Economy on a knife’s edge

The Philly Fed’s ADS Business Index gave us the old demon drop last week.  While the index had been negative since the start of Q2, the readings were fairly dovish, until last week’s updates.  The latest print shows that conditions in June and July were two to three times worse than originally thought (also that conditions were notably less ebullient in March, April and May).  As a result, the ”progressively more negative values” of the index are offering a much stronger indication of “progressively worse-than-average conditions”:

Excluding the 2008-2009 recession, the low of -0.79 in July was last seen in mid-2005 and during the 2001 recession:

A crude first pass at the data indicates that an ADS reading of -0.79 or lower has been associated with recessionary conditions 85% of the time.  Using more conservative and statistically meaningful approaches brings the recession probability below 50%, but that’s still too high for comfort, and is likely to rise in the weeks ahead — just one more piece in a disconcerting mosaic.

Other important pieces of the mosaic include:

The budget situation faced by state and local governments, which the FT recently took Congressional Democrats to task for:

Congress should pass the state aid bill next week, but more than that it needs to get a grip. Democrats are fearful of November, as they should be; Republicans are content to watch them squirm. Government is paralysed and the economy struggles.

The right fiscal policy for the US is ease sustained for the time being, followed by tightening through higher taxes and lower spending as conditions allow. It is a sad and even alarming fact that Washington’s political dysfunction now puts this straightforward advice in the realm of fantasy. Not just the US economy but the global economy too will have to bear the consequences.

Today’s FOMC statement, which indicated that the Federal Reserve intends to keep its balance sheet at around current levels, and to reinvest income into government securities in order to keep lending rates low:

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature. 

And a continuing grind lower in long term Treasury yields that implies falling expectations for economic growth and/or inflation, perhaps even concerns about deflation.  The downtrend of yields in recent months looks a bit like the one that unfolded in 2H07, about six months prior to the start of the last recession:

However you slice the data, the economy appears to be walking on a knife’s edge, or at the very least approaching one.  And the key ingredients of the grout holding this pessimistic mosaic together are, in our view, negative demographic shifts and household balance sheet deleveraging, neither of which argue in favor of fiscal austerity as the right approach for policymakers. 

In fact, a small but potentially very significant piece of the mosaic is anecdotal claims about rising rates of expatriation by high U.S. income earners.  As Rueven Brenner has pointed out, immigration and emigration have historically played an important part in the rise and fall of nations and economies.  It’s too soon to make any meaningful assessments, but this is a risk that policymakers (and voters!) must stay attuned to.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy.

Business Conditions, Sentiment, the USD and Gold

File under confirmation bias:

The Philly Fed’s Business Conditions Index is still hanging tough after its most recent update, though it’s still slightly negative relative to historical data.

A point of interest we came across on the Philly Fed’s site is its regional July Business Outlook survey (pdf). The apparent downturn in sentiment in early 2010 appears to coincide with our “strong dollar” call in January 2010, which was based heavily on increasing verbal hawkishness (pdf) from the Obama administration on fiscal matters:

The timing could very well be coincidental, but we think sentiment and fiscal expectations are related at some level, which may be supported by some other interesting features in that graph, from a “sectoral balances” point of view.*  

One is that business sentiment was most buoyant at the time of President Bush and the GOP’s major fiscal easings in 2001 and 2003 (blue circle); the other is the steady downward trend in  sentiment as the Clinton administration’s and Dole-Gingrich GOP’s widely revered budget surpluses were materializing (green line):

Again, this is purely circumstantial evidence, and would require much more analysis to see if anything academic can be made of it. But it does fit nicely with the theoretical frameworks we’re relying on to guide clients through these “interesting times”.

It might also be reassuring that the USD has taken a slight break from its strengthening trend (the red line below is the inverted trade weighted USD index inverted, and the blue line is foreign commercial paper, a measure of foreign credit and business activity in the private sector).

While it’s not at a level that augurs an imminent return to the headiness of 2007 and early 2008, some stability at current levels would be a welcome sign for the world’s credit, goods, and services markets:

There’s also an interesting new bit of evidence that supports our Nov-Jan warnings of a strengthening USD and weakening gold prices. From the FT:

…more than 10 [banks] based in Europe…swapped gold with the Bank for International Settlements in a series of unusual deals that caused confusion in the gold market and left traders scratching their heads…

The Financial Times has learnt that the swaps, which were initiated by the BIS, came as the so-called “central banks’ bank” sought to obtain a return on its huge US dollar-denominated holdings. The BIS asked the commercial banks to pledge a gold swap as guarantee for the dollar deposits they were taking from the Basel-based institution…

Some analysts speculated that the swap deals were a surreptitious bail-out of the European banking system ahead of last week’s publication of stress tests…

…two central bank officials said some of the commercial banks…needed the US dollar funding and were keen to act as a counterparty with the BIS. The gold swaps began in December and surged in January, when the Greek debt crisis erupted and European commercial banks were facing funding problems…

In other words, large banks on the continent were more than willing to swap gold for USDs with the BIS when facing credit strains and stress tests. This is something to keep in mind among all the gold bug chatter — unbacked paper or “fiat” money can become dear, even relative to precious metals. Witness gold’s long term decline against the Yen as Japan’s balance sheet recession and negative turn in age structure unfolded:

 The wrench, as we always try to point out, is the USD’s global reserve status. More dovish monetary policy in the U.S. (which can only be accomplished via renewed “quantitative easing” and its distorting impacts) could very well stoke renewed inflationary pressures abroad, with feedback effects on certain components of U.S. price levels. In fact, the deep decline in Yen per gold ounce might have been driven in part by the absence of Yen carry trade mechanisms. Once those mechanisms were in place and more widely available (circa late 1990s or early 200s?), Yen-gold was freed to the upside.

The fact that the USD is the traditional carry trade currency is a reminder that USD-gold could still have plenty of room to run, and that uncertainty is why we are not placing any bets on gold prices, either to the upside or the downside. But to the extent that any rally is driven by Ponzi-style leverage — which is still quite possible due to the anemic and slow moving nature of some of the reform measures in Dodd-Frank – gold will, like residential real estate before it, eventually come crashing back down to more normal levels.

It may even be near “normal” levels now. The caveat we’re trying to put forth is that if fiscal, trade, or monetary policymakers err on the hawkish side in the next five to ten years, then USDs will be in scarcer supply, and all else equal, that would mean lower prices generally — even for gold.

One last note — preliminary second quarter GDP came in light at 2.4%. This is a steep fall from recent quarters, and it too lends some support to our argument (and others’) that federal stimulus played a significant role in driving and/or supporting private sector activity in 2H09 and early 2010.  That’s why we think that any concerted move towards fiscal tightening in the quarters ahead — whether through tax cut expirations (we’re talking to you, Democrats) or spending cuts (ahem-ahem-ahem, GOP) — will substantially raise the probability of a second recession.

* We note that the New School’s History of Economic Thought (HET) website has yet to publish anything on the recently deceased Wynne Godley, who helped to articulate the intersectoral balances approach. As with age structure, underappreciation implies to us that Godley’s balances framework can be put to an investor’s advantage. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. You should consult with your personal financial advisor before engaging in any investment activity. Any mention of investable companies and/or securities is incidental and for illustrative purposes only.

Muddling through??

If rail car loadings are any indication, the U.S. economy is continuing to expand at a healthy clip.

Railfax reports that through the end of last week, total rail traffic continued to climb — note the rising trend in the current week versus the 4 week average and year to date, which is holding up for every category except grain and foods. We should keep in mind that the four week moving average in each category (save for intermodal) is still below 2008 levels:

Source: Railfax Report (http://railfax.transmatch.com/ accessed 7/9/2010)

Similarly bullish data was released by the Association of American Railroads, as reported by The Pragmatic Capitalist.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

Moving the Policy Discussion Forward

Some interesting articles on the state and direction of economic policy:

David Frum challenges fellow conservatives to come up with compelling policy alternatives to Paul Krugman’s recommendations:

 …if Krugman’s direct government expenditure is not a very good policy answer, his dire economic warning remains a haunting policy question. What can we do to accelerate economic growth and job creation? For those of us on the free-market side of the debate, the question is even more haunting: What’s our countervailing idea? And if our countervailing idea is tax cuts, what is our reply to the obvious rebuttal that the Bush tax cuts have been in effect through the whole of this crisis, seemingly without effect?

Marshall Auerback outlines a bevy of progressive policies in response:

…Professor James K. Galbraith sets out some useful criteria for good stimulus:

1. Open-ended support for the current operations of state and local governments…

2. Comprehensive foreclosure relief…

3. Increased Social Security benefits…and a cut in the eligibility age of Medicare…

4. A payroll tax holiday to restore effectively the purchasing power of working families. By setting the payroll tax rate at zero (and letting the government write a check to the Social Security Trust Fund for the uncollected sums), tax relief can be delivered at large scale and with immediate effect…

…And finally deploy government spending in a way which REDUCES unemployment, rather than arises as a consequence of it. We therefore suggest a new approach: a Job Guarantee Program. The U.S. Government can proceed directly to zero unemployment by hiring all of the labor that cannot find private sector employment. Furthermore, by fixing the wage paid under this ELR program at a level that does not disrupt existing labor markets, i.e., a wage level close to the existing minimum wage, substantive price stability can be expected…As we have argued before, the Job Guarantee program should remain a permanent feature of our economy, in effect acting as a buffer stock to put a floor under unemployment, whilst maintaining price stability whereby government offers a fixed wage which does not “outbid” the private sector, but simply creates a stabilizing floor and thereby prevents deflation. [Many on the right might reflexively think of such a program as socialism run amok, but as we've pointed out more than once, an employer-of-last-resort program has been proposed on the right by Nobel economist Ned Phelps. The idea is definitely worth a closer bipartisan look.]

There are good ideas out there, but there is a distinct failure of political imagination and courage to implement them. With any hope Frum’s provocative article will spur a healthy discussion on the possible solutions, rather than a retreat to tired, discredited economic shibboleths.

But Brad DeLong gives little hope that Auerback’s retreat can be avoided:

…Congress is balking. Republican legislators from states with double-digit unemployment have put party above country. Blue Dog Democrats, who think that they can marginally improve their chance of gaining more terms in office if they publicly worry about the deficit to the exclusion of all else, have put self above country and party. And, significantly, the Obama Administration has never offered a grand bargain for tax increases and entitlement caps in the future in return for more spending now to restore full employment.

We’ll toss a few cents into the discussion in an attempt to show that we can and should overcome irrational deficit phobia (yes, there are sometimes rational reasons to fear government deficits), we’re likely to make little progress towards ensuring a strong and durable economic recovery, and ironically, we’re likely to end up in a worse public debt position. 

On Frum’s question, Randy Wray has pointed out (pdf) that an accelerating pace of federal government tax receipts followed the Bush tax cuts and recovery, and may have contributed to the intersectoral strains that eventually resulted in financial collapse (emphasis added):

Every recession since World War II was preceded by a government surplus or a declining deficit-to-GDP ratio, including the recession following the Clinton surpluses. Recovery from that recession resulted from renewed domestic private sector deficits, although growth was also fueled by government budget deficits that grew to 4 percent of GDP. However…the Bush recovery caused tax revenues to grow so fast that the budget deficit fell through 2007, setting up the conditions for yet another economic collapse…

In 2005, tax revenues were growing at an accelerated rate of 15 percent per year—far above the GDP growth rate (hence, reducing nongovernment sector income) and above the government spending growth rate (5 percent)…this fiscal tightening was followed by a downturn—which automatically slowed growth of tax revenue.

Thus, conservatives might not be painted into as severe a policy corner as Frum fears. But that’s true only if they can let go of their (newfound, circa 2006?) deficit phobia and escape the intellectual tyranny of Ricardian equivalence. We think that’s easily done, but there are two basic concepts that need to be framed out before the policy conversation can make any significant progress.

First, we need to frame our modern financial economy as Knut Wicksell did over 100 years ago. There are two ‘interest rates’ at work, one on the credit (financial) side, and one on the real (economy) side. The financial rate (in reality, there are many of them) is determined in large part by the cost of a marginal unit of money. The economic rate (in reality there are many of these too) is determined by the expected return on a marginal unit of investment.

When the financial rate is below the economic rate, the result is inflation (greater expected returns on investment lead to increased demand for credit, and money eventually becomes less valuable relative to real goods and services). When it’s above the economic rate, the result is deflation (negative expected net returns on investment lead to decreased demand for credit and increased demand for saving; money thus becomes more valuable relative to real goods and services).

Wicksell’s original thesis has been tweaked to acknowledge that inflation and deflation are unlikely to persist indefinitely. We also need to incorporate the idea of leverage. Low systemic leverage (the amount of credit relative to money) implies a higher cost of credit and lower inflationary pressures. When there’s a high degree of leverage, inflationary swings can be exaggerated, and can turn sharply and suddenly into deflation (Minsky’s “Ponzi finance” or Austrian’s “crack up boom”, of which 2008-2009 was a prime example).

Second, we need to get a better grasp of money — what it is, where it comes from, and how it works. 

Under any type of gold standard, gold is essentially money, and over the long run, gold’s real value is a function of its supply relative to all other goods, services, and assets (gold’s flexibility, durability, and steady long term accumulation rate give it its monetary properties). As long as money is defined as a fixed weight of gold, the value of money will closely track the value of gold. Thus, under a gold standard, the financial rate of interest is determined in large part by developments in the gold industry relative to the rest of the economy (as an aside, Ricardian equivalence might have some merit in that type of system).

However, in a fiat currency system like the U.S. has had (officially) since 1973, money is just money, which the government sector creates at minimal cost (currently the money creation process is controlled by the Federal Reserve through its interactions with member banks and primary dealers). Thus, the financial rate on fiat money is more easily attuned to the economic rate, thereby helping to mitigate the cycles of inflation and deflation that occurred regularly under classical gold (that was Wicksell’s stated intent when he first outlined his monetary theory). Granted, it’s taken policymakers and markets several decades to learn how to run such a system effectively, and there’s still plenty of room for improvement, but that’s to be expected with any large scale innovation.

A key takeaway is that the federal government creates the money used in private sector transactions, satisfaction of tax and other liabilities to the public sector, and demand for goods and services by the public sector. Thus, saving or spending desires of the private sector can only be accomodated by the federal government (leaving aside export income), while under a gold standard, they could only be accomodated (with some qualifications) by the available supply of gold. In other words, despite the widespread belief that they are subject to the same constraints, the federal government’s budget is nothing like households’ or businesses’ budgets, and in fact, in some key respects it is the inverse (just as under a gold standard, the gold industry would need to “dis-save” gold in order to satisfy the desire for saving in other sectors of the economy).

Today, if households, businesses, and state and local governments want to run a surplus, then the federal government must by definition (again ignoring exports) run a deficit. That’s not an ideological statement, it’s a simple operational fact, which is why (we think) it opens up a lot of common ground for policy.

So what role do federal government deficits play in our economy?

Depending on how they come about, they can raise the expected rate of economic return (by increasing aggregate demand), lower the financial rate (by increasing the supply of money), or both (by financing its demand for real goods and services with new money).

Conversely, a budget surplus (or a smaller deficit) can lower expected economic returns, and can also impact the financial rate (under our Wicksellian framework, if money becomes more scarce, then the prevailing nominal interest rate becomes tighter, all else equal).

In certain environments (e.g., Japan 1990′s thru 2000′s, U.S. 2000′s thru 2020), expanded deficits make sense, while in others (e.g., Japan 1970′s thru 1980′s, U.S. 1980′s thru 1990′s), smaller deficits or even surpluses might make sense – albeit with this caveat from Wray:

…the United States has also experienced six periods of depression that began in 1819, 1837, 1857, 1873, 1893, and 1929. Comparing these dates with the periods of budget surpluses, one finds that every significant reduction of the outstanding debt, with the exception of the Clinton surpluses, has been followed by a depression, and that every depression has been preceded by significant debt reduction. The Clinton surpluses were followed by the Bush recession that was ended by a speculative, private debt–fueled euphoria, and was followed in turn by our current economic collapse. The jury is still out on whether we might yet suffer another Great Depression. While we cannot rule out coincidences, seven periods of surplus followed by six and a half depressions (with some possibility for making it a perfect seven) should raise eyebrows…our less serious downturns in the postwar period have almost always been preceded by reductions of federal budget deficits. [Note that all six depressions occurred under a gold standard of some kind, so the direction of causation is open to question.]

Where are we today? U.S. demographic composition (pdf) implies a relatively pessimistic outlook for productivity, saving, and investment, possibly until the end of this decade. Large swaths of the private sector — notably households, but also some state and local governments – are in desperate need of repairing their balance sheets. Many corporations are flush with cash but apparently reluctant to invest it in human or physical capital. In other words, the demand for saving in the private sector remains high, and probably will for some time. 

What’s the proper response?

For households, some combination of fiscal support (e.g., extended payroll tax holiday, financed by money creation if need be) and financial relief (e.g., cleaning up the mortgage mess in as fair and transparent a way as possible, possibly with greater commitment from the federal government, as opposed to the private sector incentives and public-private partnerships experimented with to date) should help.

For state and local governments, direct budget assistance, again financed with new dollars if necessary (which is essentially how it’s now done, except that primary dealer and other banks get to hold Treasury paper for “financing” the federal deficit and earn the spread over the fed funds rate).

For the corporate sector, expanded public sector demand (e.g., maintenance and productivity enhancing infrastructure improvements, R&D into promising areas like energy and health care, etc) and perhaps most importantly, tax and regulatory assurances that will decrease the level of political uncertainty that businesses now face.

All of these would mean higher deficits in the short run, but if we’re right about the underlying state of the economy for the next decade, they will mean lower future debt and deficits than would otherwise occur (unless liquidationists and entitlement cutters were to win in drastic fashion, but in that improbable case the net costs would be much greater than any savings implied by a smaller federal debt).

It’s also important to point out to the Tea Party types that, as Jamie Galbraith and many other economists have noted, only a small percentage of the rise in federal deficit and debt to GDP ratios was driven by increased discretionary outlays by the Democrats. Almost all of the rise is simply a function of counter cyclical measures like unemployment insurance in the numerator and lower GDP in the denominator.

However it turns out, the federal government is not “broke” and never can be. The only true constraint on federal deficits is inflation, and there simply aren’t any signs of elevated inflation risk  today — although USD exchange rate depreciation is a meaningful risk, depending upon the relative movements of fiscal, trade, and monetary policies in different countries and regions. As Wray observes (emphasis added):

…there is no financial constraint on the ability of a sovereign nation to deficit spend. This doesn’t mean that there are no real resource constraints on government spending, but these constraints, not financial constraints, should be the real concern. If government spending pushes the economy beyond full capacity, then there is inflation. Inflation can also result before full employment if there are bottlenecks or if firms have monopoly pricing power. Government spending can also increase current account deficits, especially if the marginal propensity to import is high. This could affect exchange rates, which could generate pass-through inflation. [Viewed in this light, the Obama administration's export initiative might be a wise idea.]

The alternative would be to use fiscal austerity and try to keep the economy sufficiently depressed in order to eliminate the pressure on prices or exchange rates. While we believe that this would be a mistake—the economic losses due to operating below full employment are almost certainly much higher than the losses due to inflation or currency depreciation—it is an entirely separate matter from financial constraints or insolvency, which are problems sovereign governments do not face.

