Markets Still In Happy-Go-Lucky Mode

Bulls are continuing to carry the day, thanks to the investing herd throwing the ‘risk on’ switch in a big way.  Factors behind the optimism include:

• Greece and Italy forming unity governments more effectively than many had hoped.
• Someone (most likely the ECB) backstopping Italian government debt.
• China seemingly headed for a soft landing.

 Here’s why we’re not jumping on the bandwagon:

• In the intermediate to long-run, the austerity measures that will be passed in Greece and Italy are going to worsen, not improve, their debt-to-GDP ratios.
• The European Central Bank (ECB) is legally and culturally limited in its ability to “monetize” government debt of European Monetary Union (EMU) countries, and is chronically under-supplying net financial assets to the eurozone.
• While losses on the most recently attacked European government credits have eased, France (along with some other northern EMU credits) still looks shaky.
• While China may be able to avoid a financial crash, real external demand is almost certain to decline in the years ahead.

Credit markets in Europe are continuing to signal a severe decline in eurozone GDP beginning in 2012. Unlike the U.S.where, for example, the Fed was believed to be riding to the rescue with QE2 in late 2010 and early 2011, which had a buoyant effect on risk markets—the ECB is very unlikely to pursue highly activist policies, and national governments are severely limited in their ability to pursue fiscal easing. As a result, we don’t expect the recession indications to turn around until the eurozone is in the throes of a painful contraction.

That will have negative effects on the rest of the world, including Asian countries that are major export partners with Europe (there’s a reason the Chinese and Japanese governments will consider throwing money at Europe’s sovereign problem, and it’s neither benevolence nor return on investment). Countries that rely on demand from Asia will also suffer in turn. Our bearish view on China continues to frustrate. It goes without saying, but the degree of suffering among its trade partners will be much lower if it can engineer a soft landing (no easy feat), and amplified if it can’t.

Of the world’s developed economies, the U.S. and Japan look relatively healthy. It’s no coincidence that their governments (central bank plus national fiscal authority) are also running the largest deficits among developed nations, as that allows their private sectors to run surpluses, which in turn allow households to save (or de-lever) and maintain consumption levels. Unfortunately, this is not occurring at levels sufficient to improve growth trajectories or meaningfully lower staggeringly high unemployment levels, which implies that current deficits are not large enough, i.e., they are more than offset by private sector demand for savings (and, perhaps, carry trade funding; more on that below).

Finally, along with France and other northern eurozone credits, there are still some worrisome signs from interbank funding markets. For example, the two-year U.S. dollar swap spread, which is the difference between a particular interest rate banks charge each other in a two-year agreement and the two-year U.S. Treasury yield, is continuing to climb, reflecting increasing strain and rising risk aversion among banks. While still shy of 2007-2008 levels, its current readings are a clear yellow light for investors and policymakers.  

Two-Year U.S. Dollar Swap Spread, Last Six Months

Two-Year U.S. Dollar Swap Spread, Last Five Years

The TED spread, which is the difference between the interest rate banks  charge each other on U.S. dollar loans outside the U.S. and the yield on similarly dated U.S. Treasuries, is behaving in similar fashion, indicating a rising demand for U.S. dollars within the global financial system (a trend likely to be exacerbated by shrinking budget deficits in the U.S.). And history, especially recent history, argues for extreme caution when the world’s primary funding currency for carry traders is in short supply (carry traders borrow in a low-interest rate currency and use the funds to invest in various assets that are expected to return more than their borrowing costs).

The bottom line: It’s not easy being bearish on risk assets when the herd is ebullient, and it’s not fun taking lumps on the short side of a portfolio when everything seems to be highly correlated based solely on whether it’s a risky or safe-haven asset. But economic and institutional realities, along with some key credit and money market indicators, almost assure more trouble ahead in our opinion, which leads us to infer that risky assets will be available at even lower prices at some point in the future. In the meantime, we continue to take risk on the long side in securities that look to us like they are already significantly underpriced.

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. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. The firm and some clients of the firm hold positions that are expected to benefit from a decline in Hong Kong’s Hang Seng Index. All views and positions are subject to change without notice.

Europe’s a Mess, but Watch Asia, Middle East

All eyes are on Europe of late, but investors shouldn’t overlook that Hong Kong’s Hang Seng stock index has seemed a bit decoupled of late (Hong Kong’s markets and economy are closely connected to events in China). Commentators are continuing to pin blame on Italy and Europe when markets hiccup (as they should), but the news flow seems to indicate problems in Asia as well: http://www.bloomberg.com/news/2011-11-10/asian-stocks-decline-on-europe-concern-as-italian-bond-yields-surge.html

There’s also been a peculiar publicity push on Iran and its nuclear weapons program of late. This could definitely cause some market agita, depending on what the behind-the-scenes endgames are (registration required): http://www.stratfor.com/memberships/204388/geopolitical_diary/20111107-irans-nuclear-program-and-its-nuclear-option

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. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. The firm and some clients of the firm hold positions that are expected to benefit from a decline in Hong Kong’s Hang Seng Index. All views and positions are subject to change without notice.

