J.A. Gould World

Capital Shrugged by Mark Spitznagel

2012-02-18T17:19:00.001-06:00

Here is a very good Project Syndicate piece by Mark Spitznagel. In it Spitznagel describes just how central banks everywhere are creating a system of disincentives because they are trying to maintain the status quo and prevent bankers and other lenders from paying the price for making poor investment decisions.

The article brings to mind an interesting quote from Emanuel Derman in which he says, "Call me naive, but I periodically find myself surprised to be living in a world where free-market interest rates are determined by someone."

Capital Shrugged by Mark Spitznagel

2012-02-16

LOS ANGELES – Capitalism’s greatest strength has been its resiliency – its ability to survive the throes and challenges of crises and business cycles to fuel innovation and economic growth. Today, however, more than four years into a credit crisis, a conspicuous enigma calls this legacy into question.

Despite recent hopes of recovery in the US, including an inventory catch-up in the fourth quarter of 2011, real US GDP growth has remained persistently below trend. Moreover, although seasonally adjusted January employment data have brought the unemployment rate down to 8.3% (while total jobs were actually lost in January), the more realistic rate of “underemployment” remains over 15% and the labor-force participation rate is at a record 30-year low. And the US is clearly not alone in its malaise, with the eurozone fighting a far more urgent sovereign-debt crisis.

So, why is this time different? The answer lies in Ayn Rand’s rhetorical invocation of despair in her 1957 epic Atlas Shrugged: “Who is John Galt?” Simply put, when the state seizes the incentives and drivers of capital investment, owners of capital go on strike.

Rand portrays innovative industrialists as akin to Atlas in Greek mythology, carrying on his back a dystopian world of growing and overbearing collectivist government. The hero, John Galt, calls for them all to shrug, to “stop the motor of the world” by withdrawing from their productive pursuits, rather than promoting a world in which, under the guise of egalitarianism, incentives have been usurped in order to protect the politically connected from economic failure.

Today, Rand’s fictional world has seemingly become a reality – endless bailouts and economic stimulus for the unproductive at the expense of the most productive, and calls for additional taxation on capital investment. The shrug of Rand’s heroic entrepreneurs is to be found today within the tangled ciphers of corporate and government balance sheets.

The US Federal Reserve has added more than $2 trillion to the base money supply since 2008 – an incredible and unprecedented number that is basically a gift to banks intended to cover their deep losses and spur lending and investment. Instead, as banks continue their enormous deleveraging, almost all of their new money remains at the Fed in the form of excess reserves.

Corporations, moreover, are holding the largest amounts of cash, relative to assets and net worth, ever recorded. And yet, despite what pundits claim about strong balance sheets, firms’ debt levels, relative to assets and net worth, also remain near record-high levels.

Hoarded cash is king. The velocity of money (the frequency at which money is spent, or GDP relative to base money) continues to plunge to historic lows. No wonder monetary policy has had so little impact. Capital, the engine of economic growth, sits idle – shrugging everywhere.

Rand, perhaps better than any economic observer, underscored the central role of incentives in driving entrepreneurial innovation and risk-taking. Whittle away at incentives – and at the market’s ability to communicate them through price signals – and you starve the growth engine of its fuel. Alas, central bankers, with their manipulation of interest rates and use of quantitative easing, patently neglect this fact.

Interest rates are more than a mere economic input that determines levels of saving and investment. Rather, as the Austrian economist Ludwig von Mises emphasized, they are a reflection of people’s aggregate time preference – or desire for present versus future satisfaction – not a determinant of it.

Interest rates thus incentivize and convey to entrepreneurs how to allocate capital through time. For example, lower interest rates and cost of capital raise the relative attractiveness of cash flows further in the future, and capital investment increases – the system’s natural homeostatic response to higher savings and lower consumption.

State manipulation of interest rates, however, does not influence time preference, even though it signals such a change. The resulting inconsistency creates distortions: as with any price control, capital receives an incentive to flow to investment that is inconsistent with actual supply and demand.

The Fed is purposefully and insidiously distorting the incentive system – specifically, signals provided by the price of money – resulting in mal-investment (and, when public debt is monetized, inflation). This can continue for a time, rewarding unproductive investments and aspiring oligarch-speculators who presume that the Fed has eliminated risk. But, as Rand reminds us, at some point the jig is up.

Today, after the largest credit expansion in history, that point has clearly been reached. Impassive capital now ignores deceptive market signals, and the liquidation of untenable mal-investment percolates through the system as immutable time preferences prevail.

The state, in the long run, simply cannot direct entrepreneurs to lend, borrow, and invest; investment capital will inevitably shrug when faced with oppressive manipulation of free markets. When that happens, we see the true result of loose monetary policy: not the creation of more economic activity, but the destruction of the natural mechanism of economic coordination and adjustment, robbing the system of its resilience. In effect, monetary policy has “stopped the motor of the world.”

At the conclusion of Atlas Shrugged, Galt aims to restore the old system anew as the collectivist regime crumbles. Will something like that, too, happen in our own dystopian world (in which all remaining Republican US presidential candidates seem to favor firing Fed Chairman Ben Bernanke)? How long must capital wait for the day when, free of distorted incentives, the engine of growth is fueled and humming again?

Mark Spitznagel is the founder and chief investment officer of Universa Investments, a California-based hedge fund.

Alan Simpson -- "Wake Up"

2012-02-14T09:26:00.002-06:00

On The Failure Of Inflation Targeting, The Hubris Of Central Planning, The "Lost Pilot" Effect, And Economist Idiocy

2012-02-06T10:43:00.001-06:00

h/t Zero Hedge

As an ever greater portion of the world succumbs to authoritarian control (whether it is of military disposition, or as we first showed, a small room of economists defining the monetary fate of the future as central banks now hold nearly a third of world GDP within their balance sheets) we can't help but be amazed as the population simply sits idly by on the sidelines as the modern financial system repeats every single mistake of the past century, only this time with stakes so high not even Mars could bail out the world. Unfortunately, with the world having operated under patently false economic models spread by hacks whose only credibility is being endorsed by the same system that created these models over the past century, the only temporary solution to all financial problem is to "try harder." Sadly, the final outcome is well known - a global systematic reset, in which the foundation of all modern democracies - the myth of the welfare state (which at last check, was about $200 trillion underfunded on an NPV basis globally and is thus the most insolvent of all going concern entities in existence) is vaporized (there's that word again) leading to global conflict, misery and war. Sadly that is the price we will end up paying for over a century of flawed economic models, of "borrowing from the future", of ever more encroaching central planning, and of an economic paradigm so flawed that as Bill Buckler puts it, "Keynes’ response to those who questioned the “longer-term” consequences of his advocacy of credit-creation as a basis for money was - “In the long run, we are all dead”. It is difficult to overemphasise the venal arrogance of this remark or the destructiveness of its legacy." Alas, the last thing the central planning "fools" (more on that shortly) will admit is their erroneous hubris, which in the years to come will claims millions of lives. In the meantime, we can merely comfort ourselves with ever more insightful analyses into the heart of the broken system under which we all labor, such as this one by SocGen's Dylan Grice, whose latest letter on Popular Delusions is a call for "honest fools" - "Frequently, when we make mistakes we try to correct them not by changing the flawed thinking which led to the mistake in the first place, but by reapplying the same flawed thinking with even more determination. Behavioural psychologists call it the “lost pilot” effect, after the lost pilot who tried to reassure his passenger: “I have no idea where we’re going, but we’re making good time!” Policy makers on both sides of the Atlantic are treating today’s malaise with the same flaky thinking which created it in the first place. How can that work?" Simple answer: it can't.

Grice explains why "Trying harder" is the only recourse of a status quo gripped in a confirmation bias so tense that even merely glancing outside the window at the Marriner Eccles building could be sufficient grounds for the whole house of cards to come tumbling down:

[This week I want to think about] the incorrect application of faulty models. In essence, that's all those studies on confirmation bias are really about. Subjects applied a faulty model - a mental algorithm saying "accept only supporting evidence" - which resulted in a biased assessment of the evidence. "Trying harder" didn't work because the problem was the faulty model, not the lack of effort, and applying that faulty model with more determination just caused an even bigger error. Psychologists have a name for this. They call it the "lost pilot effect" after the lost pilot trying to reassure his passengers by saying "I have no idea where we're going, but we're making good time!"

Flawed thinking got us into this mess. But rather than change that flawed thinking, our policy makers are applying it with even more rigour: we have more debt for insolvent borrowers, more financial engineering, more complicated banking regulations, more blaming speculators for everything, more monetary experimentation by central banks. Our policy makers have absolutely no idea what they're doing, but they're giving it a go!

"Lost pilot effect" exhibit A - Inflation Targeting, which failed miserably in the past, and will fail miserably again.

The latest from the Fed provides a wonderful example. Undeterred by the latest calamitous failure of CPI targeting regimes (a brief history of which will be presented below), it has announced an explicit 2% inflation target. But why? Would an explicit target have made any difference to the last crisis? Will it prevent the next one? And where did this 2% come from? We don't know. But we suspect that past uninformed capital market tinkering has failed to control the uncontrollable, and we're pretty sure these ones will too.

In fact, if such tinkering has in the past been the primary causes of crises, then why won't this latest attempt - the 2% inflation target - be the cause of the next one? There are certainly precedents. Targeting stable "prices" isn't a new idea. The first experiment was actually conducted in the US in the 1920s, apparently successfully. Indeed, so stable were consumer prices that the authorities assumed there was no inflationary threat. And, this brilliant new idea, that stable consumer prices were both a necessary and sufficient condition for economic stability, proved so appealing that the NY Fed adopted it as a policy objective. On January 11th 1925, then-governor Benjamin Strong wrote to a friend:

That it was my belief, and I thought it was shared by all others in the Federal Reserve System, that our whole policy in the future, as in the past, would be directed towards the stability of prices so far as it was possible for us to influence prices.”

During the 1927 Stabilization hearings before the Committee on Banking and Currency on a Bill to amend the Federal Reserve Act to provide for the "stabilization of the price level for commodities in general", the governor was asked if the Fed could stabilize prices more than it had done in the past. Strong replied “I personally think that the administration of the Federal Reserve System since the reaction of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very object.”

Like a driver focused on the speedometer rather than the speed, oblivious to the risk that the speedometer might be faulty, they kept their foot on the gas until they crashed. So focused were they on the stability of the CPI (first chart below), and so convinced that it was the be all and end all of inflation, they missed what was going on in the credit markets (second chart below).

Oddly enough, nobody discussed "inflation targeting" as one of the potential causes leading to the Great Depression. Why? Simple. Because it would confirm that the status quo's very basic definition of inflation is fatally wrong; it also means that the entire premise of "economy" is a joke as it is impossible to rely on any of the most "sacred" indicators in existence, and all the so-called economists are literally pilots, flying blind. Grice on just this possibility:

We know that episode didn't end too well. Yet to this day, on the long list of explanations for what put the "Great" into the 1930s Great Depression, the prior credit bubble which was allowed to develop - and was possibly even caused by the monetary authorities' undue attention to an arbitrary variable (consumer prices) - and the false sense of security the stability of that variable created, is barely a footnote. Amid the mountains of literature on the "lessons from the 1930s" there doesn't seem to be much on the danger posed to an economy of allowing a committee of economists to tamper with the natural functioning of the market for capital by letting them decide what interest rates should be.

Why would there be? It would be a confirmation by the same status quo it is based on a completely flawed premise. Yet the blind reliance on CPI did not prevent the Japanese bubble of the late '80s, when the Nikkey quadrupled in 5 years, yet Y/Y CPI was under 3% the entire time. Same thing with the Nasdaq bubble:

We've experienced the same thing with the tech bubble of the late 90s and the real estate bubble we're still recovering from (see charts below). On each occasion, the monetary authorities were blinded to the runaway inflation in the markets for equities (first chart below) and real estate (second chart below) by stable CPI inflation.
Inflation targeting, it seems, has a history of fostering asset bubbles because the notion that a stable CPI equates to a robust economy contains numerous false premises.

And here we reach the two main errata in all of modern economics.

The first is that inflation is measurable. Einstein once had the words “not everything which can be measured counts, and not everything which counts can be measured” on the desk in his office at Princeton. And although the world might be simpler if it wasn't so, I believe "inflation" happens to be one of the things which counts but can't be measured. The fact is that once money is created you don't know where it ends up. Maybe it will end up in the consumer goods market, maybe it won't. Or maybe it will be multiplied via the financial system into new credit which will inflate asset prices instead. Even then, we don't know which assets.

But suppose we did know where money would end up, how would you weight the assets together into one index? Should stock prices be included in the CPI? If so, what should the weight be? And if you're going to add stocks, why not add corporate bonds too? And what should their weight be? And if you're going to add bonds, why not add house prices, etc., etc.? Isn't it obvious that the rich concept of - inflation - is unobservable? So who said that proxying it with a narrow sub-category - consumer prices - was a good idea?

Why Ben Bernanke of course, that's who.

The second is the premise that consumer prices themselves should be as 'stable' as possible. But is that correct? Isn't the natural tendency of our species to do more with less, to lower the cost of a given good or service, to "increase productivity"? In other words, isn't "deflation" a part of the human condition? Jeff Bezos, the CEO of Amazon famously said there were two types of company in the world, those that work to charge more and those that like to charge less. His company, he said, would belong to the second group.

Shouldn't someone warn him of the folly of pursuing deflation? Of the untold havoc he's set to unleash by trying to undercut Apples iPad? And how about those guys at Walmart? Surely they deserve a stern ticking off oblivious, it seems, to the downright irresponsibility of their "Everyday Low Prices" strategy? Maybe all the clever economists and Ivy League Nobel Prize winners should make going to Arkansas to explain to the Waltons that they're playing with fire a matter of urgency?

Some more on the self-deception of hubris:

Or maybe the clever economists aren't so clever. Maybe they have it all wrong. Maybe deflation is most painful when there is an excess of debt, and so maybe they shouldn't be encouraging excessive debt accumulation in the first place, by distorting the interest rate market in the pursuit of aims whose consequences they don't fully understand?

This brings us to a third false premise, that there is some "optimal" rate of consumer price inflation. Judging by the targets of most central banks which have them, that rate is around 2%. But why is it 2%? Why not 3%, or 4%, or 6.78384%? What's so magical about 2%? Where did that number come from?

Grice on exposing faux experts (virtually all of them) using the methodology of one Richard Feynman:

One of my favourite people of the 20th century is Richard Feynman, the Nobel Prize winning physicist who, among other things, pioneered the study of quantum electrodynamics. In a fantastic documentary about him for BBC's Horizon show called "The Pleasure of Finding Things Out" he said something I found moving and profound. He was talking about the "experts" he saw on TV and how although he didn't have any expertise in the area they claimed to have expertise in, he felt quite sure that they didn't know what they were talking about. He said this:

"There are myths and pseudo-science all over the place. I might be quite wrong, maybe they do know all this ... but I don't think I'm wrong, you see I have the advantage of having found out how difficult it is to really know something. How careful you have to be about checking the experiments, how easy it is to make mistakes and fool yourself. I know what it means to know something. And therefore, I see how they get their information and I can't believe that they know it. They haven't done the work necessary, they haven't done the checks necessary, they haven't taken the care necessary. I have a great suspicion that they don't know and that they're intimidating people."

So if I apply Feynman's test and ask myself how hard most economists worked for their knowledge, I can't help thinking they haven't worked hard for it at all. I don't think they've worked hard to know what inflation is, or whether it can or should be targeted. I think they've just assumed it, and anyone can do that. As Feynman warned, they've fallen into the trap of fooling themselves. They've assumed that inflation can be proxied by the CPI because it's easier to do that, they've assumed that 2% is somehow the right rate for it, and they've assumed they're capable of setting interest rates at the 'appropriate' level.

And the biggest blasphemy of all: everything economists have been taught, and have taught, was wrong from the very beginning.

But what if those assumptions are wrong? What if, for example, the 'natural' rate of consumer price inflation was 0% and so by trying to keep it at the unnaturally high rate of 2% they've had to artificially goose up the rest of the economy by setting interest rates at an inappropriately low level? And what if, like force-feeding steroids to a horse because you assume it should be running faster, in doing so you kill it, distorting the credit system so grotesquely as to crash the rest of the economy?

They've assumed that wouldn't be a problem, and they assumed that if there was one they'd be able to fix it (Ben Bernanke supposedly promised Milton Friedman that there would never be another great depression because the "lessons" had been learned from the 1930s). But, assuming you know how the animal behaves isn't the correct way to go about attaining knowledge about how the animal actually behaves. So they don't attain knowledge about how the animal behaves. So the animal keeps mauling them.

But they keep doing it. Now a 2% CPI inflation target is going to make all the difference. And I find it a very strange thing. I just don't understand why they're so sure they know all this stuff despite all the evidence to the contrary. I feel like McCarthy in One Flew Over the Cuckoo’s Nest: “That’s right Mr. Martini, there is an Easter Bunny.”

Finally, we get to the bottom line: economists, and all those others who are "in charge" really are just a bunch of idiots, or, as Grice puts it far more politely, fools.

Mr. Feynman said something else which I like. He said:

“Ordinary fools are all right; you can talk to them, and try to help them out. But pompous fools - guys who are fools and are covering it all over and impressing people as to how wonderful they are with all this hocus pocus – that I cannot stand! An ordinary fool isn't a faker; an honest fool is all right. But a dishonest fool is terrible!”

I think he's right. Dishonest fools are terrible. It's a shame they're in charge.

Chris Martenson Interviews John Mauldin

2012-01-28T12:48:00.002-06:00

Try to ignore the obvious error Mauldin makes at the beginning by referring to "Richard Fisher" instead of Irving Fisher. Not that Richard Fisher isn't a better than average economist (from a policy standpoint), but he is nowhere near in the same league as Irving. h/t Zero Hedge

Priceless Headline of the Week--Life's Not Fair

2012-01-28T08:57:00.000-06:00

Doug Noland on the real Crisis of Capitalism

2012-01-20T21:12:00.001-06:00

Thoughts On The Crisis Of Capitalism

by Doug Noland

January 20, 2012

George Soros’ “The Crisis of Global Capitalism…” was published back in late-1998, following a dreadful period of global instability. Such concerns for the most part dissipated over the years with the resuscitation of global market and economic booms. The market value of global debt, equities and commodities skyrocketed. Bigger booms and busts followed and, not surprisingly, global Capitalism is today under only more intense fire.

Strangely enough, there remains a fine line between a “crisis of global Capitalism” and utter euphoria in the financial markets. The ECB’s $620bn first round Long-Term Refinancing Operation (LTRO) - along with expectations for an even more grandiose 3-year lending facility (LTRO II) next month - has the markets abuzz. Crisis resolved? The unleashing of another global reflationary backdrop on which to capitalize?

Participants certainly appreciate that the Federal Reserve has a hankering for QE3; the Bank of England (BOE) appears poised for unending quantitative easing; the Bank of Japan continues to flood its system with liquidity; the Chinese will likely soon resume stimulus measures; and “developing” central banks around the world have moved to combat a weakening global backdrop with their own brand of monetary largess. Especially after global risk markets have ushered in 2012 in robust fashion, the optimists and speculators can be excused for believing that all the crisis chatter might yet again signal “liquidity abundance, government backstops and spectacular market booms ahead.”

Prime Minister David Cameron yesterday provided his take on Capitalism in what has become a fascinating political debate in the UK. Here at home, the outcome of the November election could very well be decided by which of two opposing visions of a capitalistic economy best resonates with a divided populace. These are critical times.

The Financial Times this week ran several interesting essays in their “Crisis in Capitalism” series. Today from former ECB and Bundesbank economist Otmar Issing: “Too Big to Fail Undermines the Free Market Faith… The crisis has provided strong arguments for opponents of the financial system. Interventions to avoid its collapse have severely undermined not only confidence in financial markets but also in the market economy as a whole. Once a financial institution has become so big or interconnected that its insolvency threatens the stability of the system, politicians must intervene. The problem of ‘too big to fail’ has made society – more precisely, the taxpayer – hostage to the survival of individual financial institutions. As a result, the basis of free markets has been shaken. A market economy rests on the principle that individuals are free to act within boundaries set by a legal system... The rules of the game should be clear. Those who succeed are free to take the profits (after taxation); those who make losses have to bear the consequences, with bankruptcy the ultimate sanction. Thus, ‘too big to fail’ not only undermines a fundamental principle of market economies but also a principle of societies in which individuals are responsible for their actions.”

Also today, from Mohamed El-Erian: “The Crisis Raises Legitimate Questions About Capitalism Itself… The majority of writers agree that the crisis in capitalism is caused by two distinct failures: the inability of the system to deliver sustained prosperity through economic growth and jobs; and the perception that it is grossly unfair and socially unjust. ...To fail on both counts, and to do so in such a spectacular manner, is indeed a ‘crisis.’ It raises legitimate questions about the model itself. There are three main reasons for this. Firstly, capitalism has always, and will always be, prone to traditional market failures. The answer is to accept this, and work harder at reducing the chances of a catastrophic failure... Secondly, during the past decade, in another part of the world, a set of countries embarked on their own capitalist economic revolution... Lastly, too many of the institutions that are critical for the smooth functioning of capitalism utterly failed to deliver when they were needed most… Each of these areas can be corrected. Theoretically at least, what has occurred is less a calamity of the system as a whole, and more an issue of how it was run.”

Perhaps it’s only semantics, but while Mr. El-Erian writes “what has occurred is less a calamity of the system as a whole, and more an issue of how it was run,” I would instead focus on how it is “BEING run.” And when Mr. Issing writes, “The problem of ‘too big to fail’ has made society… hostage to the survival of individual financial institutions,” I would focus these days somewhat less on “institutions” and more on “global debt and securities markets.” I know many analysts are of the view that system fragilities are being addressed through greater bank capital cushions and more stringent regulation. This is fighting the last war. I believe that a profoundly greater risk to global Capitalism goes largely unappreciated and unaddressed.

Larry Summers this week on CBNC repeated a common view: Capitalism is inherently flawed, but it still beats the alternative. Longtime readers know I take exception with the view that Capitalism is “flawed.” One could similarly contend that the eyeball is flawed – that it is much too soft and fragile for having such a vital function. In reality, it is the nature of its operation and functionality that dictates its vulnerable structure. So it is incumbent upon those of us relying on eyeballs to guard against potential dangers, such as excessive sunlight (sunglasses), metal shavings (safety glasses) and disease (regular self-assessment and trips to the optometrist when things begin to appear out of whack).

There is certainly no doubt that Capitalism has vulnerabilities. Much less obvious is that its greatest vulnerability lies with the nature of Credit. This reality goes unappreciated by most – and largely undiscussed by the few conversant in the formidable nuances of Credit analysis. Ignoring the inherent instability of Credit is akin to staring at the lovely sun. Ironically, those that seem to best appreciate the nature of Credit instabilities – along with the risk posed to Capitalism – also tend to be those working keenly to extract the greatest amount of financial wealth from grossly distorted financial markets. Indeed, profiting from the consequences of two decades of policy measures in response to market instabilities has engendered one of history’s greatest periods of wealth accumulation (much of it through the transfer of wealth). And as the scope of policy prescriptions and market interventions turns only more incredible, the whirlwind of speculation seeking market riches becomes more intensive than ever. The markets ebb and flow and convulse, while the Crisis of Capitalism drifts nearer to the abyss.

