Sunday, September 28, 2008

The irony of the "self-fulfilling crisis"

one can think of a range of fundamentals in which a crisis cannot happen, and a range of fundamentals in which it must happen; at most, self-fulfilling crisis models say that there is an intermediate range in which a crisis can happen, but need not. It is an empirical question (though not an easy one) how wide this range is. Krugman

In centuries past if one happened to mention the devil or other such evil, one was quickly rebuked, for fear that the mere mention of a thing would evoke the thing. With the benefit of hindsight, this behavior is seen as superstitious.

Unless, of course, one is speaking of economics. Economists have, for decades, been increasingly focused on "expectations" as a causal agent distinct from the facts on the ground. So long as people don't expect high and rising inflation, regardless of actual price changes, inflation will, advocates of this perspective argue, remain under control.

These "expectation gamers" as I like to call them, will only prove effective if the economy in question is in Krugman's "intermediate range."

The irony of this view lies in the effect of gaming expectations. If an economy is in the intermediate range and the expectation gamers successfully convince economic participants "everything is fine" there will be no pressure to change policy- indeed, there will be widespread resistance to such change. To the extent there is this intermediate range, gaming expectations may, in some cases, shrink it, i.e. invite a crisis which could have been avoided.

Consider a "down to earth" example:

Two hypothetical families buy a house in 2005 at twice the price of any comparable sale in 2001.

Family A becomes aware that inflation is rising and real estate prices are topping out as mortgage rates rise and lending dries up. They immediately curtail unnecessary spending, decide against a home equity loan to redo their kitchen, and replace their SUV with a compact car.

Family B (who might get their economic views from CNBC and Fox News) believes that any unwelcome changes in prices or the economy are merely temporary and thus opt to keep their SUV and take out a home equity loan to redo their kitchen.

Family B in the current environment has had their expectations gamed, and will pay the price.

Family A might make it.

The more Family B's there are in the economy at large the greater the chance that a real crisis will erupt.

Interestingly, awareness, rather than ignorance, of an impending crisis may be the best medicine.

Friday, September 26, 2008

Unprecedented Jump in Monetary Base

Since 1975, the Fed has only allowed the Monetary Base to rise by 2% or more over a reporting period (2 weeks) 3 times.

  • In Dec. 1999, fearful of Y2K problems the Fed allowed the MBase to rise by 2.89%
  • In Sept. 2001, following 9/11, the MBase rose by 6.4%
  • Last week the Monetary Base rose by 8%
One more point of comparison: The MBase rose by 1.3% during the Crash of 1987.

Y/y change in the MBase, which had been growing at roughly 2%, just jumped to 10.9%.

Operation Helicopter Drop is well underway.

Thursday, September 25, 2008

Ben Bernanke: True to his Word

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation

Ben Bernanke Nov. 21, 2002

Almost 6 years ago, before he became Fed Chairman (and, it seems to me, his promotion was by virtue thereof) Ben Bernanke promised, in the event of a deflation scare, to "produce as many dollars as it [The Fed] wishes." Lately, it seems to me, Ben has proven to be true to his word.

Admittedly, it seemed for a time that Ben wasn't going to "blink" at the first sign of the deflation monster. Lehman was allowed to fail. But, as it became clear that Lehman was but the first of many dominoes already lined up, Ben "blinked," remembered his promise to turn on the "printing press" and hunkered down with Hank Paulson to plan the "helicopter drop of money."

As he wrote in 2002: Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.

Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.

The plan which emerged from the Paulson-Bernanke meeting (which, by rights should be called "Operation Helicopter Drop") involves, as per the CBO: CBO expects that the Treasury would probably fully use its $700 billion authority in fiscal year 2009 to purchase various troubled assets. To finance those purchases, the Treasury would have to sell debt to the public. Federal debt held by the public would therefore initially rise by about $700 billion.

"A ha," you might be thinking (if you've actually read this far down on the page) the Fed hasn't promised to buy these bonds from Treasury. True, the Fed has not promised to do that, but it seems a likely outcome, to me.

If the Fed isn't going to buy these bonds (or finance banks to do the same) who will? Assuming the CBO is correct, the fiscal deficit for 2009 (which begins Oct. 1, 2008) will easily exceed $1T, or more than 2.5 times the 2008 deficit. To put it another way, $700B worth of bonds is just under 5% of US GDP and if this is added to the CBO's earlier projection of a $438B deficit the total comes to 8.1% of GDP.

To be perfectly clear- in most media reports I've read, clarity is lacking- the "taxpayer" isn't going to be paying more. That is, taxes are not going to rise, yet. Somebody needs to come up with 5% of US GDP.

If the Bonds are sold domestically (barring a substantial increase in US domestic savings rates) the "crowding out" theory comes into play- dollars which would have gone into private investment will instead be diverted into the Bonds (or worse, interest rates could jump). A collapse in private sector investment (or jump in interest rates) is exactly the opposite of what the the Treasury wants.

Alternatively, (again, barring a substantial increase in US domestic savings rates) the Bonds can be sold to foreigners and the current account deficit would increase, dramatically.

Given that the rest of the world is none too keen on recent developments in the US, with Russian and China calling for a revamp of the international financial architecture, and even our allies chiding with "I told you so," a repeat of the Reagan era "twin deficits" response seem unlikely.

That leaves the Fed, and the "Helicopter Drop."

Got Gold?

Wednesday, September 24, 2008

The "recession avoiding" bail-out doesn't exist

Federal Reserve Chairman Ben Bernanke bluntly warned Congress on Tuesday it risks a recession, with higher unemployment and increased home foreclosures, if lawmakers fail to pass the Bush administration's $700 billion plan to bail out the financial industry. ABC News

"Nonsense," says the Dude, in response to Bernanke's views.

