Thursday, December 11, 2008

From elastic to plastic money

Consider the view put forward by Paul Ashworth, US economist for Capital Economics, as reported by the Telegraph, "You know the US Treasury will give you your money back, but your bank might not be there."

I suspect the coming months will give quite a few investors who believe as Mr. Ashworth believes, a good chance to learn about the loss of meaning of "elastic currency."

As described in the Legislation the Federal Reserve Act is: An Act To provide for the establishment of Federal reserve banks, to furbish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.

In Physics, elasticity refers to reversible deformity under stress. Like a rubber band, which, when pulled, deforms, but returns to its old shape, an elastic currency is one which is supposed to deform in value but return to its old value when the stress is removed.

Sticking with Physics terms, I'd call our money, plastic, not elastic. A plastic substance holds its deformation after the stress is removed. Perhaps the specie standard was the quality that gave money its elasticity and its removal leaves us with the current plastic money.

I agree with Mr. Ashworth, but I suspect, given the shift from elastic to plastic money, (pun on credit cards intended) that the value of that money will not spring back but will instead sink, like a piece of plastic placed over heat.

Gold too, deforms when heated, but its value is unchanged by the deformation. At times of market stress, when plastic currency loses its value, Gold's tends to rise.

Monday, December 08, 2008

The Risk in "Risk-Free" US Bonds

Find the premise which is false and bet against it - George Soros

Bubbles, as so aptly described by George Soros, generate their own rationales, which are later exposed as false.

The most recent bubble, or so I see it, in the US Bond market is no exception. One of the more prominent (and false) reasons given for the flood of money seeking safety in the US Bond Market is their "risk-free" status. According to many investors therein, US Bond investments are "guaranteed"- the US Government won't default.

This is true. However, the only US Government guarantee (now that there is no link between the US$ and Gold or other specie) implicit in US Bond investments is that the Fed and Treasury will, in the event of a shortfall, create as many $s as needed to make Bond and (given the shortened duration of US Federal debt) Bill investors "whole."

The key then, it seems to me, is determining when such money creation will be needed.

Like any other bond analysis, the main issue is cash flow- is the Treasury taking in enough $s to meet its obligations? More to the point, what trends are evident in the data that suggest ease or difficulty in meeting those obligations.

After checking the Treasury (FMS) site, I see that Federal Tax receipts are (on a 12M rolling sum) down 2.6% y/y while expenses are up and expected to rise much further over the coming months.

Leaving aside the issue of tax rates, Federal Tax receipts are (obviously) highly correlated to personal income and, lately, quite dependent on corporate profits. One of the features of the Bush regime, and to a lesser extent the preceding Clinton years, has been an increase in corporate profits relative to personal income. In 1970 personal income was 10 times corporate profits. In 1980 personal income was 11.4 times corporate profits. During the Bush years, personal income averaged 8.4 times corporate profits.

Thus, swings in corporate profits have increasingly impacted Federal Tax receipts as the graph below shows.

With Unemployment rising in the US, personal income is unlikely to rise and should fall further. This, combined with recent US$ strength is likely to weigh on corporate profits going forward. Consequently, and perhaps in accelerating fashion given recent US$ strength, US Federal Tax receipts should continue to fall.

In my view, either the Treasury defaults on its debt or it prints money in increasing amounts to "make good." In either event the value of the US$ falls.

Sadly, it seems to me, US policymakers, and their Chinese counter-parts (neither of whom, it seems, wishes to "blink") have missed the opportunity for a graceful (at least relative to the alternative) inflation (dilution of US$ liabilities). China's intransigence in letting the Yuan rise against the US$, and indeed forcing its decline- abetted by US reluctance to lose the ability to print the world's major reserve currency- has only exacerbated the decline in US real sector activity and thus further reduced Federal Tax receipts.

There is, as they say, no free lunch. Chinese purchases of US Bills and Bonds and thus the US$ will only, by virtue of the trends depicted in the graph above, hasten the day of reckoning when it's print or default.

In this game of financial "chicken" the winner is the guy who blinks first.

Wednesday, December 03, 2008

Chinese Alchemy

Before we had Chemists we had Alchemists who most famously tried to turn lead into gold and, fortunately, I believe, failed. Had they succeeded gold would have, in a sense, lost its luster.

Currently it seems the Chinese are trying to perform an equally impossible feat- turning US$s into Gold.

Brad Setser notes: On Monday China apparently decided to allow the renminbi to depreciate against the dollar.

Given China's large external surplus and the US' large external deficit Mr. Setser, and I, find this policy choice most curious.

Why would China adopt this policy?

According to Mr. Setser: China — like the US – is feeling squeezed by the dollar’s recent appreciation. In real terms, the renminbi has appreciated by far more after it stopped moving up against the dollar that it ever did when it was moving against the dollar. Allowing the renminbi to depreciate against the dollar as the dollar rises would limit China’s real appreciation.

China, it seems, is reluctant to give up its policy of export driven growth, perhaps due to a combination of inertia- Chinese culture is very, due, in part to Confucius, conservative- and (not, in my view, misplaced) fear that a shift to consumerism would disrupt Communist Party control.

This view, however, as Martin Wolf notes below, is inconsistent with the tenets of our current financial architecture.

Countries with large external surpluses import demand from the rest of the world. In a deep recession, this is a “beggar-my-neighbour” policy. It makes impossible the necessary combination of global rebalancing with sustained aggregate demand. John Maynard Keynes argued just this when negotiating the post-second world war order.

In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

Some argue that an attempt by countries with external deficits to promote export-led growth, via exchange-rate depreciation, is a beggar-my-neighbour policy. This is the reverse of the truth. It is a policy aimed at returning to balance. The beggar-my-neighbour policy is for countries with huge external surpluses to allow a collapse in domestic demand. They are then exporting unemployment

"OK," you might be thinking, "I see that, but where does the alchemy come in."

In order for an export driven growth policy to be successful over time you have to get something of value for your exports. No nation would trade manufacturing output for, say, grains of sand.

China gets, mainly, US$s in return for its exports. If the US$ sinks their massive retained earnings evaporate. Instead of letting their economy adjust the Chinese are trying to enforce a high value for the US$ through increased purchases of US debt. They are, in a sense, trying to turn US$s into Gold.

I suspect their efforts will prove about as successful as those of the alchemists of centuries gone.

Chinese alchemy is one of the primary causes of the current global deflation, which, according to Ken Rogoff leaves the world teetering on the precipice of disaster. ... Unless governments get ahead of the problem, we risk a severe worldwide downturn unlike anything we have seen since the 1930s.

Rogoff's prescription; Central Banks need to embrace inflation. I agree, although contra his view, I don't think we can, at this point, have just a little inflation any more than one can get a little bit pregnant.

The choice, as I have long argued, is between a crippling deflation or substantial inflation that eventually removes the US$ from its perch as major reserve currency. Inflation will also shift a good deal of purchasing power towards resource nations, like Russia and the oil exporters (which won't make the gang in Washington happy either) in whose company China can't really be counted.

Happily there is one way to turn US$s into Gold- even though the process will end up consuming increasing amounts of $s per ounce of Gold as time goes on- by buying it.

Tuesday, December 02, 2008

Splitting Bond Default Risk with a Maul

Last night, while reading some of the news of the day I came across this article about CDS (credit-default swap) prices on US Treasury debt hitting a record. "There's a funny story," I thought to myself, "maybe tomorrow I'll write about how silly it is to buy default insurance on an institution that can legally dilute infinitely."

Note: a Credit Default Swap is a contract which pays the buyer of the swap an agreed sum of money in the event of a "credit event" such as a default, as the Lehman collapse generated.

So here I sit, beginning at 5:30AM, jotting down notes and doing some research- turning an idea into an essay. It's a laborious but enjoyable process, interrupted by breakfast, home-schooling my son, and, these days, cutting, splitting and stacking wood- nothing like slamming a maul into a big piece of oak to work out a few "turns of phrase."

I enjoy the process of writing mainly because I can rarely see how it will end with clarity- i.e. it's a learning process. Sometimes the finished product is close to the original idea. More often what began as a central idea becomes peripheral upon reflection, and a few whacks of the splitting maul.

