Why is the Invisible Hand in My Pocket While China Grows Unchecked?

Gold Soars.  Stock Markets Tank.  US Debt Downgraded. China Calls for End to Dollar Dominance.  Riots in London. 

Devotees of Rapture Theory are likely wondering why they got left behind during the Tribulation.  More worldly, modern persons, who eschew eschatology might nonetheless be worrying about TEOTWAWKI (which is, ironically enough, the same thing).  Devotees of Cyclical Theories of History (Kondratiev, Strauss and Howe, Hinduism) are likely seeing the end of a K-wave, the Fourth Turning, or the coming of Shiva, respectively.

Was it just a little over a decade ago that the New American Century was dawning?  History itself, according to some, was ending.  With free markets across the globe open 24 hours a day the invisible hand was sure to make our future bright.

Then the invisible hand started picking pockets, crashing the Tech market in which many had invested, and foreclosing on houses in which even more had not only invested but lived.

What happened to the invisible hand?  Was it always just a scam- a means to shift income to an increasingly select few?

Back when Francis Fukuyama was proclaiming the End of History, faith in the free-market inspired invisible hand's virtue was hard to challenge publicly.  A few years ago, echoes of that faith still resonated, as was evident when the presumed bastions of free markets, the banks, were saved from the effects of their own unwise speculations and lending.  Today, the natives seem a bit (in London, a lot) more restless.  It might, given current conditions seem a bit odd to resurrect that rapidly fading totem so let me try to explain.

Recently I've been reviewing the work of Mancur Olson, particularly the role of interest (or ownership, if you wish) in fostering an invisible hand effect, or in the US' case of late, the lack thereof.  In The Economics of Autocracy and Majority Rule: The Invisible Hand and the Use of Force Martin McGuire and Mancur Olson argue persuasively (in my view): that whenever a rational self-interested actor with unquestioned coercive power has an encompassing and stable interest in the domain over which this power is exercised, that actor is led to act in ways that are, to a surprising degree, consistent with the interests of society and of those subject to that power.  In other words, for the socially virtuous invisible hand to manifest some person or group has to think they own now and will in the future, their domain- that they are part of the realm. 

McGuire and Olson's argument begins with a hypothetical discussion of a bandit's transition to a benevolent dictator: Consider the interests of the leader of a group of roving bandits in an anarchic environment. In such an environment, there is little incentive to invest or produce, and therefore not much to steal. If the bandit leader can seize and hold a given territory, it will pay him to limit the rate of his theft in that domain and to provide a peaceful order and other public goods. By making it clear that he will take only a given percentage of output – that is, by becoming a settled ruler with a given rate of tax theft – he leaves his victims with an incentive to produce.

According to this view, free markets, which were apparently considered a condicio sine qua non- a necessary condition- of the virtuous invisible hand are rather simply a medium for aligning interests, which can be either those of a bandit or of a long term owner.  Multiple financial crises over a relatively short period of time are a sign that banditry, not long term ownership are the aims of large players in our free markets.  What long term owner wants multiple crises over a short period of time?

For a real world example of the difference between a bandit and an owner, consider the case of JP Morgan.  Whatever his initial designs as a young man, from his mid-50s until the creation of the Fed in 1913 Mr. Morgan had great power over (owned, some rightly argued) American finance.  As McGuire and Olson argue, the more control he gained the more he seemed to care about systemic solvency, of course, not without expecting great gains for himself.  Morgan knew that long term American financial difficulties were not at all in his interests.  A growing American economy was a condicio sine qua non for a wealthier JP Morgan.  While hardly a benevolent dictator, I hold to my view expressed here:  I’m confident if JP Morgan were running the Fed, credit growth would have been restrained long ago.  There is some merit to having someone "own" an issue- unlike Greenspan, Geithner, Rubin et alios, who claim no responsibility.

These days, American finance is run and regulated by people who have much less "skin in the game."  As I argued previously (here): It's apparently much better to work in a senior position at a money center bank than to own one.  For JP Morgan, risking insolvency to make Wall St. analysts happy would have been absurd.  The benefits accruing to him (higher dividend pay-outs for a few quarters- selling bank shares was considered silly then) would have been overshadowed by the potential loss in corporate stock value.  Today's money center bank CEOs, whose compensation is heavily skewed towards cash can run a bank into the ground and, in the event a bail-out isn't forthcoming, retire in luxury. 

Consider the case of Dow Kim, detailed in the aptly titled NYTimes article, On Wall Street, Bonuses, Not Profits, Were Real: For Dow Kim, 2006 was a very good year. While his salary at Merrill Lynch was $350,000, his total compensation was 100 times that — $35 million.....But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.  Richard Fuld, ex-CEO of Lehman Brothers, earned some $45M in 2007, one year before that firm went bust.

Had Mr. Kim or Mr. Fuld held large stakes in their respective firms would they have been so reckless?  Would the real sector in the US be starved of cash, as is currently the case, if the reckless behavior of those like Mr. Kim, Mr. Fuld and others hadn't required their and other financial firms to be bailed out?  The large additions to public sector debt caused by the recent bail-outs are one of the main reasons the US debt rating was recently downgraded.

Meanwhile, over in ostensibly communist China, the invisible hand seems to be working just fine.  China's political leaders think like owners and through, at times, admittedly coercive policies, impose that view on others.  While China's middle class grows by leaps and bounds the American middle class is shrinking fast.

What can be done?  Assuming there is something to the views of McGuire and Olson, and I do so assume, the US needs leaders who think like owners instead of hit and run bandits.  Cash pay-outs and easily converted stock-option grants need to be replaced by long term equity holdings- players need to be forced to have "skin in the game".  Regulators too might perform better if their compensation was tied to disaster avoidance (imagine if FDIC regulators received bonuses if no banking crisis occurred not only during but 5 years after their tenure). 

In short, the US would be well served by reviving faith in the virtue of ownership.  Large public companies with diffuse ownership structures have been treated as disposable ATMs by senior officials.  Forcing people to have "skin in the game" before allowing them to make policy decisions seems like a good idea.  Even my local bank, of which I'm a shareholder, requires Directors to have a reasonably large stake therein. 

Them's Fighting Words

As the war of public words between the US and China escalates, the old adage- When you owe the bank $1Mil, you owe the bank.  When you owe the bank $10Bil, they owe you - springs to mind, with a nasty twist. Chillingly, both parties are nuclear armed with significant standing armies.

Following S&P's downgrade of US debt China's Xinhua news offers the following wise economic advice:

China, the largest creditor of the world's sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China's dollar assets.

To cure its addiction to debts, the United States has to reestablish the common sense principle that one should live within its means.

S&P has already indicated that more credit downgrades may still follow. Thus, if no substantial cuts were made to the U.S. gigantic military expenditure and bloated social welfare costs, the downgrade would prove to be only a prelude to more devastating credit rating cuts, which will further roil the global financial markets all along the way.

Alas, sometimes economic wisdom clashes with political reality.  Chinese calls for US military expenditure cuts will prick US hawks' ears the wrong way.  I can hear them now- this has been China's goal all along.

I fear the world just took a step closer to the abyss of war.

When is a Non-Default a Default?

'When I use a word,' Humpty Dumpty said, in rather a scornful tone, 'it means just what I choose it to mean — neither more nor less.'

'The question is,' said Alice, 'whether you can make words mean so many different things.'

'The question is,' said Humpty Dumpty, 'which is to be master — that's all.'

The US Government, according to most press reports, has, by virtue of a last minute- a self-designated limit, it seems worth noting- deal, avoided default.  Amazingly, both the process and situation are even more confusingly convoluted than my opening sentence. 

Imagine a world in which the debtor determines whether or not he is in default.  In that world defaults would be rare events indeed.  Alas for the debtors, but fortunately for the solvent, our world doesn't work that way, no matter how things might appear. 

In our world, debtors don't determine default, creditors do. 

Here's what some important US Government creditors have recently been saying:

1) China: (Xinhua News) With its debt already almost equaling its gross domestic product, the United States, as a major anchor of the increasingly globalized world economy and the issuer of the dominant international reserve currency, needs to roll out more responsible and effective measures to balance its budget and restore the economic health of itself and the world.

2) Russia: (Reuters) They are living beyond their means and shifting a part of the weight of their problems to the world economy...They are living like parasites off the global economy and their monopoly of the dollar. - Russian Prime Minister Vladimir Putin

3) China: (RawStory) China's foreign exchange reserves will continue following the principle of diversified investment, enhancing risk management and minimising the negative impact of volatility in global financial markets," People's Bank of China governor Zhou Xiaochuan said in a statement.

"Large fluctuations and uncertainty in the US treasury bond market will affect the stability of international monetary and financial systems, which will hurt the global economic recovery."

Also on Wednesday, the Chinese ratings agency Dagong downgraded the United States for the second time since November, with a continuing negative outlook.

Meanwhile my preferred measure of US credit worthiness (and market in which nations of less military prowess might express their views more safely), the value of Gold in US$s continues to set new records.

With combined holdings on some $1.28T of US Treasuries, China and Russia are, unlike the US, in a position to declare the US in default, which brings us back to the big egg.  Humpty Dumpty's great fall might prove prophetic (and hopefully, beneficially cathartic) but it's his words that haunt me.

The question is, which is to be the master- that's all. 

Once words (like default, creditworthy, war, ally, etc.) lose their agreed upon, dictionary meanings, might is eventually used to make right.  The US Kabuki Play that was the debt ceiling debate has apparently failed to convince our militarily armed creditors we have jumped back from the abyss.  They seem to think our non-default still looks like a near default, and are taking action.  Will we continue our dance, putting off hard (but oh-so-necessary) decisions hoping to distract our creditors with drama, or will we make honest strides towards resolving our debt issues, which, first and foremost, must include growth policies (of the non-rent-seeking kind)? 

As an aside, the notion that our debt problems can be solved simply through broad spending cuts or tax increases is absurd to me (and likely to our creditors).  If the US economy does not resume growing fast the Washington crowd can crow about avoiding default all they want, but the rest of the world will know otherwise and act accordingly. 

If the Washington crowd chooses the former "more of the same" option, we might have to have a contest (a.k.a. War) to answer Humpty Dumpty's question- which is the master?

In hindsight, it might have been better to self-declare default and immediately start picking up the pieces instead of watching and waiting while the big egg teeters on the precipice.  After all, we know how the rhyme ends.

Luckily, capitalism doesn't require putting the pieces back together again.  Indeed, capitalism works best when the broken pieces are used to make newer, better things than a silly egg on a wall, destined to fall.

Full Disclosure: Long Gold

S&P Downgrade: Be Afraid, Be Very Afraid

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.   

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)

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.

Money-Theism, The Faith That Failed

Future historians may well find post-modern man's faith in the power of money as perplexing as Cortes and his men found the faith of MesoAmerica. It is, I believe this curious faith in money's power that allowed finance to become as protected a practice as any in Christianity. How else could three men who kept markets functioning be proclaimed as "saving the world"? Why else, but for this faith, would politics allow their preeminent position to be usurped by banking?

Dedicated to Dr. Chan whose questions sparked this line of thought.

Human sacrifice. To the modern (i.e. late 15th Century on) mind, the notion of ritual human sacrifice earning the favor of the Gods seems absurd. While Hernán Cortés and his men had few qualms about killing people to achieve earthly goals, they were horrified by the MesoAmerican penchant for the practice during the Mayan and Aztec conquests.

Yet, I'm sure the Mayans and Aztecs "believed" in the virtues of human sacrifice, with some literally believing Gods' favor would follow while others, taking a more practical perspective, assumed the practice scared neighboring tribes or conditioned the population's acceptance of the regime's power.

Today, no doubt, some purists still pray to the money God, while others are motivated by more practical concerns, like Big Bonuses. So it is with all man's faiths.

Alas, for the MesoAmericans, their appeased Gods did not defend them from Cortés and his minions (or Cortés won them over with his greater blood-lust). The Gods failed.