Italy x Leverage x Stupidity = Trouble

A November 9th note to our clients:

U.S. stock markets were down fairly hard today, between 3 and 5%, due to growing fears around Europe. The punditry seem to be laying most of the blame on Italian prime minister Silvio Berlusconi, but while he has certainly not helped things, this is nonsense.

The problem in Europe is that almost no one has a grasp of gross-versus-net financial assets. In a financial economy (i.e., one with credit), under any type of monetary system, some sector of the economy has to supply new, unencumbered units of money (or interest-bearing government debt) on a perpetual basis (i.e., a financial economy requires some sector to run ongoing deficits of something that will allow it to keep stable account of its ongoing production of other things, including financial assets). Under the gold standard, it was gold mines running ‘deficits’ of gold in order to add to the money stock. Under modern monetary standards (pdf), it’s sovereign governments, either through a fiscal authority perpetually spending more than it takes in with taxes, or a central bank expanding its net liabilities (which typical central bank asset sales and purchases, even the permanent ones, don’t do), or some combination of the two.

In 1973, the U.S. and most of the world moved off of a gold standard and onto our modern fiat system of inconvertible paper money. However, mainstream macroeconomic textbooks never fully accounted for that move. In the wake of the Great Depression and World War II, and with the tailwind of the Baby Boomers in the last three decades of the twentieth century, there was so much room for private sector credit growth  that governments could run relatively small deficits and the global economy still grew at a healthy pace. So the old assumption (which is correct when money is something external like gold) that there was a difference between a government borrowing money via bond issuance and a government printing money was never properly re-examined (economist Abba Lerner was a notable exception, as was Wynne Godley more recently). Economists also mis-measure inflation and ignore factors like population age structure (for example, the Baby Boomers entering their household formation years in the 1970s were a huge factor in the so-called inflation of that era).

As a result, 90% or more of the economics profession believes (1) that it’s more prudent (indeed, virtuous, as some view it as a morality play) for governments to tax and borrow in order to finance their expenditures, and (2) that any time a central bank purchases a financial asset with newly created money, it is “printing money” and expanding the money supply, which will inevitably cause inflation or hyperinflation. But these beliefs are just plain wrong, and they’re destroying the European Monetary Union (EMU or eurozone) today and threatening the U.K., Japan, and now the U.S.

Greece’s government debt was problematic, but by itself it was not going to bring down the global financial system or world economy. But the most recent rescue package from the European Union (EU) was so badly designed that it has caused buyers of Italian government debt to go on strike (legitimately, at least until Italian debt is selling at 50 cents to the euro or less). And now interest rates demanded of Italy are too high for it to ever successfully service given its much lower expected rate of domestic economic growth.

The result is that the world’s fourth largest issuer of government debt now stands on the precipice of a debt default crisis, which is a very big deal. When you take the size of Italy’s outstanding debt, global systemic financial leverage, and prevailing economic and political stupidity into account, the potential outcomes look really bad—as bad as or worse than the 2008 financial crisis. According to one anonymous Federal Reserve official, when they carried out eurozone-related stress testing of U.S. banks, it all looked OK until they simulated Italy going under. The official, summing up their findings, said, “if Italy goes, God help us all.”

There are several key points:

• If Italy were still monetarily sovereign (i.e., had its own central bank like the U.S., U.K., Japan, Canada, et al), it could manage this crisis rather easily. But its government ceded sovereignty to the EMU and European Central Bank (ECB) when it decided to join the eurozone.
• The ECB has all the necessary firepower (as it and it alone can create an unlimited supply of new euros) but (1) EMU rules essentially put it in a straitjacket and (2) many of its members live in mortal fear (erroneously—see the macro textbook point above) of reliving the hyperinflation of 1920s Weimar Germany.
• The EU’s European Financial Stability Fund (EFSF) could potentially step into the breech and backstop (start buying) Italy’s debt, but it doesn’t have anywhere near the authorized capital required to do so. And what capital it has is collected from EMU taxpayers and outside investors and lenders, because the EMU as a whole doesn’t demonstrate any understanding of soft currency economics (the euros required can come from only one place—the ECB).

Worst of all, while sovereign nations and the EMU have all of the tools at their disposal to prevent this from happening, they aren’t likely to act until the damage to the financial system has brought the real global economy (i.e., the things that people outside of the financial industry casino do for a living) to its knees. And at current un- and underemployment levels in many parts of the world, that’s not just one more grotesque display of agency malfeasance by my industry and the political class—it’s unnecessary, unjust, and just plain immoral. I only wish that the 99’ers (99 weeks or more unemployed and the 99 percenters) as a whole had a firmer grasp of the problem (continued education disinvestment will ensure that this wish becomes a pipe dream).

