In boom times, credit rating agencies, like S&P, are thought to have the foresight of the Fates- figures of Greek (et al.) Mythology who spun, measured, and cut the threads of life. As boom turns to bust, these credit rating agencies fall into the trap of spinning too much thread which is only measured and cut after credit death occurs.
After getting caught looking in the rear view window a few too many times, our Fates of credit appear to be attempting an image rehab with Big Game- the long term credit rating of the United States. Of course, as S&P is made up of real people, not mythical figures, they aren't as brave as Clotho, Lachesis and Atropos and thus are merely threatening to measure the life-span of US AAA credit (i.e. shifting the outlook to negative), rather than pronouncing a definite end.
For my money (and let's be clear, the debt under review is that upon which the $s in my pocket are valued) S&P's focus on the debt ceiling sideshow in Congress as catalyst for default is likely misguided. Then again, I wouldn't be totally shocked to see the newbies in Congress force a default of a few bond payments just to make the Prez (who gets no more respect from me since his invasion of Libya) look bad and thus win more votes. Yes it would be colossally stupid and therefore, not out of the question. S&P puts the odds at 1 in 3.
Assuming Congress avoids the colossally stupid option and raises the debt ceiling, the "no risk of US default" views of Barry Ritholtz and Yves Smith et alios would seem to suffice. The US issues the currency in which its debt is paid, in somewhat similar fashion to the Tech companies of the 90s. So long as our foreign creditors continue buying US debt, default would be self inflicted.
If I was playing the role of the credit fate, Lachesis, who measures the thread, I wouldn't be watching the shenanigans in Congress but rather our creditors' perception of rising confusion and dissent in the US. Our nation seems adrift in a self-inflicted sophisticated fog.
We are promoters of freedom currently engaged in 3 colonial projects (Iraq, Afghanistan and now, Libya) which engenders great confusion. We want control, but we don't want to be seen grabbing it coercively. We are confused. Colonies, as history attests, are difficult ventures when such policies are overt. Covert colonialism seems to me a contradiction in terms.
Congressional pissing matches over the debt ceiling are another sign of great confusion. Those who cheer Tea Party "balance the budget" principles would, in the event the right flexes its muscles, discover the rapid reduction of government employment and spending in a highly leveraged economy creates most unpleasant effects.
This isn't to argue against deficit reduction in general (I suspect terminating our covert colonial ventures and redirecting that labor force back home on infrastructure would go a long way towards solving many problems) just the method on offer.
Worse than our confusion, from the perspective of the single party Chinese, is the dissent, notably that from S&P. While the Chinese ruling party has apparently learned to deal with US political kabuki, the notion of a US ratings agency downgrading its outlook on US debt must strike them as odd indeed. Having invented paper money, the Chinese know it rests on faith- faith that is eroded by dissent, ergo their rigorous crackdowns on such.
Eventually the Chinese, whose faith in US economic policy making was shaken during the debt crisis of 2008-09, will tire of the confused games in the US and force us to deal with them with real currency, not the funny money we call US Federal Reserve Notes. Far worse for the US than default is enforced real currency dealings. As with all sophisticated cultures, reality is a bitch.
Tuesday, April 19, 2011
Thursday, February 17, 2011
Social Security as an Interest Rate Swap
If you think of just the interest rate aspects of Social Security as a swap, those who depend on benefits are receiving fixed at 0% mind you (guaranteed interest income from non-existent bonds) and paying floating (COLA) which is rising. Oddly enough, this hasn't been a disastrous trade (I've heard of far worse swaps) over the past few years as the floating rate was near (and sometimes below) 0%.
Although they are a dying breed (compared to the late 90s) financial market traders (who obviously should have unionized in the early 90s) still pop up at cocktail parties, dinners etc. If you're not a trader and get caught in a conversation with one you might find the jargon confusing and the reduction of all life's problems into trading metaphors exasperating. In the case of Social Security, however, a bit of trader reductionism might help sway those wearing rose colored glasses who feel reform isn't a pressing matter.
Admittedly, given what happened the last few times Social Security has been reformed- regressive tax increases, the proceeds of which were deposited in the Treasury's general fund- I can understand the trepidation with which Social Security supporters approach talk of future reforms.
Some, like Mark Thoma, proclaim it isn't a problem at all, in the sense of having a major impact on our fiscal health "Look at the CBO projections," they say.
We'll get to that in a second.
Others, like Robert Reich and Brad DeLong suggest entitlement finance isn't much of a problem, IF taxes are increased (Mr. Reich argues for increasing the cap thus reducing the regressivity of the program) and/or benefits cut. They both admit, however, that tax increases aren't on the table which, as Mr. DeLong notes requires a ballot box fix. In his words, "What is the solution to our long-run deficit problem? It is simply this: elect honorable and intelligent women and men to Congress."
On reflection he adds, " I guess our long run fiscal problem is really dire and insoluble."
Maybe it is, indeed.
Taking our cue from Mr. Thoma, let's look at the CBO projections, and for more detail, the Board of Trustees Report from which the CBO took many of its assumptions.
Using the CBO's central scenario, Social Security self-finances (removing the fictitious interest earned from non-existent bonds, i.e. restricting income to taxes) through roughly 2016 and then runs modest deficits through 2019. The total shortfall from 2011-2019 is less than $150B.
I can see Mr. Thoma's point.
Yet, projections are only as good as the assumptions therein, as the financial crisis of recent years attests. The SS Board of Trustees, in their central scenario, assumes CPI inflation of 2.8% p.a. for 2011-2019 and medium term unemployment of 5.5%. The CBO assumes 2.5% inflation and 5.0% unemployment in the medium term.
The SS Board of Trustees' worst case scenario assumes CPI of 3.8% and medium term unemployment of 6.5%. Under that scenario Social Security isn't self-financing in the immediate future with increasing deficits which total $690B from 2011-2019. To put that in context, President Obama's budget includes a 6-year, $556B surface transportation program.
Thinking a bit about those economic assumptions, I'm starting to wonder if the CBO hired their worst case scenario seers from the banking industry. Those guys seem to think a stress test is flagging down a cab instead of having a waiting limo.
Let's try to imagine a worse than worst case scenario. Actually, we don't have to imagine it. Conditions from the mid 70s to early 80s in the US when inflation raged provides a real world example.
Doing some very rough spreadsheet analysis using the Trustees' data, if inflation rises at 6%, SS deficits hit $100B in 2014 and $445B in 2019 for a 2011-2019 total deficit of $1.7T.
If inflation rises at 8%, SS deficits exceed $100B in 2013 and by 2019 they are over $700B for a 2011-2019 total deficit of $2.8T, which seems to me like an awful lot of money.
The projections above aren't even a reasonable worst case as I've retained the Trustees' employment forecasts. If the nation is in the midst of a structural unemployment period, which I (and some at the Fed) suspect, receipts will be lower and payments higher.
Why do others not see what I see? I might be crazy (and if you knew me personally you wouldn't dismiss that notion easily) or I might just be noticing how a fiction, even one of which you are aware on some level, corrupts thought.
Most reasonably diligent people who've researched the problem are aware that SS is a pay as you go system. There are no income generating bonds. In the relatively low interest rate environment of the past 5 years imputed interest income from the SS "surplus" was roughly $100B per year- small potatoes. Yet the stock of "surplus" has grown to $2.5T (not really, just in the spreadsheets used for analysis). What happens when interest rates start to rise, or as some might argue, normalize.
Each basis point of lost income (not including additional deficits) is worth $250M per year. Each % of lost income is $25B. If bond yields return to a more normal (over a long run view of the US) 6% we're talking $600B per year which many models assume will appear (from where, I have no idea) as income.
On the outflow side, using the CBO 2011 expense figure of $730B, each % increase in COLA (cost of living adjustment) is $7B- tiny potatoes. Of course, even tiny potatoes add up. A 5% COLA is $35B. The other funny thing about potatoes, if you bury them in some dirt and wait a year, they COMPOUND. Adding insult to injury, the basis of calculation will increase as more people (think Baby Boomers) start taking Social Security.
This is starting to smell like a really bad trade to me.
If you think of just the interest rate aspects of Social Security as a swap, those who depend on benefits are receiving fixed, at 0% mind you (guaranteed interest income from non-existent bonds) and paying floating (COLA) which is rising. Oddly enough, this hasn't been a disastrous trade (I've heard of far worse swaps) over the past few years as the floating rate was near (and sometimes below) 0%. Given current conditions, however, I doubt even Goldman could sell such a swap these days, but I'm sure they'd love to take the other side.
On that note, here's a solution for our times. Wall St. should securitize Social Security cash flows and pawn off the risk somewhere (there's bound to be more semi-intelligent life in the Universe), making a tidy bundle in the process.
On a serious note, if you remove interest income from the CBO's projections and imagine a more inflationary future you'll see the problem I see. Assuming the US isn't going to pull an Enron or a Madoff, by which I mean leaving those who trusted them holding an empty bag (they've already taken and spent their money) making these people whole is likely to be a significant problem unless economic conditions improve dramatically.
I'll close with a paragraph from a 1988 paper by Alicia Munnell, then FRB Boston's Director of Research, delivered during a Trustees symposium on the build-up in trust fund assets.
What happens if trust fund surpluses do not produce any new saving? That is, if they are simply offset by deficits in the rest of the federal budget. In this case, the surpluses will have contributed nothing to overall saving and capital accumulation and taxpayers will be no richer than they would have been otherwise. The full burden of supporting the beneficiaries will fall on the taxpayers in the second half of the period - just as if the system had been financed on a pay-as-you-go basis all along. The only effect of accumulating Social Security surpluses would have been to alter the composition of federal revenues over time. General government expenditures during the first half of the period would be financed by the relatively regressive payroll tax rather than the more progressive income tax, and future benefit payments would be financed by general revenues.
Although they are a dying breed (compared to the late 90s) financial market traders (who obviously should have unionized in the early 90s) still pop up at cocktail parties, dinners etc. If you're not a trader and get caught in a conversation with one you might find the jargon confusing and the reduction of all life's problems into trading metaphors exasperating. In the case of Social Security, however, a bit of trader reductionism might help sway those wearing rose colored glasses who feel reform isn't a pressing matter.
Admittedly, given what happened the last few times Social Security has been reformed- regressive tax increases, the proceeds of which were deposited in the Treasury's general fund- I can understand the trepidation with which Social Security supporters approach talk of future reforms.
