Caliban's Market

Trust Is the Foundation of All Asset Valuation

2011-09-19T15:15:00.008-04:00

Jim Grant on Gold

The latest Barron's includes an interview with Jim Grant titled Jim Grant: Gold Still Looks Good, Japan Doesn't. Jim's remarks included his opinion of how markets arrive at a price for gold, which appears to be independent of such familiar and tangible things as earnings, dividends, and business prospects:

What I do think is gold is simply the reciprocal of the world's faith in the institution of managed currencies. It is one divided by T, where T stands for trust. And trust is a shrinking number and will continue to shrink. Therefore, I am still bullish on gold.

Jim traces the origins of this relationship directly to the world's central bankers and their extraordinarily easy monetary policies:

If a bubble connotes absurdity, what is absurd are the monetary conditions that supported this gold bull market. Gold is an expression of the world's justifiable distrust of the way our central bankers conduct their affairs.

I am not sure that I would limit the origins of this inverse relationship to central bankers. Legislators in numerous countries have made egregious errors over the course of decades in piling up unsustainable levels of public debt, and too many citizens have imprudently acquired unsustainable levels of private debt. All of these absurdly foolish conditions justify the world's distrust of the way its affairs are conducted.

The Problem with Repression

Jim admits that his simple "1/Trust" equation is metaphorical: "The poetry of it is that it can't be quantified." But we get his point, and in citing central bankers as the cause, Jim rightfully draws attention to the possibility that their policies could harm us even more than they have so far:

And the governments of the world are taking under advisement this notion called financial repression -- short-circuiting market mechanisms, capital controls, punitive taxes or intrusive taxes and the like.

Grant is right in warning of financial repression, and it is already here. Can you invest your money in a safe fixed income instrument that offers a decent rate of interest? Of course, you can't. As others have observed, the Fed is sacrificing savers in the interests of Wall Street bankers, and present policy distorts the signals that markets send to investors. It is no wonder that the world distrusts the monetary authorities.

Central bankers are in a bind, because monetary policies alone are clearly failing to solve the developed world's growth and debt problems. Given this failure, governments will undoubtedly turn to fiscal and regulatory instruments to address these problems. As Grant warned, our future may include capital controls, intrusive taxes, and other additional forms of financial repression.

The Future of Repression

This coming week we should see the beginning of Operation Twist, which is intended to distort the shape of the yield curve yet again. The Fed's repressive intent is obvious: Push investors farther out the yield curve, away from riskless, short duration assets. They will happily sacrifice your wealth in order to support asset prices and make it cheaper for the over-indebted to deleverage.

As with the Fed's earlier monetary tricks, Operation Twist seems likely to encourage speculation only temporarily, and the authorities will have more tricks up their sleeves, however repressive those tricks may be. However much we may hope for more meaningful, structural change, we will not see it because it would undermine the system that supports the elites who control a growing proportion of our nation's wealth. As Jesse's Crossroads Cafe wrote recently, "the monied interests ... will burn down society rather than give up their seats at the top of the hill."

The Reciprocal of Trust

For the time being, we see investors flee Europe and park their money in dollars, and in such a situation we see even the price of gold waver in response. At some point the situation in Europe will stabilize, at least temporarily, and the world's attention can then refocus on the profound and seemingly intractable economic and debt problems of the US, and on the flaws of its managed currency. Where then will investors place their trust? Can they doubt that the Fed intends to continue devaluing the dollar? If gold is the reciprocal of trust in the institution of managed currencies, as Jim Grant asserted, the fundamentals of those currencies argue that the "barbarous relic" should see a continued bull market.

Deterministic Debt

2011-08-18T16:10:00.005-04:00

We Have Seen It Coming

We had sufficient warning that another economic downturn was coming. Economic statistics signaled a slowdown, gurus talked about it, and a burst debt bubble required it. Now the idea has become more widely accepted, but what can we do about it?

Lockhart Says the Fed Could Purchase Assets

The Fed wouldn't expand QE, would it? Well, it could, and it looks like the Fed is starting to prepare the country for it. In a speech the other day, Federal Reserve Bank of Atlanta Dennis Lockhart let the country know that the Fed is ready to act and has the means if the economy stalls. “If additional actions are required, I can assure you the Federal Reserve is not out of bullets.” What kind of bullets? “Expansion of the balance sheet or changes in the composition of the Fed’s asset portfolio are available, in my view."

"Treasonous" QE

Isn't expansion of the Fed's balance sheet what set off a commodity bubble and got the world to worry about the soundness of the dollar? We know that it is ineffective against debt deflation.

Rick Perry wants us to consider QE as treason. In the Texas governon's first day on the Iowa campaign, he said that it would be "almost treacherous, or treasonous in my opinion" for Federal Researve Chairman Ben S. Bernanke to "print money" before the 2012 election. We know that QE can't touch the economy, but it was nice of Rick to disqualify himself as a serious candidate.

The Real Treason

I wonder what Rick thinks about the real treason: Ronald Reagan's avowed goal to bankrupt the United States, just to make it impossible to finance Social Security and Medicare. Reduce taxes and forget promises about reducing the size of government. Sacrifice everything to ideology. That was the real treason, and Reagan's successors, like Rick, gleefully play their ignorant and hateful part.

Who accumulated the national debt after Reagan got the ball rolling? Nearly half of the national debt since Reagan was accumulated under the administration of George W. Bush. Bush's tax cuts for the wealthy, expanded Medicare, Wall Street bailouts, and endless war are the things that finally piled up the debt to dangerous levels, and they absolutely dwarf the debt added by the Obama administration.

The Real Cause of the Problem

The economic problems of the United States -- high debt, lack of competitiveness, unemployment, real estate glut -- all have their genesis in the lies and broken promises of decades of earlier administrations. Excuses were made to stimulate current consumption and fund pet programs, all at the expense of savings that could have funded investments in the future of the nation.

Will Congress Dare to Help?

More QE seems likely to accomplish nothing for unemployment and the real economy. What we need instead are structural changes, which we are unlikely to get. If the economic pain gets bad enough, Congress may finally align itself with the suffering electorate, forget its promises to reduce the deficit, and try some fiscal stimulation. Unfortunately, real structural change seems beyond Congress's intellectual depth. Also, expanding the federal budget is likely to bring the world's attention back to the ungovernable US debt load. Policy makers are in a bind.

A Familiar Historical Pattern

None of this is a surprise. Debt bubbles (balance sheet recessions) take years to work out, and there are no nice ways out. Worse, this debt cycle is taking place as the competitive position of the US is declining. The US is standing still or falling back, as hard-working people around the world continue to climb up the economic ladder and compete on the world stage. Inflated expectations in the US will continue to be frustrated as the nation pays the price for decades of waste.

A Period of Elevated Risk

It still looks like we face a long "muddling through" period, but the trouble with "muddling through" is that it leaves little room for error. The political impasse over the federal budget and S&P downgrade woke people up to the dangers of the out-of-control US debt load, and more people are looking for exit strategies now. They know that there is no guarantee that the disastrous debt trajectory will be corrected.

More QE will only stoke the fires of speculation. Macro risks seem elevated now, and it looks like a bumpy ride ahead. Treasuries and gold are already soaring. Some people are asking: "Is gold the only safe haven left?"

Zeno's Way -- Part 3

2011-07-29T15:20:00.000-04:00

LIE: High taxes are hampering businesses in the US, preventing hiring, discouraging new businesses from forming.

TRUTH: Business taxes in the US are historically low. Business gets a much better break with taxation now than at many times in the preceding century. Just see the charts below. Taxes on business revenues today are low both as a percent of GDP and as a percent of government revenues, compared to the past 60 or 70 years.

Low taxes were supposed to encourage investment in plant and equipment, leading to higher economic growth and more employment. Did it work? I don't think that anyone would say that we are having a good period of employment and economic growth right now.

The government certainly isn't getting much of its funding from business taxes today. Of course, that's part of the problem. We are experiencing a budget crisis now in part because wealthy business interests have been getting a break. Business and the US can both afford a balanced budget.

The rest of us aren't getting a break. It's about time the special business interests paid their share of the burden of government. They get more than their share of the benefits of government.

Zeno's Way -- Part 2

2011-07-26T21:44:00.000-04:00

LIE: It is Obama's fault that high unemployment and low growth are still with us.

TRUTH: This downturn is a secular process caused by unsustainably high debt levels and precipitated by a financial crisis, NOT a standard inventory cycle recession. It will take YEARS to work this out, and the country has in fact been PERMANENTLY changed. The good old days will NEVER come back.

Don't expect one President to solve a problem that the Republicans and Democrats both worked DECADES to cause. Decades of misdirected investments cannot be reversed overnight. The damage to the country's capital is permanent, and high growth won't come back.

Other nations are rising, productive technologies are spreading, and the competitive environment has permanently been leveled. The overwhelming advantage that the US had for a short time after WW II is gone forever. If America is declining now, it is because short-sighted leaders protected their own interests by playing it safe rather than acting like true leaders.

Don't blame reality on a political party. NEITHER party wanted to look at reality.

Zeno's Way -- Part 1

2011-07-24T08:12:00.001-04:00

Ever since the Federalists and Anti-Federalists duked it out in 18th century newspapers, political interests have used the press to peddle partisan lies and half-truths to the American people. Today, political interests on the extreme right continue to spread lies and half-truths in an attempt to influence the debate about the US government's budget deficit. Right-wing ideologues in the service of elitist special interests have done the country a grave disservice in poisoning the debate with their lies about the budget deficit, lies which many so wrongly believe. These servants of the radical special interests are, in fact, steering the nation in a direction will do nothing to solve the problems underlying our economic and budgetary problems. Their proposals will instead bring hardship to millions of Americans. Today's blog entry is the first of a series to restore a more balanced dialectic by contrasting those lies to the simple truth.

LIE: If we get the government's fiscal house back in order, everything will be hunky-dory with the economy in short order.

TRUTH: Those expecting an immediate comeback in the economy are either totally deluded or vicious liars. The spending reductions needed to balance the US budget are so large that they cannot fail to cause a severe reduction in the pace of economic growth. Economic activity can only contract if the government reduces transfer payments to the elderly, the poor, and the disabled. If the military budget is cut back, there will be immediate reductions in industrial activity and in consumer spending by military personnel, their families, and the civil servants who are let go.

MORE TRUTH: The economy is not coming back in any recognizable way for years. We are experiencing a period of debt deflation, not an ordinary inventory cycle. Private citizens, the financial sector, local and state governments, and the US government are all buried under excessive debt loads. Excessive debt cannot be worked off in weeks or months in the absence of confiscatory policies that would frighten our creditors and land the nation in an even worse mess.

Strike Scene, Louis Lozowick, 1934.

Hiatus

2011-05-17T18:37:00.000-04:00

The lack of new posts on Caliban's Market is only temporary, to allow time for travel, genealogical research, and other activities. Look for new posts in a few weeks.

The Coming End of Quantitative Easing

2011-03-30T09:47:00.002-04:00

For the past few weeks there has been talk in the press that QE II will pause at the end of June, and last week several Federal Reserve Bank Presidents made statements supportive of this view. As we will see below, there is good reason to believe that the government's extraordinary programs of support are coming to an end. We should seriously consider this, because the implications appear to be serious for market liquidity, rate expectations, and the dollar.

Accommodation Is Already Being Removed

Recent Fed pronouncements about ending QE should not be unexpected, because both the Fed and the Treasury have been cutting back for some time on other programs of financial and economic support. In "Crisis Era Props Are Fading Away" the Wall Street Journal last week reported on other support programs that both Treasury and the Federal Reserve have already started to roll back.

The Treasury Department has already announced plans to sell its $142 billion portfolio of federal agency mortgage-backed securities bought at the worst of the crisis. The Federal Reserve moved to the next stage of a plan to drain liquidity from the financial system through reverse repurchase agreements, or "reverse repos." Some of these moves have been going on for months. The Fed started testing reverse repos in the fall of 2009, and it has been some time since the Treasury ended several emergency-lending programs that eased the credit markets through the crisis.

More moves are being contemplated. The Fed is considering an auction for some of the subprime-mortgage securities acquired in the bailout of American International Group Inc.

Reasons for Policy Change at This Time

As pointed out by Glenview Capital in the blog Pragmatic Capitalism, there are some fundamental reasons for QE to pause: (1) the economy has rebounded (at least by some accounts), (2) the risk of immediate deflation has receded, (3) rapidly rising prices of oil, food, and other commodities provide some indication of incipient price inflation, and (4) Fed commentary has grown more cognizant of the risks of inflation.

In addition to the reasons cited in that article, the Fed probably wants to normalize policy so as to leave some "dry powder" ready to counteract the next recession or financial panic. Also, private financial institutions have stabilized to some extent, although much of their problems are being hidden at present by Treasury and Fed programs and by official tolerance of mark-to-fantasy accounting.

Recent Federal Reserve Comments

Based on recent statements, the Fed appears now to be in favor of putting an end of QE, if conditions continue stable or improve. Not long ago, St. Louis Federal Reserve Bank President Bullard said this quite plainly: "If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we're going to start withdrawing our stimulus, and I'd start by pulling up a little bit short on the QE2 program." Then last Friday a parade of Federal Reserve Bank Presidents made well-coordinated statements like these:

Speaking at a conference in Marseilles, Bullard said “The economy is looking pretty good. It is still reasonable to review QE2 in the coming meetings, especially this April meeting, and see if we want to decide to finish the program or to stop a little bit short.”

Speaking at the same conference, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said: "If the economy evolves the way I've forecast, I would not foresee us doing further accommodation." He added that the U.S. economy would need to worsen “materially” for the bank to consider further bond-buying.

Atlanta Fed President Dennis Lockhart said in a speech last Friday that "it's a high bar" for the Fed to pursue more QE. He told reporters after his speech that he favors completing the present round of asset purchases as scheduled but opposes additional moves based on his current economic forecast.

At a speech in New York a speech in New York last Friday, Charles Plosser, President of the Philadelphia Fed, said: "If this forecast is broadly accurate, then monetary policy will have to reverse course in the not-too-distant future and begin to remove the massive amount of accommodation it has supplied to the economy." He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.

Charles Evans, President of the Federal Reserve Bank of Chicago, said to reporters at a meeting at the bank that the current program of QE was enough: "Following through on that to the tune of $600 billion, like we've said, I think is appropriate. I personally don't see as many needs for a further amount, as I probably thought last fall."

The rhetoric has continued this week. Richard Fisher, President of the Dallas Fed, said today in an interview on Fox Business that he would vote against any further monetary easing by the central bank after the current program is finished in June. He was definite about this: "I cannot foresee a circumstance where I can support any further liquidity in the economy."

Pressures on the Fed to End QE

A stabilizing economy and a stable financial system have been cited as reasons for taking a pause in QE soon. These are not the only reasons why the Fed might end QE -- or say that it is going to end QE. There are other possible motives that include both real-world finances and Washington politics.

Another reason to consider ending QE in the future, if not right now, is the dollar. The ability of this country to remain solvent depends on maintaining at least some value for the dollar. So far, the dollar has declined only gradually in reaction to the government's extraordinary support for the financial system and the economy, but many of our creditors have complained about the trend. Naturally, dollar weakness is a big issue with the Fed, and they need to do something about it before heretofore modest dollar weakness turns into panic.

Partly, the problem can be seen in the continuing flow of dollars into commodities. When consumers and investors see commodity prices rising suddenly, they try to preserve wealth by exchanging dollars for commodities. This is not what the Fed wants. They want you to hold dollars and other US financial assets, not barrels of oil or gold ingots. A related view is that the Fed needs to forestall the incipient inflation seen in rising commodity prices. In addition, all of this speculation is destabilizing to the markets.

Many observers (such as Bill Gross of PIMCO) worry that the Fed is taking a big risk by tightening policy while it has been buying one-third of all US Treasury issuance. This may be a risk, but others point out that the Fed may already have enough securities on its balance sheet to control rates, and that it doesn't have to depend on incremental purchases.

Maybe the most persuasive explanation for the Fed's recent statements is that it needs to placate the fiscal hawks in Congress. According to this point of view, the Fed is just biding its time until forecasts of robust economic growth are proven wrong. At signs of a faltering economy, the Fed can rein in talk of pursuing QE and start preparing the markets for QE III. Signs of a faltering economy may not be long in coming, considering that the most recent economic data are not uniformly encouraging, and many economic forecasts are being cut back.

Problems with Pausing QE

Unfortunately, a pause in QE would happen at a time when overall economic and financial conditions are hardly conducive to monetary tightening. As Glenview Capital wrote in the blog Pragmatic Capitalism, "a renewed emphasis on deficit reduction in Congress ... will likely slow the growth of both Federal and State/Local spending that has played a key role in reinforcing the economy to prevent a double-dip recession." This austerity-induced fiscal drag seems likely to add its own burden on the weak economy.

If they come to pass, these domestic drags on the economy will happen against a global backdrop of economic negatives. These include high oