Debasement vs. Technical Default

September 18, 2012

Debasement is a form of default. But it is not an event of default. This is critical to the path of risk assets from here. Many have termed printing money as debasement or financial repression.

A currency is debased as it is printed in order to pay off growing debts. Imagine you could simply photo copy 100 dollar bills and send them to your creditors and imagine that your creditors accepted those copies as payment to satisfy your bills. In this scenario as everyone pays their bills in copied currency, the amount of currency in circulation would grow. The value of all goods and services consumed grow much more slowly than we could photo copy bills (GDP growth is around 2%). I imagine if we were allowed to do this that we could grow our wealth by a whole lot more than 2% per year by photocopying. Therefore more money would be sloshing around chasing the same old goods and services. The richest person would become the person who could copy his money the fastest as each copied dollar would be worth less as it competes with more copied dollars and you in turn need more dollars to buy the same goods. Photo copiers would probably be worth a whole lot in this world!

Financial repression occurs as copied currency creates more demand for investments. Retirees and other savers living off of fixed (bond) income find that their income is fixed and tied to the interest rate on their bonds. So the retiree expecting $30k per year from investments and social security will get that, but what soon happens in the copied currency scenario is that he is penalized for not copying currency as the prices of essential items like milk and eggs goes from a few dollars to tens if not hundreds of dollars in our extremely imaginary scenario. In fact in this world the people who are rewarded are the borrowers because their interest payments are fixed in yesterday’s dollars but they can copy as much money as they need to in order to make interest payments and pay off their debts tomorrow.

Now consider this example in the context of a default. When a borrower defaults on a loan he is not able to pay back his lender the full amount he borrowed.

Assuming no imaginary scenario this amounts to your best buddy not paying you back all of the money he owes you.

In our imaginary scenario think of it this way. Your buddy borrows $500 when an iPhone costs $500 but he pays you back when an iPhone costs $2000. If he gives you the full $500 when an iPhone costs $2000, did he pay you back? The answer is tricky. Yes he gave you back your $500. But if you can’t buy the same things you could have when you lent it then your buddy has effectively defaulted on you.

Central banks around the world have drawn a guantlet. They have chosen to stealth fully default by paying off debts in devalued currencies. This will avert technical defaults but it won’t change the outcome if spending and revenues are not arrested and aligned to become sustainable.

Printing money to pay someone back is not making good on a promise, and it’s far less ethical than choosing not to pay someone back. It’s deceitful and deceptive and the vast majority of the worlds developed country citizens have no idea this is going on.

Is Ben Bernanke Finally Wrong?

September 18, 2012

Has anyone looked at the yield curve since QE3 was announced? Well the Fed published a paper within the last two years outlining the importance of immediate market moves as feedback for Fed policy. The rationale is that beyond the first 24-48 hours the impact of Fed announcements is less traceable due to other market news and events. Thus the Fed themselves observe interest rate impacts of major announcements and speeches to assess the efficacy of Fed Policy.

Interestingly enough, looking at Treasury Yield Curves for the 24 hour periods immediately following the announcement of QE1, QE2 and Operation Twist, term rates across the yield curve generally tightened (fell). However in the 24 hours after the announcement of QE3, all rates outside of 3 years actually increased.

I’m not claiming to know more than the next guy, but I’d be shocked if Uncle Ben thought he’d be kicking out the longer end of the curve. Granted the announcement was for MBS purchases and we can look at those curves, but widening treasury yields has negative implications throughout the bond market.

I’m not judging that the move was wrong, but I am questioning the strength of stocks and credit exposure which have both rallied since Thursday.

Printing Presses

September 14, 2012

With the announcement of a much more aggressive round of quantitative easing than most expected, Ben Bernanke succeeded in continuing the inflation of financial assets, many of which reside in the shadow economy.

My first response which I have been telling people and as many pundits have exclaimed is that this is absolutely a political decision, even if the process to the decision was acutely rational and ethical. The only way to avoid a poeticized outcome would have been to pause any aggressive announcements until after the election. But as I am learning through the process of renovating a NYC co-op, if the decision making benefits the “decider”, without recourse then in hindsight the outcome should have been clear.

