Monday, September 28, 2009
Gotta' love Google.
I was all set to open with the more familiar "the business of America is business" and decided to find the source. A quick search and I discover my error, and the correct quote. The speech containing the quote, The Press Under a Free Government, is worth a read if only to recognize the parallels to today.
But I digress.
The business of America is no longer business, but finance- as I discovered perusing the Flow of Funds data.
I've written previously about the increasing share of US domestic corporate profits earned by the financial sector so I'll just cut to the graph.
While non-financial domestic corporate profits have shrunk from a Korean War inspired 11% of GDP to average around 5% of GDP since 1970, the financial sector's profits have been growing.
As a % of equity market value the financial sector's stock is rising as well. The graph below depicts the ratio of non-financial corporate equity market value divided by that of the financial sector.
Just as we have voted in politicians who have facilitated the shift to Ponzi finance, we voted (with our money) for the institutions which make it possible.
The love affair with finance and disdain for what, during the tech boom, we called the "bricks and mortar" industry- and admittedly a failure, by some in those industries, to accept the transition to maturity- has inspired, for want of a better word, envy in the non-financial sector. While financial sector stocks seem to levitate on their own, non-financial sector stocks, if intent can be inferred from behavior, are believed to require a boost. I suspect the use of options as payment has something to do with this as well.
In the aggregate data, depicted below, non-financial stocks seem to disproportionately love the "stock buy-back" sufficiently that aggregate issuance is quite negative for the sector.
Additionally, the non-financial sector, since the mid-80s has- a true sign of envy- opted to copy finance, by breaking into that field. GE Capital and GMAC Financial are two prominent examples. The aggregate data for the sector, depicted below, shows the shift towards the increasing use of financial assets relative to tangible assets.
This, as Minsky predicted, increases the beta of the entire corporate sector to changes in financial variables.
To paraphrase Nixon, "we're all Ponzis, now."
Coming up, hopefully in the next day or two, a look at the financial sector alone, with a focus on commercial banking and a final post (for this series) on government and the missing $4.5Tln.
Sunday, September 27, 2009
When looking around for a scapegoat for the financial mess we're in, go directly to the mirror. While the government could have (should have, I believe, after looking at this data) been far more restrictive of the financial sector, we did vote them in.
First, the good news. The graph below depicts total financial wealth (i.e. non-tangible assets less financial liabilities not including mortgages) as a $ of GDP.
We're not broke, yet.
The next graph depicts the degree to which we've mortgaged our real estate.
Now for some bad news. Do you know there was a time when US households owned a good chunk of Treasury debt? Ah, the good old days of self-finance.
Now for the Minsky part. The theory above, in layman's terms, argues that over time, when an economy expands without serious contractions, finances will become increasingly risky. Minsky wrote of a shift from hedge finance (when debt, both principal and interest, can be serviced from cash flows) through speculative finance (when debt must be rolled over as only interest payments can be serviced from cash flows) and into Ponzi finance (when cash flows cannot cover interest payments and thus new debt must be added or assets sold). The idea in the Ponzi finance stage is that asset appreciation will compensate for the extra risk.
In the Ponzi stage the economy becomes increasingly sensitive to changes in asset prices, like now.
The graphs below depict what I call Household (and Non Profit Organizations) liquidity (i.e. checking, savings and other time deposits, money market funds and all credit market securities (but no equities) less total financial liabilities as a % of GDP). The second graph of non-market liquidity is the same except with credit market assets removed.
Until the early 90s, there was enough cash (and cash equivalents) on hand to pay off all debt. If we include credit market securities, like Treasuries and (oops) Asset backed securities the personal sector had enough cash on hand or offsetting interest earning assets to pay off all debt up until 2002. Zero (or near) interest rates, of course, make the choice of being liquid a bit painful. It's almost as if the Fed wants to push the economy into a Ponzi finance state.
I don't mean to suggest we (collectively) are broke, just that, as Minsky argued (and the data bears out) our balance sheets are increasingly betting on real estate and equity price appreciation with borrowed money. Worse, the data above are not representative of the average joe. There's a lot of assets owned by a few people in this data (admittedly they owe a fair bit of the debt). The point though is that even in the aggregate data, there's not much slack to deal with cash flow interruptions, like unemployment.
I'll leave you with one final graph showing total and mortgage liabilities as a % of personal income to illustrate the point.
*yes, there's still more, but I'm going to sleep now. Back some time tomorrow with another dismal chapter.
You know the old warning about mixing wine and beer (or was it gin and vodka)? Along the same line of thought, don't revisit the work of Hyman Minsky before a long term look at the Fed's Flow of Funds data. It might make you queasy.
If, however, you have a strong stomach like me, thanks, perhaps, to a few years spent eating road-side food in SE Asia (Sate Angin in Jakarta, anyone? that's a joke, btw- angin is haram and stall food is often delicious) lend me your eyes as I show you a few graphs and offer a few ideas to consider.
If you're unfamiliar with the term, flow of funds, this link might be useful. In the interests of full disclosure I traded for many years before I got my head around it.
The first graph shows the breakdown of debt owed divided by GDP (chosen more to remove inflationary effects than to suggest other relationships) among various economic sectors: HH- households and NonProfits, Biz-Non Farm Corporate and Noncorporate Businesses, Fed- Federal Government, Fin-Total Financial Sector, RoW- Rest of the World
The second graph shows the breakdown of debt owned by various economic sectors. Yes, It's true the banks do own (or at least have a hell of a mortgage on) the country.
Removing the financial sector from the second graph you can get a better sense of who's going to be second in line when bankruptcy proceeding begin on the USA (just kidding, I hope).