Some, like Mark Thoma, proclaim it isn't a problem at all, in the sense of having a major impact on our fiscal health "Look at the CBO projections," they say.
We'll get to that in a second.
Others, like Robert Reich and Brad DeLong suggest entitlement finance isn't much of a problem, IF taxes are increased (Mr. Reich argues for increasing the cap thus reducing the regressivity of the program) and/or benefits cut. They both admit, however, that tax increases aren't on the table which, as Mr. DeLong notes requires a ballot box fix. In his words, "What is the solution to our long-run deficit problem? It is simply this: elect honorable and intelligent women and men to Congress."
On reflection he adds, " I guess our long run fiscal problem is really dire and insoluble."
Maybe it is, indeed.
Taking our cue from Mr. Thoma, let's look at the CBO projections, and for more detail, the Board of Trustees Report from which the CBO took many of its assumptions.
Using the CBO's central scenario, Social Security self-finances (removing the fictitious interest earned from non-existent bonds, i.e. restricting income to taxes) through roughly 2016 and then runs modest deficits through 2019. The total shortfall from 2011-2019 is less than $150B.
I can see Mr. Thoma's point.
Yet, projections are only as good as the assumptions therein, as the financial crisis of recent years attests. The SS Board of Trustees, in their central scenario, assumes CPI inflation of 2.8% p.a. for 2011-2019 and medium term unemployment of 5.5%. The CBO assumes 2.5% inflation and 5.0% unemployment in the medium term.
The SS Board of Trustees' worst case scenario assumes CPI of 3.8% and medium term unemployment of 6.5%. Under that scenario Social Security isn't self-financing in the immediate future with increasing deficits which total $690B from 2011-2019. To put that in context, President Obama's budget includes a 6-year, $556B surface transportation program.
Thinking a bit about those economic assumptions, I'm starting to wonder if the CBO hired their worst case scenario seers from the banking industry. Those guys seem to think a stress test is flagging down a cab instead of having a waiting limo.
Let's try to imagine a worse than worst case scenario. Actually, we don't have to imagine it. Conditions from the mid 70s to early 80s in the US when inflation raged provides a real world example.
Doing some very rough spreadsheet analysis using the Trustees' data, if inflation rises at 6%, SS deficits hit $100B in 2014 and $445B in 2019 for a 2011-2019 total deficit of $1.7T.
If inflation rises at 8%, SS deficits exceed $100B in 2013 and by 2019 they are over $700B for a 2011-2019 total deficit of $2.8T, which seems to me like an awful lot of money.
 |
| all figures US$Bil |
Why do others not see what I see? I might be crazy (and if you knew me personally you wouldn't dismiss that notion easily) or I might just be noticing how a fiction, even one of which you are aware on some level, corrupts thought.
Most reasonably diligent people who've researched the problem are aware that SS is a pay as you go system. There are no income generating bonds. In the relatively low interest rate environment of the past 5 years imputed interest income from the SS "surplus" was roughly $100B per year- small potatoes. Yet the stock of "surplus" has grown to $2.5T (not really, just in the spreadsheets used for analysis). What happens when interest rates start to rise, or as some might argue, normalize.
Each basis point of lost income (not including additional deficits) is worth $250M per year. Each % of lost income is $25B. If bond yields return to a more normal (over a long run view of the US) 6% we're talking $600B per year which many models assume will appear (from where, I have no idea) as income.
On the outflow side, using the CBO 2011 expense figure of $730B, each % increase in COLA (cost of living adjustment) is $7B- tiny potatoes. Of course, even tiny potatoes add up. A 5% COLA is $35B. The other funny thing about potatoes, if you bury them in some dirt and wait a year, they COMPOUND. Adding insult to injury, the basis of calculation will increase as more people (think Baby Boomers) start taking Social Security.
This is starting to smell like a really bad trade to me.
If you think of just the interest rate aspects of Social Security as a swap, those who depend on benefits are receiving fixed, at 0% mind you (guaranteed interest income from non-existent bonds) and paying floating (COLA) which is rising. Oddly enough, this hasn't been a disastrous trade (I've heard of far worse swaps) over the past few years as the floating rate was near (and sometimes below) 0%. Given current conditions, however, I doubt even Goldman could sell such a swap these days, but I'm sure they'd love to take the other side.
On that note, here's a solution for our times. Wall St. should securitize Social Security cash flows and pawn off the risk somewhere (there's bound to be more semi-intelligent life in the Universe), making a tidy bundle in the process.
On a serious note, if you remove interest income from the CBO's projections and imagine a more inflationary future you'll see the problem I see. Assuming the US isn't going to pull an Enron or a Madoff, by which I mean leaving those who trusted them holding an empty bag (they've already taken and spent their money) making these people whole is likely to be a significant problem unless economic conditions improve dramatically.
I'll close with a paragraph from a 1988 paper by Alicia Munnell, then FRB Boston's Director of Research, delivered during a Trustees symposium on the build-up in trust fund assets.
What happens if trust fund surpluses do not produce any new saving? That is, if they are simply offset by deficits in the rest of the federal budget. In this case, the surpluses will have contributed nothing to overall saving and capital accumulation and taxpayers will be no richer than they would have been otherwise. The full burden of supporting the beneficiaries will fall on the taxpayers in the second half of the period - just as if the system had been financed on a pay-as-you-go basis all along. The only effect of accumulating Social Security surpluses would have been to alter the composition of federal revenues over time. General government expenditures during the first half of the period would be financed by the relatively regressive payroll tax rather than the more progressive income tax, and future benefit payments would be financed by general revenues.
Tuesday, February 15, 2011
US Budget: Entitlement Funding Inflection Points
Within a decade there will no longer be additional surplus funds to be used to purchase US bonds which will have to then be sold on the open market. Call it peak SS Trust Funds, although peak trust might be even more apt. Captive Bidding at the auction: How Bond Vigilantism was swamped
A few years ago, I shared my concerns about Social Security and other entitlement program funding (see above and A New Head: Imagine there's no Social Security Fund). Mine was no voice crying in the wilderness (I'm not that clever), but one of a chorus singing to an audience of deaf policy makers (perhaps my off-key voice was disturbing). These underfunded entitlement programs, according to those in charge at the time, wouldn't be an issue for 10 or more years.
While it has only been 3 years and 4 months since I shared my concerns, the underfunding, in my view, is likely to become a big issue, not just amongst TV's talking heads, but in trading rooms around the world, this year- we are near to reaching an entitlement funding inflection point- mainly due to the sharp rise and long duration of unemployment, which will have, I believe, a profound effect on the US bond market.
The inflection point- when the lack of surplus entitlement funds forces the Treasury to fund the entire deficit in the open market- will force bond investors, if they haven't already, to take a fresh look as US Federal finance at the worst time- a look that will include concerns like the following:
The language of the Social Security Trust Fund gives the illusion that it is an investment fund with tradable economic assets that can be held until needed to pay the benefits of future employees. But it is a fund in name only. It holds no real assets. Consequently it does not generate funds to pay future benefits. These so-called trust fund “assets” (essentially US Treasury IOUs) simply reflect the accumulated sum of funds transferred from Social Security over the years to finance other government operations. Former Congressional Budget Office Director June O’Neill
In an earlier post on the topic I argued (facetiously):
If the SS Trust Fund doesn't really exist, the national debt is at least $2T less than the current $9.05T. Under that head, the debt ceiling hasn't been a "real" issue for many years. In the language of my last post, it isn't that a large portion of the Treasury Market is captive, the US National Debt is actually far smaller, by at least $2T, than assumed. If all intergovernmental holdings are essentially fictitious accounting entries, the US Federal Public Sector debt to GDP ratio is actually 37%
While the Trust Fund doesn't exist except as fictitious accounting entries, the liabilities thereof most certainly do (assuming we don't want a replay of recent Egyptian protests here in the US). Just as entitlement surpluses reduced borrowing requirements and kept US bond yields much lower than they would otherwise have been, entitlement deficits will increase borrowing requirements and, I believe, push US bond yields much higher than they would otherwise be.
At this key inflection point, instead of subtracting "intragovernmental holdings" (the euphemism for the fictitious trust fund assets, now totaling some $4.6T) from total debt (leaving a 65% debt to GDP ratio), the total debt figure (nearly 100% of GDP) must be used to perform credible analysis, like calculating interest payments. This may explain the rather curious (to my mind) forecast of entitlement surpluses for many years ahead in the President's Budget. Once the surpluses become deficits the unfunded liabilities previously hidden by cash accounting methods become active just as an option, which wasn't delta hedged- option lingo for net present accounting- becomes active when its strike price is crossed. (a wonderful description of the different accounting methods can be found here)
Call it "Fiscal death, Derivatives-style."
Entitlement Funding, Long Term Unemployment and Bond Yields
As noted earlier, the rise and duration of unemployment has brought the "moment of truth" forward by reducing entitlement receipts (unemployment reduces tax receipts) and increasing outlays (formerly employed retirement aged people begin receiving SS). Fiscal Year-to-date, the off-budget surplus is just $25B, a 50% reduction from the same period last year.
The baby boomer rush to retirement has not only begun, it has been accelerated by the employment recession. Moreover, the cap on SS taxes means that an income surge among high earners, which might raise GDP, will do little to raise entitlement receipts. The only solution to that problem is employment, and lots of it.
That solution, however, carries its own fiscal risks. Rising employment means rising consumer demand (especially for gas to drive to work again) and thus, in all likelihood, higher inflation. Higher inflation (the President's Budget forecast assumes inflation remains at or under 2% through 2016) means higher interest charges on the debt stock and increased SS outlays as COLAs rise. This sunny forecast assumes no disruptions in foreign appetite for US debt.
Interestingly we may have reached a "damned if you do and damned if you don't" point with respect to employment data driven bond market reaction. If unemployment remains the same or rises, and trust fund deficits need to be financed from general receipts, bond yields should rise due to increased supply. If unemployment starts to fall as one would expect in a normal recovery, bond yields should rise as inflation pressures increase.
Geez, maybe that's why bond yields have been rising lately?
Full Disclosure: Short US Treasuries
A few years ago, I shared my concerns about Social Security and other entitlement program funding (see above and A New Head: Imagine there's no Social Security Fund). Mine was no voice crying in the wilderness (I'm not that clever), but one of a chorus singing to an audience of deaf policy makers (perhaps my off-key voice was disturbing). These underfunded entitlement programs, according to those in charge at the time, wouldn't be an issue for 10 or more years.