Post-modern man has his Gods too. He worships, inter alia, technology, democracy and, in particular, money. The money worship to which I refer has little to do with the desire therefore, but rather, the faith in money's power over nationalist warfare and thus as means to world peace.

Future historians may well find post-modern man's faith in the power of money as perplexing as Cortes and his men found the faith of MesoAmerica. It is, I believe this curious faith in money's power that allowed finance to become as protected a practice as any in Christianity. How else could three men who kept markets functioning be proclaimed as "saving the world"? Why else, but for this faith, would politics allow their preeminent position to be usurped by banking?

Pedantic Pause:
One wonders how long it will be before an elected official complains, "Will no one rid me of this troublesome banker?" and then does penance at the slain man's tomb. My sense; if it doesn't happen quickly, the odds of seeking penance are small. Alternatively, some Jack Cade type might gain power and take the advice of a friendly butcher, but direct his ire at bankers instead of lawyers.

Paraphrasing the bard: Is not this a lamentable thing, that of the body of an innocent tree should be made paper? that paper, being scribbled o'er, should undo a man?

One can trace the growing faith in the money God in both the continued trend of US decisions in favor of monetary globalization at the expense of sound domestic growth and the rush to implement European Monetary Union (EMU) before political harmonization. A common money (call it money-theism), it was believed, would end centuries of European and even world conflict. Remember the joy of the Neo-Cons (inter alios) as the Russian and Chinese economies "dollarized"?

It was proclaimed to be The End of History.

You could almost hear the Neo-Cons chanting, Tolkein-fashion: One money to rule them all, one money to find them, one money to bring them all and in the darkness bind them.

History, a decade hence, might borrow a line from Mark Twain and suggest, "rumors of my demise have been greatly exaggerated."

Ironically, the Gods of Mount Olympus have demonstrated the weakness of money-theism. Greek dissatisfaction with EMU rules (20 years ago, Greek officials would have just let the Drachma slide) supports "economist" over "monetarist" visions of the power of money which emerged on the road to Euro.

In 1970, the Werner Report forged a compromise of sorts between these two groups debating the means to create EMU. As Matthias Kaelberer details:

The major policy clash was between the "monetarists" and the "economists". The "monetarists"- a position forcefully presented by France- argued in favor of quick progress on monetary cooperation, which would then serve as a tool to harmonize economic policies. The "economists"- reflecting the position of Germany- argued in favor of prior convergence of economic policies before moving to a monetary union.

His critique of the monetarist position (written in 1993) was prescient:

Had the monetarist position succeeded, it would have offered deficit and high-inflation countries a free ride: In a complete EMU, Germany would have either had to finance the balance of payments [BoP] of the deficit countries or it would have had to accept a higher inflation rate.

In the event, "monetarists" won the battle but "economists" won the war. The PIGS went on a free ride and Germany (and the rest of core Europe), to keep EMU, must either finance the PIGS' BoP deficits or accept higher inflation.

On a wider stage, the ongoing battle between China and the US over exchange rates is another sign that money-theism, the current theme of globalization, has failed. The virtues of unified money will have to wait unless and until national political system aims and means converge.  We might even discover the drive for monetary union ignites rather than extinguishes war, but I hope I'm wrong.

It is, I believe, the end of an era.

But, my psychologists/editors at Seeking Alpha (an inside joke) are probably saying, "Where's the beef? What action should our readers take?"

The days of banker-glorification will soon be behind us. Politicians will retake the high ground and bankers will no longer be protected from the technology revolution. How much do you pay in ATM fees each year? The division of national corporate profits will shift back in favor of the real sector. If I was still trading at a Hedge Fund, I'd be short all the big banks.

The intensifying battle between bankers and politicians will likely lead to increased sovereign funding problems. States, once again, will have to pay a fair price to borrow.

I wouldn't be surprised to see double digit western sovereign bond coupons in the not too distant future. (In other words, sell western sovereign bonds).

While the theme of globalization has been exposed as false, the virtues of increased trade (which should accrue at a faster pace, once cleared of banker-parasites) are clear. The world, in my view, is not yet ready for a common money, but begs a flexible international financial architecture. Specie, as the recent rallies in Gold and Silver demonstrate, is making a comeback and may yet be resurrected as a basis, in one manner or another, of the next system.