We openly admit that:

• While some of the measures we’ve outlined could be easily implemented, others are much easier said than done.
• All of them are subject to severe agency and other risks. But that’s true for most things in life, not just politics!
• Many of the distortions and perverse incentives that got us here still need to be corrected.
• Many voters may fear — perhaps justifiably, judging by some of the rhetoric on the left — that deficits do indeed imply higher future taxes and should thus be avoided.

We also admit that under certain conditions, fiscal austerity (via higher taxes and/or lower spending) may indeed be supportive of growth. But we do not think those conditions are in play today in most developed nations.

The bottom line is that no meaningful, bipartisan measures capable of supporting of economic growth at a reasonably healthy level can be crafted until we’ve moved beyond irrational deficit hysteria. And that requires a broader and deeper understanding of how modern money and financial economies work.

URLs:

http://theweek.com/bullpen/column/204603/the-krugman-question

http://www.newdeal20.org/2010/07/02/free-market-showdown-david-frum-poses-the-question-heres-the-answer-14105/

http://theweek.com/bullpen/column/204665/keynes-amp-co-have-lost-the-stimulus-argument

http://www.levyinstitute.org/pubs/ppb_111.pdf

http://en.wikipedia.org/wiki/Ricardian_equivalence

http://654advisors.com/index.php/blog/2006/12/committees-vs-markets/

http://654advisors.com/index.php/blog/2010/07/galbraith-blasts-the-deficit-commission/

“Money we don’t have”

Good NYT article on deficit hysteria, with an especially illustrative quote from Rep. Cooper (D, TN):

“We have to stop spending money we don’t have,” said Representative Jim Cooper, a Tennessee Democrat who voted against the bill. “I hope deficit reduction fever is catching.”

The U.S. is in the midst of a balance sheet recession, with demographic ratios shifting an an unfavorable economic direction for several more years.  Under those conditions, deficit reduction fever will lead directly to the dreaded Japanese Disease —  another decade of stagnation, underemployment, and opportunity costs, all of which will impose greater burdens on future generations than expanded federal deficits would.

And policymakers — not to mention most members of the electorate, including analysts and the media — continue to commit two fundamental errors regarding fiscal policy:

1. They believe that all deficit spending must be financed with interest bearing debt, thus competing with the private sector for scarce financial resources.  However, judging by current Treasury rates, there’s still plenty of room for expanded federal borrowing.  And there’s a symbiosis between federal deficits and repair of balance sheets in the financial sector, as evidenced by the perfect quarters turned in by several major investment banks recently.  Politically, that relationship is almost nauseating, as it’s doing very little to relieve distressed households — but it nevertheless makes apparent the  dynamic between public sector fiscal deficits and private sector balance sheet relief.
2. They also believe implicitly that the U.S. is on a gold or similar standard, where fiscal and monetary policies are constrained by the supply of some exogenous factor, and governments can thus literally “run out of money.”  Governments can’t run out of money, as it is ’created’ by nothing more than digital ledger entries.  In other words, government (today, via operations of the quasi-private Fed) is the sole creator and supplier of high powered money.  Thus, the only constraint on money creation is inflation and a loss of confidence in the currency, and at the moment, those forces are emphatically not in play.  This too is symptomatic of Japanese Disease.

The fears of incumbent politicians like Cooper are certainly understandable.  But they’re borne of either ignorance about how these things work, or self-preservation.  Either way, it smacks of lousy political leadership. 

And given that Republicans are likely to benefit in November, we’d expect the trend towards fiscal conservatism to intensify.  Even President Obama, in a speech yesterday, promised the following:

• A three year freeze on all non-discretionary federal spending beginning in 2011
• Expiration of tax cuts via sunset provisions
• Elimination of 120 federal programs
• Reinstatement of PAYGO
• Higher fees on banks that are expected to lower federal deficits by $90B over ten years

He promised all of this as a way to force the public sector to budget in the same way that families and businesses do.  Again, this is wrong, and is borne of either ignorance or pandering.  And as with Congress, it smacks of crummy political leadership either way. 

The administration’s jawboning is also reminiscent of budget austerity measures touted by the Carter administration in the 1970s in reaction to the “tax revolt” — austerity measures that contributed to its eventual demise, even though they may have been more appropriate to the conditions prevailing at the time (e.g., baby boomers entering adulthood, global trade and financial integration, etc).   Today, austerity is far less appropriate, but even more vigorously pursued.  That almost certainly spells trouble for Obama in 2012 – assuming the GOP can field a worthy candidate and avoid blowing all of its political capital in the intervening years. 

You also have to wonder, were he to experience a change of heart, whether there’s any credible way for him to backtrack from his neo-liberal rhetoric.  The DLC, Brookings, Peterson, and all the other usual suspects have painted the guy into one hell of a corner.

In the meantime, assuming that reality will align with rhetoric, the political climate continues to be favorable to the USD and Treasuries, and rather risky to gold.  A contrarian call? You bet.  But it’s based on what we think is a well-grounded and – just as importantly – non-ideological assessment of the facts. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. SCM is an Amazon.com associate, and earns a commission on sales generated through links from our website. Some clients of the firm are long GLL and/or long TLT.  At the time of writing, neither the firm nor its principals owned any securities mentioned. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://www.nytimes.com/2010/05/29/us/politics/29deficit.html

http://www.japanreview.net/review_bsr.htm

http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1125&group_id=1&pageNo=2

http://www.investmentnews.com/article/20100602/FREE/100609973

http://seekingalpha.com/article/208174-how-deficit-hawks-will-keep-cutting-spending-until-we-re-all-on-food-stamps

Reflections & reading

Here’s our current take on the state of markets and political economy – plenty of fodder for anyone seeking reading material for Memorial Day weekend! 

REFLECTIONS ON MEMORIAL DAY

It’s easy to forget that this three day weekend is more than just a respite from a busy and uncertain world, but also an opportunity to reflect on the public sacrifices of so many, and what they mean to us.  Part of that is obvious, part of it less so.  As Oliver Wendell Holmes observed of Memorial Day in 1884 (emphasis added):

…to the indifferent inquirer who asks why Memorial Day is still kept up we may answer, it celebrates and solemnly reaffirms from year to year a national act of enthusiasm and faith. It embodies in the most impressive form our belief that to act with enthusiam and faith is the condition of acting greatly. To fight out a war, you must believe something and want something with all your might. So must you do to carry anything else to an end worth reaching. More than that, you must be willing to commit yourself to a course, perhaps a long and hard one, without being able to foresee exactly where you will come out. All that is required of you is that you should go somewhither as hard as ever you can. The rest belongs to fate. One may fall-at the beginning of the charge or at the top of the earthworks; but in no other way can he reach the rewards of victory.