I am convinced that a capitalistic system must have a monetary anchor to be sustainable. A functioning market pricing mechanism is fundamental to resource allocation, saving and investment, wealth creation and, in the end, social stability and cohesion. Stable money and Credit is a prerequisite. One can also think in terms of two distinct pricing systems. There is the pricing of goods and services throughout the “economic sphere.” There is, as well, the pricing of finance/Credit/risk in the “financial sphere.” It is the pricing mechanism within the financial sphere that has become so badly out of whack to the point of posing dire risk to global Capitalism.

As I’ve noted in the past, we live in period unique in financial history: There is globally no limits placed on the quantity or quality of Credit creation. There is no gold standard; no Bretton Woods monetary regime; nor even an ad-hoc “dollar standard” working to regulate global Credit expansion. Markets for pricing finance and risk have turned progressively distorted and, in the end, dysfunctional. This was a predictable outcome for a global “system” bereft of a monetary anchor. Policymakers have repeatedly responded to dysfunction and inevitable booms-turned-bust with unprecedented market intervention. This continues to only exacerbate financial market pricing distortions and attendant imbalances. What began as tinkering has regressed to the point of policymakers attempting to take virtual command over the pricing of finance. Capitalism now hangs in the balance.

I am prepared to defend Capitalism until my dying days. I expect this endeavor to be no less of a challenge than it’s been the past 12 years trying to explain the great dangers associated with a runaway Credit Bubble. Over the long-term, for Capitalism to succeed in the real economy requires a functioning pricing mechanism and sound Credit system. Distorting the price of finance ensures speculative Bubbles, the misallocation of real and financial resources, and resulting economic maladjustment. In this regard, policymakers have bordered on gross negligence.

Massive fiscal and monetary stimulus, along with unprecedented market interventions, has completely overwhelmed the capacity of the markets to effectively price risk. Instead of learning from past mistakes, policymakers are more determined than ever to dictate market pricing. Rather than recognizing the prevailing role “activist” central banking has played in fomenting dysfunctional markets, policymakers believe market outcomes beckon for only greater activism. Until governments can begin to extricate themselves from the manipulation of interest rates and risk market pricing more generally, this long cycle of destructive booms and busts will run unabated.

Mr. El-Erian posited that “capitalism has always, and will always be, prone to traditional market failures. The answer is to accept this, and work harder at reducing the chances of a catastrophic failure.” Well, what lies at the heart of these “traditional market failures”? I have a very difficult time with the notion of accepting market proclivities and correcting institutional failings when there is scant evidence that policymakers or the economic community appreciate the inherent instabilities of Credit or the dangers of unsound finance. Would less debt, leverage, government market intervention and market speculation reduce the risk of catastrophic failure? Why then the incessant inflationist solutions of massive deficit spending, interest-rate manipulation, central bank monetization and progressive government control over the markets and real economies?

Mr. Issing states that “the rules of the game should be clear. Those who succeed are free to take the profits…; those who make losses have to bear the consequences, with bankruptcy the ultimate sanction.” Yet the overarching problem today is that the global government finance Bubble has inflated past the point of being too big to fail. And the rules of the game have become dangerously clear: policymakers will do any and everything to sustain a global Credit system some years ago exposed as dysfunctional and a risk to Capitalism. Governments are conspicuously against the bearing of consequences, and market participants are being heavily incentivized to play it that way.

Makana--We Are The Many

2012-01-14T13:43:00.003-06:00

If this is the Occupy message, I fully support it. I just emphasize the need to distinguish between crony capitalism and the real thing. The thing I found most disappointing about the Occupy movement was the quickness to dismiss the benefits of capitalism. Have they not learned from history that communism, or collectivism, or fascism simply don't work?

As Ayn Rand said: "If concern with poverty and human suffering were the collectivists' motive, they would have become champions of capitalism long ago."

Hugh Hendry at LSE

2012-01-13T22:22:00.001-06:00

"The truth today has become un-palatable."

Below is an interview, done in early 2011, between Hugh Hendry and Steve Drobny. If you've read the book, The Invisible Hands, you should certainly recognize the similarity between the Plasticine Macro Trader chapter and the below interview.

I know Hendry says that he doesn't care to compete with the intellectual heavyweights of finance, but I think he's actually competing with them whether he wants to admit it or not. People think that everyone is a contrarian these days, hell even Bill Gross went all zero-hedge in his most recent letter, but I would beg to differ.

My view, just as Hendry's, is to position myself in a manner that will benefit by the outcome that results from the fact that there are no policy remedies for a debt deflation. In other words, the Fed is grossly ill-equipped to solve the problem of too much debt.

So here are some contentious viewpoints, framed as market myths, that I think could make the savvy market participant some money.

1) Gold is a store of value in a dollar-based system. I think gold is in a bubble. As Hendry has pointed out in the past, gold has been up for 12 straight years now. The only other streak that rivals it was an 11 year streak by the Nikkei from 1978 to 1989 just before its phenomenal crash. Gold investors think they are the smartest people in the world. In fact they act like they have thoroughly figured out all there is to figure out when it comes to all manner of economic subjects from banking, to the treasury, to capital markets. The market has continuously given their 'economic-worldview' positive feedback. As a result, they think they are economic geniuses, as opposed to suckers in a bubble. I think there could be a day soon that sees a massive decline in gold prices that knocks these new-world economists off their pedestals. Once their economic 'theories' are no longer confirmed by price, it will become very difficult to continue buying and indeed, to resist selling.

2) We are in a recovery. I think the entire rally since March 2009 could in fact have been one of the biggest bear market rallies of all time. The faith in the Fed has possibly never been higher than it is today. The market consensus is that the Fed is in control and more importantly that IF stock prices begin to fall, then the Fed will come in with more QE and stock prices will begin to rise again. But what if QE and higher stock prices are only spuriously correlated? What if the Fed cannot control stock market prices? In fact, there is even historical precedent in Japan of QE not being successful at raising stock prices. I believe the market could collapse in a very short period of time back to the lows that we saw in 2008 leaving people confused and disillusioned about the world. This would inflict the maximum psychological pain for investors, which is what bear markets are supposed to do I would imagine. You might think that me saying that is a selfish view, and I might agree but I feel disillusioned that other market participants don't see the world as I see it now. The market needs a healthy dose of reality.

3) The Fed can create inflation at will. Can it? I'm not so sure. In fact, I happen to be of the opinion that it is very difficult, in the current environment, to safely create 2% inflation every year. By contrast it is very easy for a central bank to destroy a currency. When monetary policy enters the realm of the unknown (QE) the risk of non-linear "accidents" certainly goes up. That being said I sincerely think we will see deflation before this crisis is over. Yes, that is persistent negative YoY CPI prints. The deflationary quagmire that I see the U.S. going into has the potential to be even worse than what has occurred in Japan. In saying that I just mean that we could see larger and more persistent deflation than Japan has seen, simply because our politics are so much more repulsed by sovereign debt. Japan has pumped incredible amounts of sovereign debt into their system to manage to "only" have modest -1% to -2% deflation. I doubt that the U.S. will have that luxury. In my future dream world I can in fact imagine a defeated Bernanke, or his contemporary, admitting that "Yes, we were wrong, the market needs to clear." Angels would sing from the heavens as economics would evolve and get back to reality, breaking free from its Keynesian and econometric shackles.

Chanos--Not a Macro Guy?

2012-01-13T21:22:00.000-06:00

Do you feel lucky?

2012-01-04T19:25:00.002-06:00

Well, do you?

I know I've mentioned it before on this blog but given the daily barrage of claims of market "cheapness" from CNBC I feel compelled to mention it again.

STOCKS ARE INFINITE DURATION SECURITIES!!!

If something has infinite duration does it make since to simply look at T-12 or forward twelve month estimates when evaluating a stock market??? I contend that the analytically correct answer to that question is "no". In my opinion it makes much more sense to look at a longer term measure of earnings such as trailing 10 year earnings like those that are used to calculate the Shiller P/E ratio http://www.multpl.com/

When risk premiums go up again, please resist the temptation to buy based on T-12 earnings "cheapness".

Things I'm Keeping My Eye On

2011-12-18T09:51:00.004-06:00

Here are a few charts that I've been keeping my eye on lately.

Each of them, in one way or another, seems to point to a divergence between the S&P 500 and various other asset classes or indexes. The biggest divergence that I've been keeping my eye on has actually been occurring for a long time now; the US treasury market. Treasury yields have continued to move lower over time and actually are lower than 2008 panic levels for most maturities. Equities have by and large ignored this move. The below chart shows the S&P 500 vs. the 10 yr treasury yield (Green) over the past 11 years.

Another perplexing thing about the equity markets these days is the persistent increase in correlation. It is a professional stock picker's worst nightmare. Stocks are trading as an asset class rather than as individual companies with individual business merits. Macro risks are the driving force. That being said we have been consistently hitting new highs in the correlation index in recent weeks, even as the short term volatility index has been declining. Here is a chart going back 4 years on the ICJ Index (Implied Correlation).

And the S&P 500 vs. the VIX Index (Green) going back 11 years

This may be the most Captain Obvious chart of the series. That European credit markets are a slow motion train wreck is undeniable at this point (just don't tell the stock market). Nobody knows for sure exactly how the European crisis is going to end, but it is hard to fathom situations that won't be chaotic. European banks are 2-3 times more levered than their U.S. counterparts. Given that the Euro-zone seems to now be in a recession one would expect charge offs to be elevated anyway. Based on the leverage that the banks have, this alone might normally force these banks to raise equity. On top of this, most banks are loaded to the gills with the euro sovereign paper of sovereigns that are being systematically locked out of the bond markets. Throw on top of all this the totally inter-connected nature of the banking systems throughout the world via not only OTC derivatives but also repo markets and the shadow banking system more generally and you have the ingredients for a financial market meltdown. It really is a total disaster.

On the bright side, European cash bond markets have rallied quite impressively over the past couple of weeks. The CDS market is calling bullshit on the rally though. As you can see below the 5-yr CDS for the four largest EMU countries (Germany, France, Italy, Spain) remain at or near their all time highs.

Another market I've been keeping my eye on is China. While the news headlines have been clogged up with European issues China has been quietly selling off. It appears that their credit bubble is hitting a speed bump and, barring any additional monstrous credit growth, could be set for a crash. When you understand the magnitude of the yearly credit growth in China it becomes clear that the banking system, and thus the economy, is completely unstable over there. Even if they can manage to push another 50% of GDP out in credit next year the piper will have to be paid eventually. China is the marginal buyer of most industrial commodities and therefore if China goes through a restructuring of their economy it will drastically affect many commodity markets. Both the Shanghai Composite and the CRB Index have been rolling over in the past weeks and months. The SHCOMP and the CRB have been moving, perhaps in a leading fashion, to a greater extent than the S&P.

The Shanghai Composite vs. the SPX (Green) going back 11 years

The CRB Index (Green) vs. the SPX going back 11 years

Van Hoisington--Still Banking on Treasuries

2011-12-17T22:02:00.003-06:00

Van Hoisington, President and Chief Investment Officer of Austin, Texas-based Hoisington Investment Management, cut his teeth in the bond bear market of 1978 to 1980. That was back when interest rates went from roughly 7% to 15%. Hoisington and the firm's economist, Lacy Hunt, are lucid exponents of the unpopular case that the three-decade-long bull market in Treasuries will continue, ratings agencies be damned. To learn Hoisington's reasoning, keep reading.

Barron's: Why only U.S. Treasuries?

Hoisington: When I first began in the business in 1974, at the Texas Commerce Bank, I had a portfolio of corporates and agencies. When interest rates go up, all assets go down. In his book Inside the Yield Curve, Marty Leibowitz of Salomon Brothers pointed out the power of maturity in terms of total returns. I just adapted the philosophy that you make more money by having the right maturity structure than you do worrying about foreign bonds, agencies and corporates. The problem is that when you are out in the very long end of the market, you have a great deal of price fluctuation, and many do not care for that volatility. That's why we don't have $100 billion under management. The Wasatch-Hoisington U.S. Treasury fund (ticker: WHOSX) itself is about $200 million, and we manage about $5.7 billion. [The fund is up 30% over the past 12 months.] It is all long-term bonds, the longest coupon and zero-coupon bonds. Philosophically, we are just as comfortable in very short-term maturities. In 1987, in our accounts, we went to 100% cash equivalents as a policy, and rates went from 7.5% to 10%. Since 1990, we've been long, because we've been in a disinflationary/deflationary cycle versus an inflationary circumstance. If we feel it is disinflationary, obviously there is no risk in 30-year Treasuries because the rates will gradually follow the inflation rate down.

Still, a 30-year bull market seems long in the tooth. Why do you see it continuing?

As far as I know, there is no time value put on bull or bear markets. Some people say it follows the business cycle. But we are disciples of Irving Fisher, who wrote his Theory of Interest in 1930 and was the first one to deconstruct the interest rate into the real portion and expected inflation. He said long rates are the function of the real rate, plus expected inflation. In the last 140 years the real rate has averaged about 2%, and it varies widely from time to time. But we also know that most of the academic work for the last several decades has basically validated Fisher's theory, and that long rates are a function of inflationary expectations. And Milton Friedman said that inflationary expectations tend to be a function of the experience of inflation. So we have had a bull market because we have had a declining rate of inflation since 1980.

Our expectation is that we are going to enter another recession next year, when we haven't really fully recovered from the previous one. We think we are in what Niall Ferguson, a Harvard historian, recently termed a slight depression. This isn't a normal business cycle. So long as there is downward pressure on prices, bond yields will either continue to go down or bottom out around the real rate, assuming that the inflation rate stops at zero. We aren't there yet, obviously, but are headed in that direction. That's why we've had a bull market and why it will continue until such time as inflationary expectations start to rise.

Isn't inflation rising?

When inflation has risen since 1990, the pattern was for headline inflation to accelerate faster than core inflation. This served to drain discretionary spending power from the household sector, which in turn either weakened economic growth or caused outright recessions. We viewed such increases in inflation as transitory.

The fundamental problem in the U.S. and globally is that we are in disequilibrium because of high debt levels. In the U.S., we have $15 trillion in gross domestic product, and we have $52 trillion in debt, which is 350% of GDP. Since 1998, we went from 250% to 350% and the debt was for mainly nonproductive investments. The prices of those investments—houses, commercial real estate, even stocks—have been falling since '08. Actually, stock prices are down since 2000. So we are in a circumstance of overindebtedness. Ken Rogoff and Carmen Reinhart, in their book This Time It's Different; and the McKinsey Global Institute; and recently Stephen Cecchetti, the former director of research of the New York Federal Reserve, in a Bank for International Settlements paper, all say that when you get debt-to-GDP ratios that are too high, your growth rate starts to fall. That is exactly what is happening. Through the third quarter, year-over-year growth rates are about 1.5%. In the last 40 years, every time you have had a 1.5% growth rate, they call it "the stall speed": You have slipped into recession because the economy is too weak to sustain any shocks. Unfortunately, we have had some shocks. We are spending about $3.6 trillion, our receipts are about $2.3 trillion and our borrowing is about $1.3 trillion. For every $3 we spend, $2 is from receipts and $1 is from borrowing. We can't continue that pattern for very long. Once you get into the 100% government-debt-to-GDP ratio range, these studies say, your growth rate slows by at least 1%. Since we are only growing at 1.5%, that takes you down to 0.5%. Plus or minus 0.5% is recessionary conditions.

Yikes. Anything else?

A couple of other things. Real disposable income is down over the last 12 months, and because people have tried to maintain their spending, the savings rate has fallen to about 3.5%. You have very little savings going into next year, falling disposable income, and no stimulus scheduled. Even if they extend the Social Security tax cut, that isn't a stimulus, it's merely an ongoing program. And about 35 states raised taxes last year and are scheduled to do so again. So the effective tax rate on consumers, if you take state, local, and federal taxes, is up $260 billion over the last two years. It's very difficult for us to see how consumer spending can sustain itself or get a lift. Then 100% accelerated depreciation, which encouraged people to buy capital equipment, goes away on Jan. 1. In the past, when accelerated depreciation charges were taken off, new manufacturing orders fell rather dramatically.

Then we have the unfortunate circumstance that basically, 60% of the world is in recession: Europe. Japan. China is looking recessionary, because for them, a 7% growth rate is not that good. Brazil recently reported a flat-to-slightly down quarter. And Korea has slowed to the slowest growth rate in three or four years.

No matter where you look, there is a global recession starting. That means our exports and consumption aren't there. There won't be any increase in government spending. So we don't see how in the world you don't have a recession.

How does this square with recent, rosier data?

That depends on how rosy your glasses are. The labor report was decidedly mixed. The unemployment rate is a well-known lagging indicator, and in November, it was skewed downward by a large number of people who left the labor force. The Fed reported a decline in real consumer net worth recently, indicating consumers are experiencing declining income and wealth, a serious cyclical development. Manufacturing activity is being supported by accelerated depreciation. Considerable weakness in manufacturing should be expected in 2012.

What are your forecasts?

We figure 2012 GDP growth will be 0.5% to 1% in real terms, and the core rate will be close to zero as we approach mid-year. We wouldn't be surprised to see the 30-year bond trade down toward 2%, and the 10-year at 1.25% to 1.5%, consistent with a zero inflation rate.

The important thing to keep in mind is that this isn't your typical business cycle. You can't say, "That was a recession, now we had a recovery, and we're going into another recession." This is all one development. In terms of real personal income less transfer payments, one of the four coincident indicators the National Bureau of Economic Research uses to determine recessions, has recovered off its recessionary low in '09, but is still a half-trillion dollars below where it was in '08. So here we go into a new recession down a half-trillion dollars in real personal income. And industrial production is still off 5% from its peak, and no higher than in '07. Full-time employment is at the same level as January 2000, while we have had an 18 million-person increase in the labor force and a 28 million-person increase in the population.

So we won't see a stimulus. What are the odds of QE3?

About fifty-fifty. We actually put the slowdown at the feet of the Federal Reserve. We think they caused this, because QE2 raised commodity prices and lowered real income. If they happen to do another quantitative easing, all they will do is help the top 10% by raising stock prices, but kill everybody else, like they did last time. They increased the wealth divide and created a circumstance that set up another downturn. I suppose they could buy some mortgages, but it seems to me that the unintended consequences of QE2 were so harmful to the U.S. economy that Mr. Bernanke should tell Congress what University of Chicago professor John Cochrane said he should: That there's nothing more they can do.

They brag about raising stock prices. But commodity prices went up and interest rates went up, from 2.7% to 3.5% on the 10-year and 3.7% to 4.5% on the 30-year, and mortgages went from 4.4% to 4.9%. Your median family income for the first time since World War II fell in this decade. The average person has been annihilated, partially due to the policies emanating from the Beltway.

Can you have a recession without an inverted yield curve?

The Federal Reserve Bank of San Francisco partially answered that question several weeks ago, when they said they took the yield curve out of their model, because the Fed took the short rate to zero and locked it there. Their model said there was a greater than 50% chance of recession in 2012. When you have a manufactured circumstance on the yield curve, it's not a market indicator.

What does this mean for the banks?

Operation Twist benefited us, so we shouldn't be mad. They were trying to bring down long rates. The banking system lives off a positive yield curve, so the unintended consequence of Operation Twist is that it harms your financial intermediaries, which means there is less credit available. Actually, the U.S. banks have improved their capital position dramatically compared with Europe. But if you look at commercial paper plus bank loans or bank credit, it has flat-lined over the last year and a half. There is either an unwillingness to borrow, or unwillingness to lend. The small banks say they are constrained by the new regulations of the Dodd-Frank bill and have been laying off people. I think those are symptoms of a flatter yield curve. We need a positive yield curve to make sure we have a healthy banking system to invigorate the economy. People are still trying to eliminate debt. Our favorite economist in the world, Irving Fisher, in his debt deflation theory of the Great Depression, said that once asset prices start to decline, and the people who were above water go under water, that process affects all other indicators, including the power of the Fed and government stimulus. The 1.5% growth rate was on the back of the most massive fiscal and monetary-policy increases in the history of mankind, and it did no good. That is why we remain bullish.

What would it take for this bull market to be over?

Marty Feldstein pointed out that an increase in taxes lowers GDP; and the Berkeley economists Christina and David Romer say a tax cut raises the GDP. If you want to get the economy growing, you need to lower taxes. Feldstein has suggested that you could take tax expenditures down from maybe 6% of GDP to 4%, and that would improve revenue by about $4 trillion over 10 years, which would leave marginal tax rates unchanged. The Harvard professor Robert Barro talked about a value-added tax, which many don't like. Getting rid of the corporate income tax, getting rid of deductions. There are some good plans out there that could be implemented, and we have pretty good demographics. So if we got our fiscal house in order, took care of some of the long-term debt issues—we have 350% debt-to-GDP and our unfunded liabilities are another 360% of GDP, which could be handled with some adjustments to Social Security and so forth—then you could get pretty optimistic and bullish about the U.S. economy and risk assets. That wouldn't be bullish for bonds. Then we would say the bull market is over.

If none of these things happen, then the ratings agencies have a problem.

It's a concern. We've scoured the literature on what happens when countries get overindebted. We knew the downgrade in the U.S. wasn't going to be a market effect, because it wasn't a market effect in Japan. We don't think another downgrade would make much difference. John Cochrane, whom I mentioned earlier, observed that the real or inflation-adjusted government debt plus the liability of the Federal Reserve—which is just another form of Federal debt—should equal the present value of future government surpluses. When people believe those two don't match anymore, then all of a sudden your rate structure is going to go up dramatically. We're in an asset class that wouldn't fare well in that circumstance. But we think we are a ways away. In Italy, you saw rates go from 4% to 7%—boom! They were in great shape at 4%. At 7% they have a huge problem, which quickly affects the rest of the world, since they have the world's third-largest bond market. That could happen in the U.S. Every one-percentage-point increase in interest rates would add $140 billion to our deficit. If you get up to $200 billion to $300 billion, that would take interest on the debt pretty close to the defense budget, and that's when you really get into trouble.

How long will this rationalization process last?

Once you reach an overindebted situation, McKinsey Global Institute and Reinhart & Rogoff suggest that up to a decade may be required. If we can get the public debt to go flat, then we can rationalize this pretty quickly. But I imagine it will take another three or four years.

Thanks, Van.

Debunking Macroeconomics by Steve Keen

2011-12-17T11:26:00.003-06:00

Debunking Macroeconomics Steve Keen

'The Probability of a Euro-Breakup is Distinctly Non-Zero'

2011-12-15T18:38:00.004-06:00

Great interview from BlueCrest's Michael Platt. Spot the disastrous chart of 10 yr German Bund yields that Bloomberg puts up there during the interview. Does nobody check this stuff before putting it on the tele?

21st Century Bank Runs

2011-12-10T18:13:00.002-06:00

This is an excellent piece on how the shadow banking system works. In the 21st century bank runs occur in the shadow banking system, not the traditional commercial banking system (yet). The authors conclude that increases in required haircuts for collateral amount to a modern day bank run that is no different in practice than the bank panics/runs in the 18th, 19th, and 20th centuries. The money-ness of assets, which the authors describe as the level of information sensitivity/insensitivity, is the important factor determining collateral haircuts. In this sense it is very much like any bond market panic. The authors also made an interesting comparison which I had never thought of, linking the modern corporate bond market to nothing but a variety of repo. That creditors have claims to the assets of the company in the event of default/restructuring is functionally the same as the company's illiquid real assets being haircut, or pledged as collateral, for the liquid loans.