It’s fair to ask whether a more activist ECB would cause inflation. There’s a risk of inflation in all monetary systems, but especially with soft currencies like today’s that can operationally be created out of thin air. But it’s first important to realize that inflation is the only constraint on the world’s ability to resolve the European debt crisis. (And as the Great Depression and other episodes show, resolving a debt crisis is likely to just lessen deflation rather than cause inflation). As noted above, inflation is an abused and widely misunderstood term (how many times have we been promised hyperinflation and exploding interest rates in the U.S. and Japan, and yet we only see it in countries like Greece and Italy that don’t have the ability to “print” money?). It’s also a chronically mis-measured and over-estimated variable according to current academic research (http://www.voxeu.org/index.php?q=node/867), viz (emphasis added): “[In] the United States, we found that most of the movements in conventional measures of inflation…are due to relative-price changes. Only around 15-20% of the movements in these measures of inflation correspond to pure inflation…” 

In a better world, governments would be focused first and foremost on putting people back to work and ring-fencing the global financial system from the real economy, and we would be able to legitimately concern ourselves with potential (and actual) inflation. Instead, we’re forced to endure chronic un- and underemployment, economic growth and investment well below potential, a series of policy errors worldwide that would be comical if not for the human suffering they cause, and policymakers throwing up their hands and saying that there’s little more that governments can do. Even the staunchest government debt Cassandras should be able to see which of these is the greater insult to future generations.

That’s the end of today’s rant. For less politically charged reading, you might enjoy our look at October’s astounding stock market performance.

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. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.

A Closer Look at October Equity Returns

The broad rally in equities in October was massive, regardless of whether one views it as a dead cat bounce or a new leg up. Either way, it was enough to cause investor whiplash, and correlations across individual stocks remain historically high.

For the S&P 500, it was the eighth highest monthly return since 1950…

…clearly a “right tail” outcome:

Though sympathetic to the ‘wall of worry’ arguments out there (and in our active strategy, licking our wounds from October), we’re still skeptical and believe that equity markets will end lower before embarking on a bull market:

• Credit markets are still flashing recession warnings for most of the world, especially Europe.
• At current levels, following their rallies, equity markets look fairly priced at the very least and highly optimistic compared to other asset classes.
• Certain credit market indicators are also warning that corporate earnings forecasts may contract by double digits, rendering low price-to-earnings arguments moot.
• Demographic headwinds will remain in place in much of the world until at least the latter half of this decade.
• Policymakers worldwide are still favoring austerity over growth.

That said, it looks to us like the U.S. economy, although we expect it to enter recession sometime between early 2012 and early 2013, could still outperform expectations along the way. One of our recently-triggered recession indicators turned around after only a month, for example:

The last time this occurred was in 1989 (a positive recession signal) and at the end of 2002 (a negative signal), so the forecasting power would appear to be no better than a coin flip, especially considering the small sample size we’re working with. The only qualitative data we can bring to bear is that in  1989, policy measures were trending in the direction of austerity (higher taxes, strong dollar, rising interest rates), while in 2002-2003 policy was headed in a more stimulative direction (other than uncertainty over whether an invasion of Iraq was imminent).

Finally, it’s interesting to take a close look at the demographic aspects. As shown below, seven of the ten largest one-month moves in the S&P 500 from 1950 through October 2011 occurred from 1974 to 1984, a period in which age structure in the U.S. and many other developed nations fluctuated dramatically. In the 1970s, Baby Boomers began entering their household formation years in earnest, while in the 1980s, they began entering their peak earning, saving, and investment years:

The volatility of the 1970s was associated with a secular bear and eventually range-bound stock market, while the volatility of the early 1980s was associated with the beginning of an almost two-decades-long bull market.

Today, Baby Boomers in advanced western economies are entering their retirement years (in Japan, this occurred about ten years earlier), which could have persistently negative implications for stock markets, at least until their children, the Echo Boomers, begin saving and investing in earnest (an activity that events of recent years may influence them away from at the margin). Thus, it seems likely that we’ll continue to see 1970s-style volatility and sideways or downward trends in stock markets for at least a few more years.

However, investors with suitably long time horizons should keep in mind that, despite the popular characterization of a lousy investing climate in the 1970s, it was actually a great time to buy stocks in general. As long as the global economy can manage to hold it together and avoid a low-probability 1940s-style outcome, long-term equity investors who stick to a disciplined process (and where suitable, take advantage of the opportunities presented by periods of high volatility, i.e., buying low and selling high) should do OK over the coming decades.

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. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.

