Poor auctions signifying…what exactly?

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

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

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

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

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

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

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

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

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

URLs:

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

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

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

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

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

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

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

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

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

Crisis, regulation, vigilance & cynicism

A cynical take on Sen. Dodd’s financial regulatory reform bill by Matt Koppenheffer for Motley Fool:

We can probably point to plenty of regulatory failures in the lead-up to the financial crisis. But I hardly think that they’re regulatory failures stemming from lack of regulators. As Valukas noted in his report, regulators were swarming on Lehman well before its collapse…

It seems to me that the issue never was whether there were people trying to address the problem, but rather that they were trying to regulate on a fuzzy mandate of not letting something bad happen within the bounds of a very permissive system. For the same reason that we have speed limit signs posted in our residential neighborhoods, we need to give regulators a clearer, tougher set of standards that they can impose on financial companies.

First and foremost, those standards need to address the lunatic business model that Lehman Brothers — and, really, most of the big financial companies — was operating on at the time of its demise.

Specifically, Lehman was increasingly building up large, illiquid, proprietary investments while primarily financing itself through very short-term agreements. What it became was a massive, teetering Jenga game right smack in the middle of our financial system that could be toppled in the blink of an eye if it lost the confidence of major counterparties…

That last paragraph echoes a beautiful turn of phrase by Bill Bernstein in the most recent Financial Analysts Journal, in which he refers to ”leveraging so unstable that it could not survive the slightest of economic breezes, let alone a 100-year storm.”

Koppenheffer continues:

…the bill includes the Volcker Rule the way Cocoa Puffs include well-balanced nutrition. Little actually gets implemented in the text of the bill. Rather, specific regulations are supposed to come from a study on the rule’s potential impact. Not only is this likely to maximize the squishiness of the eventual rules, but it also gives lobbyists plenty of time to work their magic.

In the end, I don’t see the Fed folks as a bunch of incompetent bumblers. But when it comes to smothering the next Lehman, Fannie Mae…or AIG…I do think they’ll fail miserably because they’re being given a butter knife to regulate with when what they need is a buzzsaw.

A tangential riff: If we aren’t going to impose a hard, fast cap on leverage and other risky behaviors, then perhaps the power of network effects and private sector vigilance (vigilantism?) can help fill the gaps in our financial regulatory structure. For example, it seems reasonable to expect (OK, hope) that the next Harry Markopolos will be taken more seriously.

But when the issue is not fraud by a single market participant, but rather systemic levels of leverage and risk, then it seems unlikely that any kind of enforcement powers could be brought to bear if regulatory bodies haven’t purposefully enlisted private sector assistance beforehand. 

I suppose we’re a bit cynical too.  

URLs:

http://www.fool.com/investing/general/2010/03/24/why-the-fed-will-fail.aspx

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1553816

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

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

Another banner day in the finance industry

Six broker dealers are served subpoenas by Massachusetts securities regulators over private placements, and a former high flyer is reportedly shut down by FINRA.

URLs:

http://www.investmentnews.com/article/20100322/FREE/100329978/-1/INDaily01

http://www.investmentnews.com/article/20100322/FREE/100329997

Stiglitz: The Dangers of Deficit Reduction

A timely column from Nobel economist Joe Stiglitz (emphasis added):

A wave of fiscal austerity is rushing over Europe and America…But despite protests by the yesterday’s proponents of deregulation, who would like the government to remain passive, most economists believe that government spending has made a difference, helping to avert another Great Depression.

…even deficit hawks acknowledge that we should be focusing not on today’s deficit, but on the long-term national debt. Spending, especially on investments in education, technology, and infrastructure, can actually lead to lower long-term deficits. Banks’ short-sightedness helped create the crisis; we cannot let government short-sightedness – prodded by the financial sector – prolong it.

Faster growth and returns on public investment yield higher tax revenues, and a 5 to 6% return is more than enough to offset temporary increases in the national debt. A social cost-benefit analysis (taking into account impacts other than on the budget) makes such expenditures, even when debt-financed, even more attractive.

In those last two paragraphs, Stiglitz is pointing out that if the returns on public spending are greater than the cost of financing them, then the future debt level will actually be lower. The government’s current cost of financing is simply the yield on Treasury debt. As of Friday, the ten year Treasury note yields 3.7%, while thirty year Treasury bonds yield about 4.6%. If publicly financed investments can be expected to return more than those figures, then undertaking them — and adding to current deficits and debt levels — is a no-brainer.

And as long as the yields on the securities of private sector issuers aren’t abnormally higher than those on Treasuries, the argument that the federal government is going to ‘crowd out’ the private sector is without merit.

Of course, it’s debatable (1) whether public expenditures are likely to produce returns of that magnitude and (2) whether future Congresses, Administrations, and Treasury Departments will manage the federal balance sheet appropriately. Unfortunately, no one’s openly debating these points. Instead, we’re treated to pithy but nonstop dogma from both sides, and a peculiar obfuscation by those in the middle, which in all cases overlook the basic financial calculus that Stiglitz reminds us of in his column.