"Whack, whack, whack (it's a big piece of oak- probably have to cut it into 8 segments), whack"

"Where was I?" ............right, credit default swaps on US Treasuries.

The starting point (or un-cut log, if you will) was the foolish-ness of buying credit default swaps on US Treasury Debt. After all, the Treasury won't default, they'll just print money, as Greenspan said a few years back.

"Whack!"..."bff".."bff" (that's the two, now-split halfs hitting the ground)

Let me check my research.

CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event.

In the event of a restructuring of sovereign, in this case, US, debt, the CDS would be worth owning, assuming it was cheap. Many Sovereign Debt Restructuring deals often include a shift in duration (an extension) and given the extremely short duration of US Federal Debt, such a restructuring could occur.

So buying these CDSs might not be silly after all.

"Whack!, Whack!" I have 4 pieces from the original log.

Credit Default Swaps were introduced during my last years as a professional (by which I mean back when people used to pay to read my views-interestingly I think my non-professional stuff is far more valuable than the pabulum I used to churn out. Of course, free (zero denominator) is a great way to increase value) and their rapidly increased usage certainly changes the bond trading game.

When I was trading you sold bonds you feared might default. Now you might actually buy them, driving the price higher, then buy the CDS with the (paper) profits (50 basis points goes a long way). Bond speculators can arbitrage default risk in very different ways- yet another reason why the Bond Vigilante of old is no longer effecting prices.

"Whack!, Whack!"....finally, eight pieces, ready to stack.

Derivatives, as a general proposition, split risk in different ways. Mortgage Bonds can be split into interest and principal only payment streams, risk of discontinuous price action is FX and Commodity markets can be hedged with options, and, as we have seen, the risk of a sovereign credit "event" can be hedged using CDSs.

Of course, as I was wont to argue years ago, the assumption that a combination of a derivative(s) with an underlying position(s) "collapses" (i.e. has identical payment streams) to a simple position in the underlying is not always valid. Being long, for instance (and from experience) A$ and A$ puts is not the same as having no position in A$ or being short. Indeed, the sense that one can hedge the risk of a sudden turn lower is often enough to allow the rise to continue far beyond what would have happened if "insurance" was not available in much the same way that earthquake or flood insurance allows for the financing of buildings that would not be financed without.

In some events, the availability of insurance, which is often marketed as a means of reducing volatility, actually increases it.

Ben Bernanke is currently grappling with the idea of buying Treasury paper outright as "quantitative easing," or in layman's terms, "printing money." I wonder if he would have this problem if US Treasury CDSs were not available (alternatively, the Treasury and the Fed could just announce as policy that US Federal Debt would never be restructured or defaulted, Federal Reserve Notes would be issued in any necessary amounts to fulfill obligations to bond holders- yes this is implied but so was (and is) the GSE guarantee and that is still a mess).

It is as if the Fed Chairman needs to hit the market over the head with a stick, saying, you are valuing Federal Reserve Notes (FRNs), and the Bonds which pay them, too highly. The market, foreign Central Banks in particular, is driving Treasury prices to an extreme which would likely have been arbitraged much differently 20 years ago. At some point, Ben will get his message through, FRNs are worth much less than foreign CBs think....and then things will change fast.

When burning wood, splitting a log into much smaller pieces increases heating efficiency in my wood stove. Yet, I'd much rather sit on the big old log than the eight pieces I split.

Splitting risks in the Sovereign Bond market has changed the behavior of that market, particularly in the US. Along with our open capital account, the availability of CDS, in my view, contributes to the very anomalous behavior in US Bonds of late. 20 years ago a fiscal expansion of this magnitude would have Treasury Yields soaring as the only "insurance" was to not own paper the US was issuing like mad.

I liked the old Bond market better, which might not be a surprise given that I like to split my wood the old fashioned way.

I suspect, in the end, splitting risk into parts will increase volatility, and further hamper the trade flows finance is designed to facilitate.

Monday, December 01, 2008

Lose your GUT, stay awake and stop fighting

Thanksgiving, in some perspectives, is a celebration of gluttony. The iconic scene which springs to mind is a family and friends sitting around a large table piled high with food. We eat and drink and chat and, after loosening our belts, eat and drink some more. Our gut becomes so full that a nap in front of the TV is almost as habitual as carving the turkey.

Our full guts (helped, no doubt by tryptophan in turkey and the spike in blood insulin levels as we digest our huge meal) put us to sleep. I trust this physics based opening won't put my economic view searching readers to sleep as well. Bear with me, there's some meat for you here.

That, however, is not the gut to which I mean to refer. This essay will focus on mental G.U.T.s (Grand Unification Theories), which, in my view, are even more effective at putting adherents to sleep, and for far longer than the typical post Thanksgiving nap.

Some physicists look beyond their GUT at their TOE (Theory of Everything)- the view that all fundamental interactions in nature can be explained by a single model.

For our purposes, I mean GUT to refer to any theory which is held as the final word on phenomena in any field.

To illustrate, in Psychology there are (among others) Jungians and Freudians, those who alternatively hold that Jung or Freud accurately (and among radicals, completely) described the workings of the human psyche. Jungians and Freudians, depending on their degree of adherence to their respective master, often find the views of the "other side" foolish.

Similar groupings have emerged in Economics wherein one finds Keynesians, Austrians, Marxists, and Monetarists, etc. Whereas in pre-modern times political contests (whether coercive, as in war, or persuasive, as in elections) were often, at least ostensibly, based on religion- e.g. Christianity vs. Islam, Catholicism vs. Protestantism- in modern times support of this or that view of political economy is more often the ostensible basis.

The Cold War was, in a sense, a war between Capitalism and Communism. The US Civil War was, in a sense, a war between Industrial Corporatization and (slave labor driven) Agrarianism. More recently, the US Election of 1932 was the culmination of a long battle between laissez faire Industrialists (children of those who won the Civil War) and pro-government regulation and redistribution Democrats.

Even more recently, the US election of 2008 can be seen as a victory of Keynesianism reconstituted over laissez-faire financial corporatization. The current crisis, aver the ascendant Keynesians, is proof that the doctrines of laissez faire financial corporatization are false. The new New Deal of President-elect Obama will, Keynesians like Paul Krugman assert, set the stage for a return to prosperity.

Sadly, I fear the Keynesian Triumphalism of Mr. Krugman will prove as harmful as that of the laissez-faire financial corporatists who claimed the "victory" over communism as their own. History didn't end, as Fukuyama argued, when the Soviet system collapsed, nor will it end now.

The basis of my view- there is no GUT of Economics just as there is no GUT of Physics.

As David Bohm argued in "The Qualitative Infinity of Nature": Any given set of qualities of properties of matter and categories of laws that are expressed in terms of these qualities and properties is in general applicable only within limited contexts, over limited ranges of conditions and to limited degrees of approximation.

If the above is assumed to be true in Physics, which need not take into account the beliefs of particles under study in explanatory models as social scientists must (to wit, a stone's confidence in the theory of gravity has no impact on its acceleration while a human's confidence in the economic system within which he lives has a substantial impact on his saving and consuming decisions) surely it will be more true in the social sciences.

In other words there are varying degrees of truth to be found in many schools of thought, depending on, inter alia, context and perspective. I've learned from Marx and (Adam) Smith, Keynes and Friendman, etc. To me, recurring financial crises are proof that there is no GUT, not that we were following the wrong GUT.

Those, unlike myself, who believe in a GUT, either, when in the minority, see the ills of the world as flowing solely from the prevailing GUT (i.e. they fight), or, when in the majority, work to assert the truth of their GUT, often arguing that untoward events are a function of deviation from the pure view. In that mode they can be seen to "sleep"- unaware of the phenomena of the world except as it fits into their dream.

Lost amidst the GUTS, it seems to me, is the object of the research- how to foresee economic outcomes of political economic policies, avoid or mitigate unwelcome events and generate welcome ones. The lens of the GUT obscures that which it purports to explain.

As a practical matter, a shift away from GUT faith would lead to less dogma. We could, for instance, do away with the view that deregulation (or regulation), less taxation (or more taxation), privatization (or publicization, if you will) etc. are unalloyed goods. Understanding contexts and limits, as Bohm argues, is key to foreseeing outcomes.