SOL 99ers Now the Majority of the Unemployed

CNBC reports that there are now more unemployed persons who have exhausted benefits than the number still receiving them (hat tip to Warren Mosler):

The jobs crisis has left so many people out of work for so long that most of America’s unemployed are no longer receiving unemployment benefits.Early last year, 75 percent were receiving checks. The figure is now 48 percent — a shift that points to a growing crisis of long-term unemployment. Nearly one-third of America’s 14 million unemployed have had no job for a year or more.

Congress is expected to decide by year’s end whether to continue providing emergency unemployment benefits for up to 99 weeks in the hardest-hit states. If the emergency benefits expire, the proportion of the unemployed receiving aid would fall further.

That means an even higher poverty rate in what’s supposed to be the most advanced nation on Earth, which means an even greater long-term burden on public sector budgets. It means chronic loss of skills and further deterioration in the employability of millions.  Worst, it probably means that the disturbing trend of rising suicide rates will continue.

This is the United States of America, folks. We can do better. In times past (in fact, the last time a deep financial crisis collided with negative demographic internals), this country offered dignified employment to everyone who desired a job. It was effective, and an employer-of-last-resort policy has support today from diverse points along the political spectrum. But first, we’ll have to forget everything we think we know about the federal government’s budget.

Eurozone Meltdown Brewing?

Though most eyes are focused on the latest political turmoil in Greece, economies in the rest of the European Monetary Union (EMU or eurozone) are showing signs of increasingly severe weakness. 

As we’ve previously argued, the government debt crises in the EMU can be contained as long as the European Central Bank (ECB) stands in to backstop the whole mess by buying government debt (as it alone has the power to create net new euros). However, it will take far more concerted and difficult-to-coordinate efforts to prevent the eurozone from sliding into recession (which in turn makes preventing a financial crisis more challenging). Barring a sharp recovery in credit markets, the EMU economy now looks set to contract by at least 4% in 2012.  

Recent data are confirming this view, as eurozone purchasing manufacturer indices (PMIs)—including for Germany, the prevailing economic paradigm’s darling—looked absolutely abhorrent last week. German construction figures were awful today, and productivity figures for the European Union (the EU, which includes both EMU nations and countries that do not use the euro as their official currency) are now in territory last seen during the 2008 recession. A chart of German PMI looks like a tired swimmer chained to a bunch of cinder blocks. Yet amazingly, the swimmer continues to complain that the blocks aren’t yet heavy enough. 

Eurozone Composite PMI (Source: Markit)

If a full-blown EMU debt crisis erupts, which is still a very real possibility, that figure could be five times worse; if accompanied by a currency crisis as well, it could be ten times as bad.  

Because the EU and eurozone’s institutional arrangements (1) lack a central fiscal body with the authority to implement stimulative measures, and (2) restrict activist policies by the ECB, the entire framework has a pro-cyclical bent, which means more pain ahead even if a financial crisis is avoided (which becomes increasingly difficult as fears of a slowdown intensify). This is likely to go on until a critical mass of people have finally had enough, and politicians and bureaucrats are frightened enough to take them seriously. 

But the looming problems in Europe have little to do with Greece, and everything to so with Italy, Spain, Belgium, France, and eventually Germany. 

Despite the hooplah over a new framework for Greece, bond investors are continuing to drive yields up (i.e., prices down) on Italian government debt. Italy is now uncomfortably close to an interest rate level capable of triggering a debt-default spiral. The fact that the world’s fourth largest issuer of government debt is now a non-sovereign with 100% external liabilities (because it cannot create new euros) should put serious fear into the hearts of investors (it has already done so for central bankers, apparently). 

10-Year Italian Govt Bond Yield (Source: Bloomberg)

Spanish government bond yields are also higher (and prices lower) since summer. 

10-Year Spanish Govt Bond Yield (Source: Bloomberg)

Risk aversion has also spread rather dramatically to the core EMU nations of Belgium and France. 

10Y French Less 10Y German Govt Yield (Source: Bloomberg)

And the cost to insure against a default by the German government has spiked dramatically since summer.  

German Govt 10Y Credit Default Swap in $ (Source: Bloomberg)

The distinction between “core” and “peripheral” Europe is becoming increasingly irrelevant, an outcome virtually guaranteed by the EMU’s institutional framework. And thus far, it’s required an unbroken string of better-than-bi-monthly EU summits and untold time and effort from the private sector and its regulators just to prevent Greece from taking down the eurozone (and possibly global) payments system. Will Europe have the necessary stamina and flexibility to effectively deal with a much larger crisis? It’s unlikely to receive much help from abroad either; consider that the G-20 proved itself worse-than- useless at its just-adjourned summit, with vague offers of help and still-pronounced infatuation with fiscal tightening, despite an apparent worldwide shortage of aggregate demand. 