Reading this article in the context of what is going on in Europe is terrifying. Essentially formerly information insensitive securities (Euro area sovereign debt) are becoming information sensitive securities which is causing a massive run within the European banking system as required haircuts go up. When one considers the size of this secondary, or shadow, lending market it becomes clear that even if Europe manages to get out of this crisis without any bank collapses or country defaults that given the amount of "money" that is being taken out of the system it is almost guaranteed that Europe will be in a severe recession/depression. The fact that the debt rolls required among various sovereigns and their banks is so asymmetric and that these needs are occurring in the face of an already strained shadow lending market makes it extremely hard to imagine a scenario in which the European Monetary Union does not break up. h/t Zero Hedge

Gary Gorton Shadow Banking

China's Investment Boom: On the Edge by Pivot Capital Management

2011-12-07T19:49:00.003-06:00

A great piece of research on the Chinese economy. As opaque as the data coming out of China can be it is clear that these guys have done a lot of work to get all of this together in a way that cogently tells the story of China's out of control economy. h/t Zero Hedge

PGVF 2011 China Investment Boom_on the Edge

Kyle Bass Nov. 2011 Investor Letter

2011-11-30T20:48:00.001-06:00

Hayman_Nov2011

Bill Black @ Occupy L.A.

2011-11-24T11:14:00.000-06:00

I would love to see the Occupy movement become much more about enforcing the rule of law. Bill Black is the perfect spokesperson for this as a forensic economist with both economics and law backgrounds as well as regulation experience!!! Let's get the rule of law back into the financial industry. Start issuing subpoenas to all of the major players in the mortgage space and the securitization space and get cracking on bringing cases. I saw a story recently that the justice department was going to investigate banks' debit card fees. Give me a break. Return the rule of law to finance so that people can believe in honest business and capital formation again. Fraud is the issue, not debit card fees.

Is Chanos Greek for Chinese?

2011-11-23T17:17:00.005-06:00

Chinese banks are “extremely fragile” because the lenders don’t have enough capital to offset bad loans, said Jim Chanos, president and founder of the $6 billion hedge fund Kynikos Associates Ltd.

Chinese lenders are saddled with non-performing loans accumulated in the late 1990s and early 2000s, Chanos, the short seller who predicted the collapse of Enron Corp. in 2001, said in an interview on Bloomberg Television yesterday. The banks are failing to recognize the losses on the bad loans and have carried out a lending binge since 2008, said Chanos.

“The Chinese banking system is built on quicksand and that’s the one thing a lot of people don’t realize,” said Chanos, who is shorting the shares of Agricultural Bank of China. “Everybody seems to think it is a free and clear open checkbook. It’s not. The banking system in China is extremely fragile.”

The MSCI China Financials Index of bank stocks has declined 32 percent this year on concern the quality of loans to local governments and the housing market will deteriorate as economic growth slows. State-run Central Huijin Investment Ltd., an arm of China’s sovereign wealth fund, said on Oct. 10 that it started buying stock in the four biggest Chinese lenders after their shares tumbled this year.

China spent 3.5 trillion yuan ($550 billion), equal to a fifth of its 2005 gross domestic product, bailing out and recapitalizing state-owned banks since 1998 as their lending to unprofitable state-owned businesses turned sour, according to an estimate by Moody’s Investors Service in 2007. Since September 2008, Chinese banks doled out $3.8 trillion in new loans to offset the impact of the global financial crisis, according to the International Monetary Fund.

Chanos said that he’ll keep his short positions until the government recapitalizes the banking system again.

In short selling, investors sell borrowed shares in anticipation that the securities will decline and they can buy them back at a profit.

To contact the reporters on this story: Ye Xie in New York at yxie6@bloomberg.net; Betty Liu in New York at bliu17@bloomberg.net;

To contact the editors responsible for this story: David Papadopoulos atpapadopoulos@bloomberg.net

Video Here http://www.bloomberg.com/video/81455126/

Bass, Reality, etc. etc.

2011-11-20T15:33:00.004-06:00

"You know how screwed up Europe is when you have a German pope and an Italian central banker." Kyle Bass

Record Setting Day

2011-11-15T18:41:00.005-06:00

French, Spanish, and Italian CDS spreads hit new records today. Joining the festivities, the French (shown below), Spanish, and Belgian cash 10yr spreads to German Bunds hit new euro-era records today.

The stock market in the U.S. was UP today!!! This begs the question, has the stock market totally lost touch with reality and become a completely backwards indicator of financial conditions??? The DJIA has been up for 6 of the last 7 weeks and now stands only about 6.5% from its HIGH for the year. Insanity like this can only last for so long...

Et tu France?

2011-11-10T18:36:00.000-06:00

The markets are clearly not buying the rumor from yesterday that France and Germany were considering a new "Core Europe" monetary union. Spread between French and German bonds hit a new record today.

For Sale: Italian Bonds

2011-11-09T10:19:00.001-06:00

“A country is bust when the markets decide.” Albert Edwards

Steve Keen Behavioral Finance Lecture 11

2011-11-08T18:53:00.000-06:00

2012 Theme--Get Long Cheap Vol

2011-11-07T16:59:00.002-06:00

One of my favorite speculative macro themes for 2012, and beyond, continues to be borne out in the data. Find ways in the option markets to get long relatively low implied volatility instruments. Currency and bond options tend to have significantly lower implied vols than equities. This makes since as historically the price volatility (realized vol) has been much lower in bonds and currencies. Black-Scholes pricing can struggle to price low-implied vol options way out of the money. If you can find the right liquid markets, incredibly large notional positions can be put on for small premium amounts.

I believe that the future will be wrought with unprecedented volatility in markets that are more used to collecting dust than falling off of cliffs. 2012, and beyond, will be a time when realized vol in many bond and currency markets will reach unprecedented highs, giving the person who is long those options (particularly in the correct direction) a chance to profit handsomely.

Here is an example of rising volatility in historically low volatility securities (treasuries):

Intraday Volatility (bps) in 10yr and 30yr Yields Normalized for Levels of Interest Rates

Source UBS

Italy--Too Big to Save?

2011-11-07T10:01:00.000-06:00

Massive flattening of the Italian curve over the past month. Despite ECB purchases. Yikes!!!

Money And The European Credit Crisis by Doug Noland

2011-10-29T23:21:00.001-05:00

Money And The European Credit Crisis

by Doug Noland

October 28, 2011

It would be reasonable – and it sure is tempting - to dedicate this week’s CBB to a skeptical look at Europe’s latest plan for Credit crisis resolution. I would not be without plenty of company. So I’ll instead go in a different direction. This week I found my thoughts returning back about 12 years to my earliest Bulletins. Inspired by the great Austrian economist Ludwig von Mises, my introductory article discussed the need for a contemporary Theory of Money and Credit. Not only was modern economics devoid of monetary analysis, there were critical changes unfolding within U.S. Credit that were going completely unappreciated.

Importantly, Credit creation was gravitating outside of traditional bank lending channels and liability creation. Fannie, Freddie and the Federal Home Loan Bank system had evolved into major risk intermediaries and Credit creators. I began by arguing against the conventional view that “only banks create Credit.” Securitization markets were exploding in volumes, both in mortgage and asset backed securities. I was focused on the lack of constraints on this new Credit mechanism that operated outside of traditional bank capital and reserve requirements. In contrast to the antiquated bank loan and deposit “multiplier effect” explained in economic texts, I referred to this powerful new dynamic as an “infinite multiplier effect.” Borrowing from Murray Rothbard, new "money" and Credit were created “out of thin air.”

And the more I studied monetary history the more I appreciated the importance of both money and Credit theory. It became clear to me that money had for centuries played such a profound role in economic cycles (and monetary fiascos). Yet this type of analysis was extinct. Even within the economics community, there was not even a consensus view as to a definition of “money.” There had been decades of bickering about what monetary aggregate to use in econometric models (M1, M2 or the newer M3), along with what measure of “money” supply should be monitored and managed by the Federal Reserve. Especially in light of all the financial innovation and new financial instruments, the economics profession and the Fed punted on monetary analysis. Out of sight and out of mind.

Even if one was focused on the issue, the importance of traditional monetary analysis was lost in myriad new complexities. Yet my study of monetary history and research of contemporary Credit convinced me that the analysis of “money” likely had never been more critical to the understanding of (extraordinary) market and economic behavior. I was intrigued by Mises work on “fiduciary media,” the financial claims that had the economic functionality of traditional (narrow) money. I began to view contemporary “money” as “money is as money does.” And I was especially struck by monetary analysis from the late American economist Allyn Abbott Young. Young wrote brilliantly about the historical “preciousness” of money.

And the more I studied, contemplated and pieced together analyses from scores of monetary thinkers, the more it became clear to me that “money” was critically important because of its special attributes. In particular, money created unusual demand dynamics: essentially, economic agents always wanted more of it and this insatiable demand dynamic created a powerful proclivity to issue it in excess quantities. Keep in mind that a boom financed by junk bonds will pose much less risk (its shorter lifespan will impart less structural damage) than a protracted Bubble financed by “AAA” agency securities and Treasury debt.

Centuries of monetary fiascos made it clear that money had better be backed by something of value and of limited supply (i.e. gold standard) to ensure that politicians and bankers did not fall prey to the same inflationary traps that had repeatedly destroyed currencies and economies across the globe.

While it became fanciful to speak of New Eras and New Paradigms, I saw a world uniquely devoid of a monetary anchor. There was no gold standard and no Bretton Woods monetary regime. And I saw an ad hoc dollar reserve standard, one that was for awhile somewhat restraining global Credit, begin to disintegrate from the poison of runaway U.S. Credit excess and intransigent Current Account Deficits. Marketable debt accounted for the majority of new Credit creation and these new financial sector liabilities were enjoying extraordinary demand in the marketplace. This marketable debt could also be readily leveraged (at typically inexpensive rates “pegged” by the New Age Federal Reserve) by a mushrooming leveraged speculating community, adding only greater firepower to the Credit boom. Over time, the U.S. Credit system exported its Bubble to the rest of the world.

From my perspective, contemporary “money” was just a special – the most “precious” – type of Credit. “Money” had become nothing more than a financial claim that was trusted for its “moneyness” attributes: chiefly, a highly liquid store of nominal value. This new “money” was electronic and incredibly easy to issue in unfathomable quantities. The vast majority of this Credit was created in the process of asset-based lending (real estate and securities finance), and the more that was issued the greater the demand for these “money-like” financial claims. The world had never experienced “money” like this before, and I suspected that the world would never be the same.

In this brave new financial world dominated by one incredible global electronic general ledger of debit and Credit journal entries, “moneyness” became little more than a market perception. If the market perceived a new financial claim was liquid and “AAA,” then there essentially became unlimited demand for this “money.” Not unexpectedly in such circumstances, this “money” was issued in gross excess. And most of it was created in the process of financing the real estate and securities markets. At the late stage of the boom, a hugely distorted marketplace saw Trillions of risky subprime mortgages sliced and diced into mostly “AAA” “money”-like Credit instruments. Importantly, a distorted marketplace believed that Washington would back GSE obligations and that the Treasury and Fed would ensure the stability of mortgage and housing markets.

The 2008 crisis was really the result of Wall Street risk intermediation and structured finance losing its “moneyness.” When the mortgage finance Bubble burst, the market quickly questioned the Creditworthiness and liquidity profile of Trillions of debt instruments. And as finance abruptly tightened, asset market Bubbles popped and maladjusted economies faltered. The “moneyness” phenomenon came back to haunt financial and economic systems. Not only had years of monetary inflation impaired underlying economic structures, a huge gulf had developed between the markets’ perception of the “moneyness” of the debt instruments and the Bubble state of the asset markets underpinning an acutely fragile (Hyman Minsky) “Ponzi Finance” Credit structure.

I have posited that the policy response to the 2008 crisis – monetary and fiscal, at home and abroad – unleashed the “global government finance Bubble.” Essentially, massive government debt issuance, guarantees and central bank monetization restored “moneyness” to U.S. and global Credit. I have argued that this course of policymaking risked impairing the Creditworthiness – the “moneyness” – of government debt markets, the core of contemporary monetary systems.

At its heart, the European crisis is about the escalating risk that the entire region’s debt could lose its “moneyness.” Starting with the introduction of the euro, the market perceived that even Greek debt was money-like. Despite massive deficits, a distorted marketplace had an insatiable appetite for Greek, Irish, Portuguese, Spanish and Italian debt. Importantly, the markets believed that European governments and the European Central Bank would, in the end, back individual government and banking system obligations. It proved another historic market price distortion.

Treasury and Federal Reserve backing restored “moneyness” to Trillions of suspect financial claims back in 2008 – and since then massive federal debt issuance and Federal Reserve monetization have reflated asset markets and sustained the maladjusted U.S. economic structure. The markets enjoyed an incredible windfall, and many these days expect European politicians and central bankers to similarly reflate eurozone Credit and economies.

I believe strongly that the Credit recovery and tepid U.S. economic recovery came at an extremely high price: dynamics that ensure the eventual loss of “moneyness” for U.S. government Credit, the heart of our monetary system. Many expect Germany to use the “moneyness” of their Credit to ensure the ongoing “moneyness” for European debt more generally. The conventional view is that, at the end of the day, German politicians will do a cost vs. benefit analysis and realize that it will cost them less to backstop the region’s debt than to risk a collapse of European monetary integration. The Germans, however, appreciate like few other societies the critical role that stable money and Credit play in all things economic and social. The Germans have refused the type of open-ended commitments necessary for the marketplace to again trust the Credit issued by the profligate European borrowers (and an incredibly bloated banking system).

European politicians have been desperately seeking some type of structure that would ring-fence the sovereign crisis to protect the “moneyness” of, in particular, Italian and Spanish borrowings. Increasingly, the consequences of a loss of “moneyness” at the periphery were weighing heavily upon the European banking system, with heightened risk of impairing “moneyness” at the core. This was critically important, as it was quickly limiting the options available for monetary crisis management. For example, faltering confidence in Italian debt and what an Italian debt crisis would mean to European and French banks was impacting market confidence in French sovereign Credit. So any crisis resolution structure that placed significant additional demands on French sovereign debt risked impairing the “moneyness” of French Credit at the core of the European debt structure. Understandably, the markets feared the crisis was spiraling out of control.

This week’s grand plan was to bring in parties from outside the region – to use “money” from the IMF, the Chinese, the Bric nations, Japan, global sovereign wealth funds and such to backstop the “moneyness” of European debt. With their support, the European Financial Stability Facility will have the capacity to leverage to, it’s said, $1.4 TN – providing the bazooka backstop that will ensure market confidence in European Credit generally.

Will it work? I highly doubt it, but it does buy some time - and the markets were content. It appeared to take near-term implosion risk off the table, which set the stage for a huge short squeeze and destabilizing unwind of hedges across virtually all markets. I assume the Chinese will move cautiously and, as always, work only in their self-interest. China will want assurances that their European investments are safe, which means they will want to avoid exposure to periphery and Italian Credit just like everyone else. And I suspect that EFSF debt will struggle to retain “moneyness,” as markets fret over ongoing European Credit deterioration and the future of the euro currency. There may be grand plans and grand designs for a credible “ring-fence,” but the critical issue of how to ensure ongoing Italian debt “moneyness” continues to prove elusive. Global risk markets were in virtual melt-up mode this week, yet Italian 10-year yields jumped 13 bps to 6.01%.

Too Good-- Hat Tip John Mauldin

2011-10-29T14:15:00.001-05:00

Where is the peace dividend that was supposed to come after the end of the Cold War? Where are the fruits of the amazing gains in efficiency that technology has afforded? It has been eaten by the bureaucracy that manages our every move on this earth. The voracious and insatiable monster here is called the Federal Code that calls on thousands of agencies to exercise the police power to prevent us from living free lives.

It is as Bastiat said: the real cost of the state is the prosperity we do not see, the jobs that don't exist, the technologies to which we do not have access, the businesses that do not come into existence, and the bright future that is stolen from us. The state has looted us just as surely as a robber who enters our home at night and steals all that we love.

- William "Bill" Bonner

Source: JohnMauldin.com (http://s.tt/13ERp)

Coming Weeks--My Prediction

2011-10-07T08:40:00.001-05:00

I will be away from the internet for the next week as I am getting married and will be on my honeymoon. Therefore I thought it might be fun to make a prediction and check out how it looks when I get back. The social mood is changing. This rally may last another two to three weeks (or maybe even a bit longer) and could see the S&P go back to 1250 plus or minus 30 points. The key thing to remember about this, is that the social mood is changing (see protesters on Wall St and other parts of the country) and the economic data is beginning to indicate that we are probably either in or going back into a recession. Even ignoring the pending disasters in Europe, China, and Japan stocks are not priced for a recession right now. As a result, I think that this next few weeks may be the best opportunities to sell most of the stocks that you own and only invest in the safest and most liquid instruments around (my favorite is cash). If you have some experience and are already liquid this next few weeks would be ideal to layer into your favorite short candidates (my favorites are CAT, CRM, FXI, FXA, and Long cheap VIX calls if you get a chance).

Full disclosure, I own some FXI puts (leaps).

Debt Restruction in the Main Stream? Watch out below (pun intended)

2011-09-29T18:32:00.003-05:00

Debt restructuring is where the neo-classical economist story breaks down. Neo-classical economists ignore the knock-on effects of debt destruction because their models show an asset and a liability declining at the same time which on-balance should have no effect.

BCG_Back_to_Mesopotamia_Sep_11[2]

Up, Up, and Away

2011-09-22T17:57:00.000-05:00

This is perhaps the best chart for explaining how serious the crisis is in Europe right now. Notice that 2008/2009 is but a small blip in sovereign CDS land compared to today.

These are the 5yr CDS spreads for the 4 largest economies in the Eurozone...

Ray Dalio on Europe, Economy, Strategy

2011-09-15T18:31:00.002-05:00

Kyle Bass on Europe's Endgame

2011-09-14T16:53:00.000-05:00

Your daily dose of reality from Hayman Capital's Kyle Bass

Paul Simon Sings "The Sound of Silence"

2011-09-13T20:12:00.000-05:00

Paul Simon sings a moving rendition of his 1965 hit "The Sounds of Silence" to commemorate the 10th anniversary of the September 11 attacks on the World Trade Center.

PJ O'Rourke on Libertarianism

2011-09-05T21:41:00.001-05:00

A Random (Gaussian) vs. Fractal Walk Down Wall Street

2011-08-27T14:19:00.002-05:00

Dr. Steve Keen lectures on the flaws in the EMH &; one of its applications (the CAPM). He echos many of the points made by Benoit Mandelbrot in his book, 'The (mis)Behavior of Markets.'

The End of the World Part 1 by John Mauldin

2011-08-27T13:16:00.001-05:00

The End of the World, Part 1

By John Mauldin | August 27, 2011

In this issue:
What Is the CBO Seeing (or Smoking?)
The End of the World, Part 1
Who Will Rescue the Rescuers?
The Problems of Debt in the Eurozone
Thoughts on Jackson Hole
Some Thoughts on Getting Older

Fine, then. Uh oh, overflow, population, common food, but it'll do to
Save yourself, serve yourself. World serves its own needs,
listen to your heart bleed – dummy with the rapture and
the revered and the right, right. You vitriolic, patriotic, slam,
fight, bright light, feeling pretty psyched.

It's the end of the world as we know it.
It's the end of the world as we know it.
It's the end of the world as we know it and I feel fine.
R.E.M. song from 1987
It’s not really the end of the world, but to read some of the analysis and data over the past week, it’s hard not to wonder if it’s not the beginning of the Endgame at the very least. There is more to cover than I can really do justice to, but we will just start. We HAVE to look at the US data first (briefly) and then on to Europe, where it will may be the end of the euro experiment, depending on two voting populations. Can you spell “Banking Crisis,” gentle reader? A nod to Bernanke’s finger-pointing speech, some links on the scourge of high-frequency trading, and we end on a positive note about the Boomer generation growing older. And, I answer the question that is burning in your brain: “How many years of US corn production will China’s dollar reserves buy?” Write your answer down now. This letter may print out longer than usual, as there are plenty of charts. Let’s skip the “but firsts” and jump right in.

What Is the CBO Seeing (or Smoking?)

Last week I finally stopped being wishy-washy (with my 50-50% chance of a recession call) and said the US would be in recession within 12 months. And suggested that you consider moving to the sidelines your longer-term equity investments, except your conviction stocks. (I have some of those in the biotech space and simply intend to buy more if the prices go down. But remember, I am looking out ten years and expect an eventual bubble, so I don’t care if I am early for some of my high-risk money.) Stocks typically go down about 40% or more in a recession. David Rosenberg estimates that we have seen 27% of a typical bear-market move, so that would suggest the possibility of another 30% downdraft (give or take).
None of the data this week makes me want to change my opinion on recession. Rich Yamarone (Bloomberg Chief Economist) and I traded emails as we got new data this morning, comparing notes. He does better charts than I do, so we will use his. (I hear, by the way, that he is being addressed as Lord Vader in the halls of Bloomberg. Come to think of it, his voice is rather raspy.)
As he points out, when GDP year-over-year drops by more than 2%, we have always had a recession. So with today’s second-quarter revision (first revision of many) down to just 1% (technically 0.99%, but we are among friends here), where are we? At 1.5% year-over-year. Here is the chart:

The normally bullish staff at economy.com gave us this rather dismal paragraph tonight as a summary to the week:
“The last week of the summer brings a rare Northeast hurricane and a heavy load of data that will show the economy running close to stall speed. Second quarter GDP was revised down to 1%, and the slight improvement in growth we expect for this quarter assumes no new financial shocks. Upcoming indicators for August will bear the mark of steep declines in stock prices. The employment report will be the headliner; nonfarm payrolls are expected to rise just 30,000, and the unemployment rate likely will tick up 0.1 percentage point to 9.3%. We think the ISM manufacturing survey dipped into contraction territory for the first time in two years, and auto sales and consumer confidence likely also fell during the month. There will also be significant interest in the minutes of the August Federal Open Market Committee meeting, especially given Chairman Ben Bernanke's omission of details regarding policy easing options in his Jackson Hole speech.”
Ugh. More on the Bernank later.
The Michigan Consumer Sentiment number was just awful. It dropped 8 full points (which is huge for this index) to 55.7. The index has fallen nearly 20 points in three months. In the chart below, note the close previous correlation between sentiment and GDP. Which do you think is more likely to happen: sentiment to rise or GDP to fall?

