retire, it will be 2 to 1.

Until about three decades ago, the Social Security system was no different than most private employer pension systems. These "defined benefit" plans promised retirees and other beneficiaries a certain income level, no matter what. For a variety of reasons, including the growing financial literacy of America's workers, most companies have shifted to "defined contribution" plans like 401(k)s. Meanwhile, Social Security has stood still.

As conceived, Social Security was something of a scam- since most people 70 years ago wouldn't live long enough to receive benefits, promising them created a lot of good will towards the government, cheaply. Or so they then thought. And back in 1935- as the Great Depression raged- generating good will amongst the people towards the government, or more broadly, towards the economic system in general, was crucial. When people lose faith in the system, economic growth is tough to come by.

Depressions, as was amply demonstrated 7 decades ago, are not the times to ask people to tighten their belts. At least they aren't if the ruling corporations, be they commercial or governmental, have been channeling a larger and larger share of the national flow of funds into their owners' and leaders' pockets in compensation for the previous good times.

To digress for a moment; in primitive cultures, people often "pay" for rain or sun or even to stop a volcano from erupting (I might even add to stop the globe from warming up...but that's another discussion). In my view, one of the genius aspects of laissez-faire was the separation of the responsibility for economic growth from the government. This allowed governments to transcend economic slowdowns, and allowed people to think of "the economy" as a natural, social, phenomenon- a "head" which led to the production of most of the classic works in the field.

These days, having drunk the Kool Aid, many, especially the Maestro himself, Alan Greenspan, speak of the economy as something which can "collapse" if not maintained. This is, to my mind at least, an odd idea if economics is defined as the study of the manner in which humans cooperate to produce the goods of society. Even in the dark ages after the fall of Rome there was still an economy, albeit one in which trade was in steady decline.

Let's get back to the issue at hand- the unfunded liability that is Social Security, and the effects of maintaining the illusion that it isn't.

Congress just recently raised the debt ceiling to $9.815T. If the SS Trust Fund doesn't really exist, the national debt is at least $2T less than the current $9.05T. Under that head, the debt ceiling hasn't been a "real" issue for many years. In the language of my last post, it isn't that a large portion of the Treasury Market is captive, the US National Debt is actually far smaller, by at least $2T, than assumed. If all intragovernmental holdings are essentially fictitious accounting entries, the US Federal Public Sector debt to GDP ratio is actually 37%. Either "head"- captive bidding or fictitious intergovernmental holdings- explains the recent, anomalously low yields in the US Bond market.

Of course, under that head, foreign control of the Treasury Market rises dramatically. According to the most recent Flow of Funds report, the rest of the world owns $2.184T of the $5.043T debt issued to the public or 43%, which seems to me a serious national security issue.

Bu the tangled webs get even more tangled, and the problem, the real, deep seated problem, is one of tangled webs of deception- the necessity of maintaining the illusion at full force for as long as possible (the bubble phase) and letting the air out as slowly as possible when the illusion runs into reality (the inflationary resolution phase).

As noted above, just because Santa Claus isn't real, doesn't mean the kids won't want presents. They do...and they haven't been paying for them for years, either, as we US citizens have with SS.

The last reform for Social Security, the Greenspan reform, raised taxes significantly to make the system solvent, or so the promise went. But, as June O'Neill told us, those funds actually went to general government expenses. This had the salutatory effect of keeping bond yields, both in the US, and by virtue of the US $'s role as reserve currency, the world at large, quite low, at the potentially tremendous cost of a very pissed off population upon discovery that their SS taxes were actually disguised general payroll taxes.

I suspect the desire to avoid the wrath of a taxed population scorned played a large part in Congress' decision to maintain the illusion of Santa Claus. Another factor which, I suspect, weighed in the decision, is the fear that such a deception exposed would inspire a more general desire to "peer under the financial hood" so to write, and that wouldn't be a good idea at all- the SS Fund is not the only fund ( institution) which is un (or under) funded.

Far, far more now than in the 30s, when the currency still had some real backing, faith in the health of the system is paramount. The assumptions underlying the system cannot be questioned for if they were, the recent queues around Northern Rock would become wide spread and the waves of selling would become too powerful for the CBs to contain- cascading defaults, here we come.

What a dilemma. It's a good thing the old economic tool used to get around the problem of sticky wages (in this case sticky pension expectations seems more apt) is still available- inflation.

In my view, the inability of the Bush administration to pass SS reform in 2005, when the housing bubble was still inflating, general economic growth expectations were high, and public faith in his administration, and the Republican Party, was still high, set the stage for (but did not cause) a great inflation ahead. Perhaps the defeat of SS reform in Congress and the peak of the housing bubble are more than just coincidental? If the loss couldn't be faced, it would have to be hidden, and the resolution phase begun.