In this case the ensuing lift in financial asset prices, while likely to do nearly nothing for Obama’s middle class, will probably lead to strong PR and messaging trough the campaign trail from here to convince the vast majority of easily fooled Americans that they are better off today than they were when the S&P bottomed shortly after Bush left office.

The difference this time around however is that financial asset prices no longer respond primarily to the fundamentals of the economy but are now heavily linked to the actions of central banks who rightfully believe that lowering the probability of global financial collapse can be achieved by debasing currencies in the near term.

What they remain dangerously dogmatic about is their ability to remove excess liquidity in a systematic and orderly fashion. Hubris in Wall Street a decade ago led to its near demise. It is 100% probable at this point that the hubris among central bankers will lead us to another, far more gruesome edge. The question becomes who will finance the bailouts then?

Bernanke laid out a gauntlet yesterday and is now playing a massive game of chicken with the bond market that drives the global economy. He is betting that the threat of unlimited bond buying will be enough to scare the doomsayers out of the market keeping, now, all interest rates lower for longer, further punishing savers and rewarding borrowers who are generally afraid to take many risks.

If he is right, his brilliance now has a clock on it. Endless debasement of the worlds reserve currency will last only as long as it serves the needs of the largest foreign holders. This is not a sustainable move. For the moment it benefits China who remains loosely pegged to the dollar. However it puts the US in a precarious position should US-Sino relations falter.

Bernanke, sadly, is consciously or unconsciously using money printing as a substitute for good decision making in congress who remain practically useless to the democratic process. For a moment I can argue that this is somewhat thoughtful, but the outcome will be to enhance Obama’s reelection which will undoubtedly buy him at least one more appointment in 2014.

The analogy that came to mind this morning is that Bernanke is printing dollars to take the burden off of the house and senate to print meaningful tax and legislative reform. This is similar to building a house out paper. It may deflect the winds for a while, but it will not protect you from the vast majority of “elements”.

The medium term result of this decision, particularly in the US will creep into risk asset prices as the market digests the growing risks to sovereigns currently perceived as irrefutably sound financial hubs. We now know that a banking system can only remain stable with the threat of sovereign intervention. How long will the US Government remain a credible threat to interrupt another financial crisis.

No business leaders see the economy picking up more than it has from QE1 and QE2. In fact the downturn in transportation and materials probably in some part affected Bernanke’s decision. Adding even more liquidity will not have the desired effect without a major shift in lending practices by major banks.

Eventually equity risk premia will reflect the growing burden on US Taxpayers who by the vast majority remain under employed and less wealthy than they were 10 years ago. The irony is that continued debasement will ultimately lead more currency into safe low yielding investments.

If the US has not gotten its fiscal house in order before zombie investors wake up, the consequences will put us in uncharted territory.

When Obama makes his acceptance speech I wonder if he will thank Uncle Ben.

How to Help Housing

September 6, 2012

It seems obvious to me that the only way forward from here economically is to steer the economy using carrots and sticks. Voters know legislators are to blame as congress sits at an all time low approval rating. Legislators in turn have become addicted to central bank policy as the primary tool for the recovery because while unpopular it has the advantage of not alienating independents who in a polarized democracy carry many swing votes.

As I toss and turn ideas to help make small but effective incentives to achieve sustainable outcomes it seems obvious that tax legislation, despite discontent with a completed tax code, can still help us right-size the recovery and help us avoid past mistakes.

The idea below is not more than a brainstorm and there will be others posted here over time, but at the very least thoughtful, targeted and principled policy initiatives, if ever agreed to and passed into law could finally take the burden of central banks and ultimately help us finally start a sustainable recovery.

Since housing is what became both the victim and scape goat for the financial crisis it remains a significant drag on US GDP through a variety of multiplier effects. A depressed housing market means at the very least we have lost construction jobs and spending. It also has affected consumer wealth and therefor consumer confidence and spending, and we are a consumption led economy. The anemic and controversial housing recovery has also been a major drag on the banking sector working out many issues of defaulted borrowers and underwater homeowners, leading to increased government supervision and leading to an unwillingness to lend to new home buyers.