Unemployment claims are back up over 400,000, to 417,000. If the employment gain is really just 30,000, that bodes poorly for any recovery. So, exactly how does that square with the recent Congressional Budget Office (CBO) projections? Quoting:
“CBO expects that the recovery will continue but that real (inflation-adjusted) GDP will stay well below the economy’s potential—a level that corresponds to a high rate of use of labor and capital—for several years. On the basis of economic data available through early July, when the agency initially completed its economic forecast, CBO projects that real GDP will increase by 2.3 percent this year and by 2.7 percent next year. Under current law, federal tax and spending policies will impose substantial restraint on the economy in 2013, so CBO projects that economic growth will slow that year before picking up again, averaging 3.6 percent per year from 2013 through 2016.”
Let me work you through the numbers. We grew at less than a total of 1.4% for the first six months of 2011. To get to 2.3% as an average for the year, we would need to grow by (back of the napkin) 3.2% for the last half of the year. We could reduce the deficit by a lot if we could sell what these guys are smoking to engender such optimism. I think demand would be strong, especially on Wall Street. (Note: these are the same people that told us in 2000 that all government debt would be gone by 2010. Just saying.)
Their projections are likely based on assumptions about recoveries from past recessions. But since 1945, all recessions have been business-cycle recessions. We are now in a deleveraging/balance-sheet/post-credit-crisis recession for which we have no modern analogs, except maybe Japan. And that hasn’t turned out too well, as in, two decades of going nowhere. Yet we are applying the same methodology (massive debt and deficits along with zero interest rates) that did not work there, and will soon bring Japan to ruin.
We have a fundamentally different economic scenario than at any time for the last 66 years. Why then should we expect the same outcome? EVERY indicator (employment, GDP, ISM, sentiment, etc.) is far below its average result two years after the official end of a recession. That should speak volumes.
So why does what the CBO says mean anything? Because Congress is making projections for future deficits, based on what appear to be wildly optimistic assumptions. That means future deficits are likely to be worse than expected. If we enter recession, as I expect, then revenues will be down (as unemployment will be up and profits down) and expenses will go up. That de minimis deficit reduction currently being negotiated by the “Gang of 12” will disappear in a cloud of smoke and maze of mirrors. This will mean that more pain in the terms of future spending cuts and/or tax increases will be needed. (I know a fair number of congressional staffers read this letter. Please pay attention here – your bosses need to be given a “heads up.”)
If we are in for a slow-growth, Muddle Through decade, then the deficit projections by CBO are dismally off. Get the spreadsheets. Factor in slower growth and higher unemployment and two recessions by the end of the decade (typical for the aftermath of a banking/debt crisis), and see what those deficit projections look like.
Given the large amount of data coming next week, as the month ends, I will stop here and get back to the US next week.

The End of the World, Part 1

In trying to decipher Europe it is hard to know where to start, but let’s begin with some assumptions:
For the euro to survive, one of two things must happen. Either the Germans (and the Dutch and Finns and French) decide to back the concept of some sort of eurobond financing of the balance sheets of the peripheral countries, OR there need to be massive write-downs of insolvent-country debt and the various countries need to backstop their banks, because bank losses will be massive.
The former needs buy-in from German voters. Polls show Germans are against the idea of eurobonds by something like 5-1 (75% against, 15% for). (More on Germany below.) The latter option assumes the peripheral countries will lose access to the private bond markets, thus forcing sudden and enormous austerity (read Depression levels or worse). Will they simply throw in the towel and leave the euro on their own, remaining in the free-trade zone but with their own currencies, much as Denmark, the Czech Republic, or Sweden are now? Or opt to suffer and remain in the euro?
Germany could decide not to back the peripheral country debt, and leave the Eurozone. But this would be painful for Germans. If you think the Swiss franc trade is crowded (and way overvalued) because people are looking for a safe haven, what would a new Deutschmark look like to investors? Switzerland is a country (and one of my favorite in the world, so no slight intended – I will be in Geneva for my birthday in October) of just over 7 million people, only somewhat larger than the population of the greater Dallas-Fort Worth, Texas area where I live (although with much better weather!).
Germany, on the other hand, is the world’s 4th largest country by GDP, with a population of over 82 million. It is well-run and respected. The new mark would climb to far higher levels against the remaining euro countries and other currencies, which for an export-driven nation would not be very helpful. Mercedes and BMWs cost a lot now (and don’t forget tool parts and other things Germany excels in making). Double the value of your currency in a short time? Watch your market share drop. Painful is perhaps an inadequate word.
So, what to make of the remarks this week by respected German leaders? Let’s fire up a few quotes here ( http://www.telegraph.co.uk/finance/financialcrisis/8720792/Germany-fires-cannon-shot-across-Europes-bows.html):
“German President Christian Wulff has accused the European Central Bank of violating its treaty mandate with the mass purchase of southern European bonds. In a cannon shot across Europe’s bows, he warned that Germany is reaching bailout exhaustion and cannot allow its own democracy to be undermined by EU mayhem.
“ ‘I regard the huge buy-up of bonds of individual states by the ECB as legally and politically questionable. Article 123 of the Treaty on the EU’s workings prohibits the ECB from directly purchasing debt instruments, in order to safeguard the central bank’s independence,’ he said. ‘This prohibition only makes sense if those responsible do not get around it by making substantial purchases on the secondary market,’ he said, speaking at a forum of half the world’s Nobel economists on Lake Constance to review the errors of the profession over recent years.
“Mr Wulff said the ECB had gone ‘way beyond the bounds of their mandate’ by purchasing €110bn (£96.6bn) of bonds, echoing widespread concerns in Germany that ECB intervention in the Italian and Spanish bond markets this month mark a dangerous escalation.’” (London Telegraph)

Who Will Rescue the Rescuers?

From the same article: “The blistering attack follows equally harsh words by the Bundesbank in its monthly report. The bank slammed the ECB’s bond purchases and also warned that the EU’s broader bail-out machinery violates EU treaties and lacks ‘democratic legitimacy’. The combined attacks come just two weeks before the German constitutional court rules on the legality of the various bailout policies. The verdict is expected on September 7.”
Yet “Nobel laureate Joe Stiglitz told the forum that the euro is likely to fall apart unless Germany accepts some form of fiscal union. ‘More austerity for Greece and Spain is not the answer. Medieval blood-letting will kill the patient, and democracies won’t put up with this kind of medicine.’ ”
His solution? Germany will either have massive banking losses (see below) or assume some debt. Why give up the dream of a united Europe over a few trillion and your credit rating? Yet (Ambrose Evans-Pritchard writing in the Telegraph):
“Marc Ostwald from Monument Securities said Germany is drifting towards a major constitutional crisis. ‘This has all the makings of the revolt that unseated Helmut Schmidt [in 1982], and indeed has political echoes of the inefficacy of the Weimar regime,’ he said.
“Mr. Wulff said Germany’s public debt has reached 83pc of GDP and asked who will ‘rescue the rescuers?’ as the dominoes keep falling. ‘We Germans mustn’t allow an inflated sense of the strength of the rescuers to take hold,’ he said.
“ ‘Solidarity is the core of the European Idea, but it is a misunderstanding to measure solidarity in terms of willingness to act as guarantor or to incur shared debts. With whom would you be willing to take out a joint loan, or stand as guarantor? For your own children? Hopefully yes. For more distant relations it gets a bit more difficult,’ he said.”
The final option is for the peripheral nations to eschew austerity and leave the Eurozone, launching their own currencies again. This would mean long and painful bank holidays and massive losses for European banks and local citizens, depending on how many countries left. And the lawsuits would last for decades – nothing short of a full-employment act for lawyers all over the world.
And Merkel was not helped by her own Labor Minister, Dr. Ursula von der Leyen. Rather than simply hand over further loans to Athens – money many Germans believe they will never see again – Dr. von der Leyen suggests Berlin should ask for collateral. Gold, preferably. From the Irish Times:
“One month after euro zone leaders agreed a bailout reform package, and a month before the package goes to vote before national parliaments, a senior German minister appeared to be calling for a renegotiation.
“On an aircraft back from Belgrade, a thin-lipped chancellor Angela Merkel reportedly told advisers: ‘I’m going to have to have a word with Ursula.’
“Even before she landed, German officials were in full damage limitation mode, working the phones and issuing statements denying the minister spoke for the government. ‘This is sub-optimal,’ groaned a senior government source. ‘No one is amused.’ ”
Some back-bench minister? Hardly. Dr. von der Leyen, a 52-year-old mother of seven, is one of Dr. Merkel’s most ambitious ministers and one of two names regularly mentioned as a possible successor.
But she only reflected a rather contentious Bundestag meeting this week, in which one after another representative voiced opposition, invariably noting that the voters disapproved.
Of course, none of this is helped by Finland negotiating a side collateral deal as part of their conditions for approving their portion of the next loan to Greece. And a chorus of countries have jumped on that wagon. How do you explain to YOUR voters that the Finns got actual in-the-bank collateral and you got nothing but Greek promises? But if everyone gets collateral, the whole deal will fall apart. What’s the point if you give back a large chunk of your loan? It just means you need even more!

The Problems of Debt in the Eurozone

Let’s look at some charts. This first one is the amount of principal debt in terms of GDP from July 2011 to July 2012 (plus budget deficits, in red) needed by ten European countries. Note that France and Italy are well over 20%! Source: Peterson Institute of International Economics (hat tip, Simon Hunt!)

“From the same report this chart illustrates how Germany could become the banker for the Euro Zone. The question is will it? The question will be more clearly defined in September when Germany’s Constitutional Court will rule on the legal complaints against the Euro Zone rescue packages. If the comments being made by the Bundesbank and by the country’s President are a hint as to the outcome of the court then a negative ruling is a real risk. Who then will take the losses?” (Simon Hunt)
Note in the chart that Germany holds the largest percentage of net debt.
Claims of Euro Area members from netting of Euro System cross-border payments (in billions of Euros):

And then there are the interest-rate issues. Rates were rising rapidly in Spain and Italy until the ECB stepped in. Everyone knows Greece, Ireland, and Portugal are on life support and cannot get debt on their own. The ECB inserted an IV into Spain and Italy and started them on a slow drip. The real question of the moment is, can they get off that support and stand in the markets on their own? The answer a few weeks ago was starting to look like “No.”
And look at the massive growth in ECB lending to Italian banks, which are getting shut out of the “normal” market. It has literally more than doubled in a few months:

Credit spreads at French banks are blowing out. Review how much France has to borrow in the next 12 months, in the first chart. Then look at their deficit-to-GDP (above 10%, according to Charles Gave) and realize that there is no reason why S&P should not downgrade them as well. How do they cut spending? Taxes are already at 50% of GDP. Wealthy French have voted with their feet by moving away.
The list of country woes is long in Europe. Massive unemployment in Spain and Portugal. Deficits everywhere. Voting populations in both creditor and debtor nations are upset.
It is only a matter of time until Europe has a true crisis, which will happen faster – BANG! – than any of us can now imagine. Think Lehman on steroids. The US gave Europe our subprime woes. Europe gets to repay the favor with an even more severe banking crisis that, given that the US is at best at stall speed, will tip us into a long and serious recession. Stay tuned.

Thoughts on Jackson Hole

Jackson Hole often provides fireworks and significant speeches. Bernanke came up with neither this week, which I think is a good thing. But he did forcefully point out that the Fed has done about all it can do and that the forces of civil government need to step up to the plate with credible actions. It was as close to finger pointing as a Fed Chairman can do, and parts of the speech actually sounded as if he was trying to channel his inner Richard Fisher (Dallas Fed President). Basically, he said the Fed has done what it can with as easy a monetary policy as is possible and prudent. Quoting from Joan McCullough’s remarks on the speech:
“Yeah, the Fed underestimated the severity of our ills and so this recovery is gonna take longer than expected. But underneath it all, the US still has the capability of generating growth. Here are the precise words with which he threw responsibility back at Congress and the Administration; he starts out kind of slow:
“ ‘… Notwithstanding the severe difficulties we currently face, I do not expect the long-run growth potential of the U.S. economy to be materially affected by the crisis and the recession if – and I stress if – our country takes the necessary steps to secure that outcome.’
“Just in case they didn’t understand that they had just been handed the baton, he continued with this:
“ ‘… most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.”
“With this closing castigation cum zing:
“ ‘… Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses.’ ”
As I said, for a Federal Reserve Chairman, that is as close to reading the riot act as you are going to get.

Some Thoughts on Getting Older

I turn 62 on October 4 while in Geneva. I don’t feel that old, and hope I don’t look it, but the birth certificate verifies the age. I should note that my mother turned 94 last week and is still quite active. I was talking with a Rice University classmate (of ’72) and old friend, John Benzon, who has recently retired from Price Waterhouse and is trying to figure out what “Act 2” will be. I realized that when we graduated, we had barely lived 1/3 of the lives we now have.
So with that on my mind, two items hit my inbox today. The first was from Lance Roberts of Streettalk Advisors. The San Francisco Fed did a report recently that suggested that we aging Boomers will be a drag on the stock market as we sell to support our retirement (shades of Harry Dent!). From the report:
“The baby boom generation born between 1946 and 1964 has had a large impact on the U.S. economy and will continue to do so as baby boomers gradually phase from work into retirement over the next two decades. To finance retirement, they are likely to sell off acquired assets, especially risky equities. A looming concern is that this massive sell-off might depress equity values.”
You can read his short piece and the link to the Fed piece at http://www.streettalklive.com/financial-blog/253-boomers-are-going-to-be-a-real-drag.html.
I am not so sure, though. I think the Boomer generation is a little different from previous generations. I remember going to my grandmother’s in my early years, when my aunts and uncles were the age I am now. Even though active – and most lived well into their 90s – they had a far more sedentary lifestyle than many Boomers do today. Boomers are more active and, whether for financial reasons or simply because they don’t want to retire (that would be me!), they are going to work longer than previous generations. In fact, the only cohort that has seen their employment rates rise is workers over the age of 55! Good for them (although tough on my young kids, who need those jobs).
Then I got this picture from Jon Sundt, the president of Altegris, a close friend, and my business partner. He is 50, at the tail end of the Boomer Generation. This is a wave he caught at the Mentawai Island Chain, 80 miles off the coast of Sumatra, Indonesia. He goes there every summer. They go into the middle of the Indian Ocean to find these large waves. And it is mostly Boomer surfers. (I’m not sure how much I like the guy who’s responsible for a large part of my monthly cash flow taking these risks, but that’s another story!)

Go to a gym or running trail: it is not just kids out there any more. There are lots of people my age where I work out. Some of the trainers are over 50! We all have friends who are pushing the envelope – climbing mountains, biking, etc.
And the new biotech that will come out within the next five years is going to offer cures for many of the things that kill us sooner than we simply wear out. Cancer, Alzheimer’s, sclerosis of the liver, viruses are all on the short target list. I was talking about this with Scott Burns, noted author and long-time newspaper columnist (and a long-time friend). He calls it “catastrophic success” in his next book, as living longer is a “success,” but it makes our collective pension, Social Security, and Medicare problems even worse. Maybe MUCH worse. I smiled and told him there are worse problems than living longer. I intend to be writing and traveling for a few more decades.
And as my Dad used to say (he made it to 86), “God willing and the creek don’t rise” I intend to do 62 pushups on October 4^th, which will be a personal best. I can’t do much about getting older (I will be very disappointed if I do not get a whole lot older!), but I don’t have to go quietly into that dark night. And neither do you, gentle reader. So, make sure you are around to read my musings a whole lot longer, as well. If you hang around long enough, you will even see me turn bullish! It won’t be that long, I promise. It will seem like just a few weeks from now.
And while I was having lunch with Scott, he asked me the question, “How many years of US corn production would the dollar reserves of China buy?” I mused, maybe 40. Wrong. It is only 12. And that is just corn. Not soybeans, wheat or rice or cattle, hogs or chickens. Think about that and stand back in awe at the productivity of the American farmer.
It is time to hit the send button. I stupidly forgot to save this letter and had an unexpected “hard” crash. I thought I lost almost the entire e-letter; but checking the Web, I found a back door to the temporary files where most of it was still store, so only lost a few hours re-creating it – but now it is late, 2 am). That means this letter might not be there Saturday morning, and for that I apologize. Have a great week!
Your looking forward to the next third of this life analyst,
John Mauldin
John@FrontlineThoughts.com

Three Times is Enemy Action by Daniel Cloud

2011-08-24T22:36:00.003-05:00

Another Instant Classic from Daniel Cloud ht Zero Hedge

Three Times is Enemy Action

People seem surprised by the suddenness of the decline in the stock market. It keeps trying to rally, and the rallies keep getting sold. There’s no shortage of worrying circumstances in the real world to explain a fall in prices, and it’s normal for people to disagree about whether they should be going up or down. But the violence of this move has caught many of us by surprise.

I don’t think it should have. I think there are good theoretical reasons, very simple, orthodox economic ones, to expect more of the same, to expect equally dramatic, or even more dramatic moves down, going forward.

Of course, given the fact that I presumably have some sort of bets on the table, anything I say about that belief, like anything any market participant says, should be taken with a very large grain of salt. On the other side, there’s the danger that I’m merely stating the obvious, and wasting the reader’s time. (But then why are so many of us still long?)

Nevertheless, despite the fact that I clearly can’t be trusted, and consequently won’t persuade many people to change their views, and even if there’s nothing startlingly original about what I’m going to say, I think it’s worth laying out what I believe to be the correct explanation of the crash as it’s still happening, so that later on, when we’re tempted to blame various scapegoats – derivatives traders, European politicians, bankers, our neighbors, immigrants, the opposing political party, etc., etc. – we’ll perhaps remember that one of these analyses was predictive of the timing and scale of the event at the time, while the others are invidious reconstructions after the fact.

So let me just tell you why it seems obvious that this market should now continue to move down a lot in a fairly abrupt manner, should finish crashing. As a serendipitous benefit, you’ll also get a rather interesting story about why the economy never really recovered after the crash of ’08.

What market is usually the way world markets are at the moment? If you’ve ever looked carefully at a very long-term chart of the Chinese markets – not Taiwan or Hong Kong, markets on the Mainland, Shanghai or Shenzhen, and a chart going all the way back to the early ‘90’s – you’ll notice that they tend to suddenly move straight up or straight down in what seems like a completely abnormal and un-technical way. The very long-term chart just doesn’t look like any normal chart of any real stock market. Of course, I’m exaggerating a bit – it’s a relative thing – but relative to most stock markets, it has the flavor I’ve described.

That’s because the Chinese government is still practically and ideologically committed to planning the Chinese economy, both in aggregate and in detail. When the market goes up, often it’s not because of some subtle, gradual improvement in the earning power of companies, it’s because everybody knows that it’s the policy of the government that the market should go up now, or because the government is going to renew its commitment to endlessly printing RMB to sterilize its interventions in the foreign exchange market. When the market suddenly and abruptly goes down by fifty or seventy-five percent, it’s because the government has decided it’s too high, or is going to flood the market with IPO’s of failing state enterprises, and everybody knows that. It’s a largely policy-driven market, that’s what they look like.

Of course, this creates uncertainty (that’s why it’s necessary to order the banks to lend) and wouldn’t work as a way of encouraging extensive growth, but when you’re just installing equipment invented by someone else, you can get away with this sort of very aggressive management style for a while, until, as happened in Japan, your economy eventually gets too developed for it to work any more, gets to the point where further growth would only come from encouraging individuals to have their own differing points of view, to be creative.

The Shanghai stock market isn’t one that rewards being in the minority, and being right, the way a real capital market would. It’s a market that rewards marching in lockstep with everyone else, but getting the tip-off just a little sooner, because everyone knows (in a society where the very idea of a level playing field is held to be seditious) that the beautiful people should get the beautiful breaks. Chinese people have had six decades of this sort of treatment, and they’ve gotten pretty good at doing things in unison. (The Cultural Revolution was very good training.) That’s why their market tends to sometimes move up and down in relatively straight lines.

By explicitly targeting our stock market, by adding themselves as a source of net new demand for financial assets with their two quantitative easing programs, the Federal Reserve Bank began the process of making it into that sort of market, they tried to make sheep-like obedience to government directives the new ‘clever’. Trading days increasingly resembled rehearsals of synchronized swimming routines. For the time being, we, too, are a policy-driven market, though the current policy is now, unfortunately, suddenly RISK OFF.

For the last two years, being in the majority, not trying to be too clever, not fighting the Fed, buying every dip, has been what’s paid, but now the Fed has had to back away without accomplishing anything in particular for its money, besides pushing the prices of financial assets into unsustainable positions. In the short term, they really did manage to get market participants all doing what the government told them to do, all buying in unison, all fully long at once. But the market is like a Slinky or a rubber band; stretch it too far, in one direction, and then let go, and it will snap back in the other.

Now some people are trying to sell, still in an atmosphere of only-slightly-perturbed calm, while very few people are still buying, since the Fed’s monetary signal to do so has been switched off, and rallies keep getting sold. It’s possible to identify technical support at various levels, but I’m not sure it matters, it seems to me that there will still be people who have to sell but nobody who has to buy, even at those levels, because people have been conditioned to buy when the Fed is buying, and won’t know they ought to act without that coordinating signal. Policy-driven markets tend to go up and down in straight lines when policy changes, hence I expect a surprisingly savage sell off in this one.

All of this could have been predicted by anyone who bothered to read Charles Kindleberger’s Manias, Panics, and Crashes. If you don’t own it, I suggest you buy a copy. His argument seems complicated, but it boils down to something very simple. Kindleberger argues that bubbles, in the modern world, are often caused by cross-border capital flows, and shows that we can explain much of the history of the last several decades with a very simple model.

If we just assume that every dollar that is brought into a country by foreigners to buy some financial asset, say a bond, from a local, is used by that local to buy another financial asset, say a stock, instead of used to fund consumption (and why should the mere presence of a foreigner change the local’s propensity to save?) then we can easily explain events like the Japan bubble of the late 1980’s, or the American bull market of the three decades prior to 2000, and the series of bubbles since then, as the result of events like yen purchasing after its un-pegging, and the huge net flows of Asian savings into dollar-denominated US asset markets over the relevant period. Asian institutions may have mostly bought bonds, in the US, but the portfolio preferences of American investors weren’t changed by that, or got skewed towards risky assets by the resulting bull market, so even though it was the bond market the inflows were coming into, and we did get a bull market in bonds, it was much riskier assets that went up most in price.

Asia just eventually got too big, without much of a decline in savings rates, for this game to go on forever – by the end, they needed to lend us far more money than we had any actual use for, so we could buy far more gadgets than we had time to learn how to operate, and fight endless wars without any real political objectives. The whole thing fell apart by being reduced to an absurdity, to a system that would have required every American, even the ones working for minimum wage, to buy a mansion full of robots. That couldn’t happen, so the system broke.

All that should be fairly obvious by now. But if Kindleberger’s is the correct analysis of the effects of natural sources of exogenous demand for financial assets, which come on stream gradually and ebb away gradually, what should be the consequence of an artificial source of exogenous demand for financial assets, which switches on like a light, and then switches off abruptly a year or two later?

Well, presumably anyone the Fed bought a bond from, in the course of QE’s 1 and 2, immediately took the money and bought stock, encouraged by the fact that the Fed was publicly putting its credibility behind the notion that stock markets should only go up and can be planned, successfully, in a manner that causes them to only go up, a theory I first heard from a Japanese speculator in the late 1980’s.

So you should get a big bubble in the stock market, just as you would if the source of exogenous demand for financial assets had been capital inflows. This also explains the rather pointless bubble in gold and other commodities. If the Fed really does succeed in manipulating expectations, everyone should become convinced that by getting long anything liquid they’re doing the only safe thing, that people who still see risk are idiots and troublemakers. They’ll all get two hundred percent leverage, and financial institutions will all gear themselves up sixty times again. The VIX will fall to 16. Banks and private savers will arrange their speculations in liquid assets on the assumption than the economy is very much better than their own internal data makes it seem to be, because how could the Fed and all those smart people in the market all be wrong? (Does any of this sound familiar?)