I'll close with a concrete example of a GUT in action.

In today's NYTimes Paul Krugman argues: Right now there’s intense debate about how aggressive the United States government should be in its attempts to turn the economy around. Many economists, myself included, are calling for a very large fiscal expansion to keep the economy from going into free fall. Others, however, worry about the burden that large budget deficits will place on future generations.

But the deficit worriers have it all wrong. Under current conditions, there’s no trade-off between what’s good in the short run and what’s good for the long run; strong fiscal expansion would actually enhance the economy’s long-run prospects.

Admittedly, I too am in favor of a policy of substantially expanded public works not because it is Keynesian (and, thus, it seems, in Krugman's view, right) but rather it seems to potentially offer a far better return on investment that current policy of corporate globalization, financial market imperialism and war.

Let's take a chance and redirect the flow of funds towards the US real sector. It might work, assuming, inter alia, the pigs at the new trough aren't as voracious as those at the old trough. If there aren't too many leaks in the financial pipes, real sector bricks and mortar efficiency improvements in the US may be sufficient to compensate for the increased fiscal drag, particularly when inflation and borrowing rates rise. Given the context of aging, and due to expected increased competition for energy resources, obsolete, US infrastructure, this plan might work- not because it's Keynesian, (I think it would have been much better to spend the Clinton-era surplus, leaving aside discussion of its existence, thusly and avoid the need for massive fiscal expansion under the view that funding investment from profits is better than funding it through borrowing) but because of the context.

Policy chosen on the basis of Keynesian-ness, rather than context, will soon have us wishing for a bigger whip with which to flog the dead horse. It wasn't that long ago that Greenspan's financial laissez-faire polices were considered unalloyed goods, which may well have been true in the context of the 70s and 80s, but became untrue as that context changed.

A side benefit might be a better understanding of economics itself.

Tuesday, November 25, 2008

Off for Thanksgiving

I'll be taking a break from posting until Monday morning, unless something crazy happens like a War, Gold breaking $1000, etc.. Have a good holiday (If you live in the US).

On a holiday type note, I found this Typealyzer site which analyzes blogs.

My Blog type is: INTP - The Thinkers

The logical and analytical type. They are especialy attuned to difficult creative and intellectual challenges and always look for something more complex to dig into. They are great at finding subtle connections between things and imagine far-reaching implications. They enjoy working with complex things using a lot of concepts and imaginative models of reality. Since they are not very good at seeing and understanding the needs of other people, they might come across as arrogant, impatient and insensitive to people that need some time to understand what they are talking about.

What do you readers think about that? accurate? if I care.

A more expanded view of the INTP Type on the Myers-Briggs scale can be found here.

Geithner is a Monetary Arian too

There are other factors at work as well, however, that have less favorable implications. Part of this recent dynamic in financial markets is a consequence of the present state of the international monetary system, in which a substantial part of the world economy runs exchange rate regimes tied in some way to the dollar. This has entailed a sustained period of very substantial official accumulation of dollar reserves, putting downward pressure on U.S. interest rates and upward pressure on U.S. asset prices.

These forces are surely transitory, but their impact on capital flows, interest rates and asset prices are important, not just in terms of their short-term impact on growth. If they are large enough, they have the potential to alter or distort current decisions about investment and consumption in a way that could be detrimental to our longer-run growth prospects. And they are important because they work to mask or dampen the effects on risk premiums in financial markets that we might otherwise expect to be associated with the expected trajectory of the fiscal and external imbalances in the United States. Tim Geithner, NY Fed Jan. 11, 2007

The first thought that came to mind upon reading of Obama's selection of Tim Geithner as Treasury Secretary was, "at least Larry Summers (whose decision to reduce the duration of US Federal Debt by, inter alia, repay old and slow issuance of 30 year Bonds set the stage for our current explosion in short term finance) didn't get the job." Mr. Summers is, by all accounts, very intelligent, which, in light of that decision, should not be confused with far-sighted.

The second thought was, "what are Mr. Geithner's views on finance?"

A check of the NY Fed site led me to a few speeches of his and I was pleased to find he too was concerned about the effects of officially induced stable exchange rates on US monetary policy.

Further research shows Mr. Geithner has been concerned about the link between (mainly) Asian Economies and the US$ for years.

As he argued early in 2006: this pattern [FX "pegs"- formal or informal, which necessitate increased purchases of US Treasury Debt] of exchange rate and monetary policy arrangements and the associated scale of official intervention in markets complicate our ability to assess the underlying economic conditions in our economies and to forecast the future path of output and inflation. If the effects of these policies are large enough to alter or distort the relationship between asset prices and the underlying fundamentals in our economies, and this seems likely to be the case, then we can take less comfort from traditional relationships between those variables.

The fact that official purchases of financial assets are driven by different factors than those driving private investors suggests that we would probably see a somewhat different combination of capital flows, exchange rates and interest rates in the absence of official intervention. This makes the task of assessing the probable trajectory of growth and inflation more complicated. It makes it harder to assess the likely evolution in financial conditions and asset prices. And it makes it harder to assess the effects of the present stance of monetary policy on aggregate demand and inflation.

He continues: To the extent that these forces act to raise asset prices, lower interest rates and reduce risk premia, it is harder for the markets to assess how much of the very favorable conditions are likely to reflect fundamentals and prove more durable. This can contribute to an increased willingness to raise leverage in the investment community and to take on more exposure to risk. [and so it did]

For the same reason, this phenomenon can act to mask or offset the effects of high levels of present and expected future government borrowing on interest rates, perhaps contributing to a false sense of reassurance that we can continue to run large structural deficits without risk of crowding out private investment and damaging future growth.

If Obama was looking for a guy at Treasury who saw some of our current problems before they manifested, Geithner seems a wise choice.

I'm intrigued to discover how he intends to fix the problem.

Monday, November 24, 2008

Finally- an Economic Bail-In

We’ll be working out the details in the weeks ahead, but it will be a two-year, nationwide effort to jumpstart job creation in America and lay the foundation for a strong and growing economy. We’ll put people back to work rebuilding our crumbling roads and bridges, modernizing schools that are failing our children, and building wind farms and solar panels, fuel-efficient cars and the alternative energy technologies that can free us from our dependence on foreign oil and keep our economy competitive in the years ahead. President-elect Obama

Most of the "bail-outs" lately have been aptly named. They seem to bail liquidity out of the real sector as if the real sector is weighing down the financial sector when the opposite seems to me more the case.

For whatever reason, the financial sector has not done its job of guiding investment flows such that the real sector can generate the profits which allow job creation, tax revenues and repayment to the financial sector. Bailing-out the financial sector so that it can keep doing what it has been doing seems about as wise as Senator McCain's notion of keeping Greenspan at the helm of the Fed even after death- call it Weekend at Alan's.

Aside from a lack of discussion of a shift towards more rail-based goods distribution in the US, I think Mr. Obama's bail-in plan for the real sector should pay dividends in the future. These dividends may well come at the cost of the loss of global US$ sovereignty but as economists say- there is no such thing as a free lunch.

Friday, November 21, 2008

The Myth of Economic Trinitarianism

The Fed’s ability to set the short-term interest rate independently of foreign financial conditions depends critically, of course, on the fact that the dollar is a freely floating currency whose value is continuously determined in open, competitive markets. If the dollar’s value were fixed in terms of another currency or basket of currencies, the Fed would be constrained to set its policy rate at a level consistent with rates in global capital markets. Because the dollar is free to adjust, U.S. interest rates can differ from rates abroad, and, consequently, the Fed retains the autonomy to set its federal funds rate target as needed to respond to domestic economic conditions. Ben Bernanke

Early in 2007 I dubbed Fed Chairman, Ben Bernanke, the Super (as in Superman) Central Banker in response to the above claim. While mere mortals, like BoE head, Mervyn King, worry about the effects of stable exchange rates on monetary policy, Mr. Bernanke leaps over this concern with a single assertion- FX markets are open and competitive. In a sense, shifting from a comic book to a Theological metaphor, Mr. Bernanke is an Economic Trinitarianist- he believes in the consubstantiality of stable exchange rates, open capital accounts and domestic monetary autonomy.