With that in mind this seems like a reasonable stab at a small policy decision that could have meaningful impact on the housing recovery and redefine the housing market to remove speculation which helped to cause the collapse.

If we raise capital gains on sales of real estate there are presumably a number of outcomes that could help us.

Raising this tax would help discourage home owners with a low cost basis from selling. This will shrink supply AND lower prices. Initially lower prices will help subsidize first time home purchases while mortgage rates are low. The lower supply would help banks sitting on pools of defaulted mortgages as they would be more in control of the supply dynamics in the market place aiding their pricing power to sell homes in their possession. Such a tax would not hurt homeowners whose homes are below the purchase price as they would not have gains.

If successful such a tax could be used in part to subsidize overblown property taxes in many states which would effective be a tax break back to the middle class.

Such a tax becomes a larger burden on the wealthy and speculators who own multiple homes and distort the supply demand dynamics for first-time/ primary home purchase. If this seemed to Pollyanna, there could be an exemption for primary residences.

Such a policy can help redistribute wealth in a more meaningful way and can help rebalance proper incentives in this market. Only those able to take the tax hit will and such a tax will hurt those who flip homes more than those with just one. The housing market does not need excess liquidity, it needs price stability I order to commence a meaningful and sustainable recovery.

There might be a short term sell off as people try to harvest gains, but it would set a stage for a meaningful transition in housing. An exemption for primary homes would mitigate this impact.

Such a policy would help set the stage for the housing market to “clear” reducing inventory and shadow inventories to historic norms. Stopping new construction isn’t all bad as there would be a tremendous need for home improvements.

This is a small and maybe naive start, but this is the discussion we need out of Washington and the types of ideas we should require from elected policy makers.

The Great Transgression

June 14, 2012

The United States Central Bank wether it likes it or not is ultimately responsible for global monetary policy either by controlling the default risk free rate or by nature of our reserve currency.

The current Fed has responded, with little precedent and arguably appropriately during the initial phase of the 2007-2009 crisis by printing money. They have set short term rates at zero and become the central banker to the world printing trillions of additional dollars that the world can’t seem to get enough of, particularly recently. But is this course sustainable?

Conscious capitalists argue our economy should be built and run in a sustainable fashion. This doesn’t mean just making us drink wheat grass shakes, limiting 16 oz soft drinks, or putting solar panels on our house. The point of the movement, however fragmented it is, is to design and build sustainable replacements for our unsustainable and brittle physical and economic infrastructure, products, services and systems. Sustainability is more than about feeling good about a single act or product which is selfishly individual. It’s about national security, economic development, job creation, creative destruction, and ultimately the disintermediation of unsustainable products, services and systems. Sustainability is built on a tenet of scarce resources and attacks flawed technology, flawed accounting, flawed assumptions and flawed systems-level thinking. The neo-classical economic model’s definition and treatment of externalities as costless and priceless losses to society is a failed systems-level paradigm.

You cannot solve recurring problems with larger versions of the same solution. This idea is no different than asking your two year old not to throw food on the floor. When that fails some people tell then not to do it, and then yell, scream and even resort to physical intimidation or violence. Even if the physically violent response “works” what do we think we’ve imparted to that child? Does the toddler learn manners and social graces, both of which would be sustainable lessons that they would use and pass on with adults and peers? No, violence only teaches fear. Think of any bully. A toddler raised in fear grows up to be angry, you don’t need to believe in psychology at this point to have observed it. But I digress.

The Fed, in it’s early and appropriate response to the liquidity crisis after Lehman failed has created a system of free money, and worse, a systems-level thinking of free money which at its core-no text book needed-is unsustainable.

If money is free, it is worthless. If the currency is worthless then the entire economic system is broken as we are seeing in some form in Greece right now.