Putting the pictures into words, Banks (who are, of course, owned by people, equity liabilities are not included in that data set) have always had a big lien on the country, but that lien has doubled (relative to GDP) since 1980.
Households used to be a major source of finance in the country but as their distaste for debt faded along with memories of the depression they started to borrow more than they leant. Then, as restrictions to foreign capital inflows fell (how else to maintain a trade deficit without settling in specie) the Rest of the World became a significant source of funds. In 2001, The RoW overtook US Households as a source of funding and this trend has accelerated.
Warren Buffett was wrong, we weren't going to become a sharecropper society, we already were one.
But, you might be wondering, I've got the queasy stomach but where's the Ponzi finance.
I should have part 2 of this essay ready later tonight or certainly by tomorrow.
Thursday, September 24, 2009
As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets.
Ownership or sponsorship of hedge funds and private equity funds should be among those prohibited activities. So should in my view a heavy volume of proprietary trading with its inherent risks. Paul Volcker
Speaking to the House Financial Services Committee, former Fed Chairman, Paul Volcker took dead aim at "too big to fail" and hit that nail on its head. Instead of designating certain financial institutions as "too big to fail" the US, he argued, needs to separate the aspects of finance which are too important to fail- broadly, commercial banking functions- from the more speculative practices- hedge and private equity funds and, more generally, proprietary trading.
In other words he is calling for the Banking Act of 1933 (a.k.a. the Second Glass Steagall Act), which separated commercial and investment banks, to be resurrected. With the benefit of hindsight, other things equal (which is never the case), had the Financial Services Modernization Act of 1999, which allowed consolidation of financial firms, not been enacted, the taxpayer cost to maintain a functioning commercial financial system would have been much less.
In econo-jargon, the benefits of economies of scale in consolidation are outweighed by additional costs associated with maintaining a functioning commercial financial system after the inevitable failures. This argument is predicated on the validity of Minsky's theory- capitalist finance, while a marvelous organizational tool, inevitably, over a period of generations, tends to systemic failure. If such is true, cost effective procedures for keeping vital financial functions operational, thus avoiding, inter alia, economic distress sufficient to expose a nation to invasion or substantial domestic poverty and discord (which lends itself to radical political solutions inconsistent with currently desired forms of representative government).
None of the above is an argument against more speculative financial practices. If you want to be a highly paid hedge fund manager who trades with high leverage and you don't want the Fed complaining about your risk management techniques- go ahead. If you succeed, great. If you fail, don't expect to be bailed out.
It seems worth noting that Goldman Sachs may well have failed had it not gotten the NY Fed to designate it a bank holding company (a sordid affair I opined on a few months back) and thus eligible for bail-out funds. This would not have happened if the old Banking Act was still in force. In other words, we could have exorcised the Goldman demon.
This seems to me a wise compromise. It doesn't prohibit investment, indeed, it might even lead to easier regulations on that sector. Yet, it considers commercial banking a vital part of America life, much as utility providers are, and thus government protected, and regulated. We don't want to lose the commercial flow of funds any more than we want to lose the flows of electricity or water. The phrase mature industry comes to mind, in particular the risk averse sense contained therein.
I was asked earlier today what I thought of Volcker's testimony. My reply, with my head nodding yes, "what he said."
Now we just need to wait for another financial collapse to get it passed.
Wednesday, September 23, 2009
After reading the Bloomberg article noted earlier I was worried about the continued supply of ZIRP. Fortunately, if you're a highly leveraged money center bank, the Fed has promised to continue jerking ZIRPs for an extended period.
Perhaps the conversations which inspired the Bloomberg article about potential reverse repos aimed to allay the concerns noted in the minutes of the last Fed meeting: Participants noted concerns among some analysts and business contacts that the sizable expansion of the Federal Reserve’s balance sheet and large continuing federal budget deficits ultimately could lead to higher inflation if policies were not adjusted in a timely manner. To address these concerns, it would be important to continue communicating that the Federal Reserve has the tools and willingness to begin withdrawing monetary policy accommodation at the appropriate time to prevent any persistent increase in inflation.
As most interested observers of finance know by now, the lag between investor concern and investor sale has diminished rapidly over the past few decades. Dependence on international finance decreases that lag further while the addition of increased leverage increases volatility. As Einstein might have put it, "timely" is a relative term.
For now though, the Fed remains largely unconcerned about inflation: Most participants anticipated that substantial slack in resource utilization would lead to subdued and potentially declining wage and price inflation over the next few years; a few saw a risk of substantial disinflation. However, some pointed to the problems in measuring economic slack in real time, and several were skeptical that temporarily low levels of resource utilization would reduce inflation appreciably, given the loose empirical relationship of economic slack to inflation and the fact that the public did not appear to have reduced its expectations of inflation.
With the benefit of hindsight I suspect future researchers will look back on the Fed's US centric approach to price inflation pressures as misguided. While the world may still feel the effects of a US sneeze, global commodity prices increasingly ask "how high" when the Chinese say "Jump!", regardless of US resource utilization slack. Given the continued availability of ZIRPed US$s why wouldn't speculators enjoy a ride on that train, and raise prices further still.
Has it been so long since the Fed drained liquidity that the terminology must be preceded by "so-called" and followed with an explanation?
More to the point, I can remember (and I'm not that old) when the idea of the Fed discussing, pre-emptively mind you, liquidity withdrawals with primary dealers to make sure no damage would be done would have been considered absurd. The point of liquidity withdrawal is to do damage to primary dealer balance sheets, to force them to more efficiently ration the flow of funds.