The causes of the current economic malaise, which will deepen in the coming quarters, regardless of the policy response, are large external debts combined with large and growing deficits.

The bail-out merely shifts the form of the resolution process from a sequence of private sector bankruptcies to a more generalized inflation as private (or semi-private in the case of Fannie Mae and Freddie Mac) sector corporate imbalances become nationalized.

Tuesday, September 23, 2008

Speculation's moment of Truth

Stephen J. Obie, acting director of the Division of Enforcement, said his staff "will scour today's trading activity to determine whether anyone engaged in illegal manipulative activity. No one should be trying to game our nation's commodity futures markets."

Perhaps my memory isn't what it used to be. After all, it's been more than 20 years since this Philosophy and Physics student first started trading futures. But I seem to remember my bosses telling me how important it was- as we were speculators, not end users- to "clear up" futures positions before the last trading day of any contract. To be short a future after the last trading day is to be willing to deliver the underlying commodity and to be a long a future is to be willing to accept delivery of the underlying commodity. The last trading day of any futures contract is the moment of truth, when speculation ends.

Yesterday was the last trading day for October Crude Oil. As the day wore on and the moment of truth loomed the price soared, in my view, because there were many speculative shorts who didn't have oil to deliver. As the moment of truth nears, the question, "where's the price going to go?" is replaced by "do you have it to deliver or are you willing to accept delivery?" That is, contra the implication of Mr. Obie's view above, the rapid rise was not due to speculation, but rather to the end thereof. If the CFTC wants to probe for manipulation they should be looking into the actions of those who had been selling earlier in the month.

Monday, September 22, 2008

Got busy today

I'll have the piece on the "exorbitant privilege" of the US up tomorrow.

Tentative title: Our currency, Our problem.

Friday, September 19, 2008

Currency Crisis A-B-Cs

I got a few emails requesting a little background information on economics and finance as it relates to currency crises. For those familiar with the subject this is a post to skip.

The US, like any other nation is a corporation. A corporation is, literally, an embodiment- for our purposes, a financial embodiment. Like an individual, corporations have balance sheets with assets and liabilities, and as we have been learning recently, when liabilities exceed assets and extra finance is not to be found, they can go bust.

Imagine simple corporation XYZ that makes widgets (that's right out of the textbooks). Its assets are its production plant, any cash or account balances, and uncollected billings (accounts receivable). It's liabilities are unpaid bills (accounts payable), debt and shareholder equity. We'll leave out taxes for fun. Assets and liabilities must be equal, thus the term balance sheet.

The above paragraph is a "stock" (as opposed to flow) analysis.

On the flow side, the corporation (hopefully) is making enough revenues from sales to more than cover its labor costs, maintenance costs, dividends (if applicable) and debt service payments. If so, over time, assuming constant dividends, XYZ's asset side of the balance sheet will grow as cash and account balances rise and by virtue thereof, assuming no other changes, shareholder equity will rise.

Alternatively, if XYZ is not making a profit, and its labor costs, maintenance costs, dividends (if applicable) and debt service payments remain constant, the asset side of the balance sheet will shrink and, assuming no other changes, like a debt increase (we'll get to that next), shareholder equity will shrink, perhaps even becoming negative.

Many corporations, and virtually all start-ups experience negative equity, which is not to be confused with insolvency. Insolvency refers to a corporation's inability to pay its bills and/or service its debt.

If XYZ is running low on cash it can either sell more shares (dilution) or take on more debt, if it can find a source of funds.

The same analysis applies to governments with a few modifications.

There is (except in very unusual situations) no shareholder equity of a nation. Its property, cash and account balances, and unpaid taxes are its assets while its liabilities are unpaid bills and debt.

On the flow side, taxes are its revenues which it spends on, e.g., military, debt service, education or welfare. If taxes are insufficient to cover spending, it either sells property or raises debt.

In a closed (no foreign trade or capital flows) nation, there are no currency crises in the sense of the term we're using. The government can, if mismanaged, become insolvent but it needn't worry about being forced to do anything by foreigners (we'll leave aside complications like war).

In an open nation, currency issues add a bit of complexity.

Open nations have what is called an external or current account- the inflows and outflows of trade and investments. Other things equal, a nation that runs a current account deficit, by, say, importing more than it exports, will increase the supply of its currency held by foreigners, which can be thought of as IOUs on future output. Over time, this tends to lead to a decline in the value of that currency among foreigners (a currency crisis), who may refuse to export to the nation in question more than it gets back in imports. This, in turn, often results in adjustments in the domestic economy (the real sector), reducing imports and/or increasing exports. These adjustments can be inspired by changes in relative prices or by fiat (government decree).

In general, bringing a current account in deficit back to balance and then to surplus (to repay the IOU holders) is unpleasant in much the same way that a family will find it unpleasant to shift from an increasing debt load to paying down that debt.

Sometimes (OK often) a nation will take on foreign currency denominated debt. This usually forces the nation to run a trade surplus to generate sufficient foreign currency receipts to pay debt service (interest and principal). Alternatively, and this is when things get messy, foreigners are, sometimes, willing to lend increasing amounts of money (almost always foreign currency denominated) over time. Under these conditions, the nation can choose to run a trade deficit, using the cash lent by foreigners to pay debt service and balance the trade deficit.

Eventually, though, the external debt load becomes large, the trade balance becomes very negative (I'll leave aside consideration of domestic debt) and the prospects of the nation repaying the debt in the proper currency comes into question.