Full Disclosure: Long Gold and Silver
Time Disclosure: I'm no longer a "trader" but an "investor".  I think, when investing, in units of decades, not weeks, days or hours.  In other words, those looking for the next 10/32nds in bonds are in the wrong place.

Collapse of Occult Economics and US$ Based World

I see bad libor rising
I see trouble on the way
I see market crashes and (near) defaults
I see bad times today

Don't go 'round tonight
For it's bound to take your cash
There's a bad libor on the rise

Ex-Fed Chairman Greenspan has been accused of occulting (hiding from people's view) dissent from the Fed's panglossian housing market forecasts in 2004. While I'd love for that to be true, I'm with Felix Salmon, who, after reading the whole transcript (always a good idea before jumping to an opinion) discerned the offensive quote (see below) referred to debate over Fed transparency and not the housing market.

We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand.  Fed Transcript

To my mind, a more interesting quote can be found in Ms. Minehan's discussion of US economic growth at the same meeting: And like everybody else, I don’t know why the pace of hiring has been as slow as it has been or whether it will get slower or speed up more quickly than we expect.

There's an admission worth noting, she, like everyone else at the table didn't know why the pace of hiring had been as slow as it had been (perhaps because Fed liquidity had gone more to overseas markets than at home would be my guess). In other words, the only occulting that occurred at Fed meetings was the far less sinister, but much more ominous blind leading the blind.

I think the same phenomenon lies behind TPM's discovery of occult practices at the US Treasury in their dealings with Congress (Ms. Pelosi has recently reported the meeting to first request funds came at her, not the Treasury's, request) prior to the request for TARP funds. It isn't sinister, it's just a case of enforced ignorance, as in, let's try whistling past the graveyard, it might work.

Neither Greenspan, nor Rubin, nor Summers (whose financial prescience was shown to be flawed at Harvard) nor Blankfein nor any other of the financial big wigs knows what's going to happen in the financial world because they believe this time is different. (If they did know they would have run for the hills long ago) They have thrown away the only tool that allows economic forecasting, the assumption that the rules of economics always operate (qualifying the proper conditions as they relate to the past being the tricky part of the game, whether I've done so accurately this time remains to be seen).

The collapse of occult economics to which I refer is the apocalypse (Greek for unveiling) of the US$ based system as operating under the same rules of finance that have always operated, specifically the fact that true provision of global liquidity can only come (in a US$ based trading system) through increased US$ supply, a.k.a. Triffin's Dilemma.

As I've previously discussed, Robert Triffin noted the dilemma at the heart of the US$ based global trading system- in order for the world to get the liquidity it wants US$ balances overseas will have to grow, thus eventually weakening the US$ such that it could no longer serve as global reserve currency.

Two events are conspiring to unveil Triffin's Dilemma to the world, the coming economic slowdown in China as a result of previous credit over-extension and current tightening and the current emerging crisis in the Euro periphery- the "G"-less PIGS (Portugal, Italy, Greece (who've gotten their bail-out), and Spain). The "G"-less PIGS must have felt a bit left out of the liquidity party for Greece this past weekend and are now clamoring for their own rescue package.

As an aside, I'm only partially facetious when I suggest a most profitable Hedge Fund theme, find liquidity deprived countries to invest in a fund that will blow out your spreads (CDS and swaps) and create the need for a bail-out. As an added bonus, the rescue deal will likely include a fully funded financial rescue package.

As always there are options available to policy makers. They could allow defaults to occur but that is the "it" (being deflation) Bernanke promised wouldn't happen here (in the US, and by extension, the world), and that option too would likely lead to the end of the US$ based trading system. The other option, the option that has become the rule is more liquidity, and in this case, barring a significant decline in the Euro and RMB vs. the US$, the Fed will have to supply that liquidity at a time when they would prefer to begin unloading some of the toxic securities they bought from the TBTF banks.