The Fed, of late, has been urgently defending its need to keep secrets, from Congress and even from the Treasury. 20 years ago the secrecy the Fed wished to maintain was from the Primary dealers. To wit, here's an excerpt from the NYTimes in December 1989: Apprehension about what the Fed will or will not do is a more or less constant condition among credit market participants. But the worry seems to have a sharper edge now because it is generally perceived that over the last month or so dealers have taken on big inventories of securities in expectation of another easing move.
Back then, before our financial system became so wonderful, the Fed was actually trying to regulate money. They knew that the element of surprise was a useful tool to keep primary dealers on their toes. Would you want your local health department to announce surpise inspections of local restaurants? A quarter century ago large banks had Fed watchers, who sifted the tea leaves trying to predict the size and direction of Fed interventions in the money market. Those days are now gone.
The transparency of Fed actions Greenspan provided to the primary dealers turned that body from regulator to lobbyist.
Tuesday, September 22, 2009
... the Nixon era was a time in which leading figures in both parties were capable of speaking rationally about policy, and in which policy decisions weren’t as warped by corporate cash as they are now. Paul Krugman
Missing Richard Nixon- what an odd notion. Yet, I agree with Mr. Krugman. In one key respect, Nixon was wiser than Bob Rubin, Larry Summers and the supporters of IMF Gold sales. He knew that keeping Gold was a far better policy than selling it if one wished a strong US$.
In the past I've written disparagingly about Nixon's closing of the Gold window. In hindsight, and on reflection, I should have criticized his (and others' before and especially since) policies which created greater demand for Gold than US$s. If the US$ was indeed as good as Gold, the nasty currency speculators wouldn't have been trying to drain US vaults.
In the event, as the youtube clip below relates, currency speculators did try to drain US vaults and Nixon wisely, in this regard, pulled a Roberto Duran- No mas.
Had he tried to defend the $35 link to Gold "down to the last bar" as recommended by Treasury Under Secretary Barr, I doubt the US$ would have retained its dominant position in the reformed Bretton Woods system that emerged in the late 70s.
Interestingly, for those fearful of the agreed upon IMF sales, this isn't the first time for such a policy.
Shortly after Nixon's resignation, the Ford administration, in January 1975, began selling US Gold (after removing US ownership restrictions), a practice which continued through the Carter administration. In total some 530 tonnes were auctioned. Coincidentally, the IMF sold some 700 tonnes in a series of 45 auctions beginning in 1976 and ending in 1980. The price of Gold rose from $175 early in 1975 to well over $700 in 1980 while these auctions were ongoing. This at a time when the rest of the world's ability to pay was far less than it currently is. China can buy the whole lot from the IMF with a few month's worth of current account surplus.
I won't argue causality (as other factors, importantly the Fed's earlier easy money stance and the Volcker Fed's tight money policy had large effects), but I do find it interesting that the US$ kept sinking against Gold while US and IMF reserves were being sold, and stabilized when the auctions ended.
Consider. If your bank was selling its reserves would you consider that a sign of strength or a sign of weakness?
Monday, September 21, 2009
But now that we’ve stepped back a few paces from the brink — thanks, let’s not forget, to immense, taxpayer-financed rescue packages — the financial sector is rapidly returning to business as usual. Paul Krugman
One of the tenets of Keynesian response to crisis, as his letter to FDR makes clear (excerpt below) is recovery first, reform later. Thus, it seems, Paul Krugman's amazement that the financial sector is dragging its feet on reform.
Letter to FDR: You are engaged on a double task, Recovery and Reform;--recovery from the slump and the passage of those business and social reforms which are long overdue. For the first, speed and quick results are essential. The second may be urgent too; but haste will be injurious, and wisdom of long-range purpose is more necessary than immediate achievement.
As I noted over the weekend, the time to implement change is when things are grim, as the Bush team did, pushing the Patriot Act through Congress (this is not an endorsement of the legislation, just an acknowledgement of tactical success) while smoke was still rising from Ground Zero. This seems consistent with my own experience- the mind is most open to change when times are tough.
This is not to argue that the reforms themselves must be hastily conceived. Just as the Bush team, as has been amply demonstrated, came into office with an agenda of foreign policy reform and jumped on the chance, the Obama team should have been ready with their reforms so they could hit the ground running to improve their chances of success. Given the nature of populist politics I would even think holding the Congress hostage, in a sense, by withholding recovery money until reform was passed, might be a useful tactic.
Tactics aside, I find Krugman's amazement at this turn of events funny coming so soon after his Keynesian chest beating.
But, this essay isn't a dig at Keynes, but at disciples more generally. I find Keynes work interesting, Keynesianism much less so. I find Mises work interesting, Misean work less so....etc., etc.
Carl Jung once remarked, "Thank God I am Jung and not a Jungian," which captures the essence of my point. Jung could be human. He could err. He could learn, adapt and improvise his views to the given context. Disciples, awed by their God, tend to be less flexible.
I think, in final response to Krugman's essay, the economics profession could be of more service in the current situation if they stopped rooting for the respective home teams and started working on the problem at hand- dealing with the rent-seeking financial sector.
Sunday, September 20, 2009
What a surprise, for me, to read James Grant's forecast of a barn-burning recovery. Long a member of the sky is always falling crowd, Mr. Grant's change of heart had me scanning (and then rescanning) the entrails of his essay, looking for the sardonic wink (might we be burning the barn?), but to no avail. I felt like Shakespeare's Caesar, recognizing the knife in my chest came from a trusted friend- et tu James?
I took a walk on this bright sunny day and wondered. Had Mr. Grant been bought off?- doubtful. Lost his mind?- no, the wit behind the prose was evident. Why then change one's tune after so long, when the stopped watch was finally correct?