Wham-O...instant currency crisis.

The inflows of cash become outflows, necessary foreign currency to pay debt service and maintain the trade position cannot be found and the IMF comes knocking.

Unless, of course, you happen to issue the world's reserve currency, which is tomorrow's focus.

This ain't no game, Jack!

One of the pitfalls of viewing the world from a macro perspective is a lack of attention to detail.

This morning I found myself wondering just how half of the nation's mortgage industry and a good chunk of the insurance sector got nationalized without one Congressional vote.

In a recent NYTimes article I read:

Fed and Treasury Offer to Work With Congress on Bailout Plan

Published: September 18, 2008 WASHINGTON — The head of the Treasury and the Federal Reserve began discussions on Thursday with Congressional leaders on what could become the biggest bailout in United States history.

While details remain to be worked out, the plan is likely to authorize the government to buy distressed mortgages at deep discounts from banks and other institutions. The proposal could result in the most direct commitment of taxpayer funds so far in the financial crisis that Fed and Treasury officials say is the worst they have ever seen.

Senior aides and lawmakers said the goal was to complete the legislation by the end of next week, when Congress is scheduled to adjourn. The legislation would grant new authority to the administration and require what several officials said would be a substantial appropriation of federal dollars, though no figures were disclosed in the meeting.

How sweet of the Fed and Treasury to OFFER to work with Congress.

As they say, the devil is in the details- the details that remain to be worked out.

Here's a little detail, what is the criteria to be used to determine who gets to keep their house and who doesn't? Voting records, perhaps.

I hope I'm wrong here, but it seems to me that the last time Congress rushed through legislation without sufficient attention to detail, and consequent airing in the public arena, we got the Iraq War.

This ain't no game, Jack! From a micro perspective, control of mortgage and insurance funds is a pretty good way to control a population. It would be one of the first things I'd do if I wanted to "take over" a population, covertly.

Just a thought.

Thursday, September 18, 2008

How Currency Crises Unfold (1)

It will be more and more difficult for speculators to mount another offensive. It's not going to be easy if you have concerted effort on the part of governments in the regions. Amunay Viravan Thai Finance Minister, May, 1997

Sept. 18, 2008 (Bloomberg) -- The Federal Reserve almost quadrupled the amount of dollars central banks can auction around the world to $247 billion in a coordinated bid to ease the worst crisis facing financial markets since the aftermath of the 1929 Wall Street crash.

The Fed increased the amount of dollars that the European Central Bank, the Bank of Japan and other counterparts can offer from $67 billion ``to address the continued elevated pressures in U.S. dollar short-term funding markets.'' The Bank of England, the Bank of Canada and the Swiss National Bank also participated. Several of them lent funds in their own currencies as well with the Fed adding a record $105 billion in temporary reserves

Denial, it is said, is the first stage of grief, and, apparently, along with intervention, the first policy option of governments facing currency crises. The guiding idea behind the policy is simply that, but for the action of evil speculators, no crisis would exist. In other words, the underlying fundamentals are strong.

Enter Andrew Cuomo NY Attorney General: My office will investigate and prosecute short-sellers who spread bad information and false rumors and who conspire to bring down a company's stock price or who engage in other manipulative and fraudulent conduct.

The denial phase lasts until continued losses in both currency and asset markets lead the wealthy (who tend to support the status quo) in the country to support reform minded politicians. This phase can last a few months.

During this phase the bone of contention is the fundamentals of the economy. Is it really the speculators or are we doing something wrong?

And what do you mean by a currency crisis anyway?

A currency crisis occurs when a country's currency falls swiftly and significantly enough to distress the real sector of the economy.

In the cases researched by economists over the past 50 years (i.e. during the Bretton Woods Regime) a currency crisis is usually signalled by a significant decline of the currency in question vs. the US$. The Italian and British crises of 1992 are usually considered vs. the DM.

Given that the US$ remains the anchor currency, and that, so far at least, competitive devaluations are not a policy option, I'm watching the US$'s exchange rate with Gold.

Getting back to the issue of "is it real or not?," Paul Krugman has written extensively about that question:

Suppose that a country's fundamental tradeoff between the costs of maintaining the current parity and the costs of abandoning it is predictably deteriorating, so that at some future date the country would be likely to devalue even in the absence of a speculative attack. Then speculators would surely try to get out of the currency ahead of that devaluation - but in so doing they would worsen the government's tradeoff, leading to an earlier devaluation.

We can actually be more specific: given an inevitable eventual abandonment of a currency peg, and perfectly informed investors, a speculative attack on a currency will occur at the earliest date at which such an attack could succeed. The reason is essentially arbitrage: an attack at any later date would offer speculators a sure profit; this profit will be competed away by attempts to anticipate the crisis.

It is important to notice one point about this scenario. In the case just described - as in the canonical model - the crisis is ultimately provoked by the inconsistency of government policies, which make the long-run survival of the fixed rate impossible. In that sense the crisis is driven by economic fundamentals. Yet that is not the way it might seem when the crisis actually strikes: the government of the target country would feel that it was fully prepared to maintain the exchange rate for a long time, and would in fact have done so, yet was forced to abandon it by a speculative attack that made defending the rate simply too expensive.

What if it really is just speculation:

Suppose that, contrary to our earlier assumption, an eventual end to a currency peg is not completely preordained. There may be no worsening trend in the fundamentals; or there may be an adverse trend, but at least some realistic possibility that policies may change in a way that reverses that trend. Nonetheless, it may be the case that the government will abandon the peg if faced with a sufficiently severe speculative attack.