We’ll be thinking of all servicemen and women, past and present, and hope you will too.  We’ll also be thinking of ’the Captain’ — we miss having him on the bridge with us. 

GEITHNER RALLIES EUROPE

Markets have had a nice little relief bounce this week, thanks in part to Treasury Secretary Geithner’s solidarity promoting visit to Europe.  Interbank funding markets, though somewhat improved, continue to show signs of stress.  This shouldn’t be surprising, as Geithner’s message is that the current EMU-IMF rescue plan is a good one, and just needs coordinated implementation:

“The European leaders have put together a very strong programme of reforms on the fiscal side and a very strong commitment on the financial side,” he said at a news conference alongside new British finance minister George Osborne.

“I think it’s got the right elements and again I see a very strong political commitment — you see that not just in Germany but across Europe — to make it work. I think what Europe should do is implement the program they’ve laid out.”

As we’ve pointed out, we think that assessment is just dead wrong.  Unless the ECB is somehow surreptitiously monetizing Greek debt, then the current plan virtually assures its eventual default.  And as with the once supposedly “contained” subprime crisis, it’s extremely unlikely that Greek debt can be ring fenced in a way that will prevent global financial contagion and damage to the real global economy.  The euro’s continued descent (like the flight to the USD and U.S. Treasuries) implies as much.  As long as “fiscal austerity” is given primacy the world over, then the bullish USD and UST trade should continue, and gold should look increasingly precarious. 

THE AUSTERITY BAND PLAYS ON

We commented yesterday on the OECD’s double barreled assault on recovery.  Larry Elliott of The Guardian also penned a good counter point:

…the risks of tightening too quickly are probably greater than tightening too slowly. Why? Because in the US and in the European Union (although not in the UK) deflation is now a threat. Should the global economy tip back into recession, policymakers would have no ammunition left to fire. Interest rates are at rock-bottom levels already, budget deficits have exploded, new money has been created electronically, central banks are awash with the bad debts they have scooped up from financial institutions.The best (or least bad) outcome would be for policymakers to hold their nerve, keeping pro-growth policies in place until there is evidence both of recovery becoming embedded and of the reforms necessary to prevent a second financial crisis. Unfortunately, the European sovereign debt crisis has muddied the waters, making governments – and institutions like the OECD – nervous. The voices urging austerity are currently more powerful than those urging the need for job creation. After a brief flirtation with unconventional economic policies, the old orthodoxy is making a comeback.

There’s also a good video piece on the Peter G. Peterson Foundation’s most recent fiscal scarefest, er, summit, with some pointed jabs at the man himself.  The scariest part of the video, to us, is when deficit reduction commission co-chairs Erskine Bowles and Alan Simpson offer their intensely hawkish views, as we expect them to have the President’s ear when it comes time to enact fiscal consolidation. 

INFLATIONISTAS EXPOUND

In a NYT op-ed, David Einhorn, a hedge fund manager who’s one of the best balance sheet analysts alive, tried his hand at macroeconomic analysis, with mixed results.  One particular aspect is especially curious — Einhorn derides credit rating agencies (and “modern Keynesianism”, whatever he means by that):

Modern Keynesianism works great until it doesn’t. No one really knows where the line is. One obvious lesson from the economic crisis is that we should get rid of the official credit ratings that inspire false confidence and, worse, are pro-cyclical, aggravating slowdowns and inflating booms. Congress has a rare opportunity in the current regulatory reform effort to eliminate the rating system. For now, it does not appear interested in taking sufficiently aggressive action.

Yet only a few paragraphs later, Einhorn sounds just like those same rating agencies – the ones that have gotten Japan so remarkably and consistently wrong over twenty years — when discussing the risk of sovereign debt default:

I don’t believe a United States debt default is inevitable. On the other hand, I don’t see the political will to steer the country away from crisis. If we wait until the markets force action, as they have in Greece, we might find ourselves negotiating austerity programs with foreign creditors.

Some believe this could be avoided by printing money. Despite the promises by the Federal Reserve chairman, Ben Bernanke, not to print money or “monetize” the debt, when push comes to shove, there is a good chance the Fed will do so, at least to the point where significant inflation shows up even in government statistics.

That the recent round of money printing has not led to headline inflation may give central bankers the confidence that they can pursue this course without inflationary consequences. However, printing money can go only so far without creating inflation.

The Pragmatic Capitalist penned a good rebuttal to Einhorn’s piece:

First, the government doesn’t actually print money (at least not in terms of money creation). They simply press a button on a computer that changes accounts up and down. It’s not like they find a gold miner and print up a note and “monetize” anything. Most importantly though, the government never actually has nor doesn’t have dollars. They simply change accounts up and down as they tax and spend. So what does the Fed do? They target the Fed Funds Rate via monetary operations with the belief that they are the grand wizard behind the whole operation. The Fed’s interest rate mandate or target of “price stability” actually means they can’t monetize the debt. In a Q&A session last year Mr. Bernanke admitted as much…

Now, this is generally the point in the conversation where the inflationistas begin talking about the “effective default” of the USA via dollar devaluation. The problem is, each time the crisis flares up the price action in markets makes it abundantly clear that there is no inflation, but rather continuing deflationary fears.

…The inflationistas have made the same error that Mr. Bernanke made when he supposedly “saved the world” in 2008. Mr. Bernanke assumed that banks were reserve constrained while Mr. Einhorn assumes that adding to reserves is inherently inflationary.

But as we see very low levels of borrowing (due to the private sector’s lack of debt demand – caused by the continuing balance sheet recession and de-leveraging) we also see zero signs of inflation.

Einhorn is not the only smart hedgie manager who’s worried about inflation — Seth Klarman is too:

The concern that the dollars he earns for his clients will lose their purchasing power is always on hedge fund manager Seth Klarman’s mind.   The possibility that the government will continue to print money to solve our economic problems has left him more worried than at any time in his career.

“There are not enough dollars in the world to do that, unless we greatly debase them,” he said.