With the thought of Shakespeare in mind, I drifted from the tale of a Dictator brought low to that of a tragic love affair, and a lover reconciling her love for a member of an enemy family:
'Tis but thy name that is my enemy;
Thou art thyself, though not a Montague.
What's Montague? it is nor hand, nor foot,
Nor arm, nor face, nor any other part
Belonging to a man. O, be some other name!
What's in a name? that which we call a rose
By any other name would smell as sweet;
So Romeo would, were he not Romeo call'd,
Retain that dear perfection which he owes
Without that title. Romeo, doff thy name,
And for that name which is no part of thee
Take all myself. - Juliet
"Ah," I thought, "what's in a name indeed."
The name in question, recovery.
Mr. Grant's argument is simple. We've had the bust, and a sharp one at that, thus the recovery to follow will be as sharp.
Perhaps. Like Mr. Grant I can't really know, but I think if he smelled this thing called recovery it would not smell so sweet, because the preceding decline was arrested, attenuated, adding alliteratively, adulterated. Boom, it seems to me, follows bust only when the bust has truly plumbed the depths.
We haven't, I believe, hit bottom.
To wit, according to the more classical school on which Mr, Grant usually relies, the bust is a cleansing process whereby the bad debt is purged. Call it a financial high colonic.
Our bad debt has not been purged. Our balance sheet, like Japan's, remains filled with assets of such dubious quality they have rightfully earned the name, "toxic."
To invert the sense of Juliet's musings above; although a recovery by any other name would smell as sweet, calling the proverbial bouncing dead cat a recovery will not mask its toxic air.
Saturday, September 19, 2009
Interestingly, the IMF , according to their press release, would be prepared to sell gold directly to central banks or other official sector holders if they expressed interest.
Judging by recent reports from Russia, China and Hong Kong, there is indeed an interest for Gold from official sector holders.
In the event, I suspect redistributing the world's Gold will decentralize Central Banking, and maybe even make the world's balance of payments system a but more robust as its reliance on the US$ as reserve asset of choice, declines.
It looks like the barbarous relic is coming back into vogue.
“That argument is to the financial regulation debate what the death panel argument is to the health insurance debate,” he said, referring to incendiary claims that health reform would give bureaucrats the power of life and death over senior citizens. FT
President Obama's Director of the National Economic Council, Larry Summers, has hit the nail on its head. The deeply entrenched rent-seekers in the US economy, notably those in health care and finance will use all the techniques of propaganda to maintain the status quo. These are the fruits of such virtuous (I believe) principles as free speech and bicameralism, as the founders discovered to their chagrin more than two centuries ago.
There is no such thing as a free lunch.
As is always the case, those in favor of maintaining the status quo have cultural inertia on their side. This is particularly the case when, as in the current situation, recovery efforts precede reform as the shock of crisis, which opens the mind to the virtues of change, fades.
Imagine if, instead of reforming US foreign policy in the weeks after 9/11, the Bush team directed their energies to cleaning up the mess and making the broken families whole, and waited months before trying to pass the Patriot Act, gain funding for the War in Afghanistan and initiate the War on Terror. I suspect if the Bush team waited a year before they tried to pass such reform measures they too would have run into the same inertia bogging down Obama's reforms. Legislators might have actually read the Patriot Act.
In the event, the Bush team struck while the iron was hot, while the Obama team worked to reassert a sense of normalcy into financial markets. What a different world it would be if those choices had been reversed.
The question for Obama's team is this. What are they prepared to do to pass their reforms?
Will they wait for another crisis and risk being blamed as causal agents? Or will they ram legislation through and deal with the inevitable backlash-perhaps even inspiring another crisis and further muddying the waters as their reforms are blamed? Are they willing to pay the price Bush the elder paid when he raised taxes, and allowed Clinton to reap the benefits?
Oh well, nobody said it was going to be easy.
Thursday, September 17, 2009
One alternative would involve the Fed and Big Finance backing down voluntarily, but if the events of last year didn't inspire a desire to retrench....well, what's it going to take?
I'm not, by the way, the first to suggest the possibility of violence. Perhaps he was speaking figuratively, but President Obama told Big Finance a few months ago, "My administration is the only thing between you and the pitchforks."
I suspect, however, the disagreement between my forecast and more reasonable-natured views lies in the respective senses of human nature. I base my sense on my read of history and the assumption that humans haven't changed much in the past few thousand years or even the past hundred. Nor do I think the US is immune to such conflicts.
I noted the Whisky Rebellion as an example of US intra-national violence in the last essay. While it was the first such example, it certainly wasn't the last. Estimates vary, but some 650K people died while the question of the limits of states' rights was decided in the Civil War.
The last time Big Finance squared off against the people in this country, i.e. as the Progressive Movement formed, blood and death were not uncommon outcomes. While I don't agree with his populist self-righteousness, Howard Zinn's facts in The People's History of the United States are not disputed. Police and private security guards gunned down strikers while Unions, in their turn, destroyed property and intimidated labor through all means available, including murder. According to one (increasingly ironic) read of history, the Fed itself was created, in part, to help ameliorate the effects of inevitable recessions and forestall violence.
More recently, the question of the rights of African Americans was settled in blood and death in what can be seen as an echo of the Civil War.
To be clear, I am not an advocate of violence. I'm an observer who, by way of analogy, isn't surprised to see two hungry dogs fight to the death over a scrap of meat. If you don't want them to fight, keep them fed. Sometimes though, avoiding conflict is far more difficult.