The result in such cases will be the possibility of self-fulfilling exchange rate crises. An individual investor will not pull his money out of the country if he believes that the currency regime is in no imminent danger; but he will do so if a currency collapse seems likely. A crisis, however, will materialize precisely if many individual investors do pull their money out. The result is that either optimism or pessimism will be self-confirming; and in the case of self-confirming pessimism, a country will be justified in claiming that it suffered an unnecessary crisis.

How seriously should we take this analysis? One obvious caveat understood by the economists studying this issue, but perhaps too easily forgotten by political figures, is that this analysis does not imply either that any currency can be subject to speculative attack or that all speculative attacks are unjustified by fundamentals. Even in models with self-fulfilling features, it is only when fundamentals - such as foreign exchange reserves, the government fiscal position, the political commitment of the government to the exchange regime - are sufficiently weak that the country is potentially vulnerable to speculative can think of a range of fundamentals in which a crisis cannot happen, and a range of fundamentals in which it must happen; at most, self-fulfilling crisis models say that there is an intermediate range in which a crisis can happen, but need not. It is an empirical question (though not an easy one) how wide this range is.

It is also important to remember that a country whose fundamentals are persistently and predictably deteriorating will necessarily have a crisis at some point.

That's enough wonky stuff for today.

Tomorrow: The Big Differences between the US crisis and those of nations who don't issue the world's reserve currency.

Life in a Banana Republic

Without a reduction of costs and an improvement of trade performance we will just end up being a third-rate economy- a banana republic. Paul Keating as Treasurer of Australia

To paraphrase the Republican Candidate for Vice President, "What's the difference between the US economy and that of a Banana Republic?"


OK, the difference is more than just gloss, which makes things worse. Having a currency which (currently) serves as the main global reserve insulates the US from suffering the same fate as Thailand in 1997, or at least it used to. Now, it seems, the insulation may only have served to let imbalances fester longer, which doesn't bode well.

The one-day, 10% decline in the US$ vs Gold yesterday isn't as severe as the Thai Baht's 18% decline on July 2, 1997, but it is greater than any one day decline in the Malaysian Ringgit during the Asian Crisis. The S. Korean Won posted a 14% one day decline late in 1997 (and another 13% decline within a month). Brazil's currency lost 12% early in 1999.

None of these examples of currency mis-management compares to the collapse of the Russian Ruble which lost 22%, 11%, 20%, and 11% over 4 consecutive days in August of 1998. The Ruble went on to lose 60% in one day in September of 1998. Let's hope the saying "the bigger they are, the harder they fall" isn't always applicable.

Yesterday's dollar collapse should serve as a reminder that such events aren't confined to banana republics.

I'll expand on this theme after my walk with a focus on the effects of such currency crises for debtor nations (like the US).

Wednesday, September 17, 2008

Out of Control?

We have lost control," said Hale, quoting Bernanke. "We cannot stabilize the dollar. We cannot control commodity prices." Chicago Tribune

What's the difference between a Sorcerer and a Scientist?

A Sorcerer wants you to believe his will is the cause of his miracles. A Scientist wants you to know that his miracles are part of the natural order of things.

If Fed Chairman Ben Bernanke ever thought he or the Fed or any other institution had "control" over the dollar or commodity prices he wasn't, in my view, much of an economist. The currency of institutions is credibility, not control, although when the credibility bank account is full credibility can seem like control. Credibility is earned by being right, and lost by being wrong.

I was somewhat surprised by my emotional response to today's economic developments. Today was V-Day as in vindication, but all I felt was a rising sense of dread as Gold kept soaring. Like Cassandra, I felt no joy.

As William James argued, "the truth happens to an idea." The terms apocalypse and revelation refer to the mental state when the truth happens to an idea counter to one's sense. It can (and I write from experience) be a profoundly disturbing experience which may or may not, depending upon one's willingness to adopt new modes of thinking, prove enlightening in the end.

Thus, when I consider those in the halls of power (and elsewhere) for whom today was revelatory or apocalyptic, I feel a sense of dread. To see real world events as "out of control" is to confuse one's sense of how things should be with how things really are.

As Joseph Schumpeter wrote: It is of the utmost importance to realize this : given the actual facts which it was then possible for either businessmen or economists to ob-serve, those diagnoses—or even the prognosis that, with the existing structure of debt, those facts plus a drastic fall in price level would cause major trouble but that nothing else would—were not simply wrong. What nobody saw, though some people may have felt it, was that those fundamental data from which diagnoses and prognoses were made, were themselves in a state of flux and that they would be swamped by the torrents of a process of readjustment corresponding in magnitude to the extent of the industrial revolution of the preceding 30 years. People, for the most part, stood their ground firmly. But that ground itself was about to give way.

Hopefully, today's events won't lead to a loss of credibility, and rise in confusion, but rather a Kuhnian shift. Those who had been forecasting such a turn of events based on historical research, like Ron Paul, inter alios, aren't Sorcerers but Scientists. The only thing that changed today was some people's sense of what was possible and what was not. I take comfort in seeing that there are some "laws" of economics that must be obeyed.

Cassandra Weeps

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.
"George Elliot"

For all those who were thinking, "we keep hearing about this stuff but the disaster never strikes," consider the above passage, watch CNBC, and read below.

BEIJING (Reuters) - Threatened by a "financial tsunami," the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said on Wednesday.

More later....I'm going for a walk to get my thoughts together.

Tuesday, September 16, 2008

The Sound (and Strength) of Economic Fundamentals

If an economic fundamental fell in a forest, would it make a sound?

America, it seems to me, is engaged in a form of self-mutilation I call the "death of 1000 clichés."