Most importantly for debt and deficit hawks and those who fear higher taxes (those whom econo-nerds would refer to as ‘Ricardian equivalence’ subscribers), when the financial calculus is positive, then the debt service associated with marginal federal spending can be financed organically, via higher growth, rather than through higher taxes.

In short, people on all sides of the deficit issue should be able to agree, at least on financial and economic grounds, that investments yielding more than their cost of financing, when they do not crowd out private sector borrowing or resource demand, should absolutely be carried out.

—

Unfortunately, Stiglitz overlooks his own argument when he writes the following, which make us wonder if he doubts his 5 to 6% return figures, or if he’s just offering a gratuitous slap at the financial sector (emphasis added):

As the global economy returns to growth, governments should, of course, have plans on the drawing board to raise taxes and cut expenditures…

Continuing with his love of taxes:

The financial sector has imposed huge externalities on the rest of society. America’s financial industry polluted the world with toxic mortgages, and, in line with the well established “polluter pays” principle, taxes should be imposed on it. Besides, well-designed taxes on the financial sector might help alleviate problems caused by excessive leverage and banks that are too big to fail. Taxes on speculative activity might encourage banks to focus greater attention on performing their key societal role of providing credit.

As we’ve pointed out elsewhere, the domestic financial sector is going to shrink even without  punitive measures, as demographic composition shifts away from the saving and investing age groups. Well-designed regulation might be a better approach than taxes to constraining financial sector activities to socially beneficial ones (we admit that a ‘Tobin tax’ can be the most efficient approach to regulation under certain conditions, but aren’t convinced that it’s optimal for the financial sector).

And it would be profoundly unjust for the federal government, which so strongly encouraged and underwrote the expansion of mortgage financing (Stiglitz’ “pollution”), to retroactively punish the financial sector, its employees, and its current and future clients for simply following the government’s orders.

Stiglitz also takes a step back from his underlying thesis with this sentence:

Over the longer term, most economists agree that governments, especially in advanced industrial countries with aging populations, should be concerned about the sustainability of their policies.

From a technical standpoint, this isn’t as iron clad as so many of us reflexively believe. First, we have no idea whether an aging population is bound to be a drag on an economy, whether it depends on particular conditions, or anything else. There simply isn’t much historical data available to test such a proposition. Second, if we assume that it is a significant drag, then policies that are seen as unsustainable under “normal” conditions might very well be the most sustainable under those novel conditions. This could include expanded deficit spending and public debt, and/or expansion of money supply.

[To be fair, Stiglitz is almost certainly referring to entitlement spending obligations in that passage, which might be a bird of a different feather. We're just using it as an opportunity to critique some of the conventional wisdom around demographics.]

—

Despite Sitglitz’ inability to break out of his New Keynesian box, or part ways with his passion for higher taxes, we agree wholeheartedly with his essential argument:

…even with large deficits, economic growth in the US and Europe is anemic, and forecasts of private-sector growth suggest that in the absence of continued government support, there is risk of continued stagnation – of growth too weak to return unemployment to normal levels anytime soon.

The risks are asymmetric: if these forecasts are wrong, and there is a more robust recovery, then, of course, expenditures can be cut back and/or taxes increased. But if these forecasts are right, then a premature “exit” from deficit spending risks pushing the economy back into recession. This is one of the lessons we should have learned from America’s experience in the Great Depression; it is also one of the lessons to emerge from Japan’s experience in the late 1990’s.

…we must be wary of deficit fetishism…high-return public investments that more than pay for themselves can actually improve the well-being of future generations, and it would be doubly foolish to burden them with debts from unproductive spending and then cut back on productive investments.

These are questions for a later day – at least in many countries, prospects of a robust recovery are, at best, a year or two away. For now, the economics is clear: reducing government spending is a risk not worth taking. 

URLs:

http://www.project-syndicate.org/commentary/stiglitz123/English

http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

Masters of the Universe: They’re baaaack…

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

URLs:

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

http://symmetrycapital.net/index.php/blog/2010/02/wsj-hedge-fund-career-trades/

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

Career trades and object lessons

The WSJ carried an interesting story today (subscription required) about hedge fund bearishness on the euro relative to the USD (i.e., a falling euro exchange rate):

Some heavyweight hedge funds have launched large bearish bets against the euro in moves that are reminiscent of the trading action at the height of the U.S. financial crisis.

The big bets are emerging amid gatherings such as an exclusive “idea dinner” earlier this month that included hedge-fund titans SAC Capital Advisors LP and Soros Fund Management LLC. During the dinner, hosted by a boutique investment bank at a private townhouse in Manhattan, a small group of all-star hedge-fund managers argued that the euro is likely to fall to “parity”—or equal on an exchange basis—with the dollar…

Our interest isn’t motivated by the anti-euro call, which is rather conventional and uninteresting (Robert Mundell, one of the intellectual architects of the EMU, has recently predicted movement towards EUR-USD parity, and USD parity is something of an underlying objective of the EMU, if not the ECB).

Rather, it’s in the social and market dynamics involved, and how strongly they illuminate the ongoing importance of financial market regulatory reform.