This is the purpose of the Fed, in their own words from their website:

“The Federal Reserve System, often referred to as the Federal Reserve or simply “the Fed,” is the central bank of the United States. It was created by the Congress to provide the nation with a safer, more flexible, and more stable monetary and financial system. The Federal Reserve was created on December 23, 1913, when President Woodrow Wilson signed the Federal Reserve Act into law.”

The Fed is failing its own mandate. Endless ZIRP policy and and unabashed money printing is NEITHER making us safer NOR creating more flexibility. Quite the contrary. The fed at the very least is digging us into an unsustainable trajectory that will ultimately end with even harder decisions than were made in 2008. I don’t believe the current Fed is evil, stupid or purely politically motivated, although I have my doubts on the last one. The biggest problem, which is similar to problems of the Bush administration is hubris and dogma.

The only way to create a safe and flexible backdrop for economic activity is to have the ability to move levers in multiple directions. This requires an extreme bias for moderate policies in any direction, something like steering an oil tanker in a narrow channel. An oil tanker responds too slowly to know exactly how far the captain is correcting the direction so he uses extreme caution and slight movements to stay centered and nimble. This philosophy and centeredness is completely lacking at the Fed today.

As we dig ourselves deeper into a position of sovereign indebtedness and take steps closer to eliminating the value of currency altogether we put ourselves closer to the patsy seat at the global poker table leaving little room for flexible strategy. A strategy defined by faith and hope is better suited for men of God, not leaders of the free world.

Obama ran on a platform of Hope. It was a powerful campaign, but Hope is not an economic strategy nor a sustainable model for success.

Bernanke is convinced that the depression could have been avoided using policy tools he has unsheathed since 2008. Let’s assume he is right. If not the Great Depression then what would we have ended up with instead?

A Great Repression? As noted by many others our current system of penalizing savers in favor of borrowers is a form of financial repression.

A Great Decession? The current status quo has seen the US slowly erode once dominant positions in global economic policy, trade policy, foreign policy, global defense policies and a host of once untouchable pole position of global power. A weak economy and a weak currency is a recipe for a slow fall from grace. A strong economy AND a strong currency make for an unusual bargaining position, just look at Germany in the context of broader Europe.

A Great Egression? The numbers of US Citizens renouncing their citizenship while small in absolute numbers is beginning to balloon in relative numbers. More and more wealthy Americans have lost interest in or confidence in an American future.

A Great Oppression? When wealth becomes concentrated by the few, regardless of their benevolence, there ensues a form of economic oppression where it grows increasingly harder for “just anyone” to amass great wealth. Simply put the super rich spend a small
fraction of their wealth and that slows the velocity of money in the system, limiting how often dollars change hands.

When all this plays out, and we look back in 80 years it would not surprise me that this difficult period is reflected upon as The Great Transgression. A period of time where the economic rules of law were totally and unilaterally transgressed at the expense of “saving the system”. A period where credit seniority only held weight IF the government or some other supra national entity did not intervene. A period where the many were led by the few further from their goals and dreams guided by fear of harder outcomes. A period of time where multiple transgressions were made possible through the growing frequency of global panics.

Bernanke may successfully lead us away from the known path of a Great Depression. But does he know where we end up if we maintain the current unsustainable course?

Helicopter Ben Should be Picking Up Dollars, Not Dropping them Down

May 11, 2012

The current economic policy has hinged upon the following equation:


Where P is the amount of productivity in the economy measured by GDP; M is the supply of money often measured by the M2 money supply, and V is the velocity if money (M2) or how often a dollar turns over each year.

In the simplest definition this equation represents the amount of value created by our economy (GDP) is equal to the amount of money in the system (M2) multiplied by how frequently that money “turns over” (V).

The faithful logic is that you can offset a decline in V by raising M to support P. Mathematically this makes sense and would be true if the equation followed only the rules of linear mathematics.

However, the problem is twofold: while M is the only lever that the Federal Reserve has any real control over; V is a value rooted in physics more than math and subject to inertia and indirect responses.

While M follows a linear progression (a $ in = a $ in and a $ out = a $ out) V is subject momentum where the rate of change is neither controllable or linear. The velocity of money tends to follow a trend which is partially fed by the supply of money but which is also fed by human behavior.

