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.

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/

He likes it! Hey Nicky!

At the moment, Mr. Market looks pretty satisfied with the EMU’s surprisingly large rescue plan – European stock bourses are up over 5%, France’s CAC40 over 8%, while U.S. equity futures are up over 4%.  Vienna’s ATX and the Madrid General, with their home countries also heavily exposed to troubled sovereign debt (Spain doubly so), are up over 9% and 12% respectively:

Of course, following a week when indices were down 7 to 11%, these kinds of gains still leave markets roughly 3% shy of last week’s highs.

It’s not clear how much of this consists of short covering, and how much reflects renewed belief in fundamentals.  European officials still sound as if they are strongly committed to austerity — perhaps the sizeable rescue package reflects nothing more than a desire to spread the pain to bearish traders as well?

And globally, a handful of analysts have noted that many cyclical asset prices have optimistically decoupled from leading indicators such as Chinese property markets (see this rather cautious piece by former uber bull Ajay Kapur, for example: http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1350&group_id=1&pageNo=1).

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. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.

“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.

Bernanke: “It wasn’t us.” BIS: “Yes it was.”

A couple more interesting pieces in the to-and-fro on whether the Fed and other central banks played a role in fostering asset bubbles in the early 2000s:

First, the Economist takes apart former and current Fed chairment Alan Greenspan and Ben Bernanke’s recent defenses of monetary policy:

…both [Greenspan and Bernanke] say there is no evidence that low short-term rates drove house prices upward. Mr Greenspan argues that the statistical relationship between house prices and long-term rates is much stronger than with the Fed’s policy rates, and that during the early 2000s the traditionally high correlation between policy rates and long-term rates fell apart. Mr Bernanke points to structural models which show that only a modest part of the house-price boom can be pinned on monetary policy.

…There is something odd about central bankers denying any responsibility at all for long-term rates, which are, in principle, based partly on an assessment of a stream of short-term rates. Nor is it clear that low short-term rates were as irrelevant as Messrs Bernanke and Greenspan suggest. Jeremy Stein of Harvard University, a discussant of Mr Greenspan’s Brookings paper, points out that low policy rates may have mattered a great deal for income-constrained borrowers. He points out that adjustable-rate mortgages were used much more in expensive cities, a trend that became more pronounced as the fund rates fell.

By looking only at the effect of monetary policy on house prices, Messrs Bernanke and Greenspan also take too narrow a view of the potential effect of low policy rates. Several economists have argued convincingly, for instance, that low policy rates fuelled broader leverage growth in securitised markets.

Second, the Bank of International Settlements has published a paper arguing emphatically that monetary policy in the form of low interest rates can and does contribute to speculative risk taking by banks:

Using a unique database that includes quarterly balance sheet information for listed banks operating in the European Union and the United States in the last decade, we find evidence that unusually low interest rates over an extended period of time contributed to an increase in banks’ risk. This result holds for a wide range of measures of risk, as well as macroeconomic and institutional controls…

It is a very bad thing when the leader and former leader of an institution as critical as the Fed decide to cover their asses instead of engaging in critical assessment and truth telling. Personally, I don’t find it surprising with Mr. Greenspan, as I’ve never held a high opinion of the man (in my limited view, his primary professional achievement seems to have been the elevation of personality cult management to new levels). We’re more disappointed in Mr. Bernanke – still think he’s the right man for the job though. 

URLs:

http://www.economist.com/business-finance/economics-focus/displaystory.cfm?story_id=15719180

http://www.bis.org/publ/work298.pdf?noframes=1

Masters of the Universe: They’re baaaack…

A new BIS paper has some very telling data points. First, they demonstrate the extent to which leveraged financial speculation drove foreign currency movements in the financial crisis (it’s quite reasonable to assume that this factor was at work in other asset class dislocations too). Second, it provides evidence that highly leveraged masters of the universe were back to their old tricks in fairly short order.