At the same time, nobody will want to invest any money in any real productive activity, or to own anything they can’t sell in a day or two, because the question of the Fed’s exit strategy, and the Federal Government’s exit strategy from a very stimulatory level of deficit spending, will always force them to stay liquid, the more so the more it looks like the economy might recover. (Because they know, from their past experience with this Fed, that any such exit will inevitably be accompanied by a severe financial crisis or market panic which will destroy anyone who isn’t perfectly liquid, that if they get stuck in some productive investment they can’t immediately sell, if they don’t find a chair when the music stops, they may well, if recent history is any guide, end up in jail, or branded a public enemy.) And when the music finally stops, when the pied piper finally throws up his hands and says ‘to heck with those ingrates in Hamelin town’, there will be nobody who’s not fully invested, or who’s short, left to buy from them, nor any investment going on in the real economy, and the bubble will pop quickly and loudly.

The thing that ought to be stressed, about this explanation of the pattern of events we now see unfolding, is its orthodoxy as economics. These are exactly the reasons that have always, in the past, dissuaded the Fed, or any other well-run central bank besides Japan’s (they somehow don’t seem to mind the fact that it has never worked and theoretically shouldn’t work) from ever pursuing any such policy of directly targeting asset markets over long periods of time (other than the market for government bonds, which central banks must manage) and that will dissuade any other well-run central bank from ever emulating the Fed’s current policy in the future.

You see, in economics, they have this idea that prices depend on supply and demand. You economists, all you PhD’s out there, you wise wizards and technocrats at the Fed who keep us safe from unscientific approaches to the management of the economy, may have heard of these things before, though of course they’re mysteries to the rest of us. The Fed, in doing two, successive, large scale ‘quantitative easing’ programs which basically just amounted to buying lots of bonds, temporarily increased the demand for financial assets. Market participants’ portfolio allocation preferences didn’t change, or became less conservative, so even though they were buying bonds, it was risk assets, equities and commodities, that went up in price. (This is not rocket science.)

Eventually, though, the buying would have to stop, when the program ended. That would remove a source of demand for financial assets; one market participants had grown accustomed to and reliant on. With less demand, the prices of financial assets would then fall, in the typical pattern, with equity market weakness and bond market strength. Since the monetary stimulus, by then, would have been huge, its sudden removal would create a huge hole under the market, into which it would ponderously collapse.

Of course, since the stimulus was all fakery, and was the very least the participants in the rave expected from their DJ, while its removal shows us harsh reality, and comes as an unwelcome surprise, every single time you do this, the cost of the exit will be greater than the benefit of the free lunch you thought you were getting during the bubble period. (The Fed has now had two good opportunities to re-learn this – one in 2000, and one in 2008 – but seems to have learned nothing at all, seems even more committed to blowing up bubbles with printed money, though maybe the third time, which we’re presently living through, will be the charm.)

The asset market will go down by more than the amount you pushed it up each time, as everyone tries to exit at once. The decline in GDP from the crisis will be greater than the boost to GDP from the stimulus that caused the crisis to occur. The basic idea of economics is that there’s no such thing as a ‘money machine’, that you can’t get something for nothing, and the practical wisdom of any competent economist tells him that an attempt to try will always leave you worse off.

(I shouldn’t have to say any of this, all professional economists outside the United States know it, but somehow ours have lost their willingness to contemplate the possibility of perverse policy outcomes, though those are what real economics is all about.)

This all seems blindingly obvious, and many other people have said more or less the same thing. The hardest thing to explain is how people could be fooled by the initial temporary increase in demand for financial assets, but the portfolio allocation effect seems adequate to explain that, and we have plenty of evidence that they were, the S&P 500 did double over the course of two years in the face of weak economic performance, a bad housing market and rapidly snowballing public debt.

How much should prices fall now that the artificial demand for financial assets has been removed? With expectations disappointed, it would be reasonable to expect overshooting on the downside. All of market participants’ ‘ill-gotten’ gains, ill-gotten not in a moral but a practical sense, precarious gains, resulting from just doing what the government told us to do instead of thinking for ourselves, should probably be wiped out before much of anyone has a chance to sell, and there should be some further penalty on top of that, because when the music stops there should be a disorderly scramble for chairs. (Given the number of people trying to delta-hedge, I would expect there might be gaps lower, once we really get going.)

Most people, now, are still thinking that the worst thing that can happen to them is a decline, in the S&P 500, to 1020, the lows last year before QE2 was announced. But people always have modest expectations of the extent of a decline when it starts (otherwise they’d already have sold) and this analysis ignores the fact that there was another, more or less identical quantitative easing program before QE2. (Quite how people could forget that, given QE2’s name, still strikes me as mysterious, but never mind.)

Really, perhaps after some hideously destructive rally off of this forlorn hope of support, shouldn’t we give back the ill-gotten gains from the first program as well? (I know we’re used to having them by now, but the market doesn’t care about that.) That would take us below 800. Actually, if we’re going to overshoot where we should be, we should overshoot the 2008 low, which itself was an overshooting of the 2000 low. After all, now we’ve made a lower high, this whole move up from 666 to above 1300 is just a two year long rally in a secular bear market, and in bear markets, successive lows tend to be lower as well.

(The Fed keeps doing this to us, blowing up bubbles and then backing away. Once could be happenstance, twice might be bad luck, but three times is enemy action, so it seems likely that people will recognize what’s being done to them and act to protect themselves more quickly this time, leading to a more severe, or at least more sudden market event.)

That would indicate an ultimate low somewhere below 650 on the S&P, perhaps 600? Anything that takes us below 800 will amount to an effectively complete claw-back of all the policy-driven gains, but it really seems possible that we could make a new low. This is a crazy-seeming prediction, but it’s where reason seems to lead, and even if it’s wrong, developing this sort of contrarian case is a good exercise. Think of it as a puzzle; please, knock yourself out, find a way to make me wrong, I’d love to be wrong.

Well, that, anyway, was my general theory, a few months ago, we’ll see if I was right, so to test it, I bought enough puts on the S&P 500 to hedge my own illiquid investments in real productive activity. I thought a crash was likely to occur, but I had no theory about the detailed mechanism of the panic, which makes me seem rather stupid, to myself, in retrospect.

It should have been obvious that a lot of the money we were printing was actually ending up in Europe, that that was what was being endlessly shoveled into peripheral bond markets by the European banks, it should have been obvious that as soon as QE2 ended there would be a huge hole in the funding system for these quasi-parastatal monstrosities. Naturally that would lead to selling in peripheral bond markets, and naturally that would provoke a run on the same banks by depositors with an accurate conception of how much political interference there’d been with sound balance-sheet management, how much pressure there’d already been and would continue to be, on the banks, to bail out Greek and Italian politicians with the money of German and French depositors. And naturally this run would go all the way, since the sovereigns involved could hardly guarantee bank deposits if they were effectively bankrupt themselves. So of course, what we were always going to end up with, once QE2 stopped, was a classic 1930’s style run on the European banking system, which policy-makers would react to by basically dropping out of sight because they knew the only plans worth articulating, now, were recovery plans for after the crash, that it was pointless to try to prevent it.

I suppose if it really happens, the event I’m describing will leave Europe’s banking system in collapse and the American and Asian ones, aside from a few very weak large institutions, largely intact. Europe’s present regulatory and political institutions are the result of political compromises rather than the test of time, and simply aren’t set up in a way that would permit a successful response to this sort of crisis. They’re the weakest link, because their political system is the most utopian, the most unsustainable, the most fragile, so the destruction of the QE money, and the last decade’s worth of excess Asian savings, is most easily accomplished there.

Because of course, that’s what this sort of event is largely about; a bunch of money corresponding to no existing goods and services has been created out of thin air, and if it can’t be burned off through inflation, hard to do with productivity going up so quickly and so many people joining the global work-force, it has to evaporate in a crash. Someone, somewhere, has to lose that amount of money, has to find out that they can’t actually get it and spend it when they need it, and that describes a stock market crash or a run on a banking system. And there’s always collateral damage, more than the excess, purely imaginary wealth is always lost.

We may have to recapitalize some of the American banks again – from tax receipts, this time, doing it with money borrowed from the banks themselves was never really going to work – but the event should at least scare us back onto the path of fiscal rectitude, and after all, the adjustments we really need to make still aren’t horribly harsh ones. People like me have to pay a little more tax, people who are still fairly young have to get used to the idea of retiring a little later, etc. These aren’t things that will tear our society apart, it’s just that some parts of the existing political class will have to be replaced through elections.

What’s unfortunate is simply that the event is likely to be more damaging, to the world at large, than it would have been without QE2, and the event that would have occurred last summer if we’d had no QE2 would have been worse than what would have happened if we’d had no QE1, and what would have happened if we’d had no QE1 would have been worse than if there’d been no monetary stimulus after 9/11, and what would have happened if there’d been no monetary stimulus after 9/11 would have been worse than what would have happened if LTCM had not been rescued. That was our last real chance to avoid some kind of disaster, small or large. We’ve been in trouble for a long time, now.

The very technical competence of the central bank, its ability to manage markets, is endangering the world economy, and is now apparently threatening to destroy Europe’s banking system. It would be the worst thing in the world for the Fed to launch another iteration of this failed approach, in yet another attempt to avert the inevitable disaster brought on by its last targeting of asset markets.

Of course the Fed needs to act as lender of last resort in a crisis, they’re really good at doing that, but then they never stop acting as lender of last resort, they seem to make no conceptual distinction between the lender of the last resort role and really over-the-top kinds of Keynesian stimulus, and direct, explicit targeting of the stock market (a truly bizarre and self-contradictory policy in the context of the normal, sober behavior of the Federal Reserve Bank of the United States) or else they’re just no good at leaving the limelight. Instead of backing away from the economy after the crisis and letting it equilibrate, they endlessly tease and torture it with their capricious antics, thinking they’ve saved the world by creating this or that new bubble, and then being comically surprised when they stop blowing air in and the air all comes back out.

We don’t really need this huge distorting signal; it’s causing a gigantic flutter in the world economy that’s getting faster and more violent with each cycle. Central banks should probably never target the stock market for any protracted period of time – that’s central planning, not the management of a sound currency, or even protection of the long-term growth trend. After all our protection of full employment by managing markets, over the last fifteen years, how’s employment doing?

And yet that’s what the Fed’s quite likely to try to do, again, not because they really think it will work, it will be clear to them, by then, that QE2 ended up doing enormous damage, but because the political impulse to be seen to seem to be doing something will win out, in the absence of any better option. There isn’t any way to stop that spasmodic action, the only good that can be gotten out of it is to use it to reinforce the lesson, for people outside the Fed, that central banks should never do what they may end up doing yet again, because it only makes things worse in the end. That’s why nobody should be surprised by the violence of this crash; it makes perfect sense that they’ll be worse each time.

- Daniel Cloud

Nigel Farage on the Euro

2011-08-23T18:26:00.001-05:00

The Beginning of the Endgame by John Mauldin

2011-08-13T14:34:00.002-05:00

The Beginning of the Endgame

By John Mauldin | August 12, 2011

In this issue:
The Big Bang Moment
Bang, Indeed!
"It's the Economy, Dummkopf!"
The Long and Winding Road to Crisis
Are We Already in Recession?
So What Can We Do?
Home and then Ireland, London, and Geneva

I came away from Maine, and meeting with some of the most astute economists in the world, with a series of impressions that will be the core of this week's letter. On Friday night, S&P downgraded US debt, and of course I need to comment on that. But as we talked the next two days and into the nights, I came increasingly to the opinion that this is indeed the Beginning of the Endgame. I must admit it has come about faster than I thought. But that is the nature of these things. And so, with no "but first," let's jump right in.

The Big Bang Moment

I think it relevant to start off by quoting from my book Endgame, where I quote in turn from what I think is the most important book of the last decade, This Time is Different: Eight Centuries of Financial Folly, by Ken Rogoff and Carmen Reinhart. I truly urge you to read it. The book is consciously designed so you can read the first chapter and the last five and get the thrust of the work. You can order it from Amazon.com. (The Kindle edition is only $9.99 and makes a perfect companion to my book Endgame [shameless plug].) Quoting from my book:
"We are going to look at several quotes from [This Time is Different], as well as an extensive interview [the authors] graciously granted. We have also taken the great liberty of mixing paragraphs from various chapters that we feel are important. Please note that all the emphasis is our editorial license. Let's start by looking at part of their conclusion, which we think eloquently sums up the problems we face:
"'The lesson of history, then, is that even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be. Technology has changed, the height of humans has changed, and fashions have changed.
'Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant. No careful reader of Friedman and Schwartz will be surprised by this lesson about the ability of governments to mismanage financial markets, a key theme of their analysis.
'As for financial markets, we have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowing can take place
in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.
'This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk—if only they do not become too drunk with their credit bubble–fueled success and say, as their predecessors have for centuries, "This time is different."'
[Back to my voice] "Sadly, the lesson is not a happy one. There are no good endings once you start down a deleveraging path. As I have been writing for several years, much of the entire developed world is now faced with choosing from among several bad choices, some being worse than others."
And this is key. Read it twice (at least!):
"'Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence—especially in cases in which large short-term debts need to be rolled over
continuously—is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! — confidence collapses, lenders disappear, and a crisis hits.
'Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public's expectation of future events, which makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to "multiple equilibria" in which the debt level might be sustained—or might not be. Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.'"

Bang, Indeed!

When the subprime crisis started, we were told by numerous authorities (including Ben Bernanke) that the problems would be "contained." But by 2006 it was clear to anyone who studied the toxic instruments that the losses would be in the hundreds of billions. I estimated $400 billion, which just goes to show that I'm an optimist. That crisis spread to banks all over Europe and then back to the US. Authorities used every bullet in their guns, every legal means and –well let's be charitable, perhaps they pushed the rules a bit – to try and stem the tide. And then we had a "Lehman moment" and all at once the markets seemingly froze. It was "Bang!"
My sense is that the S&P downgrade is like that moment when we were told things would be contained. In and of itself, the downgrade is not that important. What did we learn that we did not already know? The US is headed for a financial crisis if they do not get the deficit under control? This is news?
But I think it forces S&P to take a very hard look at France, whose loss of AAA would bring into doubt the whole EFSF mechanism. And Spain and Italy must come under scrutiny if S&P's move in the US is not to be seen as politically motivated. The main result of the downgrade may not be here in the US but in Europe, where there are already issues. A series of downgrades (which are warranted if the US one was) would be traumatic.
My London partner Niels Jensen penned this observation:
"If France is downgraded, a number of French banks will almost certainly be downgraded, following which other European banks will face the same destiny. Such a scenario has the potential to cause calamity across Europe. The 90 European banks which recently went through the (so-called) stress test organized by the European Banking Authority need to roll a total of €5.4 trillion1 (!) of debt over the next 24 months. A massive amount even during the best of times. Probably undoable during times of stress.
"As Ambrose Evans-Pritchard, in consultation with Willem Buiter of Citigroup, pointed out in the Daily Telegraph over the weekend:
" '... the issue is not how long Italy and Spain can ride out the storm in bond markets. There would be a banking and insurance crisis long before sovereign defaults came into play, simply because the fall in bond prices on the secondary market is causing carnage to bank books (among other transmission mechanisms).'
"With its downgrade of U.S. sovereign debt, Standard and Poors has started a chain of events which can only make things worse in an already crisis-hit eurozone. For that reason, the decision to downgrade was not only badly timed but also ill considered; that it was probably justified is of little relevance at the moment."
My latest trip to Europe and discussions with friends in Maine, plus my reading, simply reinforces my sense that we are seeing Europe unravel, or at the very least come to a very important crossroads where they must make a fateful decision. And let's make no mistake, this is a demon of a problem of their own making. Monetary union without fiscal union will not work in a world where there are so many cultures and different traditions. But how does that work? How do you exorcise that demon?
Which leads me to a sidebar. Michael Lewis is one of the greatest writers of our time. He is just brilliant. He has a piece in the latest Vanity Fair on Germany and the crisis in Europe. It is rather long (about 15 pages in a Word doc) and makes some rather interesting (if odd) scatological references, trying to explain the German world view, so if you are of a delicate mindset, perhaps you should confine yourself to the few paragraphs I quote here. But I do suggest you set aside some time to read the entire piece. (You can read the whole thing athttp://www.vanityfair.com/business/features/2011/09/europe-201109.) Here is the editor's intro to the piece:

"It's the Economy, Dummkopf!"

"With Greece and Ireland in economic shreds, while Portugal, Spain, and perhaps even Italy head south, only one nation can save Europe from financial Armageddon: a highly reluctant Germany. The ironies—like the fact that bankers from Düsseldorf were the ultimate patsies in Wall Street's con game—pile up quickly as Michael Lewis investigates German attitudes toward money, excrement, and the country's Nazi past, all of which help explain its peculiar new status."
And from the middle of the piece, these insights:
"Greeks are still refusing to pay their taxes, in other words. But it is only one of many Greek sins. 'They are also having a problem with the structural reform. Their labor market is changing—but not as fast as it needs to,' he continues. 'Due to the developments in the last 10 years, a similar job in Germany pays 55,000 euros. In Greece it is 70,000.' To get around pay restraints in the calendar year the Greek government simply paid employees a 13th and even 14th monthly salary—months that didn't exist. 'There needs to be a change of the relationship between people and the government,' he continues. 'It is not a task that can be done in three months. You need time.' He couldn't put it more bluntly: if the Greeks and the Germans are to coexist in a currency union, the Greeks need to change who they are.
"This is unlikely to happen soon enough to matter. The Greeks not only have massive debts but are still running big deficits. Trapped by an artificially strong currency, they cannot turn these deficits into surpluses, even if they do everything that outsiders ask them to do. Their exports, priced in euros, remain expensive. The German government wants the Greeks to slash the size of their government, but that will also slow economic growth and reduce tax revenues. And so one of two things must happen. Either Germans must agree to a new system in which they would be fiscally integrated with other European countries as Indiana is integrated with Mississippi: the tax dollars of ordinary Germans would go into a common coffer and be used to pay for the lifestyle of ordinary Greeks. Or the Greeks (and probably, eventually, every non-German) must introduce 'structural reform,' a euphemism for magically and radically transforming themselves into a people as efficient and productive as the Germans. The first solution is pleasant for Greeks but painful for Germans. The second solution is pleasant for Germans but painful, even suicidal, for Greeks.
"The only economically plausible scenario is that Germans, with a bit of help from a rapidly shrinking population of solvent European countries, suck it up, work harder, and pay for everyone else. But what is economically plausible appears to be politically unacceptable. The German people all know at least one fact about the euro: that before they agreed to trade in their deutsche marks their leaders promised them, explicitly, they would never be required to bail out other countries. That rule was created with the founding of the European Central Bank (E.C.B.)--and was violated a year ago. The German public is every day more upset by the violation--so upset that Chancellor Angela Merkel, who has a reputation for reading the public mood, hasn't even bothered to try to go before the German people to persuade them that it might be in their interests to help the Greeks.
"That is why Europe's money problems feel not just problematic but intractable. It's why Greeks are now mailing bombs to Merkel, and thugs in Berlin are hurling stones through the window of the Greek consulate. And it's why European leaders have done nothing but delay the inevitable reckoning, by scrambling every few months to find cash to plug the ever growing economic holes in Greece and Ireland and Portugal and praying that even bigger and more alarming holes in Spain, Italy, and even France refrain from revealing themselves.
Until now the European Central Bank, in Frankfurt, has been the main source of this cash. The E.C.B. was designed to behave with the same discipline as the German Bundesbank, but it has morphed into something very different. Since the start of the financial crisis it has bought, outright, something like $80 billion of Greek and Irish and Portuguese government bonds, and lent another $450 billion or so to various European governments and European banks, accepting virtually any collateral, including Greek government bonds.
"But the E.C.B. has a rule--and the Germans think the rule very important--that they cannot accept as collateral bonds classified by the U.S. ratings agencies as in default. Given that they once had a rule against buying bonds outright in the open market, and another rule against government bailouts, it's a little odd that they have gotten so hung up on this technicality. But they have. If Greece defaults on its debt, the E.C.B. will not only lose a pile on its holdings of Greek bonds but must return the bonds to the European banks, and the European banks must fork over $450 billion in cash. The E.C.B. itself might face insolvency, which would mean turning for funds to its solvent member governments, led by Germany. (The senior official at the Bundesbank told me they already have thought about how to deal with the request. 'We have 3,400 tons of gold,' he said. 'We are the only country that has not sold its original allotment from the [late 1940s]. So we are covered to some extent.') The bigger problem with a Greek default is that it might well force other European countries and their banks into default. At the very least it would create panic and confusion in the market for both sovereign and bank debt, at a time when a lot of banks and at least two big European debt-ridden countries, Italy and Spain, cannot afford panic and confusion.
"At the bottom of this unholy mess, from the point of view of the German Finance Ministry, is the unwillingness, or inability, of the Greeks to change their behavior.
"That was what the currency union always implied: entire peoples had to change their ways of life. Conceived as a tool for integrating Germany into Europe, and preventing Germans from dominating others, it has become the opposite. For better or for worse, the Germans now own Europe. If the rest of Europe is to continue to enjoy the benefits of what is essentially a German currency, they need to become more German. And so, once again, all sorts of people who would rather not think about what it means to be 'German' are compelled to do so."

The Long and Winding Road to Crisis

As I will show below, the US (indeed much of the world) is on the edge of yet another recession. It will not take much to push us into one, just a small shock, like say a banking crisis in Europe, alluded to by Lewis and something I have been writing about for a year.
That being said, the apparent willingness of the Germans to come up with creative ideas (and to get the French to go along) to fund the various nations in crisis, in order to avoid technical defaults, is somewhat amazing. And if there was an election today and the socialists and Greens won in Germany, they would be even more open to the idea of a eurobond, to be somehow guaranteed by member countries. The current EFSF can deal with Greece, Ireland, and Portugal until maybe 2013, and the next version will be large enough to deal with Spain, unless of course the Eurozone elites decide to call it quits, which is something they have not shown the slightest hint of doing. What is more likely is that we lurch from crisis to crisis, with each crisis somehow being averted by throwing more money at it, until the debt of the AAA guarantors like France (and to a lesser extent Italy) starts to be called into question by the markets.
Remember, the demographics of Spain and Italy are horrendous, soon to be on a level with Japan. The government portion of GDP in France is already 53% (not a typo!) and is only going to get worse as aging Boomers have been promised monster benefits that simply cannot be provided without Greek-level austerities. Their future numbers are worse than those of the US.
This can go on for a long time, or it can end in a Bang! moment this year. That is the nature of the lesson from Rogoff and Reinhart. Look at Japan. They took what were functionally insolvent banks and kept them going for decades. Where there is a political will there can be a way … but there will be an Endgame. That is also the lesson we learn from history. Japan will not be able to stave off a crisis of major proportions forever. Neither will Europe, unless they all become Germans in their national accounting.

Are We Already in Recession?