The founders of this nation, as is clear in much of their private thoughts (diaries and letters), were well aware that the unresolved issue of slavery would haunt the nation in the future (the contrary view was the nation wouldn't form if a resolution was required). Such things can be foreseen, if not always avoided.
A further point, if I may, about the meaning of resolution. In the context of this essay an issue is resolved when people are no longer willing to fight. Whether the resolution is durable is another issue entirely. Time will tell.
The relationship of money and government and the people remains unresolved. A resolution of some sort will, in my view, be required before the nation gets back on its feet, so to write. This, it seems to me, is THE political issue of the generation. I do not envy those tasked with resolving it.
Wednesday, September 16, 2009
History is filled with power struggles: Who owns the Mediterranean? Rome or Carthage, Which is the True Church? Rome or Constantinople, Whose vision of God is purest? Christ's or Mohamed's, Who decides the rules of divorce? The Pope or the King of England, From whence does the controlling power flow? The King of France or the people.
Who has the ultimate power over money? The Fed or Congress (and by the extension, the people, unless Congress wants to side with the Fed).
These are the showdowns that blaze the path of man, until the path fades and the cycle begins again. While these battles often begin in ivory towers, so to write, they end in blood and death.
Take the question of taxation. The American colonists rallied around the slogan, "no taxation without representation," and fought (and died) until the British gave up. Shortly thereafter American colonists, angry about taxes on whisky, rallied around the same slogan, and were crushed by the very same Commander in Chief who fought the British. Reason did not provide the answer (which is not to argue that the answer was not reasonable). Might made right.
Mr. Greenspan (and many others who float in policy circles) seems to think (judging by expressed views) that reason is the ultimate judge of such pivotal questions-only when times are easy, Alan. Angry, hungry, out of work and fearful people are rarely reasonable. People loved the Fed when times were easy but they are starting to hate it now that they are paying the price.
I've just finished a read of Simon Schama's Citizens: A Chronicle of the French Revolution as it seemed fitting given the emergence of a new historical power struggle. Fitting, I think, in the sense that in both cases a reasonably long lasting organizational structure had been found wanting, and despite all the proof of failure, supporters of tradition were reluctant to give an inch (or when given, they tried to retake). In the former case, three years after the Bastille was stormed, the heads began to roll, and the question was decided.
Admittedly, it is unfair to Louis XIV, the Sun King, to see Alan Greenspan playing his role- this would place Ben Bernanke in the unfortunate role of Louis XVI and his wife (perhaps his statement about the recession being over is on par with Marie Antionette's apocryphal "let them eat cake")- but then again maybe not. Both the Sun King and Mr. Greenspan opened the floodgates on spending and left it to the future to clean up the mess.
But this is a digression.
My thrust is a reminder. Policy is not chess. Greenspan wishes the Fed to be independent enough to withdraw the stimulus and fears Congress might get in the way. If Unemployment keeps rising and the Fed tries to withdraw the stimulus in winter, say, to stem a rout in the US$ (not a low probability forecast) obstructionism in Congress may be the only thing that stops the people from storming the Fed.
In other words, if the Fed remains independent, and that independence means crushing the real sector to maintain the US$ system, Liberty for the Fed may well bring Death to the Fed.
Sadly, I agree with Greenspan, in theory. Alas, his faith in the Fed's ability to fix a mess led him to miss opportunities to avoid it altogether. The die is cast.
Greenspan, however, seems not to realize this, inter alia. To wit, he went on the say, "if inflation rears its head." How high does Gold have to go (it has risen by a factor of 4 since Gordon Brown dumped Britain's stocks) before inflation is recognized?
Tuesday, September 15, 2009
I burst out laughing when I read the above line in the President's speech yesterday. "The lessons of Lehman!" I thought, "he's got to be joking." I have no doubt Big Finance took that lesson straight to heart.
Let's consider the meaning of the "lessons of Lehman." Given the context, I suspect the President wants Big Finance to see the demise of Lehman as an object lesson- as one might warn a friend trying to ride out a hurricane in New Orleans by reminding him to remember the lessons of Katrina. If this friend had just moved to New Orleans and was unfamiliar with Gulf Coast hurricanes, the "lessons of Katrina" reminder would likely be sufficient.
If, however, this friend owned a house in the French Quarter and had ridden out Katrina the reminder of the lessons thereof might evoke a chuckle and a quick retort, "Katrina taught me that the French Quarter is safe." "The lesson of Lehman," Big Finance CEOs might chuckle to themselves, "is to make sure we're too big to fail." Lehman's balance sheet wasn't big enough, thus failure was an option for them, but not for the biggest banks.
Or so they seem to think.
One of the reasons I didn't write much over the past few months (besides a general laziness and desire to enjoy the summer) was a strong feeling, whenever I looked at the data, of watching a horrible car crash in slow motion. Better, I thought, to avert my eyes.
Yesterday I spent a few hours filling up my spread sheets and catching up on policy speeches and decided the feeling that came over me wasn't as if I was watching a slow motion car crash. I feel now as if I'm a position clerk for Nick Leeson, the bane of Barings Bank, and everyone in the country works for them.
As is my wont, when a feeling like that hits me a quick Google search for "Nick Leeson" is just a few clicks away. Among the more familiar reports I was surprised to find a scholarly examination of the event from NYU's Stern School of Business, about which, more later.
In the movie, Rogue Trader, Nick Leeson explains the secret of his success in a sound bite Big Finance would love, "You keep doubling up, and sooner or later you're bound to win." In the event, Mr. Leeson found this not to be true as the losses on his long position in Nikkei futures (and related derivatives) exploded after the Kobe Earthquake sent the Japanese market plunging early in 1995.
