Deflation in the news?

Is there an incipient media trend towards deflation? Time will tell, but here’s a current example from Business Week:

Bargains are everywhere in America these days. Men’s shirts and sweaters were 3.4 percent cheaper this April than a year earlier. Prices also fell for eggs, peanut butter, bananas, potatoes, hotel and motel rooms, cosmetics, curtains, rugs, tools, and lawn care. Excluding gasoline and other energy items, the consumer price index rose just 0.9 percent for the year. That’s the smallest increase since January 1962, when John F. Kennedy was President.

Everybody likes to save money, but flat to falling prices are not entirely good. They’re a symptom of continued weakness nearly a year after the U.S. economy supposedly hit bottom. The same softness of demand that keeps goods cheap is pressuring workers. Annual growth of average hourly earnings fell from 3.5 percent in April 2007 to 1.6 percent this April.

The economic recovery, while welcome, isn’t yet strong enough to ensure against the risk of deflation…

Here’s the crux of the deflation question:

The optimistic take on the economy is that the threat of deflation is temporary and will diminish as excess capacity gets eaten up. Kurt Karl, chief U.S. economist of Swiss Re, says employment gains are producing income that will be spent, generating more jobs and more spending in a virtuous upward spiral. “I’m still bullish,” says Karl, adding, “employment growth has turned a major corner.” Deflation, he adds, “would be a permanent kind of problem only if you didn’t have any employment momentum.”

Based on what we see in the data, the broader behavioral environment, and history, we suspect that government stimulus (primarily ARRA and other counter cyclical measures) had a strong impact on private sector employment.  If so, then premature fiscal austerity will have a ‘multiplier-in-reverse’ effect, causing employment momentum to stall out.  We’ll know in a few more quarters.

URLs:

http://www.businessweek.com/magazine/content/10_23/b4181009637404.htm?campaign_id=yhoo

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://symmetrycapital.net/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://symmetrycapital.net/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://symmetrycapital.net/index.php/blog/2010/05/a-brief-now-what/

http://symmetrycapital.net/index.php/blog/2010/05/fiscal-reform-will-fail/

OECD’s double barrel

The OECD has publicly called for both fiscal and monetary tightening by “2011 at the latest”:

“Exit from exceptional fiscal support must start now, or by 2011 at the latest, at a pace that is contingent on specific country conditions and the state of public finances,” the OECD said. “The normalization of policy interest rates should commence in most OECD economies in the course of this year.”

Christina Romer, head of the White House Council of Economic Advisers, said in Paris Thursday that it would be a mistake for the U.S. to rapidly wind down stimulus measures to bring down the deficit.

It’s not clear whether her boss’ party is listening to her.  While they are telegraphing tax hikes and budget tightening, they’re also finding plenty of ways around PAYGO, according to Republican Rep. Paul Ryan.  Under some conditions, that would be a bad thing.  Under current conditions, it’s not.  But unfortunately, as long as both parties continue to parrot the argument that the federal budget is like that of any state, business, or household, then whatever fiscal expansion does manage to slip through is far more likely to be suboptimal.

In 1971, Robert Mundell, an intellectual mentor to Ryan’s old boss Jack Kemp, wrote, ”The Keynesian model is a short run model of a closed economy, dominated by pessimistic expectations…”  He also claimed that, “This model is not relevant to modern economies.”  (Monetary Theory, 1971)

We think that’s due for a reassessment.  In 1971, with Germany and Japan recovering rapidly from the damage wrought by WWII, Japan about to embark on a very favorable demographic shift, and other Asian countries joining the global economy, Mundell’s statement was correct, even for the stagflationary U.S.  But since 1989 in Japan, and 1999 in western economies, negative demographic shifts on top of burst credit bubbles have certainly fostered conditions of slow to no growth and increasingly pessimistic expectations.  And if the Robert Mundell of 1971 had seen recent empirical analyses of population age composition, he might have dropped the “short run” part of his statement. 

In other words, policymakers need to accept that Keynes is back, and disclose to their constituents why that is not such a terrible thing.  Hayek’s time will come again, but not for another decade or so. 

Political leaders would also do well to stop the many mouthpieces of the “neoliberal consensus” from desperately shoveling dirt onto the timely revival of Keynes and some of his succesors.

URLs:

http://www.montrealgazette.com/business/OECD+calls+rate+hikes+start/3072953/story.html

http://finance.yahoo.com/news/Economic-rebound-slowed-last-apf-2089533274.html

http://www.house.gov/budget_republicans/press/2007/0510extendersbill.pdf

http://newton.uor.edu/Departments&Programs/EconomicDept/macunovich/frb.pdf

http://www.ritholtz.com/blog/2009/02/time-for-a-new-%E2%80%9Cnew-deal%E2%80%9D/

Japan, not Greece – Black Widow II?