While it has only been 3 years and 4 months since I shared my concerns, the underfunding, in my view, is likely to become a big issue, not just amongst TV's talking heads, but in trading rooms around the world, this year- we are near to reaching an entitlement funding inflection point- mainly due to the sharp rise and long duration of unemployment, which will have, I believe, a profound effect on the US bond market.
The inflection point- when the lack of surplus entitlement funds forces the Treasury to fund the entire deficit in the open market- will force bond investors, if they haven't already, to take a fresh look as US Federal finance at the worst time- a look that will include concerns like the following:
The language of the Social Security Trust Fund gives the illusion that it is an investment fund with tradable economic assets that can be held until needed to pay the benefits of future employees. But it is a fund in name only. It holds no real assets. Consequently it does not generate funds to pay future benefits. These so-called trust fund “assets” (essentially US Treasury IOUs) simply reflect the accumulated sum of funds transferred from Social Security over the years to finance other government operations. Former Congressional Budget Office Director June O’Neill
In an earlier post on the topic I argued (facetiously):
If the SS Trust Fund doesn't really exist, the national debt is at least $2T less than the current $9.05T. Under that head, the debt ceiling hasn't been a "real" issue for many years. In the language of my last post, it isn't that a large portion of the Treasury Market is captive, the US National Debt is actually far smaller, by at least $2T, than assumed. If all intergovernmental holdings are essentially fictitious accounting entries, the US Federal Public Sector debt to GDP ratio is actually 37%
While the Trust Fund doesn't exist except as fictitious accounting entries, the liabilities thereof most certainly do (assuming we don't want a replay of recent Egyptian protests here in the US). Just as entitlement surpluses reduced borrowing requirements and kept US bond yields much lower than they would otherwise have been, entitlement deficits will increase borrowing requirements and, I believe, push US bond yields much higher than they would otherwise be.
At this key inflection point, instead of subtracting "intragovernmental holdings" (the euphemism for the fictitious trust fund assets, now totaling some $4.6T) from total debt (leaving a 65% debt to GDP ratio), the total debt figure (nearly 100% of GDP) must be used to perform credible analysis, like calculating interest payments. This may explain the rather curious (to my mind) forecast of entitlement surpluses for many years ahead in the President's Budget. Once the surpluses become deficits the unfunded liabilities previously hidden by cash accounting methods become active just as an option, which wasn't delta hedged- option lingo for net present accounting- becomes active when its strike price is crossed. (a wonderful description of the different accounting methods can be found here)
Call it "Fiscal death, Derivatives-style."
Entitlement Funding, Long Term Unemployment and Bond Yields
As noted earlier, the rise and duration of unemployment has brought the "moment of truth" forward by reducing entitlement receipts (unemployment reduces tax receipts) and increasing outlays (formerly employed retirement aged people begin receiving SS). Fiscal Year-to-date, the off-budget surplus is just $25B, a 50% reduction from the same period last year.
The baby boomer rush to retirement has not only begun, it has been accelerated by the employment recession. Moreover, the cap on SS taxes means that an income surge among high earners, which might raise GDP, will do little to raise entitlement receipts. The only solution to that problem is employment, and lots of it.
That solution, however, carries its own fiscal risks. Rising employment means rising consumer demand (especially for gas to drive to work again) and thus, in all likelihood, higher inflation. Higher inflation (the President's Budget forecast assumes inflation remains at or under 2% through 2016) means higher interest charges on the debt stock and increased SS outlays as COLAs rise. This sunny forecast assumes no disruptions in foreign appetite for US debt.
Interestingly we may have reached a "damned if you do and damned if you don't" point with respect to employment data driven bond market reaction. If unemployment remains the same or rises, and trust fund deficits need to be financed from general receipts, bond yields should rise due to increased supply. If unemployment starts to fall as one would expect in a normal recovery, bond yields should rise as inflation pressures increase.
Geez, maybe that's why bond yields have been rising lately?
Full Disclosure: Short US Treasuries
Monday, February 14, 2011
The Lost Secrets of the Federal Reserve
I have a very esoteric mind....if I could just remember where I put it. A. Burns
The problem with esoteric institutions, from the Priests of Ancient Egypt to today's Federal Reserve is the difficulty in retaining the well-hidden secrets these institutions are built upon. The more successfully esoteric the institution, the greater the risk "essential"- a claim deserving of vigorous debate, in my view- secrets will be lost.
The priests of Ancient Egypt, whose understanding of Nile flood cycles, inter alia, made them one of the first economic policy makers in the historical record, hid their knowledge of seasonality behind a dense a screen of esoteric theology. The science, or exoteric understanding of the effects of the earth/sun relationship was left to younger cultures, uninhibited by Egyptian taboos on such studies, to "discover."
The Egyptians worshiped the Sun and made sacrifices and offerings thereto (thus enriching the priests). The Greeks openly theorized about the sun and many other things and thus developed a more accurate world view.
In more modern times, the US Federal Reserve, the Creature from Jekyll Island, as some have called it, was formed in secret, around secrets.
I'd like the share some of those secrets (assuming I've actually divined them- an assumption the reader must determine for himself):
1) Industrial Capitalism is (and can continue to be in the future) so efficient that an ever increasing percentage of an ever increasing number of people can do nothing and yet receive the necessities of survival.
2) The social utility of money- i.e. the elastic variety of modern Central Banks- is (and has been for decades) decreasing as an allocator of capital resources and increasing as an allocator of (ever increasing) labor resources.
In other words, the problems of economics once a nation industrializes (and more so when nations trade freely) are not on the production side (the already sufficient pie, if you will, can yet grow) but on the distribution side (how shall the pie be sliced).
Consider, as an example, US agricultural production:
We, in the US, can not only feed ourselves, we can generate an exportable surplus using less than 2% of labor resources. Food is easy, which explains, in part, the obesity problems of the modern world.
Food, houses, clothes, transportation (most likely not of the automobile variety), education and health care, to name a few key "necessities" of life can be produced in excess of demand. The problem, in my view, lies in how to distribute the goods.
One solution, chosen by men steeped in the tradition of the Protestant work ethic, was the use of elastic money to keep idle hands from "the devil's work." Rather than a massive expansion of welfare, which, I believe, would be more intellectually honest and restrict money's social utility to capital resource allocation- i.e. the hard money advocated by Ron Paul, inter alios- money would be (and still is, with decreasing efficiency) used to soak up excess labor resources and "explain" the vagaries of goods distribution within a society to modern sensibilities.
Paradoxically, Rep. Paul favors not only hard money, but also further decreases in transfer payments, i.e. welfare and "make work." Hard money, in my view, generates increased efficiency- more goods for less labor- which, in turn, generates unneeded labor resources. Hard money "end the Fed" advocates need to ponder the unnecessary, but existent population problem. Swift's modest proposal of eating Irish babies, which we can expand, in the modern world, to eating unemployed people (Soylent Green!) strikes me as most unsavory. (I couldn't resist)
State enforced population restriction, like China's "one child" policy could be used, at risk of imposing human for "natural" selection on humanity. How would we know which humans are worth bringing to life?
The esoteric solution of the Federal Reserve, aided by the views of JM Keynes, worked, in my view, tolerably well so long as the secret of excess labor was understood by its leaders and national capital infrastructure wasn't in need of retooling. Greenspan's statistical fumblings with productivity coupled with his anti-welfare/anti-inflation views suggest to me that the secret was not well transmitted as does the lack of import placed on previously believed key elements of the Fed's role in fomenting social stability embodied in Humphrey Hawkins legislation. The financial sector, taking its cue from the confused Fed thinks its function is to make money rather than allocate capital resource.
The secret has been lost.
Thus, it seems to me, the current problem of long term unemployment. The policies of the idle wealthy, or leisure class, desirous of maintaining and bequeathing to their progeny their position at the head of the pie cutting table via reductions in transfer payments implemented by the financial sector risk increased social tensions, and increasingly widespread populist uprisings, such as we are witnessing in Egypt and other nations.
Solving this problem, in the context of the need to recapitalize our transportation system away from the automobile (and goods trucking) towards more efficient means, will be most difficult unless we are willing to slay a few sacred cows. The protestant work ethic inspired elastic monetary system insulates the real (production) sector from necessary conforming to new reality (decline in US and world oil production) pressures until a crisis is reached. Hard money would make the necessary transportation (and other sector) changes easier, but would increase the social tensions noted above. Increased transfer payments in the proposed hard money system should alleviate these tensions.
Sadly, as noted, the hard money advocates are not fond of such transfer payments. Perhaps they will be fonder of such socially calming methods when the turmoil in the Middle East rears its head closer to home.
The problem with esoteric institutions, from the Priests of Ancient Egypt to today's Federal Reserve is the difficulty in retaining the well-hidden secrets these institutions are built upon. The more successfully esoteric the institution, the greater the risk "essential"- a claim deserving of vigorous debate, in my view- secrets will be lost.
The priests of Ancient Egypt, whose understanding of Nile flood cycles, inter alia, made them one of the first economic policy makers in the historical record, hid their knowledge of seasonality behind a dense a screen of esoteric theology. The science, or exoteric understanding of the effects of the earth/sun relationship was left to younger cultures, uninhibited by Egyptian taboos on such studies, to "discover."
The Egyptians worshiped the Sun and made sacrifices and offerings thereto (thus enriching the priests). The Greeks openly theorized about the sun and many other things and thus developed a more accurate world view.
In more modern times, the US Federal Reserve, the Creature from Jekyll Island, as some have called it, was formed in secret, around secrets.
I'd like the share some of those secrets (assuming I've actually divined them- an assumption the reader must determine for himself):
1) Industrial Capitalism is (and can continue to be in the future) so efficient that an ever increasing percentage of an ever increasing number of people can do nothing and yet receive the necessities of survival.
2) The social utility of money- i.e. the elastic variety of modern Central Banks- is (and has been for decades) decreasing as an allocator of capital resources and increasing as an allocator of (ever increasing) labor resources.
In other words, the problems of economics once a nation industrializes (and more so when nations trade freely) are not on the production side (the already sufficient pie, if you will, can yet grow) but on the distribution side (how shall the pie be sliced).