The lesson of Leeson is that doubling up is no guarantee of success. Indeed, according to the NYU paper: Our interest in Mr. Leeson comes from the fact that doubling strategies are potentially dangerous from a systemic point of view. An important attribute of doubling strategies is that the inevitable and devastating loss is preceded by a period of high returns with low volatility. Conditional on the bad event not having happened (yet), the doubler’s investment performance appears to indicate significant investment skill. The doubler may then become too big to fail, both from the perspective of the investment firm and from the market regulators, so that the inevitable failure can have catastrophic effects, both for the firm and for the market. Among other things, this has important consequences for the effectiveness of Value at Risk-controls. Being able to track and take out these traders sooner, would limit possible systemic risks.
Of course, I'm not arguing that Big Finance is doubling up on a hidden (losing) long position in the Nikkei. Their losses are reasonably well known (if not well quantified) and, at least with respect to real estate, not about to turn into profits any time soon. This rogue is out in the open.
Like Leeson, Big Finance doesn't consider liquidation, which would realize the losses, an option. Like Leeson (whose book would make a great study in a Psych course), Big Finance would have us believe their motives are pure. I, however, find this view from the NYU paper interesting: That managers take additional risks to escape from a threatening situation is a well known theme in the field of managerial decision making. For example, Shapira (1997) and Kahneman and Tversky (1986, p. S258) show that people will take greater risks to escape losses than to secure gains. As a consequence, people's behavior tends to change in unexpected and unattractive ways when they are confronted with increasing losses. Thus in finance, where many occupations are high-wire acts, the fear of falling is constantly in the background and sometimes can lure people into disastrous activities. Individuals can become gripped by a frantic panic and may try to conceal these losses, or double up their bets like crazed gamblers trying to punt their way out of their mounting debts. This is the classic gambler’s fallacy.
There are, however, differences between the two.
Unlike Leeson, Big Finance has a supporter who agrees that liquidation isn't an option in the form of the Fed. If Nick had the Fed on his side he could have held on for a few more years (although current levels around 10K for the N225 suggest a loss orders of magnitude larger). The Fed (and Treasury) upon discovering the huge losses, not only provided liquidity to Big Finance, they provided capital support and relaxed accounting rules. As many others have covered (so I'll be brief) this support is unprecedented and ongoing. The "tide" of liquidity is high, as Warren Buffett might put it, and financial markets have responded (albeit with far less bang per buck).
Thus Bernanke, Geithner and even President Obama are engaged in a bit of cautious back-slapping.
This back slapping reminds me of another scene in Rogue Trader: 1994 is coming to a close and Leeson is long Nikkei futures and short Nikkei calls. The price is shown in big numbers, dominating the screen. He cheers and congratulates his team as as the Nikkei keeps rising and closes on its high.
In the NYU paper on the event the authors write: Leeson first sold options on the Nikkei index in October 1992, but his activity in this market really started in the second half of 1993. The value of the option portfolio fluctuated wildly over time, but it had mostly been positive. The highest value was reached by the end of December 1994, when the total value of the options was approximately US$178 million. Mainly due to the Kobe Earthquake, this reversed to a loss of approximately US$108 million by the end of February 1995 (SR App. 3K, p.179)
Given that he wasn't unwinding his risk into the rally, the cheers and back-slapping in December 1994 proved a bit premature. I'm pretty sure if he tried to unwind his position the market would have reversed.
Given that Big Finance isn't unwinding its balance sheet (I know that position can't be unwound without serious market damage) in the current environment, I suspect Bernanke's victory laps and Obama's reassurances may also prove premature, if, as I suspect, the transfer of "toxic" debt to the Fed proves as successful as similar operations in Japan. The reason for this, I surmise, is that such transfers merely buy time, which, when the losses are a large percentage of GDP, is only useful if one can grow out of the problem (which would require rapid growth) or if underlying conditions which created the loss, reverse.
These "underlying conditions" are the crux of the issue. When positions sizes are small enough for a given market, managers can play (and win) under the greater fool theory. The illusion of demand can be created long enough to sell out (or vice versa). However, when positions grow such that they cannot be dumped, the greater fool theory is disproved- you are the greatest fool. This doesn't necessarily guarantee a loss. It does, however, bring finance back to its beginning- the bets must prove out in the real sector.
Thus my concern.
Leeson bet the ranch on Japan returning to its go-go days. But Japan was an aging population with high wealth concentration in the aftermath of a bubble- a perfect recipe for risk aversion. Fortunately, Japan could self-finance and until recently seemed reasonably content to be a mature economy.
Big Finance, in a far more profound sense, has bet the ranch (our ranch) on the US returning to its go-go days. But the US (somewhat obscured by looser immigration standards) is an aging population with high wealth concentration. From whence will come the next productivity enhancing investments that (importantly) can operate within the existing capital structure (since liquidation is off the table). The computer and related communication boom was a perfect way to extend the life of the post WWII infrastructure, but those productivity effects are in the past.
Unfortunately, unlike Japan, we cannot self-finance. We need those capital markets flowing, however inspired.
Thus we took a page from the BoJ playbook and adopted a ZIRP (the world's reserve currency managers opt for a zero interest rate policy....amazing), and the effects are manifesting. Cheap $ finance is already working its magic in the commodity and equity markets. Gold is trading at $1000 as the US$ nears all time lows.