Our take is that Klarman isn’t thinking deeply enough about stocks, flows, and multipliers in making such a statement.  Monetization should be sufficient to stem deflationary pressures long before it approaches 100% of outstanding debt.  And as we noted recently, in a deflationary balance sheet recession, there is a period of ”disdeflation” that must unfold before we can arrive at actual inflation:

Deflation implies a shortage of money.  If that shortage persists, eventually all or most prices will come down, even if relative prices (e.g., the number of eggs exchanged for a quart of milk or a certain amount of gold or silver) do not move. And because most debt contracts are priced in nominal rather than real terms, this causes carnage in credit markets, e.g., waves of default, bankruptcies, and restructuring…

Under fiat monetary systems, precious metals are nothing more than a barometer of inflation (rising) and deflation (falling), and like any other prices, they are subject at times to human error and herding.  And today, with everything on the planet flashing deflation ahead, there is simply no fundamental reason for gold prices to increase.

So why has gold been rising? It’s most likely due to the fear that policymakers will use inflation to involuntarily “restructure” public sector debt…

Here’s the thing though – if there’s outright deflation, then monetizing debt, be it sovereign or private, cannot be inflationary until deflationary pressures have been completely extinguished. This idea simply mirrors the concept of ”disinflation” that has held currency with economists from the 1980s into the 2000s — similar to how today’s environment is an inverse reflection of the episodes that have people like [Einhorn and Klarman] wringing their hands about inflation, and gold bugs screaming that the sky’s the limit.  

Is it disdeflation? Whatever we choose to call it, it is not a “door” or a magical threshold that is instantly crossed as soon as central banks monetize interest bearing debt, or treasuries credit accounts with new units of money. It’s more like a long passage, with plenty of room between here (deflation) and there (inflation). Most importantly, there are places along that passage that offer a sounder economic and financial footing than what we’re currently on.    

Most importantly, if the world’s governments continue hurtling towards austerity as currently promised, at least part of his statement will prove true: “There [will not be] enough dollars in the world…”

THE INTERGENERATIONAL DEBATE

On the “sounder footing” point above, given how the intergenerational “mountain of debt” meme continues to run wild, we can’t over emphasize this: debt is not the only thing that one generation leaves to another!!!  There are also tangible and intangible assets — not only financial wealth, but also public and private resources, knowledge, security, technology, arts and culture, peace, health, etc.  Poorly timed austerity measures will mean that FEWER of those assets are available to future generations, due to Wicksell’s ‘residue of social maladjustment’; they will also require even further expansions in public sector outlays, due to poor economic performance, thus raising the dreaded debt-to-GDP levels that they’re aimed at lowering (Japan, anyone?). 

Alan Simpson acknowledges as much in the Real News video, though he seemed to be deeming it necessary, perhaps laboring under the prevailing dogma that government deficits always work against private sector economic growth.  For a competing take, we recommend Richard Koo’s take on Japan, the U.S., and balance sheet recessions. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Some clients of the firm hold positions that are expected to move inversely to gold prices.

URLs:

http://www.usmemorialday.org/observe.htm

http://people.virginia.edu/~mmd5f/memorial.htm

http://www.reuters.com/article/idUSLDE64P12320100526

http://654advisors.com/index.php/blog/2010/05/oecds-double-barrel/

http://www.guardian.co.uk/business/2010/may/27/larry-elliott-deficits-austerity

http://www.pgpf.org/newsroom/press/Top-Leaders-to-Meet-in-Washington/

http://www.nytimes.com/2010/05/27/opinion/27einhorn.html?ref=opinion&pagewanted=all

http://654advisors.com/index.php/blog/2010/05/japan-not-greece-black-widow-ii/

http://seekingalpha.com/article/207443-talking-ourselves-off-the-edge-of-the-cliff

http://www.advisorperspectives.com/newsletters10/Seth_Klarman_is_More_Worried_than_at_Any_Time_in_his_Career.php

http://seekingalpha.com/article/206104-disdeflation-an-important-and-not-entirely-new-concept

http://654advisors.com/index.php/blog/2010/05/a-brief-now-what/

http://654advisors.com/index.php/blog/2010/05/fiscal-reform-will-fail/

“An absolute general mobilization” in Euroland

Wow…the EU may, may, have finally put together a mammoth, TARP sized plan to prevent or at least mitigate a 2008-style meltdown on the continent. As described in an article by Ambrose Evans-Pritchard of The Telegraph (UK):

“It is an absolute general mobilization: we have decided to give the eurozone a veritable economic government,” said French president Nicolas Sarkozy, once again basking as Europe’s action man. “Today we have an attack on the whole of the eurozone. This is a systemic crisis: the response must be systemic. When the markets open on Monday morning we will be ready to defend the euro.”

Great caution is in order. German Chancellor Angela Merkel has so far said little. The descriptions of the deal agreed by EU leaders in the early hours of Saturday are coming from the French bloc and EU bureaucrats. How many times during the Greek saga of the last four months have we heard claims from Brussels that turned out to be a distortion of what Germany had actually agreed, causing each relief rally to falter within days? They had better get it right this time.

Perhaps it shouldn’t be surprising that the French bloc is pushing such a description, given their relative exposure to Greece and their immense exposure to Italy:

Image by Bill Marsh/The New York Times

Evans-Pritchard continues, noting what a seminal event this is for the EMU and the euro:

…if the early reports are near true, the accord profoundly alters the character of the European Union…The creation of an EU rescue mechanism with powers to issue bonds with Europe’s AAA rating to help eurozone states in trouble — apparently €60bn, with a separate facility that may be able to lever up to €600bn — is to go far beyond the Lisbon Treaty. This new agency is an EU Treasury in all but name, managing an EU fiscal union where liabilities become shared. A European state is being created before our eyes.No EMU country will be allowed to default, whatever the moral hazard. Mrs Merkel seems to have bowed to extreme pressure as contagion spread to Portugal, Ireland, and — the two clinchers — Spain and Italy. “We have a serious situation, not just in one country but in several,” she said.

The euro’s founding fathers have for now won their strategic bet that monetary union would one day force EU states to create the machinery needed to make it work, or put another way that Germany would go along rather than squander its half-century investment in Europe’s power-war [sic] order.

According to Evans-Pritchard, a key problem with the present accord, beyond German inflation phobia, is that its key components still include severe austerity measures:

The answer to this — if the objective is to save EMU — is for Germany to boost its growth and tolerate higher `relative’ inflation. This would allow the South to close the gap without tipping into a 1930s Fisherite death spiral. Yet Europe will have none of it. The weekend deal demands yet more belt-tightening from the South. Portugal is to shelve its public works projects. Spain has pledged further cuts. As for Germany, it is preparing fiscal tightening to comply with the new balanced budget amendment in its Grundgesetz.