Unlike the 2008, 2000-2001 and 1997-1998 crises, however, Fed Funds are already near zero. Quantitative easing, in the form of continued declines in acceptable collateral for Central Bank discounting will be the tool- monetization of poor credit, in large amounts.

At that point, I suspect, Gold will begin to soar against all currencies, and the search for a new global international reserve will being in earnest.

The signs of impending crisis are already manifesting: 1) global stock markets are rolling over 2) credit default swap prices for the "G"-less PIGS are rising rapidly 3) the pace of decline in US$ swap rates has eased.

In the not too distant future, if stock markets continue to weaken, US$ swaps rates will rise. US$ liquidity will, once again, be in short supply and the Fed will be called on to rescue the world.

Let the unveiling commence.

p.s. the primary rule of economics that, in my view, has been occulted from view, because it is so distasteful (to some) is the no free lunch rule...just my, rapidly depreciating, two cents

p.p.s yes, I'm way out on a limb on this one, but what the heck, I'm just a pajama-wearing blogger

Full Disclosure: Long lots of Gold

China, TBTF, and dancin' with the gal that brung ya'

QUESTIONER: Changing the part of the world and going to China. Yesterday I read a statement from Mr. Strauss-Kahn about the yuan, the currency, being definitely undervalued. I wanted to know if you had anything to articulate on this or to comment. Thank you.

MS. ATKINSON (IMF): We have said a number of times that the yuan appears to us to be substantially undervalued. We've also said that what's important is to think about the rebalancing of China's economy. More broadly it's important that the Chinese themselves are interested in boosting domestic demand and private consumption, and exchange rate movements would be just a part of that. It's also of course important to think about global rebalancing, and that means that deficit countries as well as surplus countries need to make some adjustments. IMF Press Briefing 3/18/2010

Perhaps because of my rebellious nature, I've always been attracted to the counter-trend trade. Back in my days as a Hedge Fund trader, I learned about the "max pain" (there are more colorful descriptions) trade. When the market is positioned for a currency price rise, IF (timing is everything, here) you can catch the changing winds of news, you can make a killing (or at least avoid getting caught in the slaughter). In Sorosian jargon, this is the bet against the false premise.

As James Chanos has been arguing: We’re all looking at -- one of the most obvious, obvious trades of the world right now is that the RMB, the Yuan is undervalued. Mr. Geithner, I think, is in Beijing tonight talking about whether or not China is a currency manipulator. Everyone is assuming China needs to peg its currency higher to avoid the export deflation going on.

Well, Chinese exports aren’t the problem here. And what if it turns out that by having to nationalize lots and lots of real estate, bad debts, the RMB is devalued?

These days, the mother of all "max pain" trades would be an RMB decline.  How likely might such an event be?

Let me preface my view (with which, and $4.50, you can get a coffee at Starbucks) with my more general sense that China is in the midst of an amazing transformation which has many more years to run. I wouldn't bet against China in the long term (or at least until demographics catch up to them).

However, other countries which have similarly transformed have hit speeds bumps in the process. Rapid growth creates a financial environment that begs (usually temporary) over-extension.  In China's case, their history of modern financial corporate governance is quite short (on that score, we, in the US still have more than a few kinks to work out). The burned hand, as they say, teaches best (or will after the stove is touched a few more times).

For the past few months China has been trying to slow the economy down, in particular the property market, probably in search of the elusive soft landing.  I've never been much of a believer in the "soft-landing" thesis. There are too many unknowns in a huge economy so policy inevitably over-shoots (or never uncovers the excesses at all). At some point, a threshold will be reached and we'll find out just how sound Chinese property (et alia) lending has been.

My guess is, as almost always tends to be the case, there will be a big difference between viable credit levels of an economy growing at 8% (or, according to the latest data more than 11%) and one growing at 1-2%.

Given that the Chinese banking system totals upwards of $11.5T in assets, even a small "hair-cut" means a couple $100Bil.  

China is now a key piece of our increasingly interconnected global economy. It certainly qualifies, in a more profound sense than the largest US banks, as Too Big To Fail.  We may even find that China's economy has grown sufficiently to ensure that when China sneezes, the rest of the world gets a cold.