We're inflating all right, but the US real sector will be last in line to catch those flows- the conduits are broken. In the 90s above trend employment growth came, as noted, from the Tech boom, albeit with income gains that were far lower than in previous post WWII expansions. During this century there was no above trend employment growth and income is lower. The real estate wealth effect kept people happy on the margin but that is over too. Once a critical mass of the population is underwater on their mortgages real estate inflation will lag, not lead, more general inflation- an effect we would have experienced in the 90s but for the Tech Boom.
As a comic aside, we are like a team of old baseball players who just got purchased by Steinbrenner and don't want to be replaced by newer younger guys.
I think we're going to experience a stagflation like we have never seen.
But first, we will see a Leeson-esque collapse, first of the US$, and then, when they try to tighten to save it, of large chunks of Big Finance.
Sudden and swift.
I could, of course, be wrong.
Have a nice day.
Monday, September 14, 2009
But, whether the US likes it or not, the dollar reserve system is fraying; the question is only whether we move from the current system to an alternative in a haphazard way, or in a more careful and structured way. Joseph Stiglitz
This past Friday, September 11, was chilly and rainy here in upstate NY so I "pulled a Howard Hughes" - sat in front of a TV for hours on end (clothed, mind you, and swapping his pain-killers for a nice Pinot Noir, as I'm not that much of a purist)- watching hours of 9/11 coverage and a film, Apocalypse Now. As a former resident of the Big Apple who worked just around the corner from the Trade Center at the Chase Building, I'm always moved by those broadcasts. This time round, however, I was riveted by the dawning realization of both the "man on the street" and the TV announcers, of the gravity of that day's events.
Two programs, in particular, captivated me: the History Channel's 102 Minutes that Changed America and MSNBC's 9/11: As it Happened. The initial reactions of the "man on the street" to the smoke coming from the first tower was similar to that of a motorist driving past a crash- morbid curiosity. The TV personalities too initially exhibited a desire to see more, to get closer.
Using the abyss metaphor, the initial reaction of people was that it might be deep but most wanted a better look. If you've ever walked near the edge of a cliff you too might recall the desire to see just how far the fall would be. For most people, the nearer to the edge you get, the more likely are acrophobic fears to set in- curiosity is replaced by the sense that you might fall. For me, the "edge of the abyss" feeling only happens when you feel the need to grab onto something solid. You have to feel that you are at risk, and lose the desire to peer again. As the Buddhists would put it, you must be "in the moment."
This mental transformation was captured time and again that day. For some, this transformation occurred when the second tower was hit. For most, it occurred when the towers started to fall. People no longer wanted to get close, they wanted to run away, to get somewhere safe, to step away from that abyss and not look back.
I get that sense from Mr. Stiglitz's comment above. His mind is clear- the abyss is deep and all who fall will suffer negative consequences.
By contrast, Mr. Geithner's claim above of universal acceptance rings false. If "we" were all looking into the abyss there would be little resistance to reform. In my view, most are still edging closer, trying to get a better look. The moment when fear of falling forces one to grasp something solid has yet to strike many in policy circles.
Thus I suspect Mr. Obama's speech today will do little to change opinion. Reform will have to wait until we all truly peer into the abyss, feel that fear of falling and grasp onto the solidity of sound finance.
Wednesday, September 09, 2009
The current international monetary system, with flexible exchange rates between the major currencies, the dollar as the main international reserve currency, and free international capital flows, has failed to achieve the smooth adjustment of payments imbalances. This is the conclusion reached by the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System (also known as the Stiglitz Commission) (UNPGA, 2009) UNCTaD
It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Paul Krugman
In July of 1789, King Louis XVI, during a discussion of the state of affairs in Paris, exclaimed, "This is a revolt." The duc de Liancourt, an ardent supporter of reforms replied, "No, majesty, it is a revolution."
And so it was.
And so it is.
Now, as then, the pressing need for significant reform is widely acknowledged in policy circles, but political inertia has exposed the rhetoric of change as just that- talk.
It isn't, this time, the Bastille which invokes the anger of the people, but Wall St.- a prison which holds, and destroys, not people, but futures. In place of the French lettres de cachet we have quarterly statements dashing retirement hopes, notices of foreclosure, or worse.
Sadly, just as King Louis XVI truly desired change, but was not capable of delivering it fast enough, President Obama seems equally desirous of change, and, apparently, equally incapable of delivering. To be fair to both men, I'm quite sure I couldn't deliver it either- fortunately I haven't been dealt that hand to play.
The most troubling parallel, to me, is the anger. If not closed already the window of opportunity for a graceful, reasonable solution is closing fast. Unemployment is already high and rising. Imagine how angry the people will be if (I suspect "when" is more apt) the US$ sinks and inflation jumps as winter begins to bite.
Of course, revolutions, revolts, coups and being conquered are regular, albeit often unpleasant, features of human history. Human societies can (and often do) get bogged down in a rut of comfortable habit where change, if it occurs, happens slowly. Revolutions are often the only means by which societies effect substantial change- nothing like burning the house down to inspire the need to build a better one. This cyclical view of history has been expressed in Ancient Times by Hindu Theologians and much more recently by American Historians William Strauss and Neil Howe, inter alios. In a sense, this view of decay followed by renewal lies at the heart of business cycle theory.
I too can sometimes get bogged down in a comfortable rut, waiting, it seems, for an inspiration to get the juices flowing.
The inspiration which roused me from my summer vacation rut- just in the nick of time as I need to don my "home schooling Dad" hat again- was Paul Krugman's How Did Economists Get It So Wrong?
While pondering his view I was distracted (I often surf while pondering) by reading of Michael Moore's new mantra, "Capitalism is Evil" from his film, Capitalism: A Love Story. "Semantics," the snide philosopher in me snickered, "will get you every time."