The WSJ notes that this was an invitation-only event at a private home, and included some major global macro hedge fund players. While that’s not a bad thing per se, it definitely creates some potential market asymmetries and risks:

• Asymmetries to the extent that a small number of players with (relatively) massive amounts of capital and the ability to take highly leveraged bets (that’s the implication of “career trade”) may all be thinking and moving in the same direction; and
• Market and economic risks may because concerted, highly leveraged bets are likely to accelerate what might otherwise be a more orderly return to parity, i.e., one that unfolds over a longer period of time that allows for interested agents to adjust without too much trouble.

That last one is the more interesting point in our opinion, because of what it implies about the theoretical ideal of market efficiency. If EUR-USD is bound to return to parity, is it less destructive to let it “happen naturally”, or is it healthier in the long term to allow levered up speculators to (attempt to) correct mispricings as soon and as quickly as possible?

We have some qualms with the latter approach, because: (1) it may create more market and economic havoc than would otherwise occur; (2) if successful, the “rents” associated with the resulting dislocation (even beyond the mere price adjustment) accrue to a small number of privileged players; and (3) if those bets go badly, the damage could very well spread beyond the hedge funds’ assets (LTCM being the archetypal example).

Of course, those rents accrue to a hedge fund’s passive partners too, so there may be outside institutions that benefit, rather than just the funds’ general partners (emphasis on “may”). But speculators aren’t just messing with an asset class here; they’re impacting the very measuring rods of economic activity and financial obligations, and some of them are able to employ astronomical leverage in doing so, if they desire. 

If the net social costs of that activity are negative, it becomes immaterial who the ultimate beneficiaries of the managing partners’ actions are. It also highlights how critical it is to do regulatory reform well, but soon. Speculators are absolutely critical to financial markets and economies, but optimization requires some degree of financial constraint. How many more ‘object lessons’ will we require on that point?

URLs:

http://online.wsj.com/article/SB10001424052748703795004575087741848074392.html

http://en.wikipedia.org/wiki/Long-Term_Capital_Management

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.

Greece and Goldman

There’s been a good deal of news swirl about Goldman Sachs’ role in entering into swaps contracts with Greece in order to assist it in “hiding” some of its public debt as it prepared to enter the EMU.

Here’s a good primer from 2003 on these types of swaps, and an interesting thought piece on it from Ed Harrison.

URLs:

http://www.risk.net/risk-magazine/feature/1498135/revealed-goldman-sachs-mega-deal-greece

http://seekingalpha.com/article/190390-inside-the-mind-of-an-investment-banker-greece-goldman-and-derivatives

Fiduciary churn

Ouch! Research by finance professor Scott Stewart finds that the decisions made by plan sponsors on behalf of pensions, endowments, and foundations have persistently negative economic value.  

Using the most conservative approach for interpreting his results, Stewart concluded that plan sponsors had collectively squandered $170 billion in value over the two-plus decades he studied… 

“Plan sponsors never make their money back,” Stewart told me. “If they simply went on vacation, they could save their clients $170 billion – and that doesn’t count transaction costs.” 

The good news for plan sponsors? They’re less bad than most:

Plan sponsors are, of course, not unique in their ability to destroy value in this manner. Numerous studies, including those by Dalbar and Morningstar, have documented that individual investors, for example, buy mutual funds more heavily at the market peak and tend to sell them at the market bottom.  Plan sponsors should be more sophisticated than individual investors and, according to Stewart, they are. “Although they behave like retail investors,” he said, “the amount of value they destroy is a fraction of that destroyed by individuals.”

URLs:  

http://www.advisorperspectives.com/newsletters10/pdfs/How_to_Squander_$170_Billion.pdf  

Paging Doctrinaire Katsenelson

We might have found a fellow traveller on our lonely wing nut sojourn! Value investing maven Vitaliy Katsenelson has put his Capitalist Pig Party membership on the line in calling for tighter government regulation of the financial sector:

…at the risk of been kicked out of the Capitalistic Pig Party, I support tighter regulation of too-big-to-fail (TBTF) institutions…  

Lack of tight regulation in the TBTF space leads to the worst economic system of all: asymmetric socialism. Enormous gains are reaped by employees and shareholders, but losses are socialized and paid for by taxpayers.  That is simply immoral. 

It’s a well written piece and definitely recommended. Nothing in it about public debt hysteria, so there’s limited confirmation bias available to us. Still, it’s good to see that Vitaliy’s  not a slave to dogma.

If his party does exile him, perhaps we can commiserate over Northern Lights somewhere in ‘New Siberia’ (I might even try to change his mind about hamburgers).

URLs:

http://contrarianedge.com/2010/01/29/even-capitalist-pigs-should-love-bank-regulation/

http://sportsillustrated.cnn.com/vault/article/magazine/MAG1119401/index.htm

http://contrarianedge.com/2009/06/07/the-making-of-capitalistic-pig-expanded/

Krugman vs CNBC

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

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

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

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

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

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

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

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

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

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

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

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

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

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

URLs:

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

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