My friend Barry Ritholtz posted the above question today, and wrote:
"Bloomberg reported today that " Consumer Sentiment Plunged to Three-Decade Low." That sent me scurrying to find some charts, and I ended up liking the two from UBS strategist Andy Lees, at bottom.
"The first one is an overlay the University of Michigan consumer confidence index vs the Conference Board's data. The second chart shows the long term history of the Conference Board data. At an implied level of 43.37 we would be in recession now; not only that but a deep recession.
"As the charts show, the ABC index has diverged from the Conference Board data for some time now. The correlation between consumer confidence and recession might not hold this time - although that would be the first split for 40 plus years. There is also an implication from this data series that we are already in recession. Given yesterday's data showing both imports and exports falling, we may have an implied Q2 GDP revised lower by 0.8% to 0.5% annualized growth - putting Q2 into the negative category.
"Hence, it is not unfeasible that we could be the verge of recession."

And that brings me to a chart I asked Rich Yamarone (chief econ type at Bloomberg) to update for me. Again, it is about the horrific consumer confidence number that came in today, but this time it is correlated with GDP. As you can see, there is a close correlation. With GDP growth of less than 1% for the last six months, asking if we are close to or already in a recession is not a question without merit. And either way, this does not bode well for the long-term direction of stocks and corporate earnings. Consumer confidence is really saying that a recession is in the cards. Maybe it is just weariness with the political malaise (which would be understandable), but we should pay attention.

And while I won't print the chart again, every time year-over-year GDP growth falls below 2%, we end up in a recession. It is now 1.6%. Past performance is not indicative of future recessions, but the trend is not in our favor.

So What Can We Do?

The economy is getting weaker. What can we do? The short answer is, sadly, not much. There were some in Maine who argued for more fiscal stimulus, but I think there is little political will for another major stimulus program. The last one got us up to 3% GDP growth before we fell back, and all we got was a major debt bill and a higher level of government spending. I fully get that lowering government spending will have negative short-term effects, but we are at the point in the Endgame where we must bite the bullet.
And fiscal policy is becoming a drag on the entire Eurozone, as well as Great Britain. Austerity may be warranted, but is has consequences.
What about QE3? Let's look at how that last move turned out. We ended up with more money on the Fed's balance sheet and higher commodity prices. The NFIB survey I cited last week showed there was no great demand on the part of small business for loans. 91% had what they needed. What they want are sales and customers! The trade data yesterday showed exports fell by over $2.3 billion last month. That suggests a slowing world economy. Which is borne out by numerous other indicators.
One has to applaud the Chinese for allowing their currency to rise by a significant (for them) amount this week, as almost every other government (including Switzerland) wants a weaker currency. Everyone can't devalue at the same time, just as everyone cannot export their way out of this crisis. Someone has to buy!
In short, there are no easy solutions. We have just about used up all our "rabbits in the hat" as far as fiscal and monetary policy are concerned. We now need to focus on what we can do to get out of the way of the private sector, so it can find ways to create new businesses and jobs. And that means figuring out how to get money to new businesses, because that is where net new jobs come from. But that takes time – and is a subject for another letter, as it is time to hit the send button.

Home and then Ireland, London, and Geneva

I am home for (can you believe it?) more than 40 days, which, even with the Texas heat, I need. Then I'm off to Ireland, Geneva, and a few days in London. I am sure I will be making at least one presentation in London.
Maine was more serious this time. I think more of us realize that things are going to get harder and more volatile. While our group is not exactly indigent, we do get what all this means. On Sunday night, Trey came to me. He had been listening. "Dad, it is good for you that you wrote about all this already and are right, but I don't think it's so good for the rest of us." And he is right.
Book sales have been quite steady, as more and more people are realizing that we truly are at the Endgame, and as we try to lay out how it plays out for us all. There is a lot of data in the book, and we back up our predictions with sources. As one reader wrote:
"John, I hope all is well. I just wanted to drop you a note and tell you how much I am enjoying Endgame. As a guy with a degree in economics, I read a lot of books trying to explain macroeconomics of the times, but I have to tell you this is the single best book I have read explaining how macroeconomics works to regular people like me. You have done a great service to your readers, as you do every day. Best, Steve"
You can read reviews and buy it on Amazon.
It really is time to hit the send button and find something to eat. I am starved – and maybe I'll catch a late movie. Have a great week.
Your glad God invented air conditioning analyst,
John Mauldin
John@FrontlineThoughts.com

2011 vs. 2008 by Doug Noland

2011-08-12T21:25:00.000-05:00

Compare & Contrast: 2011 Vs. 2008:

I thought a paragraph from today’s Financial Times (“This is Not a 2008 Redux,” Jennifer Hughes) succinctly captured the consensus view:

“At the bottom of all of this is a lurking fear that this is 2008 all over again. But it is not. Since then banks have written down swathes of dud loans and assets, they have built up capital and most immediately important, they have access to central bank liquidity should the market freeze up. Granted, major banks back on life support would, and should, send markets reeling, but the central bank option means investors would not face the cliff-edge event that was Lehman’s collapse.”

With astonishing market volatility, faltering marketplace liquidity, collapsing global bank stocks and the imposition of limited bans on short-selling, the unfolding global financial crisis this week definitely recalled the 2008 experience. As the FT noted, there are important differences. There are, as well, some critical similarities. I thought it was worth delving into a little “Compare and Contrast” – from my analytical perspective.

First of all, the nucleus of the current crisis is in Europe instead of the U.S. financial system. I have for awhile now posited the thesis that policy responses to the 2008 meltdown unleashed a perilous “global government finance Bubble.” The first crack in the latest Bubble developed in the eurozone (Greece), as opposed to the 2008 crisis that emerged at the fringe of U.S. mortgage finance (subprime).    Our banks and Wall Street firms were the focal point of 2008 market fears, while it is today the European banking system. It is certainly easier these days for U.S. pundits, analysts and investors to remain complacent – and content to believe that market selling is way overdone.

Global policy responses to the 2008 turmoil emboldened the view that policymakers retain powerful tools to manage financial crises. A key facet of my bearish thesis is that the bursting of the “government finance Bubble” will find policymaking increasingly ineffective and, in the end, incapacitated. A Bubble fueled by massive fiscal and monetary stimulus nurtures inevitable vulnerability to the waning capacity of these measures to sustain inflated markets and maladjusted economic structures. As we’ve witnessed in the European periphery (and, to a lesser extent, here at home), massive government stimulus reaches a point of diminishing returns. And when a crisis of confidence unfolds in government debt – as has been the case in Greece, Ireland, Portugal, Spain and Italy – newfound policymaking constraints quickly become a focal point of market worries.

Yet, a well-entrenched view holds that governments can simply create liquidity and boost bank capital, ensuring no repeat of the “cliff-edge event that was Lehman’s collapse.” Policymakers have supposedly learned from past mistakes. Especially this week, with market attention turning to French and European banks, market debate centers around the capacity for the ECB and European governments to support their fragile banking system.

I’ll again borrow the phrase “a banking system is only as good as its sovereign.” In major contrast to 2008, the issue today is not the vulnerability of heavily leveraged banking systems to a crisis of confidence in private (mainly mortgage) debt and sophisticated “Wall Street” structures. Crisis 2011 is foremost a sovereign debt issue – and this changes things profoundly.   Since ‘08, governments have issued Trillions of new debt and, at the same time, have assumed enormous amounts of private-sector risk. Increasingly, governments are losing their capacity to underpin their financial systems and economies through additional debt issuance. To keep the latest Bubble from imploding, markets are demanding that those sovereigns that retain the capacity to take on huge additional burdens do so in order to more generally backstop faltering debt structures.

The cost of protecting against a sovereign default by France (in the Credit default swap/CDS market) traded above 180 bps this week, compared to a high of about 65 bps back during 2008 market tumult. Importantly, a crisis that began last year at Europe’s periphery has now afflicted its core.   On the one hand, markets expect France and Germany to backstop the faltering eurozone debt structure (sovereign and banking system). On the other, the marketplace is recognizing that the enormity of such an undertaking risks pushing French debt over the proverbial cliff. In contrast to ’08, the pressing issue today is not susceptible firms such as Bear Stearns or Lehman – but (G7) nations such as Italy and France. Already weighed down by holdings of impaired periphery debt, the French banking system is clearly vulnerable to any waning market appetite for French sovereign Credit.

Italian CDS traded above 400 last week, double the 2008 high. Throughout the CDS marketplace, prices (especially the past week) have surged to levels significantly above those from the heart of the 2008 crisis. In the past seven sessions, Brazil CDS prices have jumped 36 bps (to 151) and Mexico 33 bps (to 152 ). This week in particular, “emerging” currencies and debt markets turned tumultuous – and worryingly 2008-like, only compounding banking and market worries. Importantly, mechanisms that transmitted instability around the globe back in 2008 are very much intact in 2011.

We’ve all listened to the argument “there’s less leverage in the system now than in 2008.” Well, I’ll assume that much of the egregious speculative excess in high-yielding U.S. mortgage Credit was wrung out of the system (not so confident the same can be said for “AAA” mortgage exposure). Clearly, the U.S. banking system has been much more cautious in their exposures to mortgage and private-sector debt, although there have been ample excesses in “leveraged” corporate finance.   I’ll also assume that Wall Street balance sheets are less vulnerable now than in 2008. But when it comes to the global leveraged speculating community, I’m not so convinced that they are any less exposed to tumultuous markets than they were in 2008. And with counter-party risk again an issue, I increasingly fear for the stability of the nebulous entity referred to as “the global derivatives marketplace”.

When the leveraged speculators (hedge funds, proprietary trading desks, etc.) were caught poorly positioned during a faltering U.S. mortgage finance Bubble back in 2008, their problems swiftly became the global financial system’s problem. As they were throughout the 2008 crisis, the leveraged players remain the predominant transmission mechanism from one market to virtually all markets.   As losses mount, speculators are forced to reduce risk and leverage throughout the global risk markets. In our highly interlinked global markets, liquidity issues and market dislocation in a key market rather quickly evolve into de-risking, de-leveraging and liquidity issues throughout.

Post-2008, a rejuvenated hedge fund community grew to record size (surpassing $2 TN). From my vantage point, their market influence seems as great as ever – at least it appeared so this week. And I’ll venture a guess that leveraged “carry trade” speculations are greater in scope today than was the case in ‘08. An important aspect of “global government finance Bubble” analysis is that the sophisticated players were emboldened – and highly incentivized - by post-’08 government reflationary policymaking.   In particular, financial and economic vulnerability ensured extremely low interest rates (and currency devaluation) in the “developed” world, while strong (domestic and global) inflationary biases virtually guaranteed higher returns and strengthening currencies for the “developing” economies/markets. While this trend – along with attendant speculation – was prominent leading up to the 2008 crisis, I fear speculative excesses might have been on an even grander scale over the past two years.

The scope of global “carry trades” (i.e. take the proceeds from shorting a low-yielding currency to speculate in instruments from higher-returning currencies) is a big unknown. How much shorting of dollar instruments (i.e. Treasurys and such) has funded leveraged speculations in the “developing” markets is a question I ponder on a daily basis. We do know that the enormous global “macro” funds have become much bigger and richer since 2008. And, from what I can discern, their returns have seemed to be at least somewhat negatively correlated to the dollar.

Currency markets turned unstable this week. Meanwhile, global risk markets – certainly including the emerging currency, equity and debt markets – became highly correlated. Market action seemed to confirm the view of heightened market vulnerability to the unwind of leveraged “carry trades.” Or, at least, the market became increasingly nervous about the ramifications from weakness in the higher-yielding currencies (quite reminiscent of 2008).

From a high of 1.60 (to the $) in July 2008, the euro sank to 1.25 during the worst of the crisis in October. On a fundamental basis, the euro would appear much more vulnerable today than it was during 2008. And while I would assume that there has been less speculative long buying buoying the euro of late, there has likely been significant hedging activity to protect against a major euro breakdown.   This type of hedging activity would tend to increase volatility – which has been the case recently. And it would also increase the risk of an accelerating euro decline – and general currency market instability – in the event the euro begins to break through important levels.   This is a big market worry.

From my perspective, the post-2008 landscape has been one of myriad Bubbles enveloping the globe. I believe China is in the midst of a historic Credit Bubble. Looking at rampant Credit and speculative excesses throughout the “developing” markets, I see ample confirmation of the Bubble thesis there as well. In hindsight, it should be indisputable that the massive issuance of debt (at artificially low borrowing costs) throughout the European periphery was a major Bubble. And I am very comfortable with the view that Washington policymaking – and resulting dollar devaluation – were fundamental to the global inflationary Bubble backdrop. From my perspective, the Treasury market has evolved into a most precarious Bubble of mispriced finance, over-issuance and severe market distortions of great consequence.

Analysis is a lot simpler in hindsight. From my analytical perspective, the sequence of how these global Bubbles might falter wasn’t obvious. Who would go first? China, Europe, “developing,” Treasurys, etc. It would make a big difference on how things would be expected to unfold. Now, with the bursting of the sovereign debt Bubble in Europe, kindred Bubbles are in jeopardy. Markets are under pressure, finance has tightened meaningfully, and faltering confidence is a major issue in Europe, the U.S. and beyond.

A strong case can be made that the global economy will prove less resilient than 2008. Credit excess over the past few years throughout the “developing” economies is a source of concern. China, Brazil, India, Russia, Mexico and others were at robust phases of their respective Credit cycles when the global crisis hit in 2008. Their markets, Credit systems and economies bounced back quickly - and proved the growth locomotive for global recovery. I fear recent excesses have created unappreciated vulnerabilities.

For now, Europe will likely remain the focal point. The continent’s debt structure is a major issue. Huge deficits have been financed by their banking sector. As confidence in sovereign debt falters, banking system stability crumbles. Here at home, we today enjoy a different dynamic. Most of our federal debt has been purchased by the People’s Bank of China, The Federal Reserve, The Bank of Japan and “developing” central banks around the world. In the short term, our debt structure is proving much more stable than Europe’s. Our banks look better by comparison – and our Treasury market appears bulletproof. The ECB has been forced into its version of “QE3”, while our divided Fed may not be as quick with additional quantitative easing as markets had expected. And perhaps, at least for now, we won’t have the world’s preeminent policy-induced currency devaluation – as the speculative trading world had confidently assumed.   Or, stated differently, shorting dollars to fund inflating “undollar” risk markets around the globe might not be the sure bet many were presuming.

But let’s not digress…   What we do know is that acute market instability has again reared its ugly head. Policymakers are reacting, of course. To this point, policy measures have succeeded in thwarting a breakdown. I am skeptical that policymaking will so easily stabilize the markets. The Fed’s move to pre-commit to “pegged” zero rates for a couple more years may somewhat benefit the speculating community – while throwing a volatile mixture on the Treasury Bubble. But who believes this is fair to savers or the right medicine for our economy?   And Europe will be walking a tightrope, as they struggle to support the faltering periphery without imperiling the system’s core. And as contagion effects continue to mount, it will come down to the markets’ view of the German taxpayer’s willingness to backstop the continent.

Sovereign debt crisis means all the easy solutions have been expended – and all the proven and conventional ones as well. When former vice Chairman of the Federal Reserve Alan Blinder was asked to comment on National Public Radio about the Fed’s new rate policy, he chuckled and said “they’re desperate.” I’ll assume it was nervous laughter. I will also presume that the marketplace will be increasingly unnerved that desperate policy measures risk destabilizing already highly unstable global markets (5% daily swings in equities; abrupt 4 point moves in bonds; 5% in currencies…). Are there any “safe havens”? There were in ’08. And all this equates to myriad market and economic uncertainties, including the risk of ongoing de-risking and de-leveraging. Best I can tell, the strongest bull argument going is that governments will support the markets. Well, the markets are in a world of hurt when that faith evaporates. This wasn’t much of an issue in 2008.

The Return of the Bear by Steve Keen

2011-08-12T21:00:00.000-05:00

Return of the Bear

On Gold, Stocks, Cash and Inflation

2011-08-12T20:40:00.004-05:00

Shiller PE on Stocks = 20.34 as of today
Approximate yield on long term investment grade corporate bonds = 5.40%
Approximate yield on S&P 500 as of today = 2.08%

In a world with zero or negative economic growth, as is the likely scenario I see over the next 10+ years, it makes sense that stocks, securities with theoretically infinite duration and inferior capital structure location, should yield more than long term investment grade corporate bonds. Based on the current dividend yields, this would indicate an S&P 500 that is at 450 or lower.

Gold is in a bubble. I totally understand the logic behind owning gold in an environment in which central bankers are being reckless with global currencies, but nevertheless it is in a bubble. It has been up every year for the past decade. Being bearish of gold is now a contentious stance. Everyone that thinks they are much better off owning gold than owning treasury bonds are not understanding the system in which they are investing. We live in a dollar system. It is the reserve currency. The U.S. bond market, even yielding depression like rates, will still return a fixed amount of dollar bills at maturity and will likely be available for sale at very near par for quite some time. Holders of gold cannot say that. Sure, gold may be worth twice as much in ten years, but it may also be worth half as much. In ten years, there is no guarantee how many dollars you will get for your gold. In a world that is dealing with contracting credit, dollar bills and their proxies will be more easily exchanged for attractively priced financial assets than gold will be. The preferred financial medium, as it stands, is still dollar bills. Gold is not money, it is a real asset.

Longer term owning cash and dollar denominated fixed income assets will likely be a losing proposition. Once the credit bubble (also known as the inflation of the past 30+ years) is unwound we will likely begin a new long term credit growth cycle that will be very harmful for dollar bills. In this environment owning claims on real productive assets (equity) will be more attractive than owning fixed dollar claims (fixed income).

Lastly, people expecting severe and immediate inflation are IMHO missing a crucial step in the analysis. The step involves where the money supply comes from. A majority of the U.S. money supply, or the printed dollars and money that are in circulation, have originated in the private U.S. banking system. In other words, this 'money' is really just credit that has been extended by the banks. As debts are defaulted on, as is requisite when asset prices and income levels no longer support debts, the supply of money aggregates shrinks. This is the old axiom, "Debts that cannot be paid, will not be paid." It has taken the current stock of money and money aggregates just to get us to the aggregate price levels that we see in all markets today. As money aggregates get destroyed (defaulted on) there are fewer and fewer dollars chasing the available supply of assets. Also, there are psychological forces at play when price levels begin to fall. Buyers begin to prefer to hold cash as asset prices continue to decline, which is a feedback loop that precipitates further price declines. Call it anti-animal spirits.

I don't think that too many people that believe in hyperinflation would dispute anything that I said in the previous paragraph. There are a few points where I believe my analysis differs from theirs. The most important point is regarding the absolute level of the U.S. denominated private debt stock. The number, at $40 trillion or so, is a formidable counterweight to quantitative easing. The private debt stock has already declined by about $6 trillion since 2008 which goes a long way to explaining why the massive quantitative easing programs of the Federal Reserve have not resulted in a hyperinflation, or even elevated inflation, already. The massive inflation that everyone is looking for, has already taken place. It has just taken place at a measured pace over a long period of time, sponsored by our central banks. Additionally, if inflation does somehow pick up as a result of money printing (or lending) by the Federal Reserve, interest rates will increase. This increase in interest rates will make the mark-to-market value of the current private debt stocks decline (which is analogous to shrinking the supply of money aggregates) while the increase in rates will make debt service more difficult and even more likely to default over time. Deflation can occur in both rising and falling yield environments. Just ask Greece or Japan.

Jim Grant on Gold & European Bank Leverage

2011-08-11T21:29:00.000-05:00

The Goings On in Europe & a Word on Financial Journalism

2011-08-11T19:40:00.002-05:00

The European sovereign crisis has quickly morphed into a European banking crisis. Financial institutions around the world are limiting their exposure to European banks and it is just a matter of time before a bank or a country goes under. Additionally, anyone and everyone that reads this consider yourself warned...CNBC is an absolute disaster during times like this. They are paid to do everything they can do to keep you in the market. You get nothing but sell-side nut jobs strolling around talking about how cheap everything is and how the problems in Europe are transitory etc. If anybody comes on trying to tell the truth about how bad things really are in the world, they get chastised, shunned, and talked over. If things in Europe are so great then why is country after country getting locked out of the capital markets??? If it were just the smaller periphery countries that were in trouble the EFSF would probably be fine. But when you add Spain and Italy, number 12 and number 8 in world GDP respectively, onto the list of the problem countries, the problem becomes obvious. Not even Germany can shoulder that responsibility.

Nevertheless, I think we have seen the first warning crashes of a financial crisis that will likely end in a collapse of the European banking system, a reworking of the EU, an elimination of the euro currency, or some combination of these. The knock-on effects on already unbalanced and over-leveraged global economies will be unparalleled and could even surpass the chaos that occurred in late 2008. The bond market is telling us that we are in the midst of a deflationary depression and it is just a matter of time before equity prices re-calibrate to reflect this truth.

Please, I beg you, don't listen to the talking heads like Jim Cramer and the various sell-side analysts and asset managers that come on CNBC to tell you that everything is fine and that stocks are a great buy. Listening to these clowns is a sure-fire way to lose money. I do nothing but read about finance and economics all day and I work at a hedge fund and I can tell you for a fact that the smart money does not listen to these people. One third of all people in the state of Alabama are on food stamps and even nationwide that figure is one in seven. The unemployment rate even if measured in the generous way that we measured it in the 1990's is closer to 13% and our labor force participation rate is declining. On top of that, our country is running a $1.3 trillion deficit just to maintain this sad status quo!!! These are all signs that WE ARE IN A DEPRESSION. It started in 2008 and will likely be several years before we begin to see the light at the end of the tunnel. Existing unsustainable debts world-wide (both public and private) need to be repudiated before credit can grow again and this nightmare of an economic downturn can finally be put behind us.

Whalen & Rosner on European Banking Crisis

2011-08-10T21:41:00.000-05:00

Relentless Growth of Government

2011-07-27T09:46:00.005-05:00

Here are a couple of charts that I put together from publicly available information. They show 1) that taxes are not particularly low on a historical basis, and 2) that there has been a persistent rise in the amount of government that this country is consuming. The government is becoming a larger and larger portion of our economy, which is an issue that Americans need to begin thinking seriously about from both a philosophical and financial standpoint.

"My reading of history convinces me that most bad government results from too much government."
Thomas Jefferson

Revenue GDP

List of Countries w/ Lower 1YR CDS rates than U.S.

2011-07-27T08:53:00.001-05:00

Welcome to the twilight zone...here are the countries, as of this morning, with a lower 1 YR CDS spread than the U.S.

Sweden 8.21
Norway 9.04
Finland 10.87
Switzerland 13.50
Germany 17.10
United Kingdom 20.68
Netherlands 22.48
Denmark 25.17
France 30.71
Abu Dhabi 30.95
China 32.03
Philippines 32.95
Malaysia 34.73
South Africa 34.80
Czech Republic 35.44
Japan 35.92
Panama 36.45
Australia 37.20
Chile 37.34
Austria 38.73
Indonesia 39.76
Mexico 41.41
South Korea 42.57
Colombia 42.73
Brazil 43.97
Slovak Republic 45.73
Peru 46.69
Russia 46.76
New Zealand 46.76
Qatar 56.20
Thailand 56.49
Israel 60.31
Kazakhstan 61.31
Poland 62.41
Belgium 72.12
Turkey 72.84
Saudi Arabia 76.52
U.S.A. 76.66

In response to this, I have to echo what Robert Barro said in this morning's journal:

"A default on U.S. government bonds would be awful, but there's no way it has to happen. In fact, Treasury Secretary Tim Geithner should take this issue off the table by announcing that if the debt ceiling is not raised he would use the available federal revenue first to cover the required payments on U.S. bonds. Any other course of action would be deeply irresponsible."