Good piece by ‘The Pragmatic Capitalist’ on Seeking Alpha - “We are not Greece. If anything, we are Japan.” 

His (or her?) point about Japanese government bonds (JGBs) is spot on.  Shorting JGBs — the so-called black widow trade — has been a popular form of hedge fund and trader hara-kiri since 1989, as bond yields continued to grind downwards for 20 years (though based on Japan’s shifting demographic ratios, it might not be as dangerous a trade in the years ahead).  It should have been a source of embarassment for rating agencies too, but the teflon nature of their sovereign ratings protected them — giving them free rein to (mis)rate collateralized debt obligations during the past decade.

The current directions of demographics and fiscal policy in the U.S. are in a Japan-like direction.  If the scary ‘bond vigilantes’ want to take a stab at Treasuries (and David Rosenberg noted in his May 6th piece that short positions in the ten year recently reached record highs), they do so at their peril.  Stay tuned for Black Widow II.

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. 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. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://seekingalpha.com/article/206293-we-are-not-greece-if-anything-we-are-japan

Buckle up?

A surprisingly negative print for initial unemployment claims today, and the Philly Fed’s Business Conditions Index rolling over…

On a seasonally adjusted basis, initial claims jumped 5.5% to 470,000 over the prior week; however, the more volatile non-adjusted figure fell almost 1%.  Because of the inherent volatility in the weekly data, a four week moving average is typically used.  From that standpoint, the magnitude of the change is not as worrisome as its direction — yet. 

The non-seasonally adjusted data is more benign at the moment:

The red and green trendlines are meant to show the hazards of model based forecasting — the red lines are based on five figure polynomials, the green ones on six figure, and they’ve been extended into 26 week forecasts.  At this point we’re just tinkering with Excel tools rather than actual data fitting, but it reveals how risky it is to rely on point estimates from any model.  It also shows that the actual underlying trend in initial unemployment claims remains uncertain, and could go either way.

A more worrisome signal is the roll over of the Philly Fed’s Business Conditions Index:

It appears that ECRI’s Weekly Leading Economic Indicators may be rolling over too:

There’s no way to know for sure if those roll overs will be brief and mild, or deep and prolonged.  In the following chart, we try to bring some historical context to that question, using demographic notations over the entire ECRI Weekly Leading Indicator dataset (1967-2010). The outlook is notably pessimistic for another five to seven years — especially if the global march towards fiscal austerity continues to pick up speed:

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 data, 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. 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. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

Merkley-Levin, Bailouts, and Austerity Fever

An important aspect of the Senate’s attempted financial reform bill is the Merkley-Levin amendment that seeks to curb proprietary trading by banks.  An overview is provided on Sen. Merkley’s site, and an interesting discussion of it has unfolded on Matthew Yglesias’ blog. Hat tip to Mike Konczal, who included this survey of CFA charterholders opinions on Merkley-Levin:

Marshall Auerback also has a good article on what he’s termed “fiscal austerity fever,” the newest global pandemic. He pithily sums up the deflation call, in this case for the U.K., based on comments by its incoming leaders:

Just today, the incoming Chief Treasury secretary, David Laws, warned the British electorate that the UK has well and truly “run out of money.” Hold on to those pounds, or you’re doomed.

Same can be said for the U.S. each time an important public official claims that we’re running out of USDs.  While such statements are utter fiction, the pursuit of such a condition (i.e., fiscal austerity) can have the very real effect of creating a shortage of money.  It happened in the late 1990s, thanks to the Bentsen-Rubin-Summers (and Greenspan) strong USD policy.  However, at that time, the U.S. economy was capable of enduring such a policy, while other countries and regions — Asia, Russia, Argentina, et al – could not — though it did eventually catch up with us c. 2000-2001. 

The strong USD policy also had the “wonderful” effect of fostering the further development of our financial bailout culture, when it caused the ridiculously leveraged trades on illiquid instruments by LTCM’s “geniuses” to collapse. As Tyler Cowen wrote in a 2008 op-ed (TOH Ritholtz):

The belief that LTCM had to be bailed out was widely held. It was 1987 redux, and the media accolades poured in. In the aftermath of the LTCM rescue, TIME put Greenspan, Robert Rubin and Larry Summers on the cover as “The committee to save the world.”  

…But this raises uncomfortable regulatory questions. If this huge leveraged fund presented such systemic risk, then why weren’t there regulations limiting the size and the leverage hedge funds could use?

That question brings us back full circle to the importance of Merkley-Levin, as well as John Geanakoplos’ call for the Fed to target leverage in addition to overnight interest rates.  We can also tie Marshall’s piece into the bundle – as we noted yesterday, imposing fiscal austerity in the face of economic contraction and high unemployment is analogous to raising collateral requirements in the face of a financial panic — both are stupid ideas. 