What, I wonder, does Mr. Moore mean by "Capitalism" and "Democracy", or Mr. Krugman by "Economics" and "Economists"?
Is Mr. Moore aware that "Democracy" was also the goal of the Bush-era NeoCons? I doubt the term refers to the same notion in these two disparate world-views.
If, as I suspect, Mr. Moore refers to the way things are now as "Capitalism", then "Democracy" likely refers to some idealized nirvana. Reality, of course, is rarely preferable to idealized dreams- a lesson painfully learned by all successful Revolutionary dreamers once their dream is put to the test. (This is not to argue that all revolutions lead to negative outcomes.)
If Mr. Moore means to argue that replacing money, markets, and private property with plebiscites or, more simplistically, "rule by the people", will make America a better place to live, I pray his argument falls on deaf ears. That is a movie whose ending has been well documented, but apparently, not shared with a wide enough audience.
Which brings me to Mr. Krugman's Economists Who Got It Wrong. In my view, (Mr. Krugman grinds a very different axe, and I'll get back to that in a second) if arguments like Mr. Moore's or the right wing's anti-government variants displayed at the "tea parties" gain traction in the enough minds- i.e. if the international revolution in the global financial architecture, noted by the UN, ignites the proverbial "fire in the minds of men" here at home- the economics profession deserves some of the blame. Surely inoculating a critical mass of the population against demagoguery and romantic notions of "prosperity for all" with some honest history should be high up on the duties of this profession.
Sadly, reminding people of the lessons of the past is a difficult thing to do...until after disaster strikes. Thus, the cycles repeat, which, at the least, allows some historian/economists a chance to forecast the repitition. Yet, the majority rarely listens to the prescient view.
As Mr. Krugman argues about this iteration: the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.
I'm sympathetic to aspects of his view: particularly the seduction of elegant mathematical proofs (about which, see the italicized paragraph below) but I think he paints with too wide a brush, and significantly discounts the effects of shifting political winds and financial incentives. Many economists saw this coming, but were unwilling to risk their careers.
Digression on Seduction by Mathematics by two eminent Mathematicians:
As far as the laws of mathematics refer to reality, they are not certain, as far as they are certain, they do not refer to reality.- Albert Einstein
Pure mathematics consists entirely of assertions to the effect that, if such and such a proposition is true of anything, then such and such another proposition is true of that thing. It is essential not to discuss whether the first proposition is really true, and not to mention what the anything is, of which it is supposed to be true ... If our hypothesis is about anything, and not about some one or more particular things, then our deductions constitute mathematics. Thus mathematics may be defined as the subject in which we never know what we are talking about, nor whether what we are saying is true. - Bertrand Russell
My 2 cents: Math is only as useful as the qualitative definitions upon which it is based, are accurate.
There is, of course, nothing new in this, nor does economics have a monopoly on such behavior. King Louis XVI threw Beaumarchais in jail for his insightful, and prescient critique of the then status quo in The Marriage of Figaro and George Bush fired Paul O'Neill and Larry Lindsey over their dissenting views over, inter alia, the cost of the Iraq War. Speaking truth to power is never an easy task. It is, as they say, in the nature of the beast- the beast, in this case, being human institutions of power.
There are other beasts one can study, for instance, the advantages and defects of organizational forms used by man to produce the goods he desires, a.k.a. economics.
Curiously, until one realizes how specific is the axe Mr. Krugman wishes to grind in his polemic, one gets the sense that the only debate in economics is between Chicago School Monetarism and Keynesian Demand Management. Mr. Krugman disparages the former and promotes the latter as if Keynes was the Messiah of Economics. To wit, in Krugman's view, Keynesian economics remains the best framework we have for making sense of recessions and depressions.
My response to Mr. Krugman begins with a quote from Augustine of Hippo; beware the man of one book.
As a student of philosophy, I read (and would urge the reading thereof) many philosophers. The sense of Kant's Idealism comes into clearer focus when one has read Hume's skeptical perspective, and so on, and so on, until you arrive back at Plato and Aristotle (alternatively, one can start with the Greeks, which isn't a bad idea for an economist either- starting with Aristotle, for example). Alas, philosophy too has become a fragmented battlefield of sorts, with each clique praying to their own God- as, apparently, Mr. Krugman prays to Keynes.
I suspect it is just as easy to assume, after reading Keynes, that demand management can attenuate and perhaps even eliminate the business cycle as, according to Mr. Krugman, it was to believe that Chicago-School Monetarism could do the same. Indeed, Friedman's views emerged during just such a period when Keynesianism was hoped to bring about nirvana..
As noted above, however, I suspect the faith in eliminating the business cycle doesn't come from reading Friedman, Keynes or any other noted economist, but from the powers that be- and this too is in the nature of the beast. Mr. Krugman wishes people to be aware that recessions are an inevitable feature of human economic life. Another apparently inevitable feature of human life is that such awareness only manifests on a grand scale through experience. As George Bernard Shaw wrote, we learn from history that we learn nothing from history.
People, and the societies comprised thereof, have a life span. Knowledge of human bodily function can improve, for a time, output and sometimes, delay, but not avoid, the inevitable decay. Regeneration occurs in those who follow. Economists too operate under similar rules. I agree with Mr. Krugman's argument that there is virtue in accepting the reality of business cycles, just as there is virtue in accepting our own mortality and that of the society in which we live. I also agree with Mr. Shaw that this virtue is realized by few, when it matters- that the cycle of more general awareness followed by ignorance, regardless of the literature available, plays a role in the larger cycles.
I take solace that I, and a few I know, (and, no doubt many others unknown to me) are reaping the benefits of that awareness.