While waiting for the other shoe to drop, frankly, I have to say that Hurricane Ike wasn't as strong as forecast and the fundamentals of the economy are sound. (a riff on this theme, very funny)

"Feel good" Americans consume substantial quantities of drugs, both legal and illegal, to achieve their desired mental state, but the most abused narcotics are the deceptions that become clichés- clichés are popped faster than valium and xanax when things don't go well. Their frequency of use is directly proportional to the delay in effective response.

Let's consider a few.

1) John McCain, who admitted The issue of economics is not something I've understood as well as I should, nonetheless continues to assert alternatively, that the economy is fundamentally sound or that the fundamentals of our economy are strong.

He is, of course, not alone in popping this cliché, which has overtaken in popularity the late 90s, early 00s bromide, "stocks are a good investment."

The currently popular cliché begs the question, "what are the fundamentals of the US economy?"

As Milton Friedman, inter alios, have argued that, "those basic forces of enterprise, ingenuity, invention, hard work, and thrift...are the true springs of economic growth." In a capitalist economy, in theory if not in fact, money and markets are the fundamental tools used to unleash those true springs. Thus, Friedman argued, The first and most important lesson that history teaches about what monetary policy can do -- and it is a lesson of the most profound importance -- is that monetary policy can prevent money itself from being a major source of economic disturbance.

In my view, money and markets, the fundamental tools of capitalism, are working against the true springs of growth- particularly with respect to thrift.

The "sound-ness" of our debt based currency has been eroding for some time and with each addition to Federal obligation (Fannie and Freddie) and dilution of Federal Reserve collateral, the erosion picks up steam. People thought they were being thrifty pouring savings into equity and housing markets, but they weren't.

2) An ancillary cliché, "we believe in (or remain committed to) free markets," is often "popped" to counteract intervention indigestion, sometimes in combination with " a strong $ is in the interests of the US."

Free markets aim to discover fair value. When fair value isn't discovered, such as occurs when markets are used as price enforcement, instead of price discovery mechanisms, markets don't clear.

Speculators often become scapegoats when prices move in unpopular directions, yet, as many in the SE US are discovering, expensive products are better than no products. As I wrote to a friend today, I wonder how many millions of barrels of oil were sold by speculators fearful of the wrath of Congress.

Speculators also take heat when prices fall. In the equity market, their actions are often resisted by management through deception, omission, and intervention (think stock buy-backs) to the cheers of share-holders.

Yet, in an increasing number of cases, management resistance obscured a signal many share-holders, in hindsight, wish they had heeded. A little more speculation and transparency along with a little less self-dealing might reduce the number of sudden collapses in equity prices en route to bankruptcy.

The same might be said for the value of the US$. I'll take a fairly valued currency over an artificially strong one any day. The latter scenario begs the "banana republic" collapse a la Thailand '97.

3) The "it's better than I expected (or was forecast)" bromide is very popular among both financial market and weather watchers who were a safe distance from the crisis to which the cliché refers.

This begs three questions which are rarely considered by hard-core users: 1) what were you expecting? 2) have you seen the carnage? 3) why not?

I heard (and read) this cliché in reference to many recent hurricanes. In part the response is a function of weather forecasters' choice to "over-forecast" a storm to save lives (an option some economy forecasters might consider) as well as the desire among hard-core meteorologists to see a really big storm- a desire which usually ebbs quickly once they get the experience.

Yet, in the cases of Katrina, Rita and Ike, the destruction was quite extensive.

Here's a look at Ike's effects.

before and after:

The "better than expected" quip has also been used recently with respect to Houston area refineries. While the refineries proper, according to my research, did escape with limited damage, they have no electricity, water, sewage, or infrastructure to either receive or deliver product, not to mention the problems of their workers getting to work.

To repeat, their frequency of cliché usage and acceptance is directly proportional to the delay in effective response- it widens rather than narrows the always present gap between reality and the perception thereof.

Altering maps to improve one's territories is akin to putting posters of sunny skies in windows when a hurricane is about to strike.

Monday, September 15, 2008

Gas Shortages?

We are looking at another week or eight or nine days before refineries are up and going, so refined gasoline is going to be in a shortage situation because of the power outages and flooding. Sen. Kay Baily Hutchison

From the operators’ reports, it is estimated that approximately 99.6 % of the oil production in the Gulf has been shut-in. As of June 2008, estimated oil production from the Gulf of Mexico was 1.3 million barrels of oil per day. It is also estimated that approximately 91.9 % of the natural gas production in the Gulf has been shut-in. As of June 2008, estimated natural gas production from the Gulf of Mexico was 7.0 billion cubic feet of gas per day. Since that time, gas production from the Independence Hub facility has increased and current gas production from the Gulf is estimated at 7.4 billion cubic feet of gas per day. MMS 9/14/08

If the MMS and the Senator from Texas are correct, why are prices for crude and products at least on the NYMEX falling?

Why, when NYMEX crude and product prices are falling fast, have gas prices at the pump in Canada and the SE US risen 40 cents since Thursday?

It would be really funny to have a gas shortage in the country while NYMEX prices are falling.

Friday, September 12, 2008

Want to see something really scary?

Click this link: Ike Animation

I spent much of yesterday absolutely engrossed in weather sites, hurricane sites to be precise.

The funny thing was that the same types of arguments arose in debating the storm as do on financial sites when debating inflation/deflation or whether stock "xyz" is going to soar or crash.

Sadly, the effect of making a wrong call with a hurricane, as in the question of evacuation, is a bit more serious and immediate than making a wrong call on a stock.

Trolls, it seems, are everywhere.

On the bright side I learned a whole lot.