And the underlying social dynamic of this stuff is disgusting — well-connected, handomely compensated financial professionals, whose trades create systemic risk, can expect public sector bailouts when their models turn out to be horribly wrong.  But it you’re a regular Jane or Joe in any other sector of the economy, then you just need to suck it up, bite the bullet, and take your medicine, if you know what’s good for you.

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 data, 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. 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. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://merkley.senate.gov/newsroom/press/release/?id=7AB3E0AC-9C6B-44D3-A9DB-12CF73B5CE98

http://yglesias.thinkprogress.org/archives/2010/05/will-the-merkely-levin-amendment-work.php

http://yglesias.thinkprogress.org/archives/2010/05/a-response-on-merkley-levin.php

http://seekingalpha.com/article/205561-fiscal-austerity-fever-goes-global

http://www.nytimes.com/2008/12/28/business/economy/28view.html?_r=1

http://www.ritholtz.com/blog/2008/12/bad-precedent-the-long-term-capital-bailout/

http://symmetrycapital.net/index.php/blog/2010/05/geanakoplos-on-the-leverage-cycle/

http://symmetrycapital.net/index.php/blog/2010/05/fiscal-austerity-collateral-requirements/

Disdeflation, an important (and not entirely) new concept

We’ve caught up on some of David Rosenberg’s recent commentaries for Gluskin Sheff (registration required for trial access), and were surprised to learn of his somewhat dovish disposition towards gold — especially after reading that Jeremy Grantham’s actually buying the stuff. What’s the world coming to?!

Rosenberg has made a name for himself in recent years by foreseeing deflation and rallying long government bonds — calls that he still stands by, perhaps more than ever (we made a similar call earlier in the year based on U.S. political rhetoric).  However, under modern monetary systems, deflation, rising government bonds, and a strong currency are irreconcilable with a rising gold price, at least over anything longer than the short run.

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 metallic monetary systems, it worked the other way — when gold or the precious metals underlying the system were in short supply, this meant that money was in short supply too — thus, both gold and money would increase in purchasing power, followed by defaults, 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.  Along these lines, in today’s piece, David quoted an email exchange that in turn quoted an op-ed by economist John Cochrane, arguing that governments will be tempted to inflate their way out of the current crisis (emphasis added): 

Did you read Cochrane’s op-ed? While we face a deflationary near-term future, the temptation will be to go through a door which, somewhat inevitably, will lead to inflation.  

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 Cochrane 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.    

UPDATE 5/19/2010 - We thought we might have coined something new here, but it looks like the term “disdeflation” has been used before, and as far back as 2001 by Julian Wiseman and 2005 by Don Luskin. Note, though, that it only produces ten hits as of today, while “disinflation” produces 237,000, “inflation” produces 41.6 million, and “hyperinflation” produces 1.2 million.  Suddenly, the learning curve ahead of us looks rather steep…although to be fair, “deflation” produces 3.4 million hits.

UPDATE 5/20/2010 – An excellent letter to the FT from Dr. John Whittaker of Lancaster University in the U.K. stating the obvious: “Even without sterilisation, there is no reason why this “monetisation” of debt should cause inflation. If banks were to lend out the extra cash they receive from selling the bonds to the ECB, this might lead to demand pressure on prices. But the banks are still repairing their balance sheets and this cash injection is unlikely to change their lending attitudes at present.”

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:  

https://ems.gluskinsheff.net/Articles.aspx

http://advisorperspectives.com/newsletters10/Jeremy_Grantham_Guarantees_Gold_will_Crash.php

https://ems.gluskinsheff.net/Articles/Potluck_with_Dave_051910.pdf

http://advisorperspectives.com/commentaries/symmetry_012010.php

http://www.google.com/search?q=disdeflation

http://www.ft.com/cms/s/0/947bd692-63a6-11df-a32b-00144feab49a.html

Fiscal Austerity ~ Collateral Requirements

We sent the following email to friends and clients earlier today:

It’s a sea of red again on stock exchanges, and from a technical (charting) standpoint, things look scary – this could be more than the usual summer lull. Even gold appears to be losing some of its momentum. This makes perfect sense to us, as a deflationary environment in a world of fiat currencies is always bad news for precious metals prices (under metallic monetary standards, precious metals could cause deflation when they were in short supply, but that’s a story for another time). 

There’s only one thing capable of turning things around before downside momentum takes us back to, e.g., the 800-900 neighborhood on the S&P 500, and that’s a change of heart at the ECB and in the eurozone, as in swapping a sufficient amount of distressed interest bearing sovereign debt for newly minted euros. That’s it. Until such time, the current fiscal and monetary directions of the continent are a surefire, double barreled recipe for D-E-F-L-A-T-I-O-N. China’s internal austerity measures, compounded by misallocation of earlier stimulus measures, are contributing to global deflationary pressures as well. We suspect that Secretary Geithner might have been hinting as much in comments he made last night, as we noted on our website today: http://symmetrycapital.net/index.php/blog/2010/05/follow-through-meaning/ 

Also on our blog today — if you can carve out an hour at some point, this presentation by John Geanakoplos on leverage and credit cycles is worth watching: http://symmetrycapital.net/index.php/blog/2010/05/geanakoplos-on-the-leverage-cycle/.  Europe’s leaders should note that in Geanakoplos’ leverage framework, imposing heavy austerity measures is analogous to raising collateral requirements – and it’s about the dumbest thing you can do when the leverage cycle is turning down.  They still have time to set things right, but putting their focus on credit default swaps (http://www.marketwatch.com/story/euro-zone-cds-spreads-tighten-in-wake-of-short-ban-2010-05-19), especially in an autonomous way, amounts to yet more dithering.

 Yes, the CDS market needs to be brought to heel, as do investments banks in general (Geanakoplos’ leverage or margin targeting idea would go a long way towards accomplishing this), but a forceful monetization of some amount of distressed sovereign debt – perhaps some equitable proportions of all EMU nations’ debts – would (1) stem a rapidly unfolding deflation and (2) burn speculators badly. This recommendation will cause inflation and central bank phobes to hyperventilate, but it’s already been done in the U.S. to a significant extent, without causing inflation.

We don’t think this point can be overstated:  imposing heavy austerity measures is analogous to raising collateral requirements, which is the dumbest thing you can do in a crisis. Combined with a relatively tight central bank, i.e., with high real interest rates, and systemic balance sheet strains, ”getting one’s house in order” is far more likely to do the opposite — as it did in the early 1930s and the 1937 double dip, and as it did in Japan in recent decades.

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.

“Follow through” meaning…?

Remarks by US Treasury Secretary Timothy Geithner yesterday that Europe must “follow through” on its support of sovereign debt markets:

Treasury Secretary Timothy Geithner said on Wednesday that he wanted to see Europe “follow through” with its rescue package aimed at stemming the spread of the Greek debt crisis.Geithner, speaking to CNBC Television in an interview, said: “Absolutely Europe has the capacity to manage through this. We just want to see them follow through.”

Could this relate to the ECB’s complete sterilization operations yesterday?

As decided by the Governing Council on 10 May 2010, the ECB will conduct specific operations in order to re-absorb the liquidity injected through the Securities Markets Programme. In this regard, the ECB will carry out a quick tender on 18 May at 11.30 in order to collect one-week fixed-term deposits with settlement day on 19 May. A variable rate tender with a maximum bid rate of 1.00% will be applied and the ECB intends to absorb an amount of EUR 16.5 billion. The latter corresponds to the size of the Securities Market Programme, taking into account transactions with settlement at or before Friday 14 May. The benchmark allotment amount in MROs takes into account the liquidity effect of non standard measures, assuming an unchanged size of the Securities Markets Programme and full sterilisation of this amount via the above mentioned liquidity-absorbing operation. Fixed term deposits held with the Eurosystem are eligible as collateral for the Eurosystem´s credit operations. The ECB intends to carry out another liquidity-absorbing operation next week.

And if so — how in the world did global markets, which had rallied going into the operation, miss that it was coming – given how clearly it had been telegraphed?!?

We suspect that Geithner is speaking code for the obvious — that distressed sovereign debt needs to be monetized, i.e., replaced with new, non-interest bearing debt, commonly referred to as euros. To the extent that it stems a deflationary debt spiral, it will not cause inflation if done effectively and without panic — it will simply stem rapidly unfolding deflationary pressures.

But given the ECB’s stubborn belief that monetization is always and everywhere inflationary and its resulting refusal to do what’s needed in a timely fashion, the risk of a full blown currency crisis continues to rise.  That risk seems to be at work in gold prices.

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.

URLs:

http://finance.yahoo.com/news/Geithner-urges-Europe-follow-rb-4018525460.html?x=0&sec=topStories&pos=5&asset=&ccode=

http://www.ecb.int/mopo/implement/omo/html/index.en.html

http://www.ecb.int/press/pr/date/2010/html/pr100510.en.html

Geanakoplos on the Leverage Cycle

We came across this gem today — video of a presentation that [future Nobel Prize recipient] John Geanakoplos gave on leverage cycles at a Legg Mason conference, with accompanying slides.

URLs:

http://www.leggmason.com/thoughtleaderforum/2008/conference/webcasts/Geanakoplos-webcast.asp

http://www.leggmason.com/thoughtleaderforum/2008/conference/John_Geanakoplos_slides.pdf

http://cowles.econ.yale.edu/~gean/publications.htm