Consumption patterns are not linear and we don’t all necessarily start and stop consuming at the same time and the same rates. Moreover, the actions of one group can affect another and positive and negative momentum can drive how much of our paychecks we choose to spend. If our peers appear to be cutting spending we may choose to follow their lead if we presume their caution is correct. Vice versa in the hay days of the late 1980’s/early 1990’s our consumption patterns were heavily influenced by “keeping up with the jones'”.  The chart below illustrates the velocity of M2 in the US since 1950.

Quarterly, Seasonally Adjusted, Updated: 2012-04-27

In theory if V is falling faster and faster, neither a linear increase in nor an imaginable amount of M is going to support P for very long.  At some point the attention needs to move from how we support economic growth to how we arrest the falling velocity of money.

Solving for V, the equation turns to V=P/M.

Turning the equation around, the only method the Fed would have to arrest the current rapid continue decline in money velocity by attempting to make V larger, is actually to reduce M which in the new equation is now in the denominator.

While reducing the supply of money in anathema to growth, the problem is that the issue is no longer solvable until V is stabilized and the only way to stabilize money velocity is to effectively make cash more scarce so that more of the cash available gets used or put to work.  A dogmatic and long term agenda focused on increasing Velocity likely would have its own negative effects, but its clear that focusing on adding more liquidity to an economy awash in liquidity is no longer boosting output and is showing signs of growing impotence.  The best solution would probably at least be to pause on the quantitative easing and let interest rates rise modestly, if nothing else but to give some time for current cash to be circulated more effectively without the anticipation that more is on its way which creates a perception of falling prices.

As interest rates rise the cost of sitting (cost of waiting) on large piles of cash increases as depositors begin to feel the lost opportunity cost of at higher rates or simply consuming the cash.  At the very least it gets people out of the mindset that prices will continually be lower tomorrow and that there is no better alternative to cash.

What the right interest rate would be us as unknown as the grand experiment we are currently in the midst of, nonetheless it seems that our current path beyond being unsustainable may simply be wrong.


Top Reasons Why the Market May Stumble

March 9, 2012

• Israel / Iran escalation explodes
• China’s slowdown stalls
• Syrian devotion creates collateral support on both sides increasing risk premia in stalemate
• Sovereign liquidity bazooka posturing has bluff called by bond market.
• Greek bond swap is a failure as new bonds plummet shortly, installing fear for efficacy of European control over the crisis.
• LIBOR fixing case escalates or gets more notable attention creating mistrust in credit markets
• Oil prices get squeezed by geopolitical events or surprisingly good data and trigger a new recession.
• Facebook IPO becomes symbol of the excess in this rally and seals the top of this market and it’s own fair in the bear market that follows. Irrational but practically fair guess.
• Obama’s GOP challengers fade and his tax policy surfaces into the election
• Major hedge fund blows up
• High frequency trading investigation roils liquidity providers creating another flash crash” as market makers unwind into these lower volumes markets with fewer retail clients buying.
• Credit rating downgrades surprise to the downside in magnitude and timing.
• European cooperation breaks down into elections as popular votes support protectionism, liquidity unexpectedly unwound.
• interest rates back up suddenly 50 bps causing shocking losses feeding the sell of in “safe assets” and spiking over more heavily into selling of “risk assets”. Dollar rallies again.
• US real estate recovery exposed as weaker than originally thought with inventory overhang growing with new sales activity much like unemployment may grow as more people reenter the workforce.
• Government enforcement of Dodd Frank puts new pressure on banks earlier than anticipated, forcing more derisking.
• Apple iPad debut falls short of lofty expectations stories turn to “after Steve jobs” and the company’s massive weighting in indexes roils markets as it corrects.
• Capacity utilization unexpectedly soars as obsolescence becomes apparent and prices rise squeezing demand already starved by higher oil and weaker borrowing by consumers.
• By weather or other natural disaster global food supplies are squeezed and prices for key commodities sky rocket crimping the global consumer.