Regardless, the stage, in my view, is set. If SS reform was a non-starter in 2005, it's truly dead now. The idea of taking ownership of one's retirement savings (a clever way to get around the unfunded liabilities) which seemed so alluring in the late 90s when the equity bubble made geniuses out of dart throwers, and, to a lesser degree, more recently, when faith in the greater real estate fool was still strong, will seem, more and more over time, downright scary. I wonder how many people across the country have said, "well, at least I can depend on Social Security (or should I write Santa Claus?)."

Assuming the War on Terror is going to continue and perhaps even expand, I find it hard to believe that a public already dissatisfied with the war will accept a breech of trust of this magnitude gracefully, or that the financial world could withstand the scrutiny that would follow such a breech.

A quick check of the St. Louis Fed site, recommended by Gary North, tells me (to the extent one can draw a meaningful conclusion from one data point, and I don't think you can) that the most recent flirtation with "monetary tightness" might have come to an end- the adjusted MBase rose by 1% over the past 2 weeks. The recent strength in the price of Gold, which seems much more able to withstand the curiously timed selling, also, perhaps, speaks to a growing realization that inflation is the only way out, and Gold then a most useful protection.

As an aside, I'm eagerly awaiting the realization that the inflation rate for TIPS is absurdly low, which should really give the precious metals complex a shot in the arm.

In sum, if the authorities want to maintain a degree of control as the losses of the unfunded pension liability problem, which, I suspect, extends far beyond SS, are apportioned, a controlled inflation will be required. Such are the costs of maintaining illusions.

I'm quite interested to see if they can control it.

I hope to write a bit more regularly this coming week.

Sunday, September 30, 2007

Captive bidding at the auction: How bond vigilantism was swamped

Time flies when you're making money: 19 years have sped by since the start of the great bond bull market. So traumatic was the preceding bear market (it spanned the administrations of U.S. Presidents from Harry Truman to Ronald Reagan, 1946 to 1981) that fixed-income investors took a pledge: Never again would they be the dupes of a central bank. They would henceforth sell at the first sign of inflation.

So market interest rates would increase before the U.S. Consumer Price Index could spurt. The Fed might nod off, but the bond market vigilantes pledged they would never sleep again.

Now look at them. With a generation's worth of capital gains tucked under their ample belts, they are snoring in hammocks or swatting golf balls. Financial markets the world over are worse off for their unannounced retirement
. James Grant

Many financial commentators have opined on the absence of the "bond vigilantes" from the US Treasury market. Bond traders now willingly accept low yields in the face of broad based commodity inflation, which hitherto would have, according to Mr. Grant, whose views I highly respect, above, inspired significant selling from the now "sleeping" bond vigilantes. I've been doing a bit of checking on the US bond market and think I have a few answers to the question, "where did the bond vigilantes go?," although a better question might be, "whose efforts have swamped bond vigilantism in the Treasury markets?"

The good old days

In 1955, US federal debt totaled $234B, of which $163B (70%) was tradable on the open market. The biggest single player was the Fed, which, in 1955, carried $24.4B worth of Treasury Securities on its balance sheet, or just under 15% of marketable debt.

Is the Fed the culprit?

Federal Reserve acquisitions of debt rose steadily from 1955 to 1970, when holdings peaked at just over 25% of marketable debt. But, as standard closed system economic theory argues, Fed purchases, i.e. debt monetization, did not keep yields down. 10 year yields rose from under 3% in 1955 to well over 7% in 1970 while consumer price inflation rose from -0.4% in 1955 to 5.7% in 1970. Bond vigilantism was apparently alive and kicking back then and Federal Reserve debt monetization led, as it should, to inexorable inflation.

Thus, we can chalk off the Fed as player whose efforts swamp bond vigilantism.

Are the foreigners to blame?

Of late, the presence of foreign purchasers, in particular, foreign official purchasers, have been cited as a reason behind the lack of bond vigilantism, even (in hindsight, partially erroneously) by me.

In 1955, foreign official holdings (the foreign private sector was not yet involved) of Treasury debt totaled $5.8B, or 3.6% of marketable debt. Foreigners were not yet players.

By 1980, this had changed. Foreign official holdings rose to just under 18% of marketable debt, while total foreign holdings rose to 20.4% of marketable debt. Despite this support, 10 year yields rose from 4.2% in 1965, when foreigners began to ramp up their purchases, to well over 12% by 1980. Consumer price inflation rose from 1.6% in 1965 to 13.5% in 1980. The decline in real yields at the back end of the curve, excluding other factors (which is rarely wise), suggests that foreign buying might have kept rates lower than they otherwise would have been, in a closed system.

Foreign acquisitions of US debt have increased dramatically since 1980. As of Q2 2007, 44% of marketable US Treasury securities are in foreign hands. 31.3% of
marketable US Treasury securities are in foreign official hands. The coincident rapid increase in foreign holdings of US debt with a multi-decade decline in yields suggests that these purchases kept yields lower than they otherwise would have been. Yet, the data from the 70s, when bond yields rose despite foreign inflows, suggests that this is not the whole story.

Enter the captive bidders

Something besides increased foreign acquisitions of US debt, happened between the early 80s and the present day which slowly but inexorably swamped bond vigilantism. That something was an increase in social security (and related programs) net income which, I argue, dramatically changed the US bond market.

From 1955 through 1980, the US Treasury market was a mainly open affair, by which I mean, most of the issued debt was marketable. In 1955, non-marketable debt made up 30% of the total and in 1980 non-marketable debt made up 33% of the total. Bond prices were, in the main, set in open markets.

Captivating the Trust Funds

In the mid 80s, in accordance with the recommendations of ex Fed Chairman Greenspan's Commission of Social Security (boy this guy's fingers are in a lot of pies), social security taxes were raised which raised the percentage of national income flowing into social insurance programs from 7.2% to 8.5% (source BEA). While a 1.3% increase in national income flow (it amounts to an increase in income from 4.8% of GDP in 1987 to 5.6% of GDP in 2006) is substantial, it doesn't fully explain the substantial rise in social insurance assets.

If changes to the income side don't fully explain the dramatic rise in social insurance holdings, something must have coincidentally reduced the outflow, which fell from 4.6% of GDP in 1993 to 4.1% in 2006. That something was a change to inflation calculations upon which cost of living adjustments (COLAs) in social security payments are made.

According to John Williams' Shadow Stats site:
In particular, changes made in CPI methodology during the Clinton Administration understated inflation significantly, and, through a cumulative effect with earlier changes that began in the late-Carter and early Reagan Administrations have reduced current social security payments by roughly half from where they would have been otherwise. That means Social Security checks today would be about double had the various changes not been made.

Assuming Mr. Williams' estimate is correct, a doubling of SS outflow from the actual $549B, which produced a SS surplus of $185B, to $1,097B, assuming no changes on the income side, would have created a deficit of $363B. In turn, this would have forced the US Treasury to sell about $800B of securities into the market instead of the $250B they actually sold in 2006. I doubt current US Treasury yields would be at such low levels if such was the case.

But it is the case. Non-marketable debt has risen from the afore noted 33% of total debt to 49%. That's right, half of Treasury bidding comes from captive bidders. So much for a free and open market in US Treasuries.

In sum then, the cumulative effects of SS tax hikes, which inflated SS income, and reductions in outflow due to recalculated COLAs are, I believe, the primary cause of our strangely low bond yield environment in the US. As one who has cited with alarm the growth of Chinese reserves to and above the $1Tln mark, I was amazed to find that Social Security holdings have grown even faster, and now total some $2Tln.

Forget about China's, here's a sovereign wealth fund just waiting to happen.

But, as the saying goes, it isn't just the size of the ship that matters, the motion of the ocean does as well. Many financial commentators have (rightly so, in my view) worried about diversification out of $s among foreign countries with large reserves, yet few worry about a similar risk consciousness coming from within the US.

Imagine a financial world in which the managers of the SS Trust were able to diversify out of US assets. Minimally imagine a
financial world in which the managers of the SS Trust were able to pick and choose amongst domestic investments. In that world, I doubt the chosen mix would be (as is currently the case) a virtually all US Treasury portfolio with an average interest rate of 5.2% and duration of 7.2 years. Simply shifting to a much shorter duration fund would cause the US yield curve to steepen dramatically.

Captive bidders and the Enron effect

That is, I argue, the captive nature of the SS Trust fund in conjunction with its size has been the main cause which engendered our low and reasonably flat curve yield environment. For it is the US Treasury itself which manages these funds. As those who lost all their retirement funds at Enron could tell you, captive trust funds invested in the company itself does not a diversified portfolio create- just the opposite effect is, in fact, created. When foxes (invariably from Goldman Sachs these days) guard the chicken coop, ultimately you have no chickens.

This too, however, shall pass. According to the SSA (Social Security Administration) by 2017, barring any further increases in taxes or calculation changes in COLAs, outgo will exceed income for SS and DI (Disability Insurance). National Health Insurance (HI) costs will deplete the funds even more rapidly. By 2041 SS and DI will have exhausted their funds and by 2019 HI funds will be depleted. So, within a decade there will no longer be additional surplus funds to be used to purchase US bonds which will have to then be sold on the open market. Call it peak SS Trust Funds, although peak trust might be even more apt.

In Greenspan we trusted

It is, perhaps, fittingly ironic that the same Greenspan who bemoans increased federal spending, recommended and oversaw the conditions which allowed such spending to occur outside of a free market mechanism. The same man who proclaimed, in his oft cited, Gold and Economic Freedom

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.
This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.

oversaw a tremendous confiscation of wealth, but not from the wealthy, from the common man. He has repeatedly said that he still stands by the views he expressed back in 1966 and I believe him. He (and others) used the lack of a monetary standard to confiscate wealth from us- wealth which was used, inter alia, to finance the current wars. Atlas, in this case, didn't shrug, he stole.

I expect, as increases in trust fund surpluses slow, US interest rates will rise, most likely dramatically in the years to come.