Let’s start with a  quick primer on “carry trades.”  A carry trade occurs when a financial market participant borrows in some currency with a low nominal interest rate (the “funding currency”) and invests the loan proceeds in some asset(s) (a “target asset”) that’s expected to appreciate at a rate that exceeds the interest rate due on the borrowed currency. The target asset can be a higher yielding currency, a credit instrument, equities or a stock market proxy, commodities or a commodity index proxy, and so on.

The Yen carry trade — borrowing low yielding Japanese Yen and using them to acquire riskier assets – has been increasingly employed by speculators since the 1990s, and appears to have played a key role in the speculative period of 2004-2008.

Speculators engaging in this activity are taking risks (sometimes massive risks) with (for the most part) Other People’s Money (OPM). When it works, they return the borrowed funding currency plus interest, and pocket the difference. When it goes terribly wrong, you wind down operations and hide from your creditors behind a corporate liability shield, forcing them to write down the value of their loans to you (their funding currency assets).

Nice work if you can get it, and amazingly, investment banks and their subsidiaries have been falling all over themselves to make these loans to privileged clients — including their own proprietary desks and funds — since the late 1990s (in competitive strategy, herd pursuit of bad ideas is usually a sign of an over crowded industry).

Better yet for the carry traders, increasingly lax financial regulation has allowed speculators to lever their carry up to levels not seen before in modern history, meaning they can borrow more money for a given level of collateral, and/or purchase more assets with a given amount of funding currency.

As some of those trades started to go bad in 2008, the result was a breathtakingly sharp and sudden reversal in the key funding currency, the Yen. This can be seen in the circled graph below, along with the following observations:

• The rate of appreciation in the Yen was far greater in 2008 than in the 1997 and 1998 global financial crises. The left most graph shows foreign exchange movements between the Yen and thirty three other currencies during the Asian crisis of 1997. Clearly, forex movements in that crisis were country specific.
• The middle graph shows currency movements against the Yen during the 1998 crisis associated with the Russian sovereign debt default. The appearance of a positive slope is apparent, implying that forex dislocations were due more to speculative behaviors including the rising use of leverage than to country-specific risks (for that we can probably thank the pioneering geniuses at LTCM and their investment bank benefactors).
• The third graph shows the appreciation of the Yen during the recent global financial crisis. The slope, which gives an idea of how sharply the Yen appreciated against those 33 other currencies, is breathtaking. The median interest rate on the target currencies (on the horizontal axis) also appears to have been roughly half of what it was in 1998.

Translating into English, this means that in 2008-09, the Yen appreciated even more sharply than it did in 1998, and against target assets that offered half the expected return of those in 1998. This calls to mind a question we raised recently, which is whether some powerful financial market participants are confusing ”efficient dislocation” with “market efficiency.” That would be understandable after all. History shows that the fatter the economic rents being justified, the more deluded the economic rationales tend to be.

In the BIS paper, the author also notes that carry trade activities are inherently pro-cyclical: borrowing activity tends to push down the market value of the funding currency, while investing activity tends to push up the market value of the target assets, and this will tend to invite increasing levels of speculation until something causes a breakdown.

Higher degrees of leverage make the pro-cyclicality and the eventual fallout that much worse. Unfortunately, while a great deal has been made of John Maynard Keynes’ alleged return in the past year, it appears that the brief 2008-09 resurgence of Hyman Minsky — who warned presciently of such dangers – has already been forgotten.

That “Minsky fade” appears to be supported by the bottom right graph (though admittedly, this case isn’t as strong as the leveraged carry trade evidence discussed above). The negative slope in that graph shows that less than a year later, the Yen depreciated markedly against many currencies, especially against higher yielding target currencies, which runs counter to the aftermath of 1997 and 1998.

The implication is that the Yen carry trade came back on line fairly quickly after financial markets regained their footing. Apparently financial cockroaches are, like their arachnid namesakes, largely immune to the effects of fallout. As described by the BIS author:

…with extreme risk aversion abating, carry trade activity – a relatively risky strategy – may have returned in the second half of 2009. Indeed, carry trades in a number of high-yielding currencies, especially those of commodity exporters, provided extraordinarily high ex post returns over this period. Moreover, near zero interest rates prevailed in many major currencies, increasing ex ante profitability not only for traditional funding currencies such as the yen. Carry-to-risk ratios support this conclusion…

A a critically important aspect of this issue is financial regulatory reform. Very little has been done from a regulatory standpoint to bring down the astronomical leverage that was available for carry trade speculation prior to 2008. Yesterday, Larry Summers gave an interview to CNBC in which he emphasized that the scope of the proposed “Volcker Rule” was limited to particular types of banks.