In other words, while Germany may have surrendered significant ground on the matter of closer fiscal integration, it has apparently not given up on its demands for severe austerity measures in other EMU nations. Note that even Sarkozy’s quote closes with the somewhat cryptic statement that “on Monday morning we will be ready to defend the euro.” Does that mean that a stronger euro will be pursued by policymakers, or that stabilization measures will be taken that, in the long run, should ensure the euro’s continued existence? The former would only exacerbate the sense of crisis and panic, so it’s tempting to assume that Sarkozy and other European leaders are committed to the second. However, Evans-Pritchard closes with two disconcerting historical references that should give pause:

While each component makes sense in its own narrow terms, the EU policy as a whole is madness for a currency union. Stephen Lewis from Monument Securities says Europe’s leaders have forgotten the lesson of the “Gold Bloc” in the second phase of the Great Depression, when a reactionary and over-proud Continent ground itself into slump by clinging to deflationary totemism long after the circumstances had rendered this policy suicidal. We all know how it ended.

We should see a good deal of dislocation (relocation?) and continuing volatility in markets tomorrow, with credit markets being key ones to watch. If European leaders can manage to soften the austerity demands, quell their inflation paranoia, and execute on a meaningful stabilization program, then things should settle down in reasonably short order.  If they can’t, then keep your seat belts fastened.

Another critical issue is whether the backstop provided by a new facility is large enough relative to the debt levels at the center of the crisis. According to data in a recent Spiegel article, it might be, all told. In 2012, there’s E370B of debt maturing in the PIIGS nations, E328B in 2011, and 276B in 2012. And something that has been completely overlooked in this crisis is that, according to Ajay Kapur’s research, most of the PIIGS countries are on the cusp of favorable turns in demographic composition, at least as it relates to financial sector performance. That certainly adds an interesting wrinkle to the story.

TOH to Zero Hedge for links to the Telegraph and Spiegel articles.

UPDATE 5/9/2010 — The ECB has announced that its bond market operations will be sterilized, which means it intends to offset the creation of new euros resulting from its planned bond market purchases. The net effect is to undo any actual debt monetization. This indicates to us that current plans to ‘protect the euro’ are indeed likely to have a deflationary bias. It will be interesting to see how forex markets react — do they think it can be done (stronger euro), or will they bet on inevitable ECB easing (weaker euro)?  This does nothing to undermine Stephen Lewis’ warning above about “deflationary totemism”.  

URLs:

http://www.telegraph.co.uk/finance/financetopics/financialcrisis/7702335/Europe-prepares-nuclear-response-to-save-monetary-union.html

http://learning.blogs.nytimes.com/2010/05/04/its-all-greek-to-me-understanding-the-debt-crisis-in-europe/

http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1125&group_id=1

http://www.businessweek.com/news/2010-05-09/ecb-intervenes-in-bond-market-as-part-of-eu-debt-crisis-plan.html 

A brief “Now what?!?”

Equity markets and indices are down over 2% today on worries about what most pundits refer to as the “Greek bailout,” which took its (supposedly) final shape over the weekend, with details to follow from the IMF and other parties. The terms, as currently laid out, are brutal, a fact reflected by the intense street protests in Greece and the government’s loss of union support. The theories and practices underlying them are highly questionable and pitifully anachronistic as well, which make it all the more frustrating.   

There’s no doubt that Greece has made some mistakes, that the lack of accurate fiscal disclosures by its previous government was extremely unethical, and that labor market reforms may be in order. But there are humane ways to approach and work through the entire imbroglio. Unfortunately, neither the IMF nor major eurozone countries seem to be giving that much thought. And as Marshall Auerback has pointed out, Germany’s longstanding inflation paranoia has it behaving as if it’s 1921 all over again; when to us, reality appears to be much closer to the deflationary late 1920s and 1930s.   

We referred to the Greek plan as pitifully anachronistic because it embodies what we might call gold standard era thinking, when the supply of new money was a function of mining output and demand for gold ownership in the private sector. At the turn of the 20th century, economist Knut Wicksell pointed out the need for a “rational monetary system“, while highlighting intellectual obstacles to it:   

It is no exaggeration to say that even to-day many of the most distinguished economists lack any real, logically worked out theory of money, a circumstance which has not, of course, been particularly conducive to the success of modern discussions in this field.   

Wicksell’s sentiments are still relevant today, and (in our view) have been powerfully echoed and expanded upon by proponents of neo-chartalism, also known as Modern Monetary Theory. Bill Mitchell, an occasionally acerbic but ever prolific member of the MMT club, recently posted the following diagram on his website:   

The essential point of the diagram is to illuminate that, under a fiat currency system, the government (whether through its treasury or via a quasi-public central bank) is the sole provider of money. And one of the resulting takeaways of this fact is that under certain conditions, fiscal austerity in the public sector will impose significant costs on the private sector. In turn, that will tend to raise the value of money, all else equal, which is the essence of deflation. And as Wicksell pointed out over a hundred years ago, deflation, like inflation, comes at a cost (emphasis added):   

…when a rise or fall occurs in the money prices of all, or of most, commodities…[a]djustment can no longer proceed through changes in demand or through a movement of factors of production from one branch of production to another. Its progress is much slower, being accomplished under continual difficulties, and it is never complete; so that a residue, either temporary or permanent, of social maladjustment is always left over.   

By linking the inflation boogeyman to public sector debt levels, prevailing economic theory sometimes leads to poor policy prescriptions and outcomes, as we are now seeing in Greece. It also fails utterly to explain the experience of Japan over the last two decades, and it looks set to fail in both the Eurozone and the U.S. in the coming decade.  So far, our contrarian calls for a strengthening USD and a dovish view of long term U.S. Treasury yields has lent support to this thesis.   

As with our recent “What Happened?!?” piece, we also think it’s important to tie the Greek “rescue” package to the current U.S. policy outlook. Today, speaking to the Business Council, President Obama once again invoked our “unsustainable fiscal deficit” and argued for immediate reimplementation of PAYGO. Looked at in terms of Mitchell’s diagram above, that implies that at best, the federal government is unlikely to add to the supply of vertical money.  It’s also important to realize that a concept like PAYGO essentially restricts the vertical money supply function to the central bank. And yet, according to recent testimony from Fed Chairman Bernanke, the Fed is targeting roughly a 50% contraction in its balance sheet, which also implies a contraction in narrow or vertical money supply (though rising velocity could give the Fed some room to work with).  Similarly, it was over tightening in both the fiscal and monetary spheres that led to the 1937 recession after several years of economic recovery.