That makes me, and, it would seem, Mr. King, heretics. We believe this Trinity to be impossible.

To be fair to my Catholic, Anglican and other Trinitarian (including Hindu) friends, I'm not arguing against Theological Trinitarianism, just using the metaphor as heuristic device.

17 Centuries ago, Emperor Constantine, in an attempt to unify the Christian faith he had adopted, called an Ecumenical Council to Nicaea to define the Christian God-head. At the time a debate was raging about the divinity of Christ. Was Christ a man who became God, as the Arian Heretics argued, or was he always God, as Athanasius argued for the majority.

In the end, the Trinitarian Orthodox view won out- the "Father, Son and Holy Ghost" were declared consubstantial (thus the importance of that phrase) or, in Latin, homoousian. Those who believed this Trinity impossible were branded heretics and persecuted with varying vigor for centuries. Defense of Arianism was a rallying cry for Goths and Vandals in their conflicts with Rome.

Fortunately, Economic Trinitarianism is an empirically testable theory which few economists hold. Even Mr. Bernanke, I'm sure, would dispute it in theory. It is the application in practice where I believe he errs, and which is a growing impediment to US real sector recovery.

The creed of Economic Arianism, if you will, is aptly put by Mervyn King:

Perhaps the key difference between the world of Bretton Woods and the world today is the size and volatility of private capital flows. Then, as now, it was recognised that no system could ensure the compatibility of:

(i) Domestic monetary autonomy; (ii) Stable exchange rates; (iii) Free capital mobility.

This "impossible trinity" has been at the heart of the debate on the international monetary and financial system for many years. A sustainable system must sacrifice one of these three objectives

Notice Mr. King places no emphasis on "open and competitive FX markets." For him, FX market stability, such as results from an exchange rate "peg" or even, as Mr. King knows all too well from the Bank of England's attempt to maintain the value of the British Pound in the European Exchange Rate mechanism, simple intervention to support a currency when private sector flows are outgoing, is enough to reduce domestic monetary autonomy.

Mr. Bernanke engages in a bit of mental slight of (invisible) hand with his assertion that the dollar is a freely floating currency whose value is continuously determined in open, competitive markets. This dogma disregards public sector efforts to support the US$, both domestically, such as occurs when the Fed buys US$s, or internationally, such as occurs when the ECB, Central Bank of China or SAMA (to name a few) intervene to stop their currencies from appreciating against the US$. Contra Mr. Bernanke, I argue, the US$ would be much lower if it was freely floating- its current stability debunks his premise.

Decades ago, when international capital flows were smaller, and the US economy (and Fed balance sheet) was much larger relative to the rest of the dollarized world (i.e. when Russian and Chinese capital markets were mainly closed and the emerging world's GDP was small) the effect of exchange rate pegs had much less effect on US monetary policy.

As Russian and Chinese capital markets opened and, in a sense, dollarized and as the third world developed their own capital markets, and domestic savings to invest therein, the effects of exchange rate pegs grew.

The Asian, Russian and LatAm crises of the late 90s were the first warning that the rest of the world was no longer the tail to the US's dog. The Fed was forced to accept easier money than it desired in 1998 (thus adding further fuel to to Tech Boom) or risk an even more severe contraction in Asian and Latin American markets. The tail of the developing world was starting to wag the US dog.

The rapid growth of the BRICs (Brazil, Russia, India and China) and Middle Eastern oil exporters has, in my view, as I've recently been arguing, reversed their position vis-a-vis the US. The rest of the world is the dog and the US is the tail.

The US$ is too small, if you will, to serve as anchor for the world. If we are to regain domestic monetary autonomy, and get the stimulus, currently in the form of increased financial sector recapitalization, flowing to the US real sector, the US$ must float freely- pegs must be cut.

The recent collapse of US real sector activity contrasts sharply with the more robust (albeit inflationary) growth apparent earlier in the year when the US$ was sinking and seems to me proof enough that Mr. Bernanke's faith (via his mental slight of (invisible) hand) in Economic Trinitarianism was misplaced.

As Mr. King argued in 2001: what is clear is that both in theory and practice there is now a recognition that pegged (fixed but adjustable) exchange rates do not provide a viable long-term middle course. More interesting, perhaps, is the absence of serious debate on the merits of the third position, namely the willingness to forego freedom of capital movements in order to retain domestic monetary autonomy and stable exchange rates. That is perhaps surprising in the light of the experience of the two major countries in Asia that escaped the financial crisis of 1997-98, namely India and China, which had in common the presence of capital controls.

Either the US$ floats freely, perhaps sinks would be more appropriate, or if the current US$ stability is desired, capital control are imposed if the US wants domestic monetary autonomy. If the latter option is chosen, US rates (due to capital restrictions into Treasuries) and inflation will rise rapidly and substantially, while the former course will extend and mitigate the transition.

Foreign Official inflows to US Treasuries are hindering what I believe to be a necessary shift in global manufacturing distribution (and goods production in general) given (despite recent declines) rising transportation costs and decades of US trade deficits.

Even Brad Setser is troubled by the rapid decline in US Treasury rates. Without faith in the stability of the US$, those rates would be much higher, i.e. the risk of such flows would be much more apparent.

Outsourced US manufacturing needs to return home (and, as my friend, James Howard Kunstler has long been arguing, become more regionalized, i.e. more widely distributed). A weak US$ seems to me a great tool to achieve this goal as it will both make US exports more attractive and increase the risk of holding US Treasuries, which in turn will make real sector investments more attractive.

Wednesday, November 19, 2008

Time to "Nationalize" the US Financial Sector

In The TARP Fund? and Empire I argued (perhaps with too much emphasis on the effects thereof being caused by the US powers that be) that TARP financed a US$ strengthening effort. This essay will expand on that theme.

A few months back I argued, The old trading mantra; "Don't Fight the Fed" may soon be replaced by; "Don't Fight the SWFs." During the same month I (in hindsight, quite foolishly) predicted The last hurrah for the "strong dollar" policy. Had I placed more emphasis on the former and less on the latter I could have scalped a few $100s on Gold.

While the Fed and Treasury didn't have the firepower to strengthen the US$, foreign interests did, and it was used. The SWFs (shorthand for foreign interests both public and private) are having more of an effect on the US economy than the Fed and Treasury.

As Brad Setser recently noted: Total Treasury purchases over the last 3 months totaled $214 billion. That’s huge.

Combining that inflow with $92 billion in net sales of foreign assets by American investors implies that the “flight to Treasuries” and “deleveraging” combined to provide about $300 billion in net financing to the US. That, in broad terms, allowed the US to run a roughly $175-200b current account deficit and cover a huge outflow from the Agency market.

China is particularly interesting case. SAFE clearly has added to the instability in the credit market over the past few months — and equally clearly contributed to low Treasury yields. That isn’t a criticism — it is just a statement of fact.

At the end of July, China stopped buying Agencies and corporate bonds and started to pile into Treasuries. Over the last three months of data (i.e. the third quarter), the US data indicates that China has bought $81.1 billion in Treasuries ($45 billion short-term) and added $17.4 billion to its bank accounts — that is a flow of nearly $100 billion into the safest US assets China can find. Conversely, China sold $16 billion of Agencies, $1.8 billion of corporate bonds and a bit less than a billion of equity

In brief, the SWFs (mainly China) supported the US$ through massive purchases of (mainly short term) Treasuries. The corporate and mortgage sectors, however, experienced a capital drain. SWF policy (if one can infer such from the data) is to keep the US public sector afloat while starving the real sector. Right-wing talk radio fears of Obama "socializing" the US are misdirected. It is the SWFs that are driving that change.

Not only are the SWFs socializing the US, they are (with complicity of the Treasury through their choice of short term financing) hanging a Sword of Damocles over the US government's head. The graph below depicts externally held short term (under 1 year) Treasury debt with interest. As of Sept. 2008, I estimate (using Treasury external debt data and recent TIC data) that total as $940B or 6.5% of GDP. I wonder how many strings will attach to our need to roll that over.