It could well be that we’re witnessing the beginning of the end for the prevailing macroeconomic paradigm. Unfortunately, before it can be drastically improved, we’ll have to endure yet more tinkering, such as nominal GDP targeting by central banks. But eventually, we will hopefully be able to lay at least some of our era’s innocent frauds to rest and replace them with principles that better reflect reality. The most important one is that a sovereign currency-issuing government does not fund itself through tax revenues or borrowing; taxation simply enforces the widespread acceptance and use of its currency. From that one fact, several important observations follow: 

• Such governments are never fiscally constrained; the only economically relevant constraint on deficits (via spending increases, tax cuts, or central bank operations that add to the net stock of financial assets) is inflation.
• Current government deficits and debt (whether interest-bearing, such as Treasury securities, or not, such as money) do not impose any burden on future generations, unless they lead to inflation at a high enough level to severely undermine investment and future productivity.
• For productive saving and investment to occur, a sovereign government, via its treasury and/or central bank, must run deficits, as that is the only sector of the economy (the restricted ability of export activities aside) capable of adding net financial assets.

Compare those to the faulty inverse propositions guiding policymakers worldwide: 

• Governments must finance their expenditures via taxation and borrowing (which assumes that net additions to the stock of financial assets ’just happen’).
• Current deficits lead to an expansion of government debt which must be paid off by future generations in the form of higher taxes and/or fewer public goods and services.
• Government must add to savings by saving, i.e., by running balanced or surplus budgets over the long-term (which fails to recognize that this is a de facto argument for contracting the supply of net financial assets, i.e., deflation).

And it’s staggering how many academic and political reputations are chained to these errors. As Warren Mosler has pointed out, there are legacies being trashed—The Emperor Wears No Clothes, writ large. 

In the meantime, the U.S. Congressional super-committee has yet to release anything promising, the Chinese government is continuing its attempts to tame inflation and crush its overheated residential property sector, and credit markets are flashing serious economic and market warnings. Blissfully unaware, most major stock markets have exuberantly extended their historic October rallies into November.

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. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.

Who Are the Real Capitalists?

A provocative piece by Bruce Judson: http://itcouldhappenhere.com/blog/the-kids-camping-on-wall-street-are-the-capitalists-not-the-people-in-the-buildings/

As we think about capitalism, it’s also useful to make an important distinction: It’s not what you say, it’s what you do. You may espouse capitalist ideals, but if you oppose responsibility, dishonor contracts, oppose competition, and embrace government subsidies, you are not a practicing capitalist.

For capitalism to work, there are several fundamental requirements: accountability, equal justice under the law, a clearly articulated purpose (and accompanying cost) for government subsidies of a specialized class of citizens, competition, and a relationship between the creation of profits and the creation of real wealth for the larger society.

Many of the protestors in New York City and around the country are jobless college graduates. The majority in all likelihood financed their education through federally subsidized student loans. A central characteristic of today’s generation of student loans is that, unlike most debts, they cannot automatically be discharged in bankruptcy…As a nation, we teach our most promising youth, from the age of 18 on, the importance of accountability. We use the federal government to subsidize an investment in human capital. In return, the beneficiaries enter into a lifetime of responsibility and accountability. It is a sacred contract. It is arguably one of the best, and potentially harshest, lessons of accountability associated with capitalism in our society today.

Judson misses or glosses over the important connections between the fiscal fetishes of the Clinton-Dole-Gingrich years, the extent of the federal government’s role in financing education, and the changes to bankruptcy laws that made student loans non-dischargeable.

In order to meet its widely lauded goal of a primary surplus, the federal government asked the private sector to take on more of the burden of human capital investment through expanding student loans for higher education. This helped the government “save” (remember, when the monopoly supplier of something saves, i.e. hoards, it means users have less of it; a fitting analogy is to imagine a utility “saving” electricity by generating less of it), but in return, banks asked for certain protections, including harsher bankruptcy laws for student borrowers, which they got. (The consumer credit industry received similar favors during the W years, as bankruptcy rules were tightened still further in the favor of creditors.)

By itself, those episodes would help Judson make his case, but they pale next to the impact and fallout of the financial crisis.

Now, let’s contrast this high accountability with the behavior that occurred in our financial sector. When our largest financial firms created havoc in the U.S. economy through undisputed greed, mismanagement, and extreme risk, some important things happened. First, the government bailed the companies out without demanding any substantial change in behavior…

Actually, as long as the USG was an equity holder and/or creditor, it kept the reins pretty tight on executives (shareholders have been left holding the bag since).

…and then the individuals responsible were not held accountable through civil or criminal law. As a result, the people who brought the nation close to the brink of economic collapse and caused untold pain and suffering — which continues to this day — returned after a brief hiatus to record levels of compensation. Individuals who earned tens of millions of dollars continue to earn these extraordinary sums. They have never been called to account for their deeds.