To wit: Did you know that NOAA releases data from a number of buoys in the Gulf (link here) so that you can check and see how nasty (and where) the seas are. At Shell drilling platform 42361, the winds are blowing at 105mph (91 knots) and the seas are rough. Yesterday the buoys were reporting 30+ foot waves.

According to this new measure: Integrated Kinetic Energy, Ike is the second most powerful Atlantic storm in the past 40 years (more powerful than Katrina or Rita by virtue of its vast wind field). I suspect this storm will do a lot of damage.

Have you ever read (or seen) a weatherman forecasting "certain death"...they're doing it now: All neighborhoods ... and possibly entire coastal communities ... will be inundated during the peak storm tide...Persons not heeding evacuation orders in single family one- or two-story homes will face certain death

Wednesday, September 10, 2008

Curiouser and curiouser

Given the steps announced by the Treasury Department and the Federal Housing Finance Agency on September 7, it is CBO’s view that the operations of Fannie Mae and Freddie Mac should be directly incorporated into the federal budget. The GSEs’ revenue would be treated as federal revenue and their expenditures as federal outlays, with appropriate adjustments for the manner in which credit transactions (like a mortgage guarantee) are reflected in the federal budget. Peter Orszag, CBO Director

I've been watching the markets with my mouth agape for most of the day. Fannie and Freddie get nationalized, the Director of the CBO says they should be "incorporated into the federal budget" and bonds are higher now than they were last Friday before the announcement- and much higher than they were a few months back.

The old trading "rule of thumb" I learned from Louis Bacon about buying markets that should fall (and vice versa) following a news item comes to mind but I think in this case the risks far outweigh the potential returns, except for the very short-term, nimble trader.

The theory behind the rule is that when capital flows outweigh new news one shouldn't fight that flow.

But, I wonder, on what views are the capital flows in question based?

The rise in Bonds roughly corresponds to the decline in commodity prices, and, I suspect, a distaste for Agencies will shift inflows into Treasuries.

However, while Treasury prices have held firm since the news and have risen quite a bit since April, Bloomberg reports:

Contracts on U.S. government debt increased 3.5 basis points to a record 18, up from 6 basis points in April, according to CMA Datavision prices for five-year credit-default swaps at 5 p.m. in London. Credit-default swaps on German government bonds cost 8 basis points and Japanese bonds 16.5 basis points.

So US Bond prices rise while fears of default rise dramatically.

Curiouser and curiouser.

Meanwhile, Hurricane Ike is spinning in the Gulf of Mexico and the models, which had been forecasting landfall in southern Texas (Brownsville), are now shifting northward which brings the Houston refineries or, if it shifts further still, a fair chunk of GOM offshore platforms.

But, oil prices are brushing off this news as well. Behind the scenes, apparently, the MMS reports: In preparation for Hurricane Ike, offshore oil and gas operators in the Gulf of Mexico have stopped re-boarding platforms and rigs following Hurricane Gustav and are maintaining the evacuated status to protect against harm.

From the operators’ reports, it is estimated that approximately 95.9 % of the oil production in the Gulf has been shut-in. Estimated current oil production from the Gulf of Mexico is 1.3 million barrels of oil per day. It is also estimated that approximately 73.1 % of the natural gas production in the Gulf has been shut-in. Estimated current natural gas production from the Gulf of Mexico is 7.4 billion cubic feet of gas per day.

The Gulf has been virtually shut since just before Gustav hit.

I wonder if one can buy futures default swaps on the NY oil market?

Tuesday, September 09, 2008

The Eye of the Hurricane

The eye is the calmest part of a hurricane. Surrounding the eye is the eye wall, which is the most violent part of a hurricane. The eye wall is almost a complete ring of thunderstorms and contains the strongest winds in the hurricane. link

I've gotten quite a few calls today from some old trading friends still plying their trade in the Big Apple. A few called to laugh at my tenacious defense of the inflation trade but most called to express their confusion at the current state of affairs.

"If you would have told me that Gold would be down following the nationalization of Fannie and Freddie, I would have laughed in your face," was the general sentiment of the latter group. My response was, "I'm as surprised as you are so take this view with a grain of salt, but I think we're in the eye of the hurricane."

The Winds of Change

On Feb. 3, 1960, Harold Macmillan, then British Prime Minister gave a speech to the South African Parliament which came to be known as The Wind of Change speech. The wind to which he referred was the strengthening sense of dissatisfaction with central control, emerging as nationalism, that was tearing the British Empire apart.

The wind of change is blowing through this continent, and whether we like it or not, this growth of national consciousness is a political fact. We must all accept it as a fact, and our national policies must take account of it.

The United States Empire, it seems to me, is currently facing a similar wind of change but unlike the Brits, our leaders are doing their best to deny this as a fact.

Has it been less than a decade since Fukuyama's The End of History was the new Bible, when prophecies of The American Century were viewed as certain?

The times, as Bob Dylan still sings, they are a changin'.

The CFR's Brad Setser argues today that: foreign central banks now are in a position where they can influence, through their asset allocation, the allocation of credit inside the US economy. Remember that the Fed is trying to mitigate financial market distress by changing the composition of its balance sheet — and right now, the aggregated dollar balance sheet of the world’s other central banks is much larger than the Fed’s own dollar balance sheet.

Ten years ago Russia was, to use today's language, in the conservatorship of the IMF. Today Russian Fin Min Kudrin reassured concerned parties that Russia is "not trying to sell these papers (i.e. Agency Debt)," but added a grain of salt, "We want to see that these companies emerge from the crisis. To buy the debt of a company that is in the middle of a crisis is another matter."