While we were electing a new President real control over economic policy, in a sense, has been outsourced.

Thus my call for "nationalizing" the US financial sector. I don't mean the government should buy it (although if that is the only way forward, so be it). I mean we need to regain control over US financial flows. As I've been arguing, a strong US$ that serves as global reserve currency is, in my view, no longer in US interests.

Years ago Warren Buffett warned of the US becoming a "sharecropper society." It seems as if we are rapidly moving in that direction.

Ironically, if current trends continue for long America may become an Empire, but we won't be calling the shots. Niall Ferguson coined the term Chimerica. Viewing that future through a historical lens, the Rome in Washington DC may be led by the Constantinople in Beijing.

To be on the safe side, I've been sending my son to Chinese School for 3 years.

你 好

Tuesday, November 18, 2008

Root cause of the crisis...same as it ever was

The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. George Soros

We are going through a financial crisis more severe and unpredictable than any in our lifetimes. Hank Paulson

Unprecedented. Unpredictable. Not exogenously caused.


One of the essential features of a scientific view of the universe is the notion that (at least some) events can be viewed from a general perspective. Once you decide that certain events are unprecedented and unpredictable you can throw any hope of a scientific response out the window.

That the Secretary of the Treasury is willing to argue thusly in the NYTimes is not a credit to his wisdom, but it is par for the course for a politician. After all, if the economic downturn was predictable, then he obviously failed, at the very least by failing to warn, if not avoid.

Far more curious, to me than a politician engaging in a bit of C.Y.A., is Mr. Soros take on recent events, particularly given his acceptance of the "mind-body" (or dualist) philosophy as basis for his economic view, reflexivity. The dualist premise is that there is always a dance between reality and conception- nothing is totally "end" or "ex" ogenous.

In his words: As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

This view is a specific application of a very old philosophical conception of consciousness which can be simply stated: there is a (variable) difference between what we think and what is. Plato wrote about his cave of shadow truth and the need to step into the light 2400 years ago. More recently and familiarly, Korzybski argued, the map is not the territory.

Soros' reflexivity is the same- the financial market map is not the real sector territory. When markets are operating efficiently, that map is a good facsimile and when they aren't, we get lost.

My argument with Soros (and his argument with himself) is that an endogenous financial sector crisis could only occur in the absence of real sector change. He makes this argument to push his view that more regulation would have helped avoid the crisis.

To stick with the map-territory analog, each time a new road is built, or an old road is washed away, burned out or becomes otherwise impassable, a (previously) perfectly good map needs to be updated. Soros is arguing that the territory is unchanged. The map, of itself, has been changed. Soros goes on to argue that if we had better regulated the map-makers, ensuring that they didn't change the map, we wouldn't have run into this problem.

I disagree.

Our crisis, in my view, is not entirely endogenously caused. There have been many changes in the underlying territory:

1) Increased competition for natural resource
2) decaying US infrastructure (the bricks and mortar mocked during the Tech Boom days)
3) redirection of resource towards destruction (with presumed hopes of loot at the end) rather than construction for almost 6 years

There are, of course, in addition, the chickens coming home to roost issue of our long standing abuse of the $ based international system to run perpetual and increasing current account deficits which increasingly constrains our options.

Our crisis, as are most financial crises, (and, in general, the root cause of most personal crises) is a result of denial of the potential (which continues as potential has become actual) consequences of our economic choices. The US went "all-in" on a Pax Americana and the cards didn't turn our way. The problem isn't, in a sense, a lack of regulation, as Soros argues, but a lack of vision.

Remember back a few years (and, if you listen to right-wing talk radio, even today...surrender monkeys) when dissent against the war, even if the dissent was couched in the form of "we need to rebuild our infrastructure and thus can't afford this Iraqi adventure," could cost one his or her job? Public opinion, which includes the financial type, became increasingly myopic- focused only on events or issues that reinforced the preferred view of reality.

Explanatory note: I'm not suggesting there is some grand conspiracy. Ever since humans became conscious we have exhibited a repeated tendency to self-deception with sometimes disastrous results. (This ability can, however, be a wonderful facility during periods of tragedy- not everyone can look grim truth in the eye all the time). The same myopia that can keep one on a very difficult path through terrible conditions with a happy ending can keep one on a very difficult path through terrible conditions with no pot of gold at the end of the rainbow.

In his American Theocracy, Kevin Phillips argues that this myopia is a recurring feature of modern western empires. A nation rises by virtue of a capital stock geared to a reality. Success in that context of reality leads the owners of the capital stock to take the reins of the country. As the underlying reality (as it always does) shifts, begging a redirection of the capital stock, the owners of the now increasingly obsolete capital stock fight the change by, inter alia, propagandizing a self-serving view of reality which becomes increasingly at odds with the facts on the ground.

Recapitalizing (and/or re-regulating) a financial sector that continues to adhere to a view of American dominance of natural resource flows will not help if, in truth, America is not directing those flows. The financial sector map won't match the real sector territory.

This, in my view, is the root cause of our crisis- political/economic inertia from a nation that had risen to the top of the food chain.

And that is one of the oldest stories around.

As the Talking Heads used to sing back when I was in school:

And you may ask did I get here?

Letting the days go by/let the water hold me down
Letting the days go by/water flowing underground
Into the blue again/after the moneys gone
Once in a lifetime/water flowing underground.

And you may ask yourself How do I work this?
And you may ask yourself Where is that large automobile?
And you may tell yourself This is not my beautiful house!
And you may tell yourself This is not my beautiful wife!

Same as it ever was...same as it ever was...same as it ever was...Same as it ever was...same as it ever was...same as it ever was...Same as it ever was...same as it ever was...

Sunday, November 16, 2008

If only he kept his fly zipped

Eliot Spitzer's editorial in today's Washington Post, How to Ground the Street, makes me wish he had kept his fly zipped (or frequented cheaper hookers and thus stayed off the radar).

excerpt: When my office, along with the Department of Justice, warned that some of American International Group's reinsurance transactions were little more than efforts to create the false impression of extra capital on the company's balance sheet, we were jeered at for attacking one of the nation's great insurance companies, which surely knew how to balance risk and reward.

And when the attorneys general of all 50 states sought to investigate subprime lending, believing that some lending practices might be toxic, we were blocked by a coalition of the major banks and the Bush administration, which invoked a rarely used statute to preempt the states' ability to probe. The administration claimed that it had the situation under control and that our inquiry was unnecessary.

Time and again, whether at the state level, in Congress or at the
Securities and Exchange Commission under Bill Donaldson, those who tried to enforce the basic principles that would allow the market to survive were told that the "invisible hand" of the market and self-regulation could handle the task alone.

Saturday, November 15, 2008

The TARP Fund? and Empire

A few weeks back I almost felt hopeful.

The Fed and Treasury had decided to take some of the more toxic "assets" off US banks, and gotten funding therefore. The Fed had substantially expanded its balance sheet. A new President who had been listening to Buffett and Volcker, and seemed keen to rebuild American infrastructure, was elected.

"Maybe," I thought, "inflation, even if it meant the end of US$ hegemony, would finally be embraced."

By embracing inflation I mean accepting that US imbalances are so large that a deflationary resolution would ignite a depression that would make the Great one of the 30s seem minor. It would be a sign of submission to economic reality- the US$ as currently constituted is doomed. Let's stop fighting it. Let it find its level. Let's devise a new international financial architecture within which all particiapting nations are expected to play by the rules instead of one nation dictating to the others.

Alas, my hopes have faded. President-elect Obama, in my view and as of this moment, is not the radical, right-wing talk radio claims. Ex-Clintonite men like Rahm Emanuel and (horror of horrors) Larry Summers were on the short list of his Cabinet (or already there). These men are not radical "new ideas" men. They are status quo perpetuators.

Perhaps, like Winston Churchill, who famously quipped, "I have not become the King's First Minister in order to preside over the liquidation of the British Empire," but was clever enough to realize his error and begin liquidation, President Obama will see that our Empire too begs liquidation. America as a nation, even now, seems to me without peer. The American Empire, however, seems a fast fading pipe dream.

Or it would if certain people would stop filling the pipe.

Was life in America so horrible before we opted for Empire- before we decided (inter alia) to issue the world's reserve currency? Has our quality of life, in all senses of that phrase, actually improved since we started walking this path? We were a Nation that used to believe in a better tomorrow and have become an Empire that requires it- for we have already borrowed against it.
One of the key features of a stable and enduring Empire is a strong currency that facilitates rather than hampers commerce throughout the Empire. That strength, however, should flow from wise economic policies- whether that wisdom is gleaned, as in the ideal of capitalism, from the action of free markets discovering prices and allocating investment accordingly, or elsewhere. Like the stock price of a well managed company, the value of the US$ (the currency of our Empire) should rise in a sense, of its own accord. Just as a well managed company's stock price should not require stock buy-backs to rise, so too should our US$ not need intervention.

Yet, it seems to me that is just what is happening. The vehicle by which this is financed, I speculate, is TARP.

Reflective pause: My view is not that those at Treasury and the Fed are operating under some grand plan but rather that they are fumbling, partially in the dark, trying to maintain US$ supremacy between the two ever narrowing, by virtue of the ever increasing imbalances, constraints of a crippling depression and a hyper-inflation that makes international use of the US$ as reserve undesirable.

After Bear Stearns collapsed, the chosen policy seemed to me to be $ depreciation, but this soon led the international community, Europe in particular, to complain about "beggaring thy neighbor." The inflationary constraint of loss of US$ supremacy had been reached. Accepting loss of US$ supremacy is part of what I mean by embracing inflation in the same way a chemo patient in embracing his treatment must accept the loss of hair and otherwise ill health.

What happened in the middle of September that drove Hank Paulson to Congress for funds? Why did he wish to keep the disposition thereof a secret? Why, even though the legislation requires transparency, is that disposition still a secret?

Few things inspire true confidence more than transparency.

Perhaps there are good reasons for the opacity about TARP, not the least of which is the sense that there is not now nor was there ever a clear plan but rather a fear of being exposed as fumblers in the dark. My speculation is but one of many theories that fit the facts.

Yet the government's embrace of Goldman Sachs, and its predatory (as in market forcing) Hedge Fund mentality makes me suspicious. These folk believe the financial cart pulls the real sector horse with or without consent. Recent history demonstrates their tendency to bump into constraints rather than anticipate them. Thus the wisdom, to those in charge, of recapitalizing a banking sector without requiring change in the way it does business. If the dead horse won't run, flog it harder.

But, back to my earlier question. What happened in the middle of September? What drove the Republican Executive Branch to the Democratic Congress hat in hand, destroying their (admittedly small) chance of retaining control of that office? What difference would a few weeks have made?

In a word, disintermediation. In a short span of time, the US$, which had been rallying, suddenly began to fall. LIBOR jumped. Oil prices rose, and for one day exploded. Gold prices jumped $100. Background complaints about the need to move away from the US$ as anchor of world trade came to the foreground with a bang.

Again, the inflationary constraint of fear of loss of US$ supremacy had been reached.

Since then, $100s of billions have been allocated, but for what? Credit conditions for trade, housing and other real sector investment remain tight. Yet reserves for Federal Reserve System banks have increased by a factor of 10 (check it out). Money is flowing, but not to the real sector.

Imagine the boom (albeit of a sufficiently inflationary type that would likely have put paid to the US$'s days as major global reserve) that would result from those billions flowing into infrastructure rebuilding. The absence of a boom tells me that money is staying in the financial sector enforcing prices (like a strong US$ on FX markets, weaker Gold and strong US Treasuries) which quiet calls for a shift away from the US$.

Enron, a corporation that turned its back on organic growth and opted for increasingly short term (and opaquely financed) leverage to finance stock buy-backs to keep its "currency" (i.e. stock price) strong collapsed in the first year of the Bush Administration. It would be ironic if our currency collapsed just the same way in the last year of that administration.

Regardless of the timing, it seems to me the stage is set. Barring a swift turn in the real sector, the TARP fund, whose financing is on the shortest terms, will, in a sense, go bust as well. Prices that justify the US$'s status as major global reserve are, in my view, inconsistent with those which will improve the real sector, both domestically and internationally. A strong $ is no longer in US interests.

The financial cart has long been leading the real sector horse, fortunately, horses are (usually) smart enough to not follow off a cliff.

Tuesday, November 04, 2008

The end of voting season

Over the past few weeks I've felt like a kid waiting for Christmas- stuck, as time seems to pass slower and slower.

"Are we there yet, Daddy?"

Yes we are.

The day I've been waiting for has arrived.

"Voting" season will pass....and weighing season will commence.

Threw you a curve on that one, eh?

While election day was one of the milestones on my calendar, a more pressing issue was the election mind-set wherein impressions and popularity outweigh reason. After the elections markets, recalling Buffett's quip about voting and weighing machines, are more apt to weigh- which would be a welcome change.

A glance at election cycles past informs me that election years (up to election day) are those least likely to contain "unwelcome" surprises while the 12 months thereafter are far more likely to contain those same surprises.

"Hey," you might be thinking," didn't the Nasdaq crash in 2000 and what about this year?"

A closer look at equity price action in 2000 shows that the Nasdaq did crash in April of 2000 (I still vividly remember getting that phone call in Motown, a bar in Roppongi, Tokyo) but recovered substantially into September and didn't break into new low territory until after the election.

The Nasdaq lost another 65% (double the % losses during the earlier "crash") in the 10 months after election day.

As to this year, we'll just have to see how the next 12 months unfold. I suspect the worst is yet to come.

In addition to election day, I've been waiting for the Treasury's refunding statement, which was issued (in part) yesterday. The Treasury plans to borrow $550B this quarter- a record by large measure. Tomorrow they should inform us how they plan to borrow, i.e. what mix of bills to notes to bonds.

Within the next few weeks the Treasury will then begin implementing their plan, and finding out how much appetite exists for US debt.

At the end of the month, we'll see if the COMEX has enough Gold warehoused to met delivery desires for the widely held December Gold Futures contract.

Yes, this November should be like Christmas to a finance geek like myself.

Let's hope I have reason to give Thanks when the month ends.

Wednesday, October 29, 2008

A dam burst and helicopter drop all at once?

As I've recently been noting, the Treasury is sitting on a pile of cash- we might, recalling Fed Chairman Bernanke's idea of a "helicopter drop" of money, consider this one huge payload.

At 4PM today (when the Treasury posts its daily statement) I found that the helicopter has begun to drop its payload. $115B of TARP money was distributed, which leaves $593B left to drop.

Coincidentally, the Fed decided to drop its key rates by 50 basis points, bringing the Funds rate down to 1%.

Additionally, the Fed announced: Today, the Federal Reserve, the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore are announcing the establishment of temporary reciprocal currency arrangements (swap lines). These facilities, like those already established with other central banks, are designed to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.

Of late, many financial commentators have noticed the wide spread between the Fed Funds rate and Libor rates. It seemed as if there was a dam keeping liquidity in the US and not allowing it to reach emerging markets starving for US$s.

With this Fed creation of new swap lines, that dam may be about to burst.

To recap, the Treasury has begun the release of 5% of GDP in financial sector recapitalization and direct credit market support, coupled with substantial declines in the Fed Funds rates, even more substantial increases in the monetary base and new Fed swap lines to emerging markets.

Now that's financial shock and awe!

or, if you prefer, a Tsunami allegory:

When a tsunami is unleashed, right before the waves start to hit, the water recedes dramatically and then begins to flood in....wave after wave.

Was the most recent substantial withdrawal of credit (and coincident decline in equity and commodity markets) the water receding before the Tsunami hits?

The least risky deal in the world?

Imagine, if you will, a corporation- a very large corporation, mind you, that was earnestly seeking investments in the fixed income markets.

This corporation currently has a total debt load of 4 times annual revenue, which is roughly 60%financed through sale of mainly short term paper, and roughly 40% financed through internal pension and related programs.

This corporation has almost never produced a profit and, in the last year alone, increased its debt load by 40% of revenue, again, mainly through sales of short term paper.

For the past few decades, this corporation has consistently worked to reduce its borrowing costs, thus reducing profits for investors. Meanwhile, the currency in which interest income is paid (that's right, this corporation controls the value of the currency in which its loans are repaid) has fallen substantially against most goods and services, often more than erasing the ever lower interest payments. Over the past few years, loans to said corporation have produced negative returns.

Would you loan money to such a corporation?

If not, do you own any US Treasury Bonds, Bills or Notes? If you do, you are loaning money to that corporation.

To be fair, there are, to my mind, good reasons (for some) to loan money to this corporation- patriotism, fear of collapse, etc.- but those reasons have very little to do with profit seeking.

Are Philosoper Kings rare or the norm?

Until philosophers are kings, or the kings and princes of this world have the spirit and power of philosophy, and political greatness and wisdom meet in one, and those commoner natures who pursue either to the exclusion of the other are compelled to stand aside, cities will never have rest from their evils, — nor the human race, as I believe, — and then only will this our State have a possibility of life and behold the light of day. Plato's Republic

During a recent phone conversation with my friend, Stephen Plant, I opined, in reference to the curious unwillingness of the US Treasury to put the (now $714B ) already raised "bail-out" funds to work, that the party in power might be waiting to put the funds to work until after the election, perhaps to avoid a collapse of the US$.

There are, of course, many other potential reasons behind this policy choice. Perhaps (from a less skeptical perspective) simple operational difficulties of implementing such a large and complex task are slowing them down. Perhaps (with a greater degree of skepticism) they were waiting to "paint the tape" (i.e. drive the Dow higher) in the last week before the election. As with all public policy choices, its a combination of desires that tends to explain best.

I base my (more skeptical) speculations on my study of history both of politics in general and the current administration in specific. Rarely, it seems to me, and, as the opening quote above suggests, to Plato as well, are nations led by truly altruistic experts. Much more common are those who skillfully disguise their self-aggrandizing policies in the clothes of altruism or, are not expert at all.

While it is true that abundant evidence of such policies in the past does not necessarily mean that the current Treasury policy falls into the same category, that same evidence at least suggests the current policy might so fall.

I would prefer to believe that the current policy is a result of altruistic expert views. However, I try not to let my preference get in the way of the evidence, or dismiss such speculation as a "conspiracy theory" - a term whose highly pejorative connotation in these United States seems a bit strange given that the nation was founded by conspiracy.

Treasury Watch

As of Oct. 27, 2008, The US Treasury's Total Operating Balance is: $714B

What are they waiting for?

Friday, October 24, 2008

What's going on at Treasury?

We need to get something done as quickly as possible. US Treasury Secretary Paulson, on 9/29/08 after the House rejected his initial proposal

If you happened to watch any TV news or read any print over the past few weeks, you will likely recall many public officials citing the urgent need to pass the rescue package as quickly as possible.

After some horse trading and a bit of grandstanding, the package was passed.

You'd figure, given the cries about the urgency of the bill, that once passed, funds would be raised and allocated quickly. I assumed the same.

If you assumed as I did, you would be (partly) wrong.

As I'm about to show you, funds were raised, but, as best I can tell, most haven't been spent.

The graph below depicts the US Treasury's Total Operating Cash Balance.

Yes, as of Oct. 23, the US Treasury is sitting on US$716B in cash. If I were a "Gordon Gecko"-type corporate raider, I'd think the US Treasury looks about ripe for a take-over. Drain the cash and let it go bust.

The head scratcher to me is....if it was so urgent to pass the bill, why not put the cash to work? Was the intent simply to soak up lots of short term liquidity and prop up the US$?

Notice I used "short term" for that has been the chosen financing option for this rapid and substantial expansion of the public debt.

As of end August 2008, total US Treasury Securities Outstanding was $9.646T, of which $5.479T was held by the public and the rest was "intragovernmental" (i.e. social security, Medicaid, etc.). Of the roughly $5.5T held by the public, $1.2T was in the form of bills.

As of end September 2008, total US Treasury Securities Outstanding was $10.025T (a 1 month increase of $379B), of which $5.809T (a 1 month increase of $330B) was held by the public. Of the roughly $5.8T held by the public, $1.5T was in the form of bills.

As of October 23, 2008, total US Treasury Securities Outstanding was $10.524T (a 23 day increase of $499B), of which $6.25T (a 23 day increase of $441B) was held by the public. Of the roughly $6.3T held by the public, $1.9T was in the form of bills.

In sum, since the end of August, the Treasury has increased the public debt by $878B, most of which was raised from the public ($771B) in the form of bills (roughly $680B). Its coffers are full, but funds are not (as best I can tell) flowing. Meanwhile, the average duration of US debt has become perilously short.

Do the guys in charge think of the US Treasury as a going concern? The way it appears to be run, I have my doubts.

A look at relative value

Saturday, October 18, 2008

An explanatory post

In hindsight, it might have been a defensive reaction to the Palin-led anti-intellectual nosedive of acceptable public discourse (who would'a thought one could nose-dive from the Bush-era level of discourse) at a time of obvious crisis- my reading tastes shifted some 10 days ago. Out went the recently written "how did we get here" expositions. In came the work of David Bohm and David Foster Wallace.

Overkill? Sure. But a balm to the mind all the same.

In a world where deliberation, planning and forethought have been deemed passé (from the Iraq War through the current economic crisis, policy makers have, in my view, reacted like drunk drivers- ignoring upcoming problems and then over-correcting, sometimes too late) filling my mind with prose that is complex, deliberate and well-planned has been a joy.

Revisiting Wallace's Infinite Jest has been equally joyful and tragic. The intensity of his prose reminds me of van Gogh's late work. The world must have been leaping at these minds all the time- like an Acid trip that never ended. I enjoy losing myself in both artists' work, and empathize with their reaction. Fortunately the spell is broken when I put the book down or turn away from the painting.

Yesterday, I got a break from home-schooling duties and I couldn't put the book down, thus the lack of contact, both via phone or blog.

Bohm's work, for practical purposes, has been most enlightening. His notion of an "implicate order" of reality-and-our-experience-thereof (for Bohm the distinctions are more artifacts of language than real) has implications for the more prosaic and pressing issues about which I opine.

Expect to see frequent use of Bohm's focus on context in upcoming arguments.

Thursday, October 16, 2008

The only thing we have to fear is.... ourselves...the consequences of our past actions

At his first inaugural address in 1933, Franklin Delano Roosevelt famously opined, let me assert my firm belief that the only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. Admirers of FDR find solace in the view- unreasoning, unjustified terror was the cause of the national paralysis, and, by virtue thereof, reason would banish fear, and the paralysis would cease. Ironically, the national paralysis was ended by fear- fear of a global Axis victory, which finally put US manufacturing overcapacity to profitable use, almost a decade later.

Leaders today, as then, are pushing the same view.

President Bush avers, Over the past few days we have witnessed a startling drop in the stock market, much of it driven by uncertainty and fear.....This is an anxious time. But the American people can be confident in our economic future. We know what the problems are. We have the tools to fix them. And we're working swiftly to do so.

While Bush's articulation wasn't as elegant as FDR's the view is the same. Fear not. Be confident. We have the tools.

I'm reminded of a scene from Fast Times at Ridgemont High wherein, after crashing a car, Surfer Dude Spicoli, trying to calm his passenger's unreasoning fear of retribution, says, Relax, all right? My old man is a television repairman, he's got this ultimate set of tools. I can fix it.

See the video.

Neither the passenger in the car, people in the 30s or people today, who fear the future are, in my view, being unreasonable, or lack justification. Spicoli's lack of fear of the possible consequences of his joy ride is akin to the Bush administration's lack of fear of the possible consequences of their economic joy ride. Spicoli's "don't hassle it" retort reminds me of Dick Cheney's "deficits don't matter" retort.

Cars can crash. Deficits do matter. The previous lack of fear of consequences, once exposed as unreasoning, inspires an even greater fear- of the consequences we didn't fear before.

Money, like a car, is a tool. Used wisely they can facilitate commerce or transportation alternatively. Used recklessly, they can impede commerce or transportation, and, in extreme cases, cause injury and death.

Children, beginning to drive, often lack the fear of a crash their parents have learned. Parents of these children hope that the fear can be learned without too much pain. Fear serves a purpose. It keeps us from doing something stupid, like crashing a car or borrowing more than we can hope to repay.

Man, to quote Mr. Spicoli, has got this ultimate set of tools. Fear of their misuse seems to me a good thing, and a sound platform upon which to rebuild.

Wednesday, October 15, 2008

Uncle Sam's A.R.M.

As many home-owners have or are in the process of discovering, adjustable rate mortgage (A.R.M.s) payments can quickly become unmanageable when rates reset. As interest charges double or triple the wisdom of a long term fixed rate mortgage becomes clear.

Fortunately the wise men at the Treasury Department are well versed in such matters and didn't succumb to the temptation of "teaser" rates.



According to the US Treasury, as of June 2008 (thus not inclusive of the recent bail-outs and mortgage market nationalization), of the $2.72T in government debt owned by foreigners, $1.2T has a duration of under 2 years. In other words, interest rates on that $1.2T ($1.4T including interest payments) will be reset in the next 24 months.

Expanding the scope to include all US external debt, as of June 2008, of the $11.7T of debt owned by foreigners, $6.3T has a duration of under 2 years.

One of Hyman Minsky's claims to fame is his research on the transition from financial stability to fragility in a capitalist economy experiencing a bubble- the Financial Instability Hypothesis.

The Levy Institute, continuing Minsky's research, argues: The aim of these hypotheses is to show that the normal functioning of “a capitalist economy endogenously generates a financial structure which is susceptible to financial crises”because of the higher sensitivity of the economy to changes in income, cash commitments and asset prices. Thus, it is important to explain how the financial structure of the economy (or a sector) changes. This implies studying how it is affected by the prevailing convention regarding the appropriate balance-sheet and cash-flow structures, and by thedevelopments in the productive economy: both the expectation and actual sides of the economyaffect the financial structure of the economy.

The logic of this financial instability hypothesis is that during a prosperous economicperiod, there are forces that progressively lead the economy from conservative financialpositions (hedge positions) to positions for which the articulation of cash flows is high andbalance sheets are illiquid and highly leveraged (Minsky 1986a, 210-211):

The logic of this theorem is twofold. First, within a financial structure that is dominated by hedgefinance, there will be a plentiful supply of short-term funds, so that short-term financing is“cheaper” than long-term financing. Accordingly, firms will be tempted to engage in speculativefinance. Second, over a period of good times, the financial markets will become less averse torisk. This leads to the proliferation of financing forms that involve closer coordination of cashflows out with cash flows in—that is, narrower safety margins and greater use of speculative andPonzi financing. (Minsky 1986b, 5)

In other words, Minsky, a proponent of financial regulation, argued that unregulated finance was prone to succumb to the temptation of lower short term rates. Debt duration would decrease and financial stability would be lost.

And so it has.

With the fiscal deficit expected to rise dramatically over the next 2 years, the US Treasury will not only need to finance that expansion, it will also need to roll-over the maturing short term debt.

Good luck.

In the event foreigners are reluctant to buy all this new paper, some horse trading might ensure. For instance, our creditors might be willing to extend additional finance if we agreed to changes in the international financial architecture, such as are being proposed now.

Tuesday, October 14, 2008

To vote or to weigh?

In the short term, the market is a voting machine. In the long term, it is a weighing machine. Warren Buffett

(Explanation: The father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine–tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine–assessing the substance of a company. The message is clear: What matters in the long run is a company’s actual underlying business performance and not the investing public’s fickle opinion about its prospects in the short run.)

Rome, it is said, was not built in a day. Crops do not emerge from seed and produce their fruit in a day either. Banks do not create profit in a day either, but only over time.

Time is the necessary ingredient which makes compound interest profitable. $100,000,000.00 invested in a 10% coupon bond is only worth $100,027,397.26 the next day. It will take 365 days for the value of the investment to grow to $110,000,000.




Apparently not.

In optimal conditions, it will be many years before the financial sector generates sufficient profits to repay recent government investments. Those optimal conditions include a wide spread between short rates and long rates such that banks can borrow short and lend long. The bigger the spread, the greater the profit.

But it will take time- many years of a wide spread.

Judging by recent action in the equity markets, and assuming no helping government intervention (an erroneous assumption, in my view), recent policy choices of partial nationalization and recapitalization are popular. The votes, as per the opening Buffett quote, have been cast.

Yet, the weighing remains to be concluded.

In the late 90s billions of $s were invested in Tech companies. Few, despite tremendous popularity for the entire industry, survived the eventual weighing. Ultimately, running a profitable business became more important than the ability to attract investments.

The banks have proven quite adept at attracting investments. Whether they can run a profitable business remains to be seen.

Friday, October 10, 2008

Even big guys have to take their losses

"Cut your losses and let your winners run," is a lesson every successful trader learns...the hard way. Trading, you see, is an implicit recognition of superiority- for only a quicker, smarter chap will be able to make money trading. Yet, that basic sense of superiority must be tempered by painful experience. The successful trader needs to grasp that he or she may be smarter than other traders but not the fundamentals themselves.

Fundamentals matter.

Even, eventually, for the biggest players.

Of late, the powers that be have been fighting the tape- trying to keep equity prices up, interest rates down, and precious metals down further. It is a Sisyphusian task.

In the US Bond market, foreign Central Banks, with help from the US Fed, have been trying to keep yields low. Unsurprisingly, at least to those of who for whom fundamentals matter, the credit markets have seized up. Private sector flows into Treasuries, as Brad Setser has long been noting, long ago dried up. The yield is wrong. If one wishes to attract private sector capital back into Treasuries, yields must rise.

Asian Central Banks and Sovereign Wealth Funds continue to manifest the faith evident in the run-up to the last crisis a decade ago- if we stop people from selling, the price won't fall. They, apparently, have yet to accept that prices are set in people's minds, and only manifest in the market. They also, apparently, haven't learned that key trading lesson, the first guy who dumps a declining market wins, even if the trade itself is a loser.

Better to lose a little than lose a lot, which is why cutting one's losses is vital.

But, as I noted above, this view is only learned through bitter experience. One has first to realize that one can lose, that publically perceived reality is not infinitely malleable. Recent market action is teaching the powers that be this bitter lesson.

I've been asked to toss out my 2 cents worth of opinion on possible solutions to the current mess. The following might not be worth 2 cents but here it is.

1) The US needs to accept that in the absence of private sector bond inflows, cutting interest rates only exacerbates pressure on the Fed, and other Central Banks. The US needs capital, and they will now have to actually compete for it, by paying the right price.

2) The Fed has recently thrown in the towel on its multi-year attempt to restrain the growth of high powered money. The Monetary Base is up 19.6% y/y and 17.6% q/q. I believe they should continue this action while rates rise to equilibrium. Once beyond equilibrium, the Fed can tighten as Volcker did in the early 80s.

3) The US needs to quickly shift gears on spending- redirecting military flows to infrastructure flows. The multiplier effects of the two wars have been negative. Oil is more expensive and capital is being consumed. The multiplier effects of improved, far less energy intensive infrastructure would be, in my view, very positive.

4) Fortunately, current conditions are very different from those of the Great Depression. Then the US was a major exporter- capacity was far in excess of domestic demand. Thus the disastrous impact of reduced international trade. A shift back towards current account balance would not involve, as it did in the 30s, massive lay-offs, but rather large scale hirings in, inter alia, manufacturing. As noted above, however, rebuilding infrastructure and bringing manufacturing back home will require capital, for which we will have to compete.

5) The US financial sector needs to be nationalized (the purist in me prefers a clearing of the decks, so to write, but that has a tendency to invite both nasty domestic political changes, and/or foreign invasions) and soon. Portfolios need to be marked to market in order to get capital moving again and this process is likely to be too difficult for current management to do and survive. During this week's Presidential Debate, Warren Buffett's name was suggested as a possible Treasury Secretary. I think, given the current crisis, his distaste for derivatives would be a much needed attitude in that post.

6) Most importantly, the US (and the financial world at large) needs to cut their losses. The experiment in fiat money has run its course, and failed. Gold should be embraced instead of demonized.