If true, over leveraged areas of global financial markets are likely to continue escaping prudent regulation, which means that the pronounced cycles of euphoria and distress in risky asset classes will continue. While those swings create opportunities for contrarian investors, the dynamic behind them is a zero-sum or even net-negative economic game. In the long run, it causes more economic harm than it’s worth.

And while interest rates have converged substantially since the 1990s, current spreads are likely to persist in the decade ahead for multiple reasons, not least being variation in demographic cycles, which will mean lower nominal rates in most developed countries, and higher rates in most emerging markets.

In other words, the roach bait isn’t going anywhere soon. That means that sound regulation absolutely must fill the void in order for the gains from financial market speculation to approach something resembling a social optimum.

UPDATE 3/2/2010 – AP report on further progress in Senate Finance on financial regulation

URLs:

http://www.bis.org/publ/qtrpdf/r_qt1003f.pdf?noframes=1

http://654advisors.com/index.php/blog/2010/02/wsj-hedge-fund-career-trades/

http://news.yahoo.com/s/ap/20100302/ap_on_bi_ge/us_financial_overhaul

Mosler blowing minds (sort of)

Warren Mosler was given a brief spot on CNBC this morning to discuss his version of modern monetary theory, an idea that deserve a wider audience. The cognitive dissonance he induced among the host, a co-hosting economics reporter, and a successful hedge fund manager was pretty apparent. Warren lacks the charisma to make a quick sale, but as the co-host pointed out in the wrap up, it was a start.

Shovel-ready news bits

It’s another shovel ready snow day in the mid-Atlantic, with our second two footer in five days. Too bad we can’t ship the stuff to Vancouver efficiently. A couple of interesting things on the wires today:

The Fed’s exit strategy

Ben Bernanke outlined the Fed’s game plan for tightening monetary policy when the time is right. In our judgement he said the right things for the most part. The relatively new policy tool that is getting the most attention is the payment of interest on excess reserves that member banks have on deposit with the Fed (“IOER”).

Our initial take on IOER when it was legislated in 2008 was that it offered a way around the zero bound on the Fed’s interest rate target, but that was wrong. We overlooked that (1) the interest is not necessarily paid with new USDs, but could be paid out of cash flows earned on the voluminous assets that have been taken onto the Fed’s books and (2) the incentive effect of the interest payments is to “tie up” banks’ reserves outside of credit creation channels.

Fortunately, the Fed’s current interest rate is not competitive with spreads on public and private sector credit; instead, it appears to compete solely on the basis of risk, as banks don’t have to worry about mismatching assets and liabilities (borrowing short term and lending long term). But overall, it’s hard to see how those two effects of IOER support economic activity in the present. Apparently we’re not the only ones trying to get our heads around this.

ABC News poll

Headline numbers from a recent ABC News poll look bad for President Obama and Democrats, but there are some interesting things under the hood. First the headlines:

• Trust in Democrats’ ability to handle critical policy issues such as the economy and terrorism gave decline steadily since last year, with the overall gap versus Republicans falling from roughly 25% to 5%. 
• Obama’s approval ratings are below 50% on creating jobs, the economy, health care, and the deficit (his approval on terrorism is a very healthy 56%).

Some of the nuances that should be very relevant for political strategists include:

• While the margin has dropped considerably from 13%, 49% of independents lean towards Dems, 45% towards the GOP (p.5).
• While respondents viewed the loss of the Dems’ Senate super majority positively, 58% view the GOP as obstructionist, and 68% say that obstructionism should only be used infrequently (p.4).
• 48% describe themselves as “anti-incumbent”, below the 54% and 53% that preceded the “throw the bums out” elections of 1994 and 2006.

Health care reform is especially interesting; while most respondents view the present outcomes negatively:

• 80% support banning limits on pre-existing conditions.
• 56% support a personal health insurance mandate, including public assistance.
• 65% say the current approach is overly complicated, and 59% say it’s too expensive.
• 74% of those with private insurance trust their carrier to handle claims fairly, and more of these folks oppose the current reform packages.

One takeaway is that there’s plenty of room for strategic and tactical maneuvering by both parties in the quarters ahead.

Another, based on that last bullet point on health care, is that there appears to be a powerful asymmetry at work, one that I’m much more sympathetic to nowadays: people who have satisfactory health coverage are going to have a harder time empathizing with the challenges faced by those who don’t. That seems pretty rational, if not a little cut throat – if it ain’t broke for me, why should I have to pony up for your troubles?

My wife, who has worked in architecture for almost twenty years, was out of work for most of 2009. If not for the COBRA subsidy, we would have been in a much deeper financial hole, to the tune of about $600+ per month. When the subsidy was set to expire in December, we applied for coverage with the carrier we had through her prior employer, but were denied coverage for preexisting conditions, namely minor wear and tear to one of my knees and heightened anxiety in a person who had just lost her job and income. Huh??? 

And if you’ve ever tried to purchase a policy as an individual, you know how frustrating it is to try making comparisons between apples, oranges, cumquats, dragon fruit, and a bunch of others (let alone issues like financial strength and ratings). You also have to be a very savvy insurance consumer to detect the coverage gaps at work in different kinds of policies.

The family’s now fully insured thanks to good news on the employment front, but this is an issue that we have a whole new perspective on — one that’s firmly supportive of well designed health care reform.  

URLs:

http://news.yahoo.com/s/ap/20100210/ap_on_bi_ge/us_bernanke_exit_strategy

http://www.ny.frb.org/newsevents/speeches/2009/dud090729.html

http://www.newsneconomics.com/2008/12/why-exactly-does-fed-pay-interest-on.html

http://abcnews.go.com/images/PollingUnit/1102a22010Politics.pdf

Krugman vs CNBC

A couple of CNBC commentators ripped Paul Krugman for today’s op-ed on budget deficits, with Rick Santelli saying something about lining a bird cage. We aren’t defending Krugman against charges of self-contradiction or factual inaccuracies, but we are definitely siding with him on the economic substance of his argument (the lonely wingnut’s sojourn continues).

Prevailing rhetoric holds that the U.S. government is over extended, and that there’s precious little room for additional economic stimulus. That would be true if US dollars could only be obtained by taking them from people who have them, or by digging new ones out of the ground. In that case, servicing our debts — both private and public — would be quite burdensome. But the reality is that in a modern monetary system, monetary units are simply ledger entries. Whether carried in hand as a Treasury obligation, or held digitally in a bank account, all dollars are created out of thin air by the Federal Reserve in response to demands of the banking system.

The federal government does not have direct control of the Federal Reserve, so its control of money creation is only indirect (if Congress wished, it could wrest control of USD creation from the quasi-private Fed, a measure that a small number of radical but diverse members might like to see). But existing arrangements do not change the basic fact that the U.S. has the capacity to print the money (the non-interest bearing debt) used to service its public debt. That means that the only meaningful constraint on the level of our pubic debt is people’s willingness to accept the USD. And despite the sophomoric rhetoric on that point, people are still overwhelmingly willing to accept USDs.

The claim that Congress is “spending money that we don’t have” is even more egregious. To reiterate: if USDs could only be dug out of the ground, or pulled out of taxpayers’ pockets, then the argument might make some sense. But as long as we have the ability to create USDs out of thin air, then Congress has the ability to spend new USDs instead of existing ones.

The conservative argument against this type of Keynesian activism rests on a couple of key pillars, and under certain conditions, they’re valid: (1) as long as government constraints on the private sector are moderate, an economy will grow at or near full capacity; (2) public demand for capital will always tend to ‘crowd out’ private sector borrowing; and (3) public sector allocation of capital is inevitably distorted, which imposes long run economic costs. 