He continued: Kudrin said holders of U.S. assets could be worried by the impact of tax cuts carried out by President George Bush's Administration or the military action in Iraq on the U.S. budget and current account deficits.

"In this sense, of course, if the United States is an acknowledged flexible, liberal economy, and we are using dollars as a reserve currency, then of course we expect very consistent and very balanced actions from the U.S

"Ah, the zeal of the newly converted," I think to myself as I read former Communist Russia lecture the US about Capitalism.

The answer to the question, Who won the Cold War?, doesn't seem nearly as obvious now as it did a few years ago.

But, you might be wondering, what's this eye of the hurricane nonsense?

The hurricane comprised of the winds of change hit US$ and US economic supremacy head on, if you will. The leading eye wall hit during the first half of this year as commodity prices soared. The eye, or focal point of the storm, came into clear view as the Treasury nationalized Fannie and Freddie.

We will see during the second half of the year if the lagging eye wall is as powerful as the leading.

Or if I'm just all wet.

Sunday, September 07, 2008

The Mortgage Option

It's a case where market psychology became more important than the fundamentals, and that's why they had to act. There's no immediate crisis. It's not like they're going to run out of money tomorrow or Monday. It's a decision that the market is simply not going to accept the status quo. Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee.

Is it just me or do others notice how often unwanted changes in market prices (or, in this case, difficulties in clearing) are attributed to "psychology" or "speculation." The same chaps who cheered the rapid ascent of US equity prices during the 90s as a sign of US superiority (no psychology or speculation driving that!) now decry the rise in oil prices as speculatively driven and argue, as per the above, that with housing values falling and unemployment rising, international investor fears of GSE Mortgage Bonds defaulting is just psychological.

Evacuating a city before a hurricane hits is, under that head, psychological too. After all, my house isn't flooded or blown over....yet.

I suspect, now that Fannie and Freddie have been nationalized, (yes, I know the powers that be would prefer a different term, and they might benefit from a read of Shakespeare's views on the smell of rose by any other name) the good Senator is about to learn that the fundamentals of US housing finance are unsound.

After all, if the fundamentals were solid, surely at least a few SWFs who have been so eager to purchase equity stakes in major financial institutions (like Citi, UBS and ML, to name a few) would be willing to inject some capital into the GSEs.

OK, enough ranting. Let's take a look at the policy.

According to
RGE Monitor:

Key features of government intervention (final deal to be announced before Asian markets open):
1) Fannie and Freddie and their combined $1.6 trillion investment portfolio business financed through agency bond issuance will be taken under a government-run conservatorship for an orderly restructuring process--> new housing law says that under a conservatorship, the authorities would aim to preserve Fannie and Freddie assets, rather than dispose of them.
2) The value of the companies' common stock would be diluted but not wiped out, while the holdings of other securities, including company debt and preferred shares likely to be protected by the government. (Washington Post)
3) taxpayer backstop for combined $5.3 trillion F&F owned or guaranteed debt: taxpayer funds will be used to pay any cash-flow shortfalls (e.g. due to borrower defaults) on mortgages F&F own or guarantee;
4) capital infusions to F&F in conservatorship on a quarterly basis depending on reported results instead of large capital infusion upfront;
5) Fire CEOs and replace the board

Points 3 and 4 are the keys to assessing the impact of this policy on US public sector finance, and consequently, US Bonds and the US$, inter alia.

Unlike the last US mortgage industry bail-out, which was financed by a combination of direct Treasury appropriations ($55.9B) and RefCorp Bond sales ($30.1B), this bail-out will not require a large upfront capital infusion, perhaps because, as the
NYTimes avers, It is not possible to calculate the cost of any government bailout.

What makes calculation so difficult? The nature of a mortgage contract is a good place to start.

As Michael Lewis described so humorously in Liar's Poker, "no trader or investor wanted to poke around suburbs to find whether the homeowner to whom he had just lent money was creditworthy." Additionally, "[mortgage owners] couldn't be certain how long the loan lasted." If interest rates fell, people refinanced and that sweet 9% per annum investment turned back into cash, which could no longer be invested at 9%.

Default on one side and refinancing on the other makes analysis of mortgage cash flows more option like than bond like (admittedly, other bonds can default or be refinanced, but this is more the exception than the rule- to wit, there isn't a refinance index for corporate of government bonds, as there is in the mortgage industry).

Ever clever mortgage investors, however, found a way to hedge refinance induced discontinuities, they bought US bonds, with leverage. In that way, when interest rates declined and refinancing increased, mortgage investors had, in a sense, already invested the cash received at higher rates.

Alas, declining interest rate induced refinancing is not what ails the US mortgage market, rather it is defaults caused by rising rates (and inflation in general). The hedge which worked so well in the case of falling rates, came at the cost of increased risk under opposite conditions.

Who would'a thunk it?

It seems worth noting that one of the factors which kept US Gov't Bond rates so low while the mortgage machine was humming along was the leveraged hedge.

But, I digress. Let's try to get some sense of the risk of default, applied to the scale of the problem.

Unlike refinancing, which at least leaves investors with principal, in the form of cash, intact, default turns bond holders into real estate investors, in a falling market. I suspect neither China nor Japan is keen on owning large tracts of US suburbia, which may partially explain the attractiveness of the new policy.

As noted earlier, rising defaults seem to be a function of a combination of rising rates, particularly in the case of the ARMs promoted by Mr. Greenspan a few years ago, rising prices in general and stagnant wages. If we wanted to get technical a first stab might be f (i, cpi, w) = default rate where i = change in interest rate, cpi = actual inflation rate, and w = % change in wages for a certain term and type of mortgage.