More Buffett Nostalgia

2011-07-23T22:29:00.000-05:00

Me asking Buffett a question on Squawk Box on March 1, 2010.

Howard Marks--Down to the Wire

2011-07-23T13:39:00.002-05:00

Howard Marks Debt Ceiling

Back to the Basics by John Mauldin

2011-07-17T08:18:00.003-05:00

Back to the Basics

By John Mauldin | July 15, 2011

In this issue:
GDP = C + I + G + Net Exports
Increasing Productivity
The Trillion Dollar Question
A Summer of Ultimatums
Vancouver, New York, and Maine

This week we are going to revisit some themes concerning the problems of the debt and the deficit. I am getting a number of questions, so while long-time readers may have read most of this in one letter or another, it is clearly time for a review, especially given the deficit/debt-ceiling debate. I will probably offend some cherished beliefs of most readers, but that is the nature of the times we live in. It is the time of the Endgame, where things are not as black and white as they have been in the past.
Let’s begin with a question that is representative of a lot of the questions I have been getting, from reader John:
“John, it appears that you're arguing that two contradictory things have the same effect: adding government spending doesn't help the economy, and reducing government spending hurts the economy. Which is it? At first, you say that adding government spending doesn't help, no new jobs are actually created, it fails the sharp pencil test, etc. So, we should reduce this waste, right? Well, yes, you say, but that will reduce GDP too. I just don't get it. You seem to have it both ways: increasing government spending is bad, and reducing it is bad. What is your point?”
Yes, I am saying both things, and they are not contradictory. We are coming to the end of the debt supercycle in the US, and have reached that point in much of Europe, and soon will in Japan. So while I am going to focus on the US, at least this week, the same principles apply to all the developed world.
For some 65-odd years, we have added to the national debt – individually, corporately, and as governments. But as Greece is finding out, there is a limit (more on that later). Eventually the bond market decides that loaning you more money is not a high-value proposition. If your home or your government is debt financed, you are forced to cut back. While the US is not there yet, we soon (as in a few years) will be.
One way or another, the budget deficits are going to come down. As we will see later, we can choose to proactively deal with the deficit problem or we can wait until there is a crisis and be forced to react. These choices result in entirely different outcomes.
In the US, the real question we must ask ourselves as a nation is, “How much health care do we want and how do we want to pay for it?” Everything else can be dealt with if we get that basic question answered. We can radically cut health care along with other discretionary budget items, or we can raise taxes, or some combination. Both have consequences. The polls say a large, bipartisan majority of people want to maintain Medicare and other health programs (perhaps reformed), and yet a large bipartisan majority does not want a tax increase. We can’t have it both ways, which means there is a major job of education to be done.
The point of the exercise is to reduce the deficit over 5-6 years to below the growth rate of nominal GDP (which includes inflation). A country can run a deficit below that rate forever, without endangering its economic survival. While it may be wiser to run some surpluses and pay down debt, if you keep your fiscal deficits lower than income growth, over time the debt becomes less of an issue.

GDP = C + I + G + Net Exports

But either raising taxes or cutting spending has side effects that cannot be ignored. Either one or both will make it more difficult for the economy to grow. Let’s quickly look at a few basic economic equations. The first is GDP = C + I + G + net exports, or GDP is equal to Consumption (Consumer and Business) + Investment + Government Spending + Net Exports (Exports – Imports). This is true for all times and countries.
Now, what typically happens in a business-cycle recession is that, as businesses produce too many goods and start to cut back, consumption falls; and the Keynesian response is to increase government spending in order to assist the economy to start buying and spending; and the theory is that when the economy recovers you can reduce government spending as a percentage of the economy – except that has not happened for a long time. Government spending just kept going up. In response to the Great Recession, government (both parties) increased spending massively. And it did have an effect. But it wasn’t just the cost of the stimulus, it was the absolute size of government that increased as well.
And now massive deficits are projected for a very long time, unless we make changes. The problem is that taking away that deficit spending is going to be the reverse of the stimulus – a negative stimulus if you will. Why? Because the economy is not growing fast enough to overcome the loss of that stimulus. We will notice it. This is a short-term effect, which most economists agree will last 4-5 quarters; and then the economy may be better, with lower deficits and smaller government.
However, in order to get the deficit under control, we are talking on the order of reducing the deficit by 1% of GDP every year for 5-6 years. That is a very large headwind on growth, if you reduce potential nominal GDP by 1% a year in a world of a 2% Muddle Through economy. (And GDP for the US came in at an anemic 1.75% yesterday, with very weak final demand.)
Further, tax increases reduce GDP by anywhere from 1 to 3 times the size of the increase, depending on which academic study you choose. Large tax increases will reduce GDP and potential GDP. That may be the price we want to pay as a country, but we need to recognize that there is a hit to growth and employment. Those who argue that taking away the Bush tax cuts will have no effect on the economy are simply not dealing with either the facts or the well-established research. (Now, that is different from the argument that says we should allow them to expire anyway.)

Increasing Productivity

There are only two ways to grow an economy. Just two. You can increase the working-age population or you can increase productivity. That’s it. No secret sauce. The key is for us to figure out how to increase productivity. Let’s refer again to our equation:
GDP = C + I + G + net exports
The I in the equation is investments. That is what produces the tools and businesses that make “stuff” and buy and sell services. Increasing government spending, G, does not increase productivity. It transfers taxes taken from one sector of the economy and to another, with a cost of transfer, of course. While the people who get the transfer payments and services certainly feel better off, those who pay taxes are left with less to invest in private businesses that actually increase productivity. As I have shown elsewhere, over the last two decades, the net new jobs in the US have come from business start-ups. Not large businesses (they are a net drag) and not even small businesses. Understand, some of those start-ups became Google and Apple, etc.; but many just become good small businesses, hiring 5-10-50-100 people. But the cumulative effect is growth in productivity and the economy.
Now, if you mess with our equation, what you find is that Investments = Savings.
If the government “dis-saves” or runs deficits, it takes away potential savings from private investments. That money has to come from somewhere. Of late, it has come from QE2, but that is going away soon. And again, let’s be very clear. It is private investment that increases productivity, which allows for growth, which produces jobs. Yes, if the government takes money from one group and employs another, those are real jobs; but that is money that could have been put to use in private business investment. It is the government saying we know how to create jobs better than the taxpayers and businesses we take the taxes from.
This is not to argue against government and taxes. There are true roles for government. The discussion we must now have is how much government we want, and recognize that there are costs to large government involvement in the economy. How large a drag can government be? Let’s look at a few charts. The first two are from my friend Louis Gave, of GaveKal. This first one reveals the correlation between the growth of GDP in France and the size of government. It shows the rate of growth in GDP and the ratio of the size of the public sector in relation to the private sector. The larger the percentage of government in the ratio, the lower the growth.

I know, you think this is just the French. We all know their government is too involved in everything, don’t we. But it works in the US as well. The chart below shows the combined US federal, state, and local expenditures as a percentage of GDP (left-hand scale, which is inverted) versus the 7-year structural growth rate, shown on the right-hand side. And you see a very clear correlation between the size of total government and structural growth. This chart and others like it can be done for countries all over the world.

Now let’s review a graph from Rob Arnott of Research Affiliates. The chart needs a little setup. It shows the contributions of the private sector and the public sector to GDP. Remember, the C in our equation was private and business consumption. The G is government. And G makes up a rather large portion of overall GDP.
The top line (in dark blue) is real GDP per capita. The next line (yellow) shows what GDP would have been without borrowing. So a very real portion of GDP the last few years has come from government debt. Now, the green line below that is private-sector GDP. This is sad, because it shows that the private sector, per capita, is roughly where it was in 1998. The growth of the “economy” has been limited to government.

Notice that real GDP without government spending or deficits has been flat for 15 years (which, as a sidebar, also explains why real wages for private individuals are flat as well, but that’s a topic for another letter). Now, here is what to pay attention to. For the last several years, the real growth in GDP has come from the US government borrowing money. Without that growth in debt, we would be in what most would characterize as a depression.
This is why Paul Krugman and his fellow neo-Keynesians argue that we need larger deficits, not smaller ones. For them the issue is final aggregate consumer demand, and they believe you can stimulate that by giving people money to spend and letting future generations pay for that spending. And sine WW2 they have been right, kind of. When the US has gone into a recession, the government has embarked on deficit spending and the economy has recovered. The Keynesians see cause and effect. And thus they argue we now need more “hair of the dog” to prompt the recovery, which is clearly starting to lag behind what they think of as normal growth.
But others (and I am in this camp) argue that business-cycle recessions are normal and that recoveries would come anyway, and are not caused by increased government debt and spending but by businesses adjusting and entrepreneurs creating new companies. Correlation is not causation. Just because recoveries happened when the government ran deficits does not mean that they were the result of government spending. This is not to argue that the government should not step in with a safety net for the unemployed – again, a subject for another letter.
Let’s see what Rob Arnott says about this conundrum:
“GDP is consumer spending, plus government outlays, plus gross investments, plus exports, minus imports. With the exception of exports, GDP measures spending. The problem is, GDP makes no distinction between debt-financed spending and spending that we can cover out of current income.
“Consumption is not prosperity. The credit-addicted family measures its success by how much it is able to spend, applauding any new source of credit, regardless of the family income or ability to repay. The credit-addicted family enjoys a rising “family GDP” – consumption – as long as they can find new lenders, and suffers a family “recession” when they prudently cut up their credit cards.
“In much the same way, the current definition of GDP causes us to ignore the fact that we are mortgaging our future to feed current consumption. Worse, like the credit-addicted family, we can consciously game our GDP and GDP growth rates – our consumption and consumption growth – at any levels our creditors will permit!
“Consider a simple thought experiment. Let’s suppose the government wants to dazzle us with 5% growth next quarter (equivalent to 20% annualized growth!). If they borrow an additional 5% of GDP in new additional debt and spend it immediately, this magnificent GDPgrowth is achieved! We would all see it as phony growth, sabotaging our national balance sheet – right? Maybe not. We are already borrowing and spending 2% to 3% each quarter, equivalent to 10% to 12% of GDP, and yet few observers have decried this as artificial GDP growth because we’re not accustomed to looking at the underlying GDP before deficit spending!
“From this perspective, real GDP seems unreal, at best. GDP that stems from new debt – mainly deficit spending – is phony: it is debt-financed consumption, not prosperity. Isn’t GDPafter excluding net new debt obligations a more relevant measure? Deficit spending is supposed to trigger growth in the remainder of the economy, net of deficit-financed spending, which we can call our “Structural GDP.” If Structural GDP fails to grow as a consequence of our deficits, then deficit spending has failed in its sole and singular purpose.
“Of course, even Structural GDP offers a misleading picture. Our Structural GDP has grown nearly 100-fold in the last 70 years. Most of that growth is due to inflation and population growth; a truer measure of the prosperity of the average citizen must adjust for these effects.”
And thus the graph above showing private GDP and the difference in the GDP numbers that are reported in the media. I used Rob’s entire (and brilliant) piece as an Outside the Box last May. If you missed it, you can go to http://www.johnmauldin.com/outsidethebox/does-unreal-gdp-drive-our-policy-choices/ and review it.

The Trillion Dollar Question

Now, in our review, let’s get back to reader John’s question. I have used this chart before, but it bears another quick look. This is from the Heritage Foundation. It is a year old, and one can quibble about the specifics. That is not the point of today’s issue. The point is that, whatever the deficit is, it is huge. This is a chart of something that will not happen, as the bond market will simply not finance a deficit as large as the one that looms in our future. Long before we get to 2019, we will have our own Greek (or Irish or Portuguese or Japanese, etc.) moment. (Or Spanish or Italian or Belgian – so many countries, so much debt!)

For the sake of the argument and our thought experiment, let’s split the difference on that chart. Somehow we must then find about $1.2 trillion in cuts or taxes to get the deficit down to below the growth rate of nominal GDP. And another few hundred billion if we actually want to balance the budget.
And that, gentle reader, is no small hill to climb. Let’s say we cut spending and/or raise taxes by $200 billion a year for 6 years. That is more than 1% of GDP each and every year! Go back to the first chart. That means that potential GDP growth will be reduced by over 1% a year! Every year. We would need to rely upon private GDP growth, which Rob’s chart shows has been flat for almost 15 years! The growth of the last 11 years has been a government-financed illusion.
There are no good choices. The time for good choices was years ago. I was and still am a fan of the Bush tax cuts. They were not the problem; a few years after the cuts, tax revenues were up considerably. The problem was a profligate Republican Congress which allowed spending to rise even more. And you can’t just blame it on the wars. That contributed, but it was not even close to the lion’s share. If we had held the line on spending, we would have paid off the entire debt and been in good shape when the crisis hit in 2008. The following graph is from today’s Wall Street Journal editorial page. They use it to show how much Democrats allowed the budget in terms of GDP to rise and spin out of control.
I would point out that in the 8 previous years, under Bush/Hastert/Delay et al., there was also a rise in the growth of government, as the chart shows. While it was not as large, it was clearly there. The drop in the previous period was the Bill Clinton/Newt Gingrich years. How many people are nostalgic for that pairing? Say what you will about them, their collaboration was a good era for growth in the private sector – the last we have had.

And that is the crux of the problem. Either we willingly cut the deficit by a far more significant amount than anyone is discussing, or we hit the wall at some point and become Greece. $4 trillion? No, let’s talk about 10 or 12.
And that, John, is the problem. We have painted ourselves into the corner of no good choices. We are left with difficult and disastrous choices. We have condemned ourselves to a slow-growth, Muddle Through Economy for another 5-6 years, at best, as we are forced to right-size government. If we raise taxes to partially solve the problem, we have to recognize that higher taxes will result in slower private growth. That’s just the rules. There are no easy buttons to push.
So, we must cut spending and the deficit, and yes, it is going to slow the economy for a period of time. The economic literature suggests that a spending cut will have 4-5 quarters of effect and then be neutral going forward. But we are going to have to make those cuts year after year after year.
I know the Tea Party types want to do it all at once, but that would guarantee a decade-long depression. You just really don’t want to go there. It MUST be a slower, controlled “glide-path” approach. I wrote about this back in 2009, along with all the other options. Nothing has changed: http://www.johnmauldin.com/frontlinethoughts/the-glide-path-option-mwo110609/.
The present contains all possible futures. But not all futures are good ones. Some can be quite cruel. The one we actually get is determined by the choices we make.
It is getting time to close, so a few quick observations. While choosing a President and Congress next year will be a referendum of sorts, I would like to see a real, non-binding referendum appear on our primary ballots. How much Medicare do we want? Should we raise taxes? How do we get to $10 trillion in cuts? You would have to confirm you have read a 20-page document outlining the choices and consequences, and that should be posted everywhere and mailed to everyone. We need to have a real national conversation.p>
If Obama says he wants $4 trillion in cuts, then let him give us details rather than asking Congress to give him a plan, as he did today. He has his brain trust; surely they can come up with some details. The problem is that if he offers specifics he will have to show his supporters what he is willing to cut. And those cuts will not be without pain.
The real issue, as I have said, will boil down to how much Medicare we want and how we want to pay for it. Congressman Ryan’s cuts don’t get us even halfway there.

A Summer of Ultimatums

In closing, this from my friends at GaveKal:
“ In the past 24 hours, we have seen the Greek deputy finance minister announce that Athens would fall far short of planned asset sales (this can only come as a surprise to investors born yesterday) and the Greek prime minister publish an open letter to Eurogroup Chairman Juncker warning that Greece has done all that it could. Mr Panandreaou went on to say that the onus is now on European policymakers to meet in a closed forum, with no damaging press leaks, and emerge with a strong, unambiguous message – we have to assume that the irony of asking for more secrecy through an open letter to the general media was perhaps lost on the Greek PM. Diplomacy aside, it seems that Greece is placing an ultimatum on Europe and this for a very simple reason: the end game for the EMU is approaching much faster than most investors had expected. Indeed, the choice between fiscal union or disintegration may well have to be faced this very summer.
“In his eloquent letter, Papandreou boldly stated that, in essence, Greece is no longer prepared to make further concessions and will thus blow up Europe's financial system if it is subjected to any more pressure. In other words, it is now time for all additional concessions to come from the side of Germany, the ECB and the EU. The willingness of Papandreou to speak so boldly is hugely important since it marks a recognition by the debtors that they now have the whip-hand in these negotiations. The Greeks (and Irish) for some reason failed to realize their power last year, but they do now. This transforms the balance of power in the negotiations. As a result, Germany and the ECB have reached the moment of truth – either they comply with the debtor countries' demands or they abandon the euro. This ultimatum probably helps explain why the euro has been so weak and why it should be heading even lower.”
There will be yet another emergency meeting next Thursday. The crisis is coming to the final innings. Will Germany and the ECB finance Greece? Print money in a fashion that would make Bernanke and Krugman envious? But if we in the US do not get our own act together, in the not-too-distant future we will face our own moment of truth as the bond market forces us to choose between disastrous and worse. The cuts we will have to make under pressure will be far worse than those we can make now.
I will probably write about Europe next week. I think the brewing crisis could cause a banking crisis and a recession in Europe, which, just as our subprime crisis caused world pain and a global recession, will also bring their pain to our shores. We are not immune. Stay tuned.

Vancouver, New York, and Maine

In a few weeks I head to Vancouver and then to New York City and Maine for the annual fishing trip, one of the outings I truly look forward to each year. Both cities and Maine will afford me memorable times with great friends, which is one of the things that gives life meaning and makes it fun and keeps me young.
And speaking of young, I must admit to a guilty pleasure. I am a Harry Potter fan, and tonight I am going to see the final episode. Joe Morgenstern of the Wall Street Journal, and my favorite movie reviewer, gave it rave reviews. While I have not read the books, I have followed the story and am looking forward to the final chapter. But it is bittersweet, as I will miss my friends who I have watched for all these years. And to watch the film-making technology change over time has been a revelation, too. What a world we live in.
Time to hit the send button. Enjoy your week and spend it with friends when you can.
Your just another muggle tonight analyst,
John Mauldin

Steve Keen Debunking Economics

2011-07-15T18:49:00.001-05:00

More Van Hoisington Brilliance

2011-07-13T12:42:00.000-05:00

These guys get it...

HIM2011Q2NP

Dr. Steve Keen On the Edge with Max Keiser

2011-07-10T19:18:00.001-05:00

One of Max Keiser's best, and most disciplined, interviews is this one with Dr. Steve Keen. Keen rightly points out the argument for deflation In absentia even more massive money printing from the central banks. The problem with keeping a debt bubble afloat is finding more and more parties that are both willing and capable of taking on more debt. The last un-infected balance sheet in the U.S. (and many other locales around the developed world), is the sovereign, but it is quickly becoming politically untenable to add more debt there. Deflation will likely be the dominant theme in the next decade as the Federal Reserve will be influenced by politics as well, and not have the fire power to counter the Japanese disease. When analyzing the sheer numbers involved with this collapsing debt bubble, it becomes clear that the Federal Reserve would need to print enormous amounts of money, just to keep up with the collapsing amount of money aggregates in the economy. I am thoroughly impressed with Dr. Keen's analysis, and I think he may be one of the very few that is getting it right.

Economic Rebound "Not Happening" in 2011

2011-07-10T10:28:00.000-05:00

Achuthan of the ECRI has been more correct than most with his forecasts of late. Last summer for example when many economists started calling for a double dip, he was among the few that refuted the argument. Now, when many economists are calling for a second half recovery, he is on the other side. Worth a listen.

What Happened to the Jobs? by John Mauldin

2011-07-09T17:49:00.000-05:00

The US jobs report came out this morning, and it was simply dismal. This week we look at not only the jobs report but also “what-if” proffers for the US and global economies. There’s a lot to cover, so let’s jump in.

First, there were only 18,000 jobs created in June, the lowest since September 2010. While private employment rose by 57,000, government workers dropped by 39,000, continuing a trend as governments at all levels work to cut their budgets. Long-time readers know I think it is important to look at the direction of the revisions, and we got no help. May was revised down by 29,000 jobs and April a further down 15,000.

I saw some headlines and talking heads in the mainstream media saying the poor number was due to “seasonals,” and I just shook my head. If you are that reflexively bullish when presented with what was clearly a bad report, how can you be taken seriously? You know who you are. And then Philippa Dunne of the Liscio Report sent the following note. She is one of the best data mavens there is on jobs and employment.

“After the release, some bulls turned to that old reliable excuse – bad seasonals. According to one analysis making the rounds, had the BLS used last year's factor – computed, of course, using exactly the same concurrent technique as this year's factor – the gain would have been 221,000! (Whoever did this made a mistake by comparing the NSA and SA levels for the two months – you have to compare the over-the-month changes.) Still, if you're going to play this game, you should be consistent, and apply last year's seasonals to several months, not just one. If you do that, May's gain of 25,000 would turn into a loss of 19,000, and June's gain would be a mere 73,000, all total payrolls. In any case, why should you do that? The seasonals are recomputed every month based on recent experience and calendar quirks, and should be more aggressive in a recovery. (Hope we won't be using the trend set in the depth of the recession as the bar going forward.) Also, there is no adjustment to the headline number – the sectors are adjusted separately (96 different industries at the 3-digit NAICS level, to be precise) and the total is the sum of those components. The whole argument is bogus.”

The household survey was even worse. Total employment fell by 445,000. Full-time employment is down by 0.5% in the last year, while part-time is up 3%. David Rosenberg calls this the just-in-time labor market. The total number of unemployed rose to over 14 million. If you count the discouraged workers not in the official unemployed, the total number rises to 20.6 million, up 483,000 last month. This put the unemployment rate back up to 9.2%.

So How’s That Stimulus Thing Working Out?

We were told that the stimulus would have us down to 6.5% unemployment by now. The team at e21 has the real story:

“Back in January 2009, Christina Romer and Jared Bernstein of the Obama adminstration produced a report estimating future unemployment rates with and without a stimulus plan. Their estimates, which were widely circulated, projected that unemployment would approach 9% without a stimulus, but would never exceed 8% with the plan. The estimates, along with real unemployment rates, are posted below:

If you update the graph for today’s report, you find that there is another red dot higher than the last one. The last three months have seen the unemployment rate rise (chart from e21). They further note:

“For example, there is new research that suggests that the stimulus may actually have resulted in a net loss of jobs. Regardless of the exact number of jobs lost or created, however, the fact that some economists are even arguing that it had a negative impact tells you that the stimulus may very well have been a wash overall.

“Larry Lindsey offered his own review of the stimulus this week, arguing that it failed what’s colloquially known as the Sharp Pencil Test. As he explains, ‘if you sit down and do a back of the envelope calculation of the [stimulus] program’s costs and benefits, there is no way to conjure up numbers that allow it to make sense.’ Here is more on how Lindsey applies this test to the stimulus:

“ ‘[E]ven if you buy the White House’s argument that the $800 billion package created 3 million jobs, that works out to $266,000 per job. Taxing or borrowing $266,000 from the private sector to create a single job is simply not a cost effective way of putting America back to work. The long-term debt burden of that $266,000 swamps any benefit that the single job created might provide.’