In the event of a speed bump, support, in one form or another, will certainly be forthcoming and that support will not be predicated on how the IMF or other nations wish China to develop but on the infrastructure already in place in the same way that TBTF banks were given support based on their infrastructure in place (i.e. continued prop. trading, continued derivatives, etc.) and not on the proposed models envisioned in reform plans.

In times of crisis, ya' gotta dance with the gal that brung ya'.

China is an export driven economy (net exports were 8.9% of 2009 GDP), and the best way to goose such an economy is by letting the currency slide. Moreover, China has been the recipient of substantial capital inflows (the cumulative current account surplus only accounts for roughly 65% of the growth in FX reserves over the past 15 years- just to give a flavor and sense of magnitude). During a crisis, these flows will tend to reverse (or minimally, stop flowing in).

In other words, I wouldn't be surprised to see a not insignificant RMB decline in the medium term, as palliative to a domestic credit problem, before it resumes its more general uptrend against the US$.

I leave for future essays questions of the impact of China's first "speed bump" as a maturing, and huge world power on the international financial architecture (and the impact of a necessary increase in China's current account surplus on the US). Suffice it to write that if such an event occurs (and it will sooner or later) I suspect many known, but currently politically intractable flaws in the regulatory arena (or lack thereof) will come into sharp focus. But they will have to wait.

To repeat, in times of crisis, ya' gotta dance with the gal that brung ya'.

And from a broader perspective, the gal that brung us all to the dance is the gal of monetary stimulus to fix all that ails us.  I'm not, at the moment, arguing for a rethink of this policy, just observing.

The Big School and Convertibility Lost

As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!"

Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost

There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.

Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.

As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?

In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.

I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"

Big School Rules.

In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"

The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.

I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:

The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?

All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion

There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.

Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.

A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.

Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.

Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;

While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.

Big School means Big Problems

Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.

My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.

Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.

Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.

Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China

Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.

As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.

This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.

I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.

In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading.  Markets to spend one's $s, even if one never shops there, engender a sense of stability.

Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)

The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.

What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS.  An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.

GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.

One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.

Global US$ reserves have done nothing but rise since, at an increasing pace.

In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.

Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.

How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.

Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.

Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?

How will the US respond if an economy as large as China's needs a boost in international liquidity?  How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction?  Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?

What if Japan needs IMF support?

How far off might such events be?

Big Questions for the Big School

US Industry, A Dim Bulb

Wang Jianwei, a graduate engineering student in Liaoning, China, was recently surprised to learn that he had been described as a potential cyberwarrior before the United States Congress due to a paper he published last spring- “Cascade-Based Attack Vulnerability on the U.S. Power Grid”.

My first thought on reading this news was that China would likely only resort to such a tactic in the event of actual war given that China and Asia in general generate (I couldn't resist) great profits from the US grid. Asian electronics exports wouldn't be of much use without a functioning grid in the US.

Further reflection on this topic recalled my days as emerging market economist; specifically one of the key bits of data in that field, electricity generation and consumption. Back then (the 90s) higher electricity consumption was seen as one of the few unalloyed goods in emerging economies- the more electricity an economy consumed the more it would grow.

Applying that view to the US, the graph below paints a picture of wonderful growth.

Yet, looks, in this case might be deceiving. While US electricity consumption has been growing it is being used to power a different mix of activities.

Until the mid 80s US Industry was the biggest consumer of energy, as the graphs below depict. Since the era of financial deregulation and industrial off-shoring (among other changes) Residential (all those new electronics exports from Asia) and Commercial (all those new office towers filled with people and computers in cubicles) use have continued to grow while Industrial use has lagged. US Industry uses roughly the same amount of power today as it used in the early 90s.

Meanwhile China's electricity consumption has been growing by leaps and bounds. The CIA's World Factbook lists China's electricity consumption as a close second to the US.

However, Chinese Industry currently uses, according to their Statistical Yearbook, almost 2.5 times as much electricity as US Industry. Current (2008) Chinese Industrial Electricity Consumption of some 2500B KwH is up from 883B KwH in 1999.

Suffice it to write that, if this data is a guide, the US is no longer the industrial workshop of the world.