As long as those assumptions are valid, then Congressional thrift, beyond a basic level of social insurance and national defense spending, is a desirable objective. However:

(1) History doesn’t lend strong support to the idea that an unbridled private sector will always and everywhere produce positive growth; and if monetary policy is constrained by a zero bound (i.e., interest rates can’t go below zero), then whenever growth is below potential, fiscal stimulus is appropriate (and can be enacted in myriad ways that appeal to lefties or righties). This is especially true for long economic cycles, such as the Great Depression, Japan from 1989 until 2008 or so, and several developed western economies since roughly 1999. Judging by the available empirical research, demographic composition could be the main driver of these cycles (and if the effect is strong enough, it might deemphasize the importance of rationality vs behavioralism in theory and policy making).

(2) When private sector demand for capital is contracting, as can happen in a long down cycle, then public sector demand for capital (i.e., deficits and debt issuance) is beneficial, and should foster rather than crowd out private sector credit demand. However, under certain conditions, this will only work if money creation is supportive of public sector credit demand, i.e, if new money is created to finance the public sector debt (the conservative point of view tends to see this as banana republic monetary policy, but that isn’t always the case). Today, banks are taking advantage of a steep yield curve to borrow funds from the Federal Reserve (which creates new USDs) to purchase higher yielding Treasury debt, i.e., a significant amount of our public debt is being ‘monetized’. While that would be a bad thing in an inflationary environment, it’s a good thing when it offsets deflationary forces. Almost everyone who parrots the prevailing rhetoric is overlooking this dynamic.

(3) Public sector capital allocation is certainly prone to distortion in as much as it is not subjected to competition and the judgement of diverse agents. But asymmetries in the private sector can have powerfully negative effects too (financial crisis, anyone?). And while there’s room in our political system for new institutions designed to allocate public resources more optimally, the existing ones, such as voting, negotiation, and oversight, should do a good enough job in the meantime.

Krugman wrote that “there’s no reason to panic about budget prospects for the next few years, or even for the next decade,” and apparently this has some pundits and analysts pulling their hair out. But if prevailing demographic ratios are going to drive another decade of subpar economic outcomes…then he’s absolutely right!  

When the real economy is humming along, we can leave the creation and allocation of new USDs to the private sector, and rein in public deficits without doing too much harm. But when the state of the real economy is uncertain, as it certainly is now (pun intended), the refusal to finance public spending, investment, and intermediation via the creation of new dollars (within the constraints dictated by inflation objectives and expectations) is inherently deflationary and destructive. And that is what undermines the sophomoric notion that we are “leaving a mountain of debt to our grandchildren.” If the public sector is not active enough to offset destructive forces acting in the economy today, then our grandchildren will be worse off. Like most economic variables, public debt levels mean nothing in isolation. And we shouldn’t just look at it relative to current GDP. We must also look at it relative to opportunity cost, or looked at another way, to future GDP. There are actions that the public sector can take today to favorably impact GDP in the future, but they all require financing, including deficit spending. We should only be frightened of deficits when they are scarier than the opportunity costs imposed by government saving. Today, that is simply not the case.

So Krugman is right to be concerned about the policy outlook, which he has a rather pessimistic view of:

Washington now has its priorities all wrong: all the talk is about how to shave a few billion dollars off government spending, while there’s hardly any willingness to tackle mass unemployment. Policy is headed in the wrong direction — and millions of Americans will pay the price.

We’ve expressed similar concerns since 2H09, but it now looks to us as though the Obama administration is “triangulating” on deficits and the federal debt, with no intention to substantially withdraw fiscal stimulus in the government’s 2011 fiscal year (though again, we’re still trying to figure out how the president’s emphasis on PAYGO fits into this). If we’re right, then the readjustments underway in exchange rates, specifically the Euro and USD, are being driven by the Euro and sovereign debt concerns, rather than from the USD side. That means we should settle into a new exchange rate equilibrium in the coming weeks, at which point risky assets should start to recover. It’s going to be a bumpy ride, but we’ll get there.

URLs:

http://www.nytimes.com/2010/02/05/opinion/05krugman.html

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. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.