“At minimum, the public now deserves a response from policymakers about what they have learned from 2009 and 2010 – about what actually does and does not help get the economy growing and producing more jobs.”

The small businesses that are the real drivers of employment are not participating the way they do in a normal recovery. Bill Dunkelberg, fishing buddy and the chief economist for the National Federation of Independent Business, writes me this afternoon:

“Writing about our current weak economy (Philadelphia Inquirer Currents, June 26), Mark Zandi argued that employment will improve because ‘…U.S. companies are in great financial shape’. Dr. Zandi must be referring to companies like GE which just posted profits of $17 billion (and paid no income taxes) and whose CEO is the head of President Obama’s job creation committee. This is the view in Washington and Wall Street that only thinks in terms of the “biggies” (that make large donations to re-election committees). For perspective, GE employs about 150,000 people in the U.S. Last week, over 400,000 people filed initial claims for unemployment (e.g. lost their jobs). There are 6 million firms in the U.S. that employ 1 or more workers. This includes GE, but 90% of them have fewer than 20 employees. These firms are not ‘in great financial shape’ as Dr. Zandi asserts. In a recent survey of a sample of 350,000 of them, 46% reported that profits were still falling two years into the ‘recovery’ compared to 18% reporting that earnings were improving. Firms like GE might hire more due to their good fortune, but there aren’t many of them and they don’t employ many workers anyway. It’s the small businesses that Treasury Secretary Geithner said must be taxed more to support government that provide the needed jobs, not ‘tax-free’ GE. Regulations such as the new mandatory sick leave passed by City Council are detrimental to the job creation needed by making labor more expensive to hire, a bad idea.

“Dr. Zandi also suggests that state and local governments be given more funding to prevent the predicted loss of 250,000 public sector jobs over the next 12 months, funded I guess by more debt, since the Federal government is a bit short of cash (like $1.5 trillion in deficit). ‘Ending this job loss would go a long way to lifting the job market,’ he asserts. My math says that would reduce job loss by about 5,000 per week. With monthly job loss over 400,000, this hardly makes a difference. Government employment has become bloated because governments don’t have to worry about profitability. When faced with budget problems, politicians tend to make cuts in services like libraries or police protection that hurt voters to show taxpayers why the government can’t live with less instead of cutting patronage jobs and the like whose efforts would not be missed. Government can’t create jobs, but it can create a lot of policies and taxes that prevent jobs from being created.”

I wrote last year about the studies that show that on a net job-creation basis, large businesses reduced their employment over the last two decades. Of course, there are exceptions; but on average, large businesses are not where you get new jobs.

And many of the jobs we got this last month, as few as they were, were not of the high-paying variety. Leisure and hospitality were up 34,000. The average work week was down, and earnings dropped a penny an hour. After inflation, workers are behind, year over year.

By the way, I get the unemployment thing. Today we found out that my daughter Amanda has lost her job. Sales at the place she worked were down a lot. Another two of my kids can’t get enough hours. At 17, Trey is looking for a job, but so far no luck. It’s tough out there. Let’s look at a few charts from David Rosenberg. First is the average duration of unemployment, which has risen to an all-time high.

Even worse, 44% of those unemployed have been so for at least six months, again close to an all-time high.

OK, I have to use just one more chart, which shows how bad things really are.

This Time Is Different

I have quoted at length in past letters from Ken Rogoff and Carmen Reinhart’s masterful work, This Time is Different. While the market may have been surprised by such a low jobs number, it is PRECISELY what is typical following a credit crisis, as they demonstrate in their book.

And now the Fed is done with QE2 (except that they will take the mortgage roll-off from their portfolio and use it to buy treasuries), and the fiscal authorities are going to put the brakes on government spending, or at least slow things down.

Everything is very fluid, but the headlines in today’s Wall Street Journal suggest a deal on the order of $4 trillion in on the table. I assume it will be back-loaded, but it is a start. But assume that the first year sees real spending cuts of $200 billion. That is a reduction of 1.5% in GDP. It’s that pesky old equation I keep using:

GDP = C (total consumption) + I (Investments) + G (government Spending) + net exports

Now, the literature suggests that the effect on the economy from a reduction in G should be over within about 4 quarters, on average. But then we reduce “G” again the next year. Maybe not by as much overall, but at least by another $50-100 billion. This is going to put a real headwind in the face of economic growth for years, but we simply have to do it or we become Greece.

The economy will already be slowing down. A recession in 2012 is a real possibility if there is any type of shock coming from Europe, and what will happen there is anyone’s guess. I think most European leaders are basing their thinking more on hope than on reality. When Greece defaults there will be a domino effect; you can count on it. And you could actually see a banking crisis before we get actual sovereign defaults.

Gentle reader, you need to understand that the market does not get it. Neither in Europe nor in the US. When someone says the market has already priced in a default, go back and ask them how well the market priced in a crisis in the spring of 2008. The market doesn’t know jack.

I got a lot of internet buzz from a throwaway line in an interview on CNBC in London. I said that if the market knew what Bernanke and the leadership of the central banks talked about after their third glass of wine, the market would wet its pants. That is not to suggest I don’t think Bernanke or Trichet can hold their liquor. It means that they get the problem more than they let on in public and are simply trying to stem as much damage as they can.

Banking crises are followed by credit crises by 2-3 years. It is getting close to that time. We need 3-3.5% GDP growth in the US to really make a dent in jobs. We are not going to get it. There is nothing we can do other than Muddle Through as best we can. Prepare accordingly.

Vancouver, New York, and Maine

I am home for a few weeks. In late July I head for Vancouver to speak at the Agora Wealth Symposium. Then the next week I go to New York for a few days, before heading up with my youngest son, Trey, to Maine for the annual Shadow Fed fish fest organized by David Kotok. It is one of the highlights of my year. So many friends are there. More on that in coming weeks.

In New York I’ll be meeting with Barry Habib. We will soon be announcing a joint venture that we are both excited about. Barry launched the Mortgage Market Guide and sold it a few years ago and is ready for a new venture. As an aside, Barry is the producer of Rock of Ages, a major Broadway hit that is now being done as a movie with Tom Cruise, Catherine Zeta-Jones, Paul Giamatti, Russell Brand, and a lot of other stars. (Barry, how do I get invited to the set?)

If you want Barry’s take on housing and mortgages, he was on CNBC this morning for an in-depth interview. I am proud to be his friend and look forward to working with him. You can see it at http://video.cnbc.com/gallery/?video=3000031675 .

That’s it for this week. I have to say, this has been one of the roughest weeks emotionally and personally for me in a very long time. Nothing that is world-ending, but sometimes being Dad is tough. This is the first week in many years that I did not get my usual 30-40 hours of reading and research in. I am so far behind, but I will catch up.

And a huge thanks to Louis and Kelli Gave, who let 14 of us invade their vacation lake home in Oklahoma with 6 of my kids and their families and friends. It was a great 4^th of July. And to see some of the tornado damage up close was amazing. We are so fragile; we have no idea.

Have a great week. Enjoy your friends and families this summer.

Your thinking more about the important things in life analyst,

John Mauldin
John@FrontlineThoughts.com

Hugh Hendry Opines on Japan Again

2011-07-04T20:36:00.001-05:00

David Stockman on Ratigan

2011-06-28T07:28:00.000-05:00

A broad critique of "crony capitalism" as well as the newly coined Blackberry Panic of 2008.

The Brilliance of George Soros

2011-06-25T16:44:00.002-05:00

I recently re-read The Alchemy of Finance by George Soros. Perhaps I was too naive when I read it the first time, but it is quite clear that the man has an impressive grip on the relationship between the real world and the financial world. I don't agree with all of his conclusions, particularly his advocation for an international central bank and his occasional anti-capitalism rants, but I certainly do respect him for his philosophical candor. The last few chapters (starting at the evaluation of the real-time experiment) are the best in the book. Even if you don't have the inclination to read the whole book I think that the ending shows the true brilliance of George Soros and the way that he thinks about life and the markets.

Here are some of the best quotes from the book (excluding any from the last few chapters):

On credit, monetarists, and collateral values:

"It has long been assumed that monetary values are a passive reflection of the state of affairs in the real world. Classical economics focused on the real world and neglected the problems connected with money and credit; even Keynes couched his general theory in real terms. Monetarists sought to stand the relationship on its head: they argue that it is possible to control inflation by controlling the growth of the money supply..."

"In my opinion, all these views are based on a fundamental misconception. Money values do not simply mirror the state of affairs in the real world; valuation is a positive act that makes an impact on the course of events. Monetary and real phenomena are connected in a reflexive fashion; that is, they influence each other mutually. The reflexive relationship manifests itself most clearly in the use and abuse of credit."

"Loans are based on the lender's estimation of the borrower's ability to service his debt. The valuation of the collateral is supposed to be independent of the act of lending; but in actual fact the act of lending can affect the value of the collateral. This is true of the individual case and of the economy as a whole. Credit expansion stimulates the economy and enhances collateral values; the repayment or contraction of credit has a depressing influence both on the economy and on the valuation of the collateral. The connection between credit and economic activity is anything but constant--for instance, credit for building a new factory has quite a different effect from credit for a leveraged buyout. This makes it difficult to quantify the connection between credit and economic activity. Yet it is a mistake to ignore it. The monetarist school has done so, with disastrous consequences."

On Economics as a Science:

"To preserve the integrity of economic theory as an axiomatic system, its assumptions ought to be explicitly stated. We may then conclude that economic theory is no more relevant to the real world than non-Euclidean geometry, but at least we would know where we stand. Instead, we have been deceived by a methodological subterfuge."

"Social scientists have gone to great lengths trying to maintain the unity of method but with remarkably little success. Their endeavors have yielded little more than a parody of natural science. In a sense, the attempt to impose the methods of natural science on social phenomena is comparable to the efforts of alchemists who sought to apply the methods of magic to the field of natural science. But while the failure of the alchemists was well-nigh total, social scientists have managed to make a considerable impact on their subject matter. Situations which have thinking participants may be impervious to the methods of natural science, but they are susceptible to the methods of alchemy. The thinking of participants, exactly because it is not governed by reality, is easily influenced by theories. In the field of natural phenomena, scientific method is effective only when its theories are valid; but in social, political, and economic matters, theories can be effective without being valid. Whereas alchemy has failed as natural science, social science can succeed as alchemy."

On the International Debt Problem

"The self-validating process of credit expansion--inflation for short--was unsound in more ways than one. Prices and wages rose at accelerating rates. Balance-of-payments deficits and surpluses were perpetuated. The balance sheets of the banks deteriorated. Much of the investment activity financed by bank lending was misdirected. The creditworthiness of the debtors was illusory. Yet, as long as the process validated itself, the world economy prospered. Consumption remained high while saving was discouraged by low or negative interest rates. Investment was stimulated by the availability of cheap loans, and there was a flight from monetary to real assets. The combination of high consumption, high inventories, and strong investment activity created boom conditions."

"I contend that the central banks were acting under the influence of a false ideology. It was a time when monetarism was gaining ground among central bankers. Monetarism holds that inflation is a function of money and not of credit. If monetarism is valid, the growth of money supply needs to be regulated, not the growth of credit."

On Friedman's Floating Rate Monetary Contraption

"Money shows up on one side of the balance sheet of banks and credit on the other. Milton Friedman tells us that it is the money side that counts because the other side is determined by the money side. The theory of reflexivity leads me to believe that his theory is wrong. I would expect that the two sides influence each other in a reflexive fashion, and his dream of controlling the money supply is impractical. I lack sufficient expertise to take him on directly, but I can point to the empirical evidence that shows that the money supply always fails to behave in accordance with the regulators' wishes."

On The Collective System of Lending and how it Interacts with the International Debt Problem

"There can be no doubt that without the active and imaginative intervention of the authorities the international debt crisis would have led to the collapse of the banking system, with disastrous consequences for the world economy. The last time such a collapse occurred was in the 1930s."

"The institutional setup gives central banks the authority, and obligation, to act as lenders of last resort. But the debt problem was too big to be handled by providing liquidity to the banks. The amounts involved far exceeded the banks' own capital; if the countries in question had been allowed to go into default, the banking system would have become insolvent. Accordingly, the central banks exceeded their traditional role and banded together to bail out the debtor countries."

"The Collective system of lending operates on the principle of voluntary cooperation. The regulatory authorities had to exert themselves to make it possible for the heavily involved banks to extend new loans and to induce less involved banks to cooperate. The only way they could achieve these objectives was by maintaining the fiction that the outstanding loans were unimpaired and no special reserves had to be set up against them. There was some divergence of opinion among the various supervisory agencies but the Federal Reserve, as lender of last resort, maintained the upper hand. The banking system was considered too weak to be given any strong medicine. Accounting standards were modified and special efforts were made to enable banks to meet them."

"The banking crisis of 1984 has left us with an unresolved dilemma. There is a basic imbalance in deregulating deposit-taking institutions and guaranteeing depositors against loss. The guarantee enables financial institutions to attract additional deposits at will, and deregulation gives them wide latitude in putting those deposits to use. The combination of the two is an invitation to unrestrained credit expansion. The problem has been inherent in the system of Federal deposit insurance since its inception, but at the time the FDIC was founded banks were strictly regulated. The imbalance between risk and reward became more pronounced as the trend toward deregulation gained momentum, and it reached a critical point in the crisis of 1984."

"The Federal Reserve was forced to expand its role as lender of last resort and guarantee all depositors against loss whatever the size of their deposits. This removed the last vestige of the discipline that depositors are supposed to impose on banks. In the absence of that discipline there is nothing left but the regulatory authorities to stop financial institutions from engaging in unsound lending practices."

The Bonfire of the Currencies by Jim Grant

2011-06-17T18:27:00.000-05:00

Courtesy of the CFA Institute, here is the keynote presentation at the CFA Institute 2011 Annual Conference.

Greatness

http://www.cfainstitute.org/learning/products/multimedia/Pages/56028.aspx

Weekly Update by Doug Noland

2011-06-13T07:28:00.001-05:00

The King of Non-Productive Debt by Doug Noland

http://www.prudentbear.com/index.php/creditbubblebulletinview?art_id=10541

There is important confirmation of the “bear” thesis to discuss. But, as usual, let’s first set the backdrop:

The world is in the midst of history’s greatest Credit Bubble. A dysfunctional global financial system essentially operates without mechanisms to regulate the quantity and quality of debt issuance. In response to severe banking system impairment and fiscal problems in the early-nineties, the Greenspan Fed helped nurture a Credit system shift to nontraditional marketable debt. The bank loan was largely replaced by mortgage-backed securities (MBS), asset-backed securities (ABS), GSE debt instruments, derivatives and a multitude of sophisticated “Wall Street” Credit instruments. The Credit expansion grew exponentially, while becoming increasingly detached from production and economic wealth-creation (the boom, in fact, exacerbated deindustrialization).

The Fed implemented momentous changes in monetary management to bolster the new “marketable debt” Credit system structure, including “pegging” short-term interest rates; serial interventions to assure “liquid and continuous markets;” and adopting an “asymmetrical” policy framework that disregarded asset inflation/Bubbles, while guaranteeing the marketplace an aggressive policy response to any risk of market illiquidity or financial/economic instability. Massive expansion of marketable debt coupled with a highly-accommodative policy backdrop incited incredible growth in speculation and leveraging. Over time, trends in U.S. Credit, policy and speculative excess took root around the world.

Global markets suffered a devastating crisis of confidence in 2008. The failure of Lehman Brothers, in particular, set off a panic throughout global markets for private-sector debt, especially Credit intermediated through sophisticated Wall Street structures. Unprecedented government intervention reversed the downward spiral in Credit and economic output. Especially in the U.S., Trillions of private debt instruments were put under the umbrella of government backing. Meanwhile, Trillions more were acquired by the Fed, ECB and global central bankers in the greatest market intervention and debt monetization in history. Policy making – fiscal and monetary, at home and abroad – unleashed the “Global Government Finance Bubble”.

Currency market distortions have been instrumental in sowing financial fragility and economic instability. Chiefly because of the dollar’s special “reserve currency” status, U.S. Credit system excesses have been accommodated for way too long. Global central banks have been willing to accumulate Trillions of our I.O.U.s, providing a critical liquidity backstop for the marketplace. Highly liquid and orderly currency markets have been instrumental in ensuring a liquid Credit market, which has provided our fiscal and monetary policymakers extraordinary flexibility to inflate our Credit, our asset markets and our economy. Meanwhile, massive U.S. Current Account Deficits and other financial flows have inundated the world, creating liquidity excess and unfettered domestic Credit expansion throughout the world. Global imbalances, having mounted for decades, went “parabolic” over the past few years.

I would argue strongly that the euro currency regime owes much of its great success to the structurally weak U.S. dollar. For all the flaws and potential pitfalls of a common European currency, the euro has from day one looked awfully appealing standing side-by-side with the dollar. And the buoyant euro created powerful market distortions that promoted Credit excess throughout the region, especially in Europe’s periphery (Greece and the so-called “PIIGS” would never have enjoyed the capacity to push borrowing to such extremes had they been issuing debt denominated in their own currencies). The weak dollar and strong euro – along with the perception that the Eurozone and ECB would never tolerate a default by one of its sovereigns – were instrumental in promoting profligate borrowing, lending, spending and speculating.

I have recently turned more focused on differentiating between “productive” and “non-productive” debt. This is an important analytical distinction – although, by nature, a challenging gray area for Macro Credit Analysis. At the time of its creation, there might actually be little difference from a systemic perspective whether a new financial claim is created in the process of financing real investment or an asset purchase or, instead, to fund a government stimulus program. In each case, new purchasing power is released into the system. The key is that the new Credit stimulates economic “output” through increased spending, incomes and/or asset inflation. Especially during the halcyon Credit boom days, the markets will pay scant attention to the assets underpinning the new debt instruments (particularly when policymakers are actively intervening and distorting markets!).

However, don’t be fooled and don’t become too complacent. At some inevitable - if not predictable - point the markets will care tremendously whether a Credit system is sound or not. Regrettably, the current era’s (unrestrained global finance, structurally-unsound dollar, “activist” policymaking, rampant global speculation, etc.) unique capacity for sustaining non-productive debt booms poses major problems. In short, the booms last too long and activist policymaking ensures they end up afflicting the heart of Credit systems. These protracted Bubbles are resolved through problematic crises of confidence, debt revulsion and economic restructuring.

First of all, booms create a fragile mountain of debt not supported by underlying wealth-creating capacity. Second, Credit Bubbles inflate various price levels throughout the economy, creating systemic dependencies requiring ongoing debt and speculative excess. And, third, the boom in non-productive debt will tend to foster consumption and malinvestment at the expense of sound investment in productive capacity.   When the boom eventually falters, market revulsion to unsound debt, the economy’s addiction to uninterrupted Credit expansion, and the lack of capacity for real wealth creation within the (“Bubble”) real economy ensure a very severe crisis and prolonged adjustment period. These dynamics become critically important as soon as a government (finally) loses its capacity to perpetuate the Bubble (i.e. Greece, Portugal, Ireland, etc.)

As a crisis unfolds, the markets eventually must come to grips with a very harsh reality: There will be denial and it will take some time to really sink in - but the markets will come to recognize that too little of the existing debt is backed by real wealth. Non-productive Credit booms are, after all, essentially “Ponzi Finance” schemes. Worse yet, only huge additional injections of debt/purchasing power will hold economic collapse at bay. Fundamentally, non-productive Credit booms foment deleterious effects upon the economic structure – that only compound over time. As we have witnessed with Greece and Ireland, “bailout” costs can quickly skyrocket to meaningful percentages of GDP - and will keep growing.

And once stunned by the downside of “Ponzi Finance,” markets will be keen to mitigate risk exposure to the next episode.   This is the essence of “contagion effects.” Especially in interlocking global markets dominated by leveraged speculation and trend-following trading strategies, de-risking and de-leveraging in one market tend to quickly translate to risk aversion and faltering liquidity throughout the marketplace. Markets perceived as liquidity abundant can almost overnight be transformed to liquidity-challenged. This dynamic went to devastating extremes during the 2008 crisis – only to begin mount a resurgence with last year’s Greek debt crisis and contagion.

It has been my thesis that last year’s aggressive market interventions – QE2, the European fiscal and monetary “bailouts,” and massive global central bank monetization – incited a highly speculative Bubble environment vulnerable to negative liquidity surprises. And now we’re down to the final few weeks of QE2. The European bailout strategy is unwinding, with little possibility of near-term stabilization. Meanwhile, the US economy has downshifted in spite of massive fiscal and monetary stimulus. Risk and uncertainty abound; de-risking and de-leveraging are making a comeback.

Bloomberg went with the headline, “Fed’s Maiden Lane Sales Trigger Bank Stampede to Dump Risk.” At The Wall Street Journal, it was “As ‘Junk’ Bonds Fall, Some Blame the Fed.” Both articles noted the deterioration in pricing for a broadening list of Credit market instruments, including junk bonds, subprime mortgage securities, and various Credit derivatives. And while the Fed’s liquidation of an old AIG portfolio is surely a drag on some prices, I believe the rapidly changing liquidity backdrop is more indicative of global de-risking dynamics. This is providing important confirmation of the bear thesis.

There are fascinating dynamics at work throughout our Credit market. Arguably, the U.S. is the King of Non-Productive Debt. In the wake of a historic expansion of non-productive household debt comes a Bubble in government (Treasury and related) Credit. The assets underpinning too much of the U.S. debt mountain are of suspect quality, although this hasn’t mattered recently. And in true Bubble fashion, the marketplace has increasingly gravitated to Treasury debt as the “Greek” crisis escalates and contagion effects gather momentum. The corporate debt market has enjoyed extreme bullish sentiment – along with waves of investment and speculative inflows. While the corporate balance sheet appears sound, I would counter that corporate earnings and cash flows have been artificially inflated by unsustainable federal deficits. In particular, the bubbling junk bond market would appear vulnerable to the deteriorating liquidity backdrop.

Elsewhere, there is the murky world of subprime derivatives and such. This bastion of speculative excess certainly enjoyed the fruits of policy-induced reflation. But not only has housing performed dismally, there are now the market issues of de-risking and liquidity uncertainties. Today from the WSJ: “Since April, prices of many subprime mortgage securities have declined between 15% and 20%... The decline in subprime mortgage bonds accelerated in the last two weeks…” From Bloomberg this morning: “Declines in credit-default swaps indexes used to protect against losses on subprime housing debt and commercial mortgages accelerated this month, reaching almost 20% in the past five weeks..” Also from Bloomberg: “Default swaps on the six largest U.S. banks have gained an average of 19.4 bps to 137.2 bps since May 31…”

In conclusion, support seemed abundant this week for the thesis which holds that the U.S. Credit system and economy are much more vulnerable to contagion effects than is commonly appreciated. Treasury and dollar rallies appear constructive for system liquidity. In reality, it is likely that both markets are heavily impacted by speculative trading (speculators, in various forms, have used Treasury and dollar short positions to finance higher-returning holdings). Strength in the Treasury market and the dollar are indicative of – and place additional pressure on – the unwind of leveraged trades. And it is when the speculator community finds itself back on its heels and backing away from risk that liquidity becomes a critical market issue.