The upshot of all this is that leaders in the public sectors of both the U.S. and the Eurozone are clearly signalling their intentions to “crowd out” private sector saving and, potentially, income. And unfortunately, electoratal majorities in key countries seem to support this direction. Normally, we expect electoral outcomes to approach optimal, but in this particular case, we suspect that the historic lack of economic and financial education might steer us wrong. Then again, voters with incomes might be making some rational inferences about deficits, austerity, and taxes. If so, the burden of adjustment could rest even more heavily on the on the un- and under- employed (believe it or not, that’s something that a handful of policy pundits have advocated, and that at least one senator briefly pursued).   

Either way, deflation will be the inescapable result of excessive restriction or contraction in vertical money.  We’re currently getting slight whiffs of it from credit markets and price indices (although the latter are still positive); cooling measures in China are also likely to help it along. As noted in our “What Happened?!?” piece, we don’t expect it to manifest in an economic downturn until 2012 or 2013, but it could show up in market prices before that. We’ll be watching commodity markets closely, as a broad decline in those prices would provide an especially powerful confirming signal.  Stay tuned…   

URLs:   

http://www.newdeal20.org/2010/03/30/greece-and-the-eurozone-angie-aint-it-time-to-say-goodbye-9235/   

http://www.newdeal20.org/2010/04/12/the-piigs-problem-maginot-line-economics-9697/   

http://en.wikipedia.org/wiki/Inflation_in_the_Weimar_Republic   

http://en.wikipedia.org/wiki/File:GDP_depression.svg   

http://mises.org/books/interestprices.pdf   

http://bilbo.economicoutlook.net/blog/?p=7864  

http://www.econlib.org/library/Essays/wcksInt1.html   

http://654advisors.com/index.php/blog/2010/04/a-brief-what-happened/ 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

Poor auctions signifying…what exactly?

A good deal is being made of subpar Treasury auctions this past week and whether they signify a turning point in the market’s appetite for U.S. government debt. It’s certainly possible, but we suspect that there’s a more nuanced and global explanation.

First off, a 10 year Treasury yielding almost 4% annually does not look like a bad deal given the intermediate growth outlook in the U.S., despite what so many other pundits are saying (unless you believe that we’re on the verge of persistent domestic inflation, i.e., a widespread USD surplus…anyone?).

Second, if Treasury auction participants came to market with only cash and held no other assets, then the prevailing theory would be harder to refute. However, the most important participants in treasury auctions are the New York Fed’s primary dealer banks, which are divisions of BNP, Bank of America, Barclays, Cantor, Citigroup, Credit Suisse, Daiwa, Deutsche Bank, Goldman Sachs, HSBC, Jefferies, JP Morgan, Mizuho, Morgan Stanley, Nomura, RBC, RBS, and UBS. These bank divisions and their parents already own large amounts of financial assets. Thus, they also need to manage risk when making purchase commitments. And one of the biggest risks of the past week was whether the Eurozone could agree on an assistance plan for Greece.

The following members of the Fed’s primary dealer banks are also primary dealers for Greek debt: Barclay’s, BNP, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Merill Lynch (assumedly this is Bank of America), Morgan Stanley, Nomura, RBS, and UBS. This provides just a glimpse of the overall mosaic, as dealers also act as agents or conduits for public, and not just principals. However, it’s an important one, and it’s reported (and reasonable to assume) that several of them do own large slugs of Greek government debt.

Thus, given the uncertainty surrounding management of Greece’s funding crisis, and how it spiked again this past week as Germany dug in its heels, it’s quite possible that some of the usual buyers of U.S. Treasury debt are simply distracted and/or increasingly risk averse (even using low central bank interest rates to finance the purchase of protective credit default swaps, which probably offered more comfort in the immediate environment than new Treasuries).

 Consider, for example, that French and German banks are believed to be exposed to $119B of Greek debt. Assuming sane leverage ratios of 10x (a dangerous assumption to make), the potential financial loss is equivalent to a significant percentage of the two countries’ annual GDP of $6T (e.g., a 15% decline in the value of Greek bond holdings, if unhedged, would equal roughly 3% of combined French and German GDP).

As tempting as the U.S.-Treasury-on-the-brink hypothesis is for the public debt Cassandras, we think ours does a better job of incorporating the sharp strengthening of the USD over the past week, and market behavior since yet another agreement began to take shape.

Combined with the fact that speculative credit markets are looking awfully frothy, some other strange market signs, and the likelihood of federal fiscal consolidation in 2011, we think you have a recipe for an eventual rally in Treasuries. It reminds us a little bit of the post 9/11 Treasury market selloff. Caveat venditor?

IMPORTANT DISCLOSURES: The author does not own shares of any companies mentioned. Clients of the firm own shares of ALBKY, SHY, TLT, MFG, and NBG. A principal of the firm owns shares of C, GS, and MS. Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

URLs:

http://www.newyorkfed.org/markets/pridealers_current.html

http://www.bankofgreece.gr/Pages/en/Markets/HDAT/DispItem.aspx?Item_ID=3220&List_ID=1af869f3-57fb-4de6-b9ae-bdfd83c66c95

http://www.businessinsider.com/germany-will-have-to-become-greeces-abu-dhabi-since-way-too-many-foreigners-hold-greek-debt-2010-1

http://dealbook.blogs.nytimes.com/2010/02/25/banks-bet-greece-defaults-on-debt-they-helped-hide/

http://online.wsj.com/article/SB10001424052748703798904575069712153415820.html

http://www.bloomberg.com/apps/cbuilder?ticker1=DXY%3AIND

http://www.businessweek.com/news/2010-03-27/bunds-fall-greek-bonds-rise-after-eu-leaders-agree-aid-plan.html

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aJZgGddV4mIY

http://ftalphaville.ft.com/blog/2010/03/24/185091/new-negative-territory/

Hamilton: Credit crisis causes vs symptoms

Short but interesting post from James Hamilton at Econbrowser on a recent conference re credit market dislocation. His main point is that many (if not most) economists are focusing on the Lehman collapse and its aftermath as problem, rather than symptom of a historic run up in credit. It’s accompanied by some straightforward eye candy.

There’s also a link in the comments section to this New Yorker profile of Ben Bernanke – like Hank Paulson’s recent tell (not quite) all, it’s an interesting story.

URLs:

http://www.econbrowser.com/archives/2010/03/modeling_proble.html

http://www.newyorker.com/reporting/2008/12/01/081201fa_fact_cassidy?currentPage=all