Consider, as an example, US agricultural production:
- 1900: 41 percent of workforce employed in agriculture
- 1930: 21.5 percent of workforce employed in agriculture;
- Agricultural GDP as a share of total GDP, 7.7 percent
- 1945: 16 percent of the total labor force employed in agriculture;
- Agricultural GDP as a share of total GDP, 6.8 percent
- 1970: 4 percent of employed labor force worked in agriculture;
- Agricultural GDP as a share of total GDP, 2.3 percent
- 2000/02: 1.9 percent of employed labor force worked in agriculture (2000); Agricultural GDP as a share of total GDP (2002),
- 0.7 percent
We, in the US, can not only feed ourselves, we can generate an exportable surplus using less than 2% of labor resources. Food is easy, which explains, in part, the obesity problems of the modern world.
Food, houses, clothes, transportation (most likely not of the automobile variety), education and health care, to name a few key "necessities" of life can be produced in excess of demand. The problem, in my view, lies in how to distribute the goods.
One solution, chosen by men steeped in the tradition of the Protestant work ethic, was the use of elastic money to keep idle hands from "the devil's work." Rather than a massive expansion of welfare, which, I believe, would be more intellectually honest and restrict money's social utility to capital resource allocation- i.e. the hard money advocated by Ron Paul, inter alios- money would be (and still is, with decreasing efficiency) used to soak up excess labor resources and "explain" the vagaries of goods distribution within a society to modern sensibilities.
Paradoxically, Rep. Paul favors not only hard money, but also further decreases in transfer payments, i.e. welfare and "make work." Hard money, in my view, generates increased efficiency- more goods for less labor- which, in turn, generates unneeded labor resources. Hard money "end the Fed" advocates need to ponder the unnecessary, but existent population problem. Swift's modest proposal of eating Irish babies, which we can expand, in the modern world, to eating unemployed people (Soylent Green!) strikes me as most unsavory. (I couldn't resist)
State enforced population restriction, like China's "one child" policy could be used, at risk of imposing human for "natural" selection on humanity. How would we know which humans are worth bringing to life?
The esoteric solution of the Federal Reserve, aided by the views of JM Keynes, worked, in my view, tolerably well so long as the secret of excess labor was understood by its leaders and national capital infrastructure wasn't in need of retooling. Greenspan's statistical fumblings with productivity coupled with his anti-welfare/anti-inflation views suggest to me that the secret was not well transmitted as does the lack of import placed on previously believed key elements of the Fed's role in fomenting social stability embodied in Humphrey Hawkins legislation. The financial sector, taking its cue from the confused Fed thinks its function is to make money rather than allocate capital resource.
The secret has been lost.
Thus, it seems to me, the current problem of long term unemployment. The policies of the idle wealthy, or leisure class, desirous of maintaining and bequeathing to their progeny their position at the head of the pie cutting table via reductions in transfer payments implemented by the financial sector risk increased social tensions, and increasingly widespread populist uprisings, such as we are witnessing in Egypt and other nations.
Solving this problem, in the context of the need to recapitalize our transportation system away from the automobile (and goods trucking) towards more efficient means, will be most difficult unless we are willing to slay a few sacred cows. The protestant work ethic inspired elastic monetary system insulates the real (production) sector from necessary conforming to new reality (decline in US and world oil production) pressures until a crisis is reached. Hard money would make the necessary transportation (and other sector) changes easier, but would increase the social tensions noted above. Increased transfer payments in the proposed hard money system should alleviate these tensions.
Sadly, as noted, the hard money advocates are not fond of such transfer payments. Perhaps they will be fonder of such socially calming methods when the turmoil in the Middle East rears its head closer to home.
Tuesday, February 08, 2011
JPM Begins to Believe (in Gold) ...about time, eh?
Trinity (seeing Neo turn to face an Agent): What's he doing?
Morpheus: He's beginning to believe.
Today's Wall St. Journal reports, JPMorgan will accept Gold as a type of collateral:
Gold hasn't reinvented itself as a currency yet. But it is getting closer.
J.P. Morgan Chase & Co. (NYSE: JPM - News) said it will allow clients to use the metal as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements.
By making the announcement, J.P. Morgan is effectively saying gold is as rock solid an investment as triple-A rated Treasurys, adding to a movement that places gold at the top tier of asset classes.
Alexander Bain famously (at least in my view) argued: Belief is often accompanied by strong emotion, yet emotion, as such, does not amount to believing. Fictitious narratives may stir the mind more strongly than real; we may disbelieve and yet tremble...... We are thus driven to the alternative query— Is, or is not, Belief essentially related to Action, that is, volition? I answer, it is. Preparedness to act upon what we affirm is admitted on all hands to be the sole, the genuine, the unmistakable criterion of belief. Columbus shewed his belief in the roundness of the earth, and in the existence of an unbroken ocean between Europe and the east coast of Asia, when he undertook his voyages. The Emotions and The Will
In other words- under this head- by adopting this policy, and acting upon it, JPM is demonstrating its belief in Gold as an asset class.
For their next trick I hear they plan on re-inventing the wheel.
Staying in Henny Youngman banker mode (Take my money--Please!) JPM just figured out that Gold might be as valuable as triple-A rated Treasuries (Take my money and give me your Gold-- Please!!).
The WSJ authors add (and the hits just keep on coming): In the past, worries about a lack of liquidity in the gold market have prevented banks from taking gold as collateral. But as investors piled into the market in recent years, the market has deepened.
But seriously folks, there's no liquidity in the Gold market, just Gold, on one side, and liquidity, on the other. Prices in that market, which have risen by roughly 500% since 2001, explaining, perhaps JPM's policy shift, reflect participants belief in the relative values thereof (Gold vs. liquidity).
Sadly, JPM might discover, as Neo did in the Matrix, that the "real world" of specie collateral is, for bankers, drab and gray compared to the exciting times of the Financial Matrix year 1999.
As Morpheus might put it, you've been living in a dream world JPMorgan. Welcome to the credit desert of the real (money, that is).
To wax explicit (and make this essay actionable), if JPM has finally gotten around to seeing the virtues of Gold collateral based trading, it will be in their interest to see it holds its value. If you haven't gotten on the Gold train yet, you might want to consider it.
Remember, it ain't a bubble until the big banks get involved.
Full Disclosure: Long Gold, no position in JPM
Morpheus: He's beginning to believe.
Today's Wall St. Journal reports, JPMorgan will accept Gold as a type of collateral:
Gold hasn't reinvented itself as a currency yet. But it is getting closer.
J.P. Morgan Chase & Co. (NYSE: JPM - News) said it will allow clients to use the metal as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements.
By making the announcement, J.P. Morgan is effectively saying gold is as rock solid an investment as triple-A rated Treasurys, adding to a movement that places gold at the top tier of asset classes.
Alexander Bain famously (at least in my view) argued: Belief is often accompanied by strong emotion, yet emotion, as such, does not amount to believing. Fictitious narratives may stir the mind more strongly than real; we may disbelieve and yet tremble...... We are thus driven to the alternative query— Is, or is not, Belief essentially related to Action, that is, volition? I answer, it is. Preparedness to act upon what we affirm is admitted on all hands to be the sole, the genuine, the unmistakable criterion of belief. Columbus shewed his belief in the roundness of the earth, and in the existence of an unbroken ocean between Europe and the east coast of Asia, when he undertook his voyages. The Emotions and The Will
In other words- under this head- by adopting this policy, and acting upon it, JPM is demonstrating its belief in Gold as an asset class.
For their next trick I hear they plan on re-inventing the wheel.
Staying in Henny Youngman banker mode (Take my money--Please!) JPM just figured out that Gold might be as valuable as triple-A rated Treasuries (Take my money and give me your Gold-- Please!!).
The WSJ authors add (and the hits just keep on coming): In the past, worries about a lack of liquidity in the gold market have prevented banks from taking gold as collateral. But as investors piled into the market in recent years, the market has deepened.
But seriously folks, there's no liquidity in the Gold market, just Gold, on one side, and liquidity, on the other. Prices in that market, which have risen by roughly 500% since 2001, explaining, perhaps JPM's policy shift, reflect participants belief in the relative values thereof (Gold vs. liquidity).
Sadly, JPM might discover, as Neo did in the Matrix, that the "real world" of specie collateral is, for bankers, drab and gray compared to the exciting times of the Financial Matrix year 1999.
As Morpheus might put it, you've been living in a dream world JPMorgan. Welcome to the credit desert of the real (money, that is).
To wax explicit (and make this essay actionable), if JPM has finally gotten around to seeing the virtues of Gold collateral based trading, it will be in their interest to see it holds its value. If you haven't gotten on the Gold train yet, you might want to consider it.
Remember, it ain't a bubble until the big banks get involved.
Full Disclosure: Long Gold, no position in JPM
Monday, February 07, 2011
An Email Assertion: Austrianism is Dead
In a recent email debate I wrote the following, which I thought some might find interesting:
I remain somewhat puzzled at the notion of an Austrian resurgence as, in my view, Austrianism is dead. When modern nation-states were emerging in Europe in the 19th Century the views of Menger had a chance to make policy differences. Once the welfare state promoters won WWII Austrianism, due to intransigence on the part of party intellectuals, died as a political guide.
Austrians, in my view, argue from a tabula rasa perspective, yet the slate is already full. Achieving Austrian goals would require a cultural revolution akin to that seen in Russia and China within the past century, the Confederate States of America in the 19th, or, more ominously, the downfall of the Roman system of slave labor.
In Menger's time peasantry was still common. A culture existed which could provide for itself (or at least which was believed to do so well enough that the devil taking the hindmost wasn't a concern). Importantly, populations were much smaller then. Without industrial food production etc. large numbers would starve long before they learned to farm, and small farms would ensure that populations (and profits derived from commerce therewith) remained at those lower levels.
Debating whether we should have a welfare state is like debating whether we should have TV or the internet- the Rubicon was crossed long ago and humanity has adapted thereto. The issue now is how to manage the system we have, regardless of how one would create a system ex nihilo, given those extremely rare opportunities in history when slates are truly clean.
Of course, in the event of some nasty, protracted and globally destructive war, dusting off their books would seem a wise decision (with the understanding that no welfare means a hands off approach on indigenous ways of life).
On a related note, Keynesianism, under the same head, is just as dead. Policy was implemented with his views in mind, but where to from here remains to be seen.
Will the next über-Economist please stand up!
I remain somewhat puzzled at the notion of an Austrian resurgence as, in my view, Austrianism is dead. When modern nation-states were emerging in Europe in the 19th Century the views of Menger had a chance to make policy differences. Once the welfare state promoters won WWII Austrianism, due to intransigence on the part of party intellectuals, died as a political guide.