There’s at least one exception, though for the people and organizations most instrumental in the crisis, Judson’s right.

Can this be right? What about the many civil settlements negotiated by the federal government and the SEC? I would argue that, in light of the extraordinary profits these firms and individuals generate, such settlements are now viewed as a “cost of doing business.” They appear to have almost no impact on the behavior or attitude of the nation’s financiers.

Interestingly, the long-term returns on capital of the U.S. financial industry are pretty lousy overall. Book values in many cases are where they were 10 or 20 years ago, meaning that dividends have been the primary source of return for equity holders. Of course, the executives and certain other employees of the industry did astoundingly well over that period.

Now let’s contrast the kids on the street with the employees of The Street. The kids are accountable for their debts. They know it, and they simply want jobs so they can fulfill their civic responsibilities. In contrast, the occupants of the building on Wall Street act as if the rules of accountability — which are central to a viable system of capitalism — apply to everyone except them. Instead, many of the Wall Street elite have developed a dangerous sense of entitlement.

All while railing about the virtues of free enterprise and de-regulation.

I would argue that in a true, competitive capitalist society, the idea of entitlement is anathema to all participants. It suggests that rewards are disbursed because of who people are, as opposed to the tangible wealth they create for the nation.

There are plenty of damning emails and other evidence from the subprime crisis, but Enron remains the most potent example of the severe agency risk that’s taken hold of the financial industry. The recordings of Enron power traders conspiring to withhold electricity from the California market in order to turn a profit are nauseating and infuriating.

It’s worth noting that old timers on Wall Street may still remember that until 1970 the New York Stock exchange mandated that investment banks be organized as some of the most accountable businesses in existence. Prior to going public, in the late 20th century Wall Street firms were organized as old-fashioned partnerships. The central idea of these partnerships was that every partner was fully liable for all of the debts incurred by the firm. If the partnership could not meet its obligations, the partners were required to meet these obligations with their own funds until they were personally bankrupt as well. It was a self-policing system that provided high incentives for investment banks to manage the risks they undertook. When every partner is liable, each has the highest possible incentive to ensure that the firm is not exposed to potential default. If they fail in this responsibility, both the firm and the individual partners can be wiped out. This rule was meant to avoid precisely what happened in the financial crisis.

Judson’s echoing Michael Lewis’ Liar’s Poker here, and it ties in to my earlier point about the financial industry’s returns on capital. Once investment banks went public, partners who had to carefully balance risk and reward became executives who were incentivized and enabled (by directors, compensation consultants, and lackadaisical shareholders) to take large risks at others’ expense in the pursuit of personal reward.

Now these same publicly held financial institutions have been bailed out by the government and the high-paid executives are apparently immune — both with respect to their pay, their sources of employment, and their personal funds — from any day of reckoning…

[Pretend] you are a visitor from a foreign country or an alien world with no knowledge of Wall Street or capitalism. Then the principles of capitalism are explained to you and you are asked to identify the capitalists in this confrontation: the people in the buildings or the people congregating on the street. Which would you choose?

Good stuff. Contrast with CNBC’s characterization of crass opportunism among the Occupiers as capitalism.

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. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.

The Light at the End of the Tunnel Has Been Turned Off

Funny email posted by Edward Harrison at Credit Writedowns: http://www.creditwritedowns.com/2011/10/federal-notice-to-all-working-citizens.html

Due to the current financial situation caused by the slowdown in the economy, Congress has decided to implement a scheme to put workers of 50 years of age and above on early, mandatory retirement, thus creating jobs and reducing unemployment.

This scheme will be known as RAPE (Retire Aged Persons Early).

Persons selected to be RAPED can apply to Congress to be considered for the SHAFT program (Special Help After Forced Termination).

Persons who have been RAPED and SHAFTED will be reviewed under the SCREW program (System Covering Retired-Early Workers).

A person may be RAPED once, SHAFTED twice and SCREWED as many times as Congress deems appropriate.

Persons who have been RAPED could get AIDS (Additional Income for Dependents & Spouse) or HERPES (Half Earnings for Retired Personnel Early Severance).

Obviously persons who have AIDS or HERPES will not be SHAFTED or SCREWED any further by Congress.

Persons who are not RAPED and are staying on will receive as much SHIT (Special High Intensity Training) as possible. Congress has always prided themselves on the amount of SHIT they give our citizens.

Should you feel that you do not receive enough SHIT, please bring this to the attention of your Congressman, who has been trained to give you all the SHIT you can handle.

Sincerely,

The Committee for Economic Value of Individual Lives (E.V.I.L.)

PS – Due to recent budget cuts and the rising cost of electricity, gas and oil, as well as current market conditions, the Light at the End of the Tunnel has been turned off.

