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.