Austrians, in my view, argue from a tabula rasa perspective, yet the slate is already full. Achieving Austrian goals would require a cultural revolution akin to that seen in Russia and China within the past century, the Confederate States of America in the 19th, or, more ominously, the downfall of the Roman system of slave labor.
In Menger's time peasantry was still common. A culture existed which could provide for itself (or at least which was believed to do so well enough that the devil taking the hindmost wasn't a concern). Importantly, populations were much smaller then. Without industrial food production etc. large numbers would starve long before they learned to farm, and small farms would ensure that populations (and profits derived from commerce therewith) remained at those lower levels.
Debating whether we should have a welfare state is like debating whether we should have TV or the internet- the Rubicon was crossed long ago and humanity has adapted thereto. The issue now is how to manage the system we have, regardless of how one would create a system ex nihilo, given those extremely rare opportunities in history when slates are truly clean.
Of course, in the event of some nasty, protracted and globally destructive war, dusting off their books would seem a wise decision (with the understanding that no welfare means a hands off approach on indigenous ways of life).
On a related note, Keynesianism, under the same head, is just as dead. Policy was implemented with his views in mind, but where to from here remains to be seen.
Will the next über-Economist please stand up!
HuffPo's 30 Pieces of Silver?
"The love of money" goes the old saying, "is the root of all evil."
I didn't even finish reading the news headline on AOL's purchase of The Huffington Post before the old adage popped into my head.
Confused?
Allow me to explain.
HuffPo's readers can likely recall Ms. Huffington's MoveYourMoney project- an attempt to shift the flow of funds away from big banks and towards smaller community based financial institutions. How intriguing to find, mere months from the inception of such a project, a big money deal from AOL- owned, in large part, by Big Finance (top institutional holders include BlackRock (partially owned by BoA), Capital Group, Vanguard, BoNY, and State Street) which will pay HuffPo's owners some $300M in cash.
Is the $300M in cash- a substantial increase from Judas' 30 pieces of silver- a bribe?
Not, I think, in the crude, direct sense. Yet, it (the big money) will likely perform similar functions in the minds of recipients and those functions, and subsequent effects, are the subject of this essay.
Big Finance distributes big money and big money modifies the behavior of recipients. Some such recipients, unlearned in the art of keeping money, certain sports stars or lottery winners come to mind, prove the old adage about fools and their money. Other recipients demonstrate more wisdom in money retention, yet, in some cases, at a cost.
Have you ever heard or read about the difference between owing the bank $100K or owing them $1Bil? In the first case, you clearly owe the bank and they will ruin you financially if you don't pay. In the second, the bank really owes you and they will be ruined if you don't pay.
Reversing the arrow of causation, if you have $300M in a bank (or the financial markets supported thereby) instead of the bank owing you, you, in a sense, owe the bank. Just as stock option grants increased participation in tech company success in the late 90s (and left many earnest wanna-be millionaires holding an empty bag when the currency proved of little value) so too do big money payouts today (whether the currency in this case will prove of more durable value remains to be seen). A personal fortune of a couple $100M, very often makes one, as Gordon Gecko once remarked, a player- a participant- in a game one has a new-found vested interest.
Few and far between are men like Ted Turner who convert their wealth into ranch-land and retire on the range.
My point being: big finance distributes big money and big money recipients who wish to hold on to their loot will participate in big finance, even, I suspect, (although I have no direct knowledge thereof) in the case of HuffPo's owners, despite their "break the banks" advocacy.
Is this rank hypocrisy?
In my view, yes.
Of course, I haven't been offered $300M for my blog.
This, it seems to me, is the problem (not that I haven't been offered the loot) but an honest reflection of what would happen if such were offered.
Imagine writing a wonderful blog that attracted millions of minds, or as HuffPo did, combining a number of opinion blogs with news, most ably I must add. Imagine being offered 10s of millions of dollars for it a few years later? Would you turn it down?
If one truly wished to be a "gadfly" (in the Socratic sense) to Big Finance, I think you would have to turn it down. Thus the problem. Those able to attract attention and mold opinion also attract money, which aligns their interests with those against whom they rail.
It's a conundrum with no easy answer (except waiting for the currency of the moment to be withheld to new gadflies, or rapidly decline in value).
Fortunately, my very intermittently updated blog has no chance of attracting such viewership or lucre, so I won't have to take that test- a test that ensnares most who rise to the level of testing.
The love of money, indeed.
Disclosure: No positions in any companies noted
I didn't even finish reading the news headline on AOL's purchase of The Huffington Post before the old adage popped into my head.
Confused?
Allow me to explain.
HuffPo's readers can likely recall Ms. Huffington's MoveYourMoney project- an attempt to shift the flow of funds away from big banks and towards smaller community based financial institutions. How intriguing to find, mere months from the inception of such a project, a big money deal from AOL- owned, in large part, by Big Finance (top institutional holders include BlackRock (partially owned by BoA), Capital Group, Vanguard, BoNY, and State Street) which will pay HuffPo's owners some $300M in cash.
Is the $300M in cash- a substantial increase from Judas' 30 pieces of silver- a bribe?
Not, I think, in the crude, direct sense. Yet, it (the big money) will likely perform similar functions in the minds of recipients and those functions, and subsequent effects, are the subject of this essay.
Big Finance distributes big money and big money modifies the behavior of recipients. Some such recipients, unlearned in the art of keeping money, certain sports stars or lottery winners come to mind, prove the old adage about fools and their money. Other recipients demonstrate more wisdom in money retention, yet, in some cases, at a cost.
Have you ever heard or read about the difference between owing the bank $100K or owing them $1Bil? In the first case, you clearly owe the bank and they will ruin you financially if you don't pay. In the second, the bank really owes you and they will be ruined if you don't pay.
Reversing the arrow of causation, if you have $300M in a bank (or the financial markets supported thereby) instead of the bank owing you, you, in a sense, owe the bank. Just as stock option grants increased participation in tech company success in the late 90s (and left many earnest wanna-be millionaires holding an empty bag when the currency proved of little value) so too do big money payouts today (whether the currency in this case will prove of more durable value remains to be seen). A personal fortune of a couple $100M, very often makes one, as Gordon Gecko once remarked, a player- a participant- in a game one has a new-found vested interest.
Few and far between are men like Ted Turner who convert their wealth into ranch-land and retire on the range.
My point being: big finance distributes big money and big money recipients who wish to hold on to their loot will participate in big finance, even, I suspect, (although I have no direct knowledge thereof) in the case of HuffPo's owners, despite their "break the banks" advocacy.
Is this rank hypocrisy?
In my view, yes.
Of course, I haven't been offered $300M for my blog.
This, it seems to me, is the problem (not that I haven't been offered the loot) but an honest reflection of what would happen if such were offered.
Imagine writing a wonderful blog that attracted millions of minds, or as HuffPo did, combining a number of opinion blogs with news, most ably I must add. Imagine being offered 10s of millions of dollars for it a few years later? Would you turn it down?
If one truly wished to be a "gadfly" (in the Socratic sense) to Big Finance, I think you would have to turn it down. Thus the problem. Those able to attract attention and mold opinion also attract money, which aligns their interests with those against whom they rail.
It's a conundrum with no easy answer (except waiting for the currency of the moment to be withheld to new gadflies, or rapidly decline in value).
Fortunately, my very intermittently updated blog has no chance of attracting such viewership or lucre, so I won't have to take that test- a test that ensnares most who rise to the level of testing.
The love of money, indeed.
Disclosure: No positions in any companies noted
Wednesday, November 17, 2010
John von Neumann: Playing for Keeps
It should be noted that children at play are not playing about; their games should be seen as their most serious-minded activity. Michel de Montaigne
According to Lewis Straus, one of the original five Atomic Energy Commissioners, when John von Neumann, eminent mathematician and co-author of Theory of Games and Economic Behavior (available at Archive.org), lay dying of cancer in 1956-7, “gathered round his bedside, and attentive to his last words of advice and wisdom, were the Secretary of Defense and his deputies, the Secretaries of the Army, Navy and Air Force, and all the military Chiefs of Staff.” That’s quite a bit of attention being paid to one man and I can’t think of another person since who has been held in such high regard by the US’ Military Industrial Complex’s power elite.
Ironically enough, he earned this high regard from such serious people, in part, by preaching that life was (heuristically) a game. The irony fades when one discovers that Johnny, as he was universally (according to the biographies I’ve read) known, thought of both poker and nuclear deterrence as different forms of similar games. Moreover, the sense of “game” to which von Neumann referred was consistent with the opening quote- a serious endeavor to which good players bring their full attention. Life lived as a game, in my view, is life lived aware, with a focus on constant improvement, or as Socrates put it, a life examined.
Reading von Neumann's analysis of the complexities involved in trying to model economic behavior- the theory behind the symbols- was, for me, a window into the mental process of a true genius. The process, for me, was the "meat", far more mentally nourishing than the "conclusions" which might be construed by some as useful economic strategies.
But, I digress. Onward to the perspective.
Reading von Neumann's analysis of the complexities involved in trying to model economic behavior- the theory behind the symbols- was, for me, a window into the mental process of a true genius. The process, for me, was the "meat", far more mentally nourishing than the "conclusions" which might be construed by some as useful economic strategies.
But, I digress. Onward to the perspective.
For von Neumann (leaning on the work of Austrian Economists) the quantum of modern economics was an exchange, or in game-speak, a move. The sum of all such moves, and their effects on production, distribution, etc. comprise the game we call economics. In that sense, von Neumann’s sale of the book was a move, and a pretty good one at that.
Importantly, within that perspective, there are no disinterested umpires, although some players do “double duty” just as a poker player will, from time to time, both deal and play. Such “double duty” demands extra scrutiny from the other players whether the game is poker or international finance. If you wish to assume simple selection of a player as Treasury Secretary or dealer guarantees righteousness, I want to deal a few hands of poker to you and your friends.
There are a few other “sacred-cow-slaying” passages of the book which caught my attention.
Beware of Omniscient Economists: First let us be aware that there exists at present no universal system of economic theory and that, if one should ever be developed, it will very probably not be during our lifetime. The reason for this is simply that economics is far too difficult a science to permit its construction rapidly, especially in view of the very limited knowledge and imperfect description of the facts with which economists are dealing. Only those who fail to appreciate this condition are likely to attempt the construction of universal systems.