Europe’s Debilitating Currency Fetish

In 1994, U.S. Treasury Secretary Lloyd Bentsen implicitly embarked on what came to be called the ’strong dollar’ policy. Bentsen’s successor Robert Rubin ran with it, while Fed Chairman Alan Greenspan continuously fawned over it. And based on U.S. economic performance from then until 2000, it seemed like a positive thing.

It wasn’t, of course, and economic experience since then continues to demonstrate that monetary fetishes tend to be harmful. In the 1990s, what seemed to confer stability in the U.S. caused untold havoc abroad–currencies and economies in Asia, Russia, and Argentina collapsed, due in no small part to an undersupply of U.S. dollars relative to global demand for them. (Interestingly, the one notable Asian country that escaped the carnage was China, which had devalued the RMB against the USD circa 1994.) Eventually the strong dollar fetish caught up with everyone as the U.S. economy slipped into recession in 2001.

Fast forward to today’s European Monetary Union (EMU or eurozone), which has become the current center of strong currency fetishism, as embodied in the policies of the European Central Bank (ECB). The eurozone has pursued a strong euro policy for several years and continues to, despite:

1. Eurozone national governments’ increasing inability to fund themselves;
2. The weight of market evidence clearly pointing to a nasty recession in Europe by mid-to-late 2012; and
3. Recent research (pdf) that calls into serious question the accuracy of inflation measures troubling the ECB et. al. (only 15-25% of conventional inflation measures may constitute actual monetary inflation).

Since the middle of 2011, corporate bond spreads in Europe have been implying a severe recession there, likely beginning by the third or fourth calendar quarter of 2012. And despite eurozone policymakers finally trying to hammer out a framework that will prevent a systemic, Lehman-like meltdown, the economic outlook being expressed in credit markets has only worsened in the second half of this year. Especially worrisome is that the fears afflicting government debt markets have encompassed French debt during this same period, emphasizing that the fiscal stability of the eurozone’s core is now clearly in question:

Ten-Year French Government Yield Over German Bund (Source: Bloomberg)

So Germany is now the last meaningful bastion of sovereign strength in the eurozone. But it’s not clear that German policymakers and/or voters understand the dynamics involved that are sure to make this a temporary state of affairs. For example, quoted in an NPR report this morning, a young German father watching the Occupy Frankfurt festivities worried about the inflationary impact that would result from ”printing money,” rather than asking, for example, how Germany will avoid the same fiscal fate as the rest of the EMU, or who in Europe will buy Germany’s net exports, if euros remain in chronically short supply.

The irony was especially rich for two reasons. First, ‘inflation’ (see caveat in point #3 above) has been running hot during the ECB’s current tightening phase, which has seen real money supply measures cratering. And second, the man quoted was able to attend the Occupy Frankfurt festivities thanks to generous German child-care measures that mandate time off from work for parents. While the German economy remains one of the world’s most advanced, inflation phobia and an out-of-paradigm electorate on fiscal and monetary reality are forcing it down a track that could see many of its eurozone era-enabled gains, such as shorter work weeks and state-mandated downtime for parenting, undone in fairly short order.

The Bentsen-Summers-Greenspan strong dollar fetish in the U.S. eventually collapsed under its own weight, as shown below (people hyperventilating about the USD’s decline should note that its trade-weighted value is still higher than it was when Bentsen and Rubin’s strong dollar policy went into effect). If the eurozone is to survive, its strong euro fetish will have to collapse as well.

Source: St. Louis Federal Reserve

That said, the euro’s relative strength could remain a secular story, much as the Japanese Yen has since the mid-1980s. However, we think there’s a meaningful probability of a short-to-intermediate-term break, similar to the Yen’s path in the late 1990s:

Source: St. Louis Federal Reserve

A trajectory similar to the dollar-yen exchange rate from 1995 to 1998, when the USD appreciated  by roughly 80% (meaning the yen depreciated by roughly 44%), would have the euro buying a mere 77 U.S. cents, as compared to the $1.39 it buys today. Of course, it can be argued that the strong dollar policy exacerbated the yen’s decline, but as seen in the following exhibit, Japanese government spending as a percentage of GDP did accelerate sharply during that period:

Government Final Expenditures as Percentage of GDP (Source: St. Louis Federal Reserve)

Today, contrary to the strong dollar period, U.S. government spending as a percentage of GDP looks likely to remain in the high single digits for the foreseeable future, which is definitely a countervailing headwind to potential euro depreciation. If we make a back-of-the-envelope assumption that 50% of the Yen’s 1995-1998 depreciation was driven by domestic Japanese policy, and assume a roughly 20% decline in the euro, that would put the EUR-USD exchange rate much closer to parity at around $1.11 to the euro.