So long as i and cpi were rising faster than w the default rate would, I assume, rise.

This, it seems to me, presents policy makers, having opted to guarantee some $5.3T of mortgages, with a very difficult scenario given the effect wage arbitrage has had on restraining US incomes. Keeping inflation down might require higher interest rates, which, assuming stagnant wages, might actually raise the default rate.

Rising defaults, by virtue of the need to guarantee, increases the fiscal deficit which will eventually push rates higher still, perhaps pushing more mortgages into default and the cycle begins again.

The key, it seems to me, is keeping inflation down. If oil prices continue their climb (despite the recent sharp decline oil prices are still up 35-40% y/y), and interest rate increases are needed, the cost of this bail-out could easily be in the 100s of billions with a trillion not out of the question.

An alternative method of keeping a lid of inflation is a strong US$, which, it seems to me, has been a focus of recent Central Bank activity.

If the powers that be can keep the US$ stable without igniting a more globalized inflation (which, I suspect, will prove quite difficult) the effects of this bail-out might not be catastrophic.

If, however, the US$ starts to fall and oil, and other prices begin to rise again...well let's just call that US$ doomsday.

On that note, have you read the news about Hurricane Ike?

Friday, September 05, 2008

The Inflation Addiction

Now the chief effect of inflation which makes it at first generally welcome to business is precisely that prices of products turn out to be higher in general than foreseen. It is this which produces the general state of euphoria, a false sense of wellbeing, in which everybody seems to prosper. ..... It is this seemingly blessed state in which there are more jobs than applicants which Lord Beveridge defined as the state of full employment--never understanding that the shrinking value of his pension of which he so bitterly complained in old age was the inevitable consequence of his own recommendations having been followed.

But, and this brings me to my next point, "full employment" in his sense requires not only continued inflation but inflation at a growing rate. Because, as we have seen, it will have its immediate beneficial effect only so long as it, or at least its magnitude, is not foreseen. But once it has continued for some time, its further continuance comes to be expected. If prices have for some time been rising at five percent per annum, it comes to be expected that they will do the same in the future
. F. A. Hayek Can we still avoid Inflation?

During the past few years of generally rising prices there have been intermittent periods of price declines. Each of these periods has been hailed (by some) as the onset of a deflation or (by others) as a mere pause in a longer trend. Either outcome is certainly possible- the Central Banks can always deflate- but the political will to weather the storm caused thereby is rare.

Of late, as Gold holders like myself are keenly aware, commodity prices have not been rising. And, as has tended to occur, to greater or lesser degrees, during each such "deflationary" phase over the past few years, equity markets have tended to fall and unemployment has tended to rise.

Today's US Unemployment data seems a case on point.

In my view, the reason previous such phases have proven to be but a pause, instead of a new trend, and why I believe this phase will resolve similarly, is political- the will to endure the hardships of terminating the inflation has not manifested. Ron Paul's message did not appeal. Faith in a painless fix remains strong. Our addiction to inflation remains.

As Arthur Burns argued 30 years ago: But whatever the virtues or shortcomings of central banks may be, the fact remains that they alone will be able to cope only marginally with the inflation of our times. The persistent inflation that plagues the industrial democracies will not be vanquished-or even substantially curbed-until new currents of thought create a political environment in which the difficult adjustments required to end inflation can be undertaken.

Until that new current of thought gain credence, I'll stick to my inflationary outlook.

Wednesday, September 03, 2008

On the Gustav "non-event"

From the MMS: (9/3/08) From the operators’ reports, it is estimated that approximately 95.8 % of the oil production in the Gulf has been shut-in. Estimated current oil production from the Gulf of Mexico is 1.3 million barrels of oil per day. It is also estimated that approximately 91.6 % of the natural gas production in the Gulf has been shut-in. Estimated current natural gas production from the Gulf of Mexico is 7.4 billion cubic feet of gas per day.

From Entergy (Major Electricity Supplier to Lousiana): (9/3/08) Hurricane Gustav caused the second largest number of outages in company history, behind only Hurricane Katrina. Gustav restoration rivals the scale and difficulty of Hurricane Katrina restoration.

Back to School

It's early September. Labor Day is past and the kids are heading back to school. For me, as a homeschooling Dad, it's time to get back to work- teaching. Less time on the golf course and more time at home also means more time publishing my musings to this blog.

Thinking back on the summer just passed a line from the Grateful Dead's Truckin' comes to mind- What a long, strange trip it's been.

Back when school closed in the latter half of June the commodities markets were on fire, but soon to roll over. Oil was trading at $135/bbl on its way to $145+ while Gold was hovering around $900 after a late March run above $1000, to cite two examples.

Many, apparently, got on the long commodity train only to find, in hindsight, that it was ahead of schedule. One such fund, Ospraie Management, LLC, has "exceeded the 30% drawdown threshold that provides investors a right to redeem their shares," and has decided to close shop.

This event, as The Oil Drum guys posted recently, is reminiscent of the collapse of Amaranth 2 years ago. Apparently, the old "rule" that oil prices (which lag demand) peaks between Memorial and Independence Days, still holds.

Interestingly, US petroleum (and product) stocks, at least according to the EIA's monthly data, peaked in Sept. '06 at 1,785M bbls (87 days of use), as Amaranth was shutting down. As of 8/22/08 (thus not inclusive of Gustav effects) US petroleum (and product) stocks are 1,700.6M bbls (84 days of use). While Gustav was no Katrina, current levels of petroleum stocks, having climbed some 50M bbls since March '08, may also prove to be a local peak.

Timing, when trading with leverage, is everything.