On the Ideal of Free Competition: The classical definitions of free competition all involve further postulates besides the greatness of that number. E.g., it is clear that if certain great groups of participants will for any reason whatsoever act together, then the great number of participants may not become effective; the decisive exchanges may take place directly between large "coalitions," few in number, and not between individuals, many in number, acting independently. Our subsequent discussion of "games of strategy" will show that the role and size of "coalitions" is decisive throughout the entire subject.
The Futility of “Maximizing Utility”: A particularly striking expression of the popular misunderstanding about this pseudo-maximum problem is the famous statement according to which the purpose of social effort is the "greatest possible good for the greatest possible number." A guiding principle cannot be formulated by the requirement of maximizing two (or more) functions at once. Such a principle, taken literally, is self-contradictory, (in general one function will have no maximum where the other function has one.) It is no better than saying, e.g., that a firm should obtain maximum prices at maximum turnover, or a maximum revenue at minimum outlay. If some order of importance of these principles or some weighted average is meant, this should be stated. However, in the situation of the participants in a social economy nothing of that sort is intended, but all maxima are desired at once by various parties. (see also: Fed mandate of maximum employment with minimal inflation)
Finally (for this essay, I think the book is well worth a read, no summary of mine would suffice) von Neumann raises the issue of economics as a non-zero-sum game, i.e. a game in which the sum of all payments equals the sum of all losses. As we’ve been slaying sacred cows, let me join the fray.
The apparently widespread assumption of perpetually rising GDP can be thought of as the apparently equally widespread assumption of non-zero-sum games always increasing the pot of winnings. I think this is a dangerous assumption. “Moves” by big players, “double duty” players, and coalitions, and their effects on others’ moves can increase as well as decrease the pot of winnings. To wit, it seems likely to me that continued social distribution of losses and privatized winnings (bank coalition bail-outs being a case in point) will (and, in my view, has already) decrease the pot of winnings.
In all games, cooperation is key, especially in games like economics, that are played for keeps.
Wednesday, November 10, 2010
US Bonds: Waiting for the First Rat
US 10yr Notes have had a tough few days with yields rising some 15bp. Irish Bond traders might be wondering, if a few days yield rise of 15bp can be described as “tough” what word would one choose to describe government debt trading in Ireland lately. Yields on Irish 10yr government debt rose by more than 60bp today, making the total yield gain since May more than 400bp. I think “crisis” seems most apt.
What’s the difference between Irish Debt and US Debt trading besides currency denomination? That is, why are Irish yields rising dramatically and US yields not? After all, both nations have a large stock of government debt, a not insignificant portion of which was necessitated by bail-outs of highly leveraged banks and are running substantial continued deficits (admittedly the expected Irish deficit is roughly 3 times the US relative to GDP). Why are Irish yields so sensitive to news of additional deficits while US yields remain stable?
The French refer to this conundrum as the “exorbitant privilege” of the US. If Ireland were to announce a policy of Irish Central Bank monetization of the next 9 months of debt issues, Irish Debt would, I suspect, crash more severely than it has. Yet, this is just what the Fed announced last week. It’s good, it seems, to issue the world’s reserve currency.
Press coverage of Irish debt trading speaks of investors demanding ever-higher yields as risk compensation given Ireland’s fiscal woes, while the fear in the US is just the opposite, i.e. of another asset bubble being created, despite, it seems, the US’ fiscal woes.
Perhaps the answer to the query, “what’s the difference between Irish and US debt trading?” is simply time.
At some point in all markets, the metaphoric rats leave the sinking ship. In the Irish 10yr, it seems 6% was the yield of no return. Leveraged owners of the debt started to flee (sell) while Ireland’s financial needs grew (due to, if for no other reason, higher borrowing costs) and debt sales begat more debt sales.
To repeat, at some point in all markets, the metaphoric rats leave the sinking ship, even, I believe, US debt markets.
Of course, when the feasting has been very good for a long time and when a rat might fear repercussions from leaving early, a wise rat might wait until other rats left safely before leaving himself. A wise bond trading rat might watch US yields and flee when they rose above some level, say 4% in the US 10yr. An even wiser rat, having decided the meal was not to his liking (or so I understand the debt rating downgrade from a Chinese rating agency), might sell while the selling was good, say while the ship’s owner (the US) was buying.
I’m most curious to watch US debt trading in the coming months as Treasury data on foreign inflows details the movement of the rats off the ship. Once the other rats know that many are leaving the exodus will become a stampede (lots more leveraged longs in US debt markets than in Irish debt).
Who knows, in the not too distant future the press might speak of US Bond investors demanding ever higher yields.
Disclosure: No positions in US Treasuries (yet)
Disclosure: No positions in US Treasuries (yet)
Tuesday, November 09, 2010
Do We Need Another World War?
Ask the average guy on the street if we need another world war and he might respond with, “We need another world war like I need a hole in the head.” Yet, there are medical conditions which can be solved by holes in the head, such as cranial swelling, i.e. when your brain gets too big for your skull.
War, according to Carl von Clausewitz, is merely the continuation of politics by other means. In other words, when talking fails to resolve an issue in need of resolution, military force will accomplish what persuasion couldn’t.
However, winning a war, which, in Clausewitz’ view, means achieving political goals via military means, is easier said than done. As Machiavelli warned, It ought to be remembered that there is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in the introduction of a new order of things. Because the innovator has for enemies all those who have done well under the old conditions, and lukewarm defenders in those who may do well under the new.
The end results of WWII are consistent with Machiavelli’s warning. Nazi Germany, Japan and Italy started the war to, inter alia, create a new world order and they succeeded, in part. At war’s end, a new world order was created, with the US on top.
Having proved its dominance on the battlefield (leaving aside, for this essay, the stunning success of the Russians against the Germans), and carrying the big stick in the form of Atomic Weapons, the US could talk softly, solving, for a time, international financial conundrums which had proven intractable within the context of the League of Nations. From this perspective, the “success” of the UN, IMF and World Bank, in contrast to the “failure” of the League of Nations is more a function of US power exercised through the new international institutions than some new-found commitment to cooperation.
Of course, US dominance of world politics was due not just to military might but to its substantial Gold holdings, undamaged by war capital infrastructure, domestic commodity resources, and sheer economic size. It seems to me the more recent failures of international financial institutions is more a function of the US resource depletion, gold reserve and capital infrastructure exports, and rapid economic growth of China and other populous nations, than some new found weakness in those institutions.
Defendants don’t fear the Judge who imposes sentence but the power of the state behind him.
The last world war was, in a sense, a schoolyard brawl decisively won, and broadcast globally, by the strongest kid, who happened to have the richest parents.
I ask the opening question from the above perspective. Do we need another world war to breathe new life and power into current or new international financial institutions- solving problems currently deemed intractable?
Barring a new enlightened faith in the virtues of international cooperation by top policy makers, and given the pressing need to apportion financial losses accruing from, inter alia, unprofitable international investments, the answer may be yes.
Fasten your seat belts.
Sunday, November 07, 2010
Are We There Yet?
With the US$ sinking and Gold setting new highs every few days those, like me, who have been waiting for the final collapse of the current $ based international financial system have one question on our minds- “are we there yet?”
“Not yet. But we’re getting very close.”
This past week the US electorate, in a fit of justified pique over Democratic failure to fix the broken (at least from the perspective of the majority of US citizens) economy, put Republicans back in charge of the House of Representatives. Big Finance must have viewed election results with glee. Gridlock, as we Americans lovingly refer to government divided and thus incapable of passing radical legislation, means the Volcker Rules (or other meaningful financial reforms) have an even slimmer chance of becoming law.
Coincidentally, the Federal Reserve announced plans to buy, during the next 9 months, $600B of long dated US Treasuries- a policy they refer to as “quantitative easing”. I prefer “monetizing debt” to avoid confusion.
While Big Finance in the US celebrated the return of Gridlock and the gift from the Fed, our foreign financiers most likely took a less sanguine view of the policy changes. US banks will soon be free to take even bigger risks while the Fed actively drives the value of the US$- the ultimate “asset” our financiers are promised- ever lower.
The wonderfully apt, in this case, phrase, “thick face,” no doubt crossed many Chinese minds as they pondered US Treasury Secretary Geithner’s proposed current account targets to “accelerate global rebalancing” in the context of US debt monetization and ever more impotent regulation of the big banks who have led the world to the current impasse.
To wit- Cui Tiankai, a deputy foreign minister and one of China’s lead negotiators at the G20, said on Friday, “We believe a discussion about a current account target misses the whole point,” he added, in the first official comment by a senior Chinese official on the subject. “If you look at the global economy, there are many issues that merit more attention – for example, the question of quantitative easing.”
It seems to me a sign of the times that Mr. Geithner didn’t respond to current concerns over the declining $ as Nixon’s Treasury Secretary, John Connally once did, i.e. the US$ “is our currency, but your problem.” The swagger of US policy makers evident in decades past is now shrouded in sophisticated euphemism- but the effects will be similar.
“But, are we there yet?”
“Not yet.”
There is, in my view, one last road sign before we reach our destination. When the US Bond Market begins to “fight the Fed”- a strategy normally as wise as spitting into the wind- we will begin the end stage of our journey to a new system of international finance. When US Bond prices fall despite Fed intervention (better yet, when bond prices fall on news of increased intervention) the excrement will be about to hit the fan in international finance.
We must, however, be getting close. I noticed the Fed established the Office of Financial Stability and Research this past Thursday. Talk about closing the barn door after the horses have all escaped.
Tuesday, May 25, 2010
Bernanke and the Depression of Damocles
It's showtime for Ben Bernanke, Fed Chairman. The moment of truth, so skillfully postponed by months of swapping good money for toxic debt, is once again at hand.
He will either be the hero or a punch line in some future Fed Chairman's speech.
To wit, in Bernanke's own words:
The first lesson--economic prosperity depends on financial stability--seems obvious, but this connection was not always well understood. After the stock market crash of 1929, many thought a financial and economic crisis was necessary--even desirable--to wring out speculative excesses that had built up in the 1920s. Remarkably, despite the fact that the Federal Reserve had been founded to mitigate financial panics, the central bank made essentially no effort to prevent the wave of bank failures that paralyzed the financial system at the start of 1930s. Indeed, the Treasury Secretary at the time, Andrew Mellon, believed in the tonic effects of weeding out weak banks and famously advised President Herbert Hoover, "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … It will purge the rottenness out of the system."
The Depression of Damocles hangs over his head while he deliberates long run strategies for managing the Fed's balance sheet- a hot topic at the Fed's meeting late last month.
The staff next gave a presentation on potential longer-run strategies for managing the SOMA. At previous meetings, Committee participants had expressed support for steps to reduce the size of the Federal Reserve's balance sheet over time and return the composition of the SOMA to only Treasury securities. The staff discussed the potential portfolio paths and macroeconomic consequences of a number of different strategies for accomplishing these objectives. To date, the Desk had been reinvesting the proceeds of all maturing Treasury securities in newly issued Treasury securities, but it had not been reinvesting principal and interest payments on maturing agency debt and agency MBS, nor had it been selling securities. One strategy considered in the staff presentation was a continuation of the current practice, which would normalize the balance sheet very gradually. In addition, the staff presented information on a number of other strategies that included sales of SOMA holdings of agency debt and MBS and under which the proceeds of maturing Treasury securities would not be reinvested; these strategies differed by the date and circumstances under which sales would be initiated, by the average pace of sales, and by the degree to which the timing and pace of such sales would be adjusted in response to financial and economic developments.
Ironically, the Fed is not debating whether to "liquidate" à la Andrew Mellon, toxic debt purchased from the banking sector, but rather the pace of liquidation.
The modern Fed, if it tries to drain liquidity by liquidating toxic assets, may well, like its counterpart in the early 1930s bury the economy under a mountain of unpayable debt in order to maintain a "strong dollar", which, as an aside, has risen roughly 20% so far this year in Forex markets.
Let's return to Ben's jab at Andrew Mellon, The first lesson--economic prosperity depends on financial stability--seems obvious, but this connection was not always well understood. Whether this first lesson is currently well understood at the Fed remains to be seen.
While there are many aspects of financial stability, one key feature is sufficient income to service liabilities, a task which gets most difficult the higher the ratio of liabilities to income.
The graph below depicts total US financial liabilities (source Fed's Flow of Funds data) divided by US national income (source BEA).
As you can see, current trends do not engender a sense of US financial stability. Income needs to rise to avoid a Mellon-esque liquidation. Financial stability, in my view, does not flow from support to financial institutions, which but buys time, but from a financially stable real sector. Right now, the last thing the US real sector needs is less liquidity and a strong dollar.
The question, in my mind, is why the Fed tolerates a "strong dollar". Will the words of men like Bob Rubin- "a strong dollar is in the US national interest"- become Mr. Bernanke's ironic epithet?
In time, economic historians may realize the only interests served by a strong dollar in recent times are those of the TBTF banks, who get a "free ride" on the exorbitant privilege of the US$'s role as main global reserve. Bernanke, to avoid being the goat, needs to solve Triffin's Paradox as Alexander the Great solved the Gordian Knot, by cutting it in half- and choosing to support the domestic (real) economy.
The real economy in the US needs a weak dollar and inflation or it will not be able to service its debt. How one can think finance needed the Fed's shock and awe in 2008-09 but the real sector doesn't, and can instead service its debt with a long and gradual decline in unemployment, escapes me. The US needs some inflationary shock and awe.
"But," you might be thinking," hasn't the US been inflating?"
Yes and no. While the monetary base has tripled over the past decade, growing even faster than in the 70s, when it doubled, broader money stock measures are not responding in kind- M2 has roughly doubled during the past decade while it more than tripled during the 70s. Credit, more and more over the years, is flowing to the financial markets, (and overseas- some $300B of US currency is in foreign hands source: BEA) bypassing the US real sector.
Debates over the pace of Fed credit draining via toxic debt liquidation is ample proof. US monetary policy has been hijacked by international financial concerns who don't want the value of their dollar holdings inflated away (but don't seem to realize current income without inflation only invites default).
Bernanke needs to make a choice. Supporting the TBTF banks and the "strong dollar" as basis of global reserves got us into this mess. More of the same won't get us out of it.
Friday, May 21, 2010
THE Riddle Has Been Solved
Many readers will think that the last person whose opinion should be consulted on the issue of rating agency reform is a former rating agency employee. Maybe they’re right, but I did learn one thing from rating hundreds of complex securities. Contrary to what some may think, there are no easy solutions here. Unintended consequences are guaranteed. Gary Witt, former MD of Moody's Investor Services
What riddle?
Why is the industrialized world in the mess it's in?
Mr. Witt, writing at The Baseline Scenario answers this question, in my view, correctly.
We're in the mess we're in because there are no easy solutions. There haven't been easy solutions for quite a few decades as all of the "low hanging fruit" of industrialization currently being harvested in countries like China has long ago been harvested in the west.
Industrialization for economies is like adolescence for humans. It's a period of time when natural growth overpowers constraints that would hobble children or mature adults. There are easy solutions for adolescents and young adults but as we age our choices are more often an exercise in finding the lesser evil.
So it is, I believe, for US (and European and Japanese) economic policy makers. Shifting away from a financially centered economy will be painful. Wealth will be lost, interest rates will rise, and investment capital will become more scarce. We'll have to compete again, which tends to difficult for those who have grown accustomed to dominating.
"What evil," you might be wondering, "makes the above the better option?"
The alternative, in my view, is all of the above, but worse, and with less ownership. We won't be competing, we'll be sharecropping, as Warren Buffet once quipped.
In other words, I believe our economic woes are already built into the system. The expected growth in the New American Century, upon which dream, in part, credit was extended, didn't materialize. Our choices now are between growing out of our dilemma- paying down debt with income(and lots of inflation)- or selling assets in lieu thereof.
Western Economies are, in a sense, middle-aged. There are no quick fixes available, just choices between accepting reality and having it forced on us.
What riddle?
Why is the industrialized world in the mess it's in?
Mr. Witt, writing at The Baseline Scenario answers this question, in my view, correctly.
We're in the mess we're in because there are no easy solutions. There haven't been easy solutions for quite a few decades as all of the "low hanging fruit" of industrialization currently being harvested in countries like China has long ago been harvested in the west.
Industrialization for economies is like adolescence for humans. It's a period of time when natural growth overpowers constraints that would hobble children or mature adults. There are easy solutions for adolescents and young adults but as we age our choices are more often an exercise in finding the lesser evil.
So it is, I believe, for US (and European and Japanese) economic policy makers. Shifting away from a financially centered economy will be painful. Wealth will be lost, interest rates will rise, and investment capital will become more scarce. We'll have to compete again, which tends to difficult for those who have grown accustomed to dominating.
"What evil," you might be wondering, "makes the above the better option?"
The alternative, in my view, is all of the above, but worse, and with less ownership. We won't be competing, we'll be sharecropping, as Warren Buffet once quipped.
In other words, I believe our economic woes are already built into the system. The expected growth in the New American Century, upon which dream, in part, credit was extended, didn't materialize. Our choices now are between growing out of our dilemma- paying down debt with income(and lots of inflation)- or selling assets in lieu thereof.
Western Economies are, in a sense, middle-aged. There are no quick fixes available, just choices between accepting reality and having it forced on us.
Thursday, May 20, 2010
Imagine There's No Credit Market: Another Look At German Controls
Imagine there's no credit market
It's easy if your try
John Lennon (if he'd lived long enough)
[Money] is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order. J.S Mill
Centuries ago there were these things called markets. At the end of a harvest farmers would take their produce to a common area and (hopefully) exchange their goods for other goods or money. In some cities remnants of this history still exist, like civil war battle re-enactments. We call some of these "farmer's markets".
Over time, the word, "market" was applied to any process wherein people exchanged things, even if there was no designated place to meet and most of the exchanges were done by proxy. Thus we use phrases like "credit markets", for instance, which, unlike today's farmer's markets, don't exist. There is no common place to go when one has savings one wishes to lend to meet up with borrowers and haggle over terms.
If I told some friends the financial capital of the nation was allocated in Narnia, Middle Earth or Hades, they might think I needed some time in a rubber room. Yet I could tell the same people the financial capital of the nation is allocated in credit markets, and seem wise despite the fact that Narnia and credit markets are both simply mental constructs. They don't exist.
One of Ludwig von Mises' great contributions to Economics was his focus on human action as the quantum of economics. Aggregates (like GDP), averages (like median income), and credit markets (like the US bond market) are mental constructs, nothing more. When people talk about the US economy, for instance, they are talking about an idea, for such a thing does not exist.
We, humans, exist (sidestepping valid, but for our purposes, irrelevant philosophical issues). We live, breathe, eat, sleep and act, and in so doing, we change the world, which also exists, and are changed by it. This idea we call "an economy" is a construct we imagine to be composed of the actions of millions of people, making, working, buying, selling, and saving.
Confusion over this key point is rife. Politicians talk about saving the economy and speculators talk about freeing the markets, but neither exists to be saved or freed. People all over the world think their investments are worth what a bunch of intermediaries say it is worth, instead of what it eventually returns.
A general sense is seemingly shared by many- when an aggregate measure (GDP) expressed in currency, mind you, not tons of steel, bushels of wheat, etc. of a non-existent construct (the US economy) rises, times are thought to be good. It seems to me, however, there is no time but our time, lived individually, not collectively. The economy to each of us is the sum of our actions conditioned by the sum of all others'.
I had the above points in mind while devising yesterday's model of a grain market with speculators. Instead of conceiving of it as a motion picture- a series of frames projected faster than the human eye samples, thus creating an illusion of continuous motion, or reality- I focused on the frames, which, in the case of markets, are transactions or exchanges.
I wrote that the model could be used for any exchange and as I've gotten some requests, here's the model applied to monetary exchanges, what we call credit markets.
As in our grain market model, there are producers, consumers and middle-men. Producers have money, consumers want money, and the middle-men bring the two together. The producers lend their money to consumers in hopes of future repayment plus some profit, what we call interest. As in our grain market model, profits are allocated based on individual transactions. Usually producers lend their money to middle-men who, in turn, lend it to consumers.
Let's imagine a farmer who had such a bumper crop he ended up with 2000 pieces of silver. Let's imagine a town administrator who wished to borrow 2000 pieces of silver to pay workers to build a bridge over a nearby river and thus increase tax revenue during the local market season. The administrator bets he can collect an extra 2100 pieces of silver during next year's harvest market.
In a small town, the administrator might visit the farmer and agree to borrow his silver and repay it next year plus 100 pieces in interest (not a bad deal as the taxes would be collected each year the bridge was still working). In a larger town, the farmer might bring his money to a bank, and the banker might lend it to the administrator and take, say, 30 pieces of silver for his trouble.
As in our grain market model, the middle-man/banker doesn't increase the total profit of the transaction, nor does he decrease the risk the bridge won't be completed and tax revenues won't be collected. If the administrator defaults on his obligation, the banker is still obliged to repay the farmer, from his own pocket, if need be, or he goes out of business (unless, of course, he's a TBTF banker who gets government to impose an additional tax on citizens to pay for his errors in judgment).
In the above model, the banker provides "liquidity" to the farmer, borrowing his money at a rate somewhat lower than he believes he can lend it to the administrator. Today, hordes of commercial paper and bond traders do exactly the same thing. Perversely, their liquidity providing actions, as they trade with each other waiting for a new producer with money to lend, or consumer, wanting to borrow it, has come to be called "credit markets" when real credit market action only occurs when new money is lent.
Thus, when people speak of "rescuing the credit markets" they really mean to say rescuing the liquidity providers who failed to assess lending risks so profoundly they can't make required payments. When people talk of German restrictions killing the credit markets, they really mean killing the middle-men (which may or may not have a deleterious effect on government borrowing).
German restrictions on certain types of equity and credit transactions are not aimed at reduced government borrowing. They are aimed at reducing the amount (and means of capture) of profit "earned" by middle-men in the transaction- profits, mind you, as per our model, in the case of government borrowing, come either as a result of the money's original owner getting less interest than a direct deal would generate, the government paying more interest (which only comes from higher tax revenues) than a direct deal would generate, or some combination thereof.
Like all markets, credit markets create nothing (which I suspect, is a big problem with naked CDS, from whence do the profits come in the event of default?), they merely distribute. As per J.S. Mill, their purpose is increased efficiency of a task that would otherwise occur.
If all of the TBTF banks were put of business tomorrow by government decree, and forced to distribute whatever capital and deposits they could, there would still be people with money willing to lend, and borrowers willing to borrow (most likely at rates far higher than are apparent today).
Some might argue such would be the end of the credit markets, which, leaving aside debate over the termination of a figment of one's imagination, might not be such a bad thing.
Let's play along with John Lennon and imagine no market for government bonds. Let's imagine a government, like mine in the US, which, instead of announcing an auction of $113B in 2-year notes to be mediated by direct dealers (there's a neat contradiction in terms) simply lists its borrowing needs and potential terms on an internet site, which willing borrowers could view and perhaps post their desired terms. These days, an auction program could perform most of the same functions the direct dealers do- putting together sellers and buyers- at a small fraction of the
cost.
There are, of course, some things auction programs can't do, like sell toxic debt at low rates to unsuspecting people, but we might not really miss that.
Some eager bond traders would likely argue the above scenario would lead to more volatile interest rates. I agree. Prices of exchanges like the above would be much more responsive to current events. Countries like Greece would have gotten a much earlier warning of trouble ahead, which, in hindsight, seems a good thing.
In sum, liquidity providing actions of "credit market" middle-men has run amok. As per J.S. Mill, that credit markets are exerting a distinct and independent influence of their own means they are out of order. With increasing frequency, credit is mispriced or unwisely extended and liquidity, the raison d'être of these people, dries up when it is needed most. Yet the middle-men who fail in their tasks expect to be rescued from their failures, and given even more ways to profit from lending other people's money, while the pool of available savings shrinks.
Sad.
p.s. In one sense I'm quite happy about all of the financial sector bail-outs governments have provided these credit-market middle-men. Before the bail-outs, one had to argue that finance was like a tax on monetary exchange, now this point is clear, finance is, in fact, a tax- and a growing one at that.
It's easy if your try
John Lennon (if he'd lived long enough)
[Money] is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order. J.S Mill
Centuries ago there were these things called markets. At the end of a harvest farmers would take their produce to a common area and (hopefully) exchange their goods for other goods or money. In some cities remnants of this history still exist, like civil war battle re-enactments. We call some of these "farmer's markets".
Over time, the word, "market" was applied to any process wherein people exchanged things, even if there was no designated place to meet and most of the exchanges were done by proxy. Thus we use phrases like "credit markets", for instance, which, unlike today's farmer's markets, don't exist. There is no common place to go when one has savings one wishes to lend to meet up with borrowers and haggle over terms.
If I told some friends the financial capital of the nation was allocated in Narnia, Middle Earth or Hades, they might think I needed some time in a rubber room. Yet I could tell the same people the financial capital of the nation is allocated in credit markets, and seem wise despite the fact that Narnia and credit markets are both simply mental constructs. They don't exist.
One of Ludwig von Mises' great contributions to Economics was his focus on human action as the quantum of economics. Aggregates (like GDP), averages (like median income), and credit markets (like the US bond market) are mental constructs, nothing more. When people talk about the US economy, for instance, they are talking about an idea, for such a thing does not exist.
We, humans, exist (sidestepping valid, but for our purposes, irrelevant philosophical issues). We live, breathe, eat, sleep and act, and in so doing, we change the world, which also exists, and are changed by it. This idea we call "an economy" is a construct we imagine to be composed of the actions of millions of people, making, working, buying, selling, and saving.
Confusion over this key point is rife. Politicians talk about saving the economy and speculators talk about freeing the markets, but neither exists to be saved or freed. People all over the world think their investments are worth what a bunch of intermediaries say it is worth, instead of what it eventually returns.
A general sense is seemingly shared by many- when an aggregate measure (GDP) expressed in currency, mind you, not tons of steel, bushels of wheat, etc. of a non-existent construct (the US economy) rises, times are thought to be good. It seems to me, however, there is no time but our time, lived individually, not collectively. The economy to each of us is the sum of our actions conditioned by the sum of all others'.
I had the above points in mind while devising yesterday's model of a grain market with speculators. Instead of conceiving of it as a motion picture- a series of frames projected faster than the human eye samples, thus creating an illusion of continuous motion, or reality- I focused on the frames, which, in the case of markets, are transactions or exchanges.
I wrote that the model could be used for any exchange and as I've gotten some requests, here's the model applied to monetary exchanges, what we call credit markets.
As in our grain market model, there are producers, consumers and middle-men. Producers have money, consumers want money, and the middle-men bring the two together. The producers lend their money to consumers in hopes of future repayment plus some profit, what we call interest. As in our grain market model, profits are allocated based on individual transactions. Usually producers lend their money to middle-men who, in turn, lend it to consumers.
Let's imagine a farmer who had such a bumper crop he ended up with 2000 pieces of silver. Let's imagine a town administrator who wished to borrow 2000 pieces of silver to pay workers to build a bridge over a nearby river and thus increase tax revenue during the local market season. The administrator bets he can collect an extra 2100 pieces of silver during next year's harvest market.
In a small town, the administrator might visit the farmer and agree to borrow his silver and repay it next year plus 100 pieces in interest (not a bad deal as the taxes would be collected each year the bridge was still working). In a larger town, the farmer might bring his money to a bank, and the banker might lend it to the administrator and take, say, 30 pieces of silver for his trouble.
As in our grain market model, the middle-man/banker doesn't increase the total profit of the transaction, nor does he decrease the risk the bridge won't be completed and tax revenues won't be collected. If the administrator defaults on his obligation, the banker is still obliged to repay the farmer, from his own pocket, if need be, or he goes out of business (unless, of course, he's a TBTF banker who gets government to impose an additional tax on citizens to pay for his errors in judgment).
In the above model, the banker provides "liquidity" to the farmer, borrowing his money at a rate somewhat lower than he believes he can lend it to the administrator. Today, hordes of commercial paper and bond traders do exactly the same thing. Perversely, their liquidity providing actions, as they trade with each other waiting for a new producer with money to lend, or consumer, wanting to borrow it, has come to be called "credit markets" when real credit market action only occurs when new money is lent.
Thus, when people speak of "rescuing the credit markets" they really mean to say rescuing the liquidity providers who failed to assess lending risks so profoundly they can't make required payments. When people talk of German restrictions killing the credit markets, they really mean killing the middle-men (which may or may not have a deleterious effect on government borrowing).
German restrictions on certain types of equity and credit transactions are not aimed at reduced government borrowing. They are aimed at reducing the amount (and means of capture) of profit "earned" by middle-men in the transaction- profits, mind you, as per our model, in the case of government borrowing, come either as a result of the money's original owner getting less interest than a direct deal would generate, the government paying more interest (which only comes from higher tax revenues) than a direct deal would generate, or some combination thereof.
Like all markets, credit markets create nothing (which I suspect, is a big problem with naked CDS, from whence do the profits come in the event of default?), they merely distribute. As per J.S. Mill, their purpose is increased efficiency of a task that would otherwise occur.
If all of the TBTF banks were put of business tomorrow by government decree, and forced to distribute whatever capital and deposits they could, there would still be people with money willing to lend, and borrowers willing to borrow (most likely at rates far higher than are apparent today).
Some might argue such would be the end of the credit markets, which, leaving aside debate over the termination of a figment of one's imagination, might not be such a bad thing.
Let's play along with John Lennon and imagine no market for government bonds. Let's imagine a government, like mine in the US, which, instead of announcing an auction of $113B in 2-year notes to be mediated by direct dealers (there's a neat contradiction in terms) simply lists its borrowing needs and potential terms on an internet site, which willing borrowers could view and perhaps post their desired terms. These days, an auction program could perform most of the same functions the direct dealers do- putting together sellers and buyers- at a small fraction of the
cost.
There are, of course, some things auction programs can't do, like sell toxic debt at low rates to unsuspecting people, but we might not really miss that.
Some eager bond traders would likely argue the above scenario would lead to more volatile interest rates. I agree. Prices of exchanges like the above would be much more responsive to current events. Countries like Greece would have gotten a much earlier warning of trouble ahead, which, in hindsight, seems a good thing.
In sum, liquidity providing actions of "credit market" middle-men has run amok. As per J.S. Mill, that credit markets are exerting a distinct and independent influence of their own means they are out of order. With increasing frequency, credit is mispriced or unwisely extended and liquidity, the raison d'être of these people, dries up when it is needed most. Yet the middle-men who fail in their tasks expect to be rescued from their failures, and given even more ways to profit from lending other people's money, while the pool of available savings shrinks.
Sad.
p.s. In one sense I'm quite happy about all of the financial sector bail-outs governments have provided these credit-market middle-men. Before the bail-outs, one had to argue that finance was like a tax on monetary exchange, now this point is clear, finance is, in fact, a tax- and a growing one at that.
Subscribe to:
Posts (Atom)