The upshot for investors:

• Credit markets are signalling an increasingly nasty recession in Europe beginning sometime in 2012, and incoming data are confirming. 
• Ongoing hawkishness at the ECB and political dithering over fiscal challenges will raise the probability of recession as long as they continue.
• Recession will almost certainly force the ECB and the European Union to support the enactment of stimulative measures that expand government deficits and/or the ECB’s balance sheet.
• This in turn should drive the euro sharply lower in the short-to-intermediate-term.
• Longer-term, another premature return to austerity seems a safe bet in Europe, so the euro’s secular strength could remain intact, following a path similar to Japan’s since 1990.
• We put a very low probability on this outcome, but if policymakers refuse to allow economic conditions to force their hands, then the eurozone is almost certain to break up, in whole or in part, which would be likely to cause even more severe upheaval in currency and other financial markets.

Given this outlook, risk assets in Europe seem likely to offer even more compelling values in the future.

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. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice. Neither the firm, its principals, or its clients hold securities issued by or directly related to Lehman Brothers.  

MMT Goes To Washington

Sen. Bernie Sanders of Vermont (who doesn’t lend himself to a simple R- or D-, but is instead an independent, a professed democratic socialist, and someone who caucuses with the Democrats) has formed an advisory panel of economists to help him draft Federal Reserve reform legislation. The current lineup, as posted on the Senator’s website, is:  

• Joseph Stiglitz, the 2001 winner of the Nobel Prize. The economics professor at Columbia University is a former chief economist for the World Bank.
• Jeffrey Sachs, director of The Earth Institute and an economics professor at Columbia University. He also is special advisor to United Nations Secretary-General Ban Ki-moon.
• Lawrence Mishel, president of the Economic Policy Institute, the premier research organization focused on U.S. living standards and labor markets.
• William Black, associate professor of economics and law at the University of Missouri, Kansas City. He worked with the Federal Home Loan Bank Board, the Federal Savings and Loan Insurance Corporation and the Office of Thrift Supervision.
• Nomi Prins, a senior fellow at Demos, was a managing director at Goldman Sachs, a senior manager at Bear Stearns in London, a senior strategist at Lehman Brothers, and an analyst at the Chase Manhattan Bank (now JPM Chase)
• Jane D’Arista, an Economic Policy Institute research associate, has written on the history of U.S. monetary policy and financial regulation, The former Boston University School of Law professor previously served as a staff economist for Congress.
• Tim Canova, professor of economics and law and co-director of the Center for Global Law & Development at the Chapman University School of Law in Orange, Calif. He was an early critic of financial deregulation and warned of the dangers of the bubble economy.
• Robert Johnson, senior fellow and director of the Project on Global Finance at the Roosevelt Institute. He was chief economist of the Senate Banking Committee and a senior economist for the Senate Budget Committee.
• Dean Baker, co-director of the Center for Economic and Policy Research in Washington, D.C. He was a senior economist at the Economic Policy Institute, a consultant for the World Bank and the Joint Economic Committee of the U.S. Congress.
• Gerald Epstein, chair of the economics department at the University of Massachusetts at Amherst. Epstein also is the co-director of the Political Economy Research Institute.
• Robert Pollin, co-director of the Political Economy Research Institute and economics professor at the University of Massachusetts-Amherst. He has worked with the Joint Economic Committee and the U.S. Competitiveness Policy Council.
• Stephanie Kelton, associate professor at the University of Missouri, Kansas City and a research scholar at the Center for Full Employment and Price Stability.
• James K. Galbraith, professor of government at the Lyndon B. Johnson School of Public Affairs.  He served in several positions on the staff of the U.S. Congress, including Executive Director of the Joint Economic Committee.

What’s interesting is that modern monetary theorists (or MMT’ers, whose names are in bold above) appear to be over-represented when compared to their proportions in the economics profession. That probably shouldn’t be surprising given Sanders’ political leanings. (Update: Rumor has it that Randy Wray, also of UMKC, has been added).

However, it does mean that MMT, at least for the time being and on the Dem side of the aisle, is now solidly through the door and in the room when it comes to policy discussions in Washington. And for those of us who believe that economic policies should reflect and be based on certain operational realities (pdf) of our fiscal and monetary system, it’s an encouraging development. And while I’m not familiar with all of the names on the list, the ones that I do recognize should at least be sympathetic to MMT views.

Hopefully, as a result of their involvement:

1. Public discussions of the Federal Reserve (and central banks generally) and monetary policy will become more honest and realistic (both within and without the U.S.).
2. Fears of U.S. government insolvency will vanish in favor of an acknowledgment that the only constraint on the federal budget is inflation.
3. The full-employment half of the Fed’s dual mandate will finally get some constructive attention, through support of an employer-of-last-resort program for example.

All in all, a very encouraging development. Stay tuned…

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. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice. Neither the firm nor its principals nor its clients own securities issued by or directly related to any public companies mentioned herein.