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.

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.

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.

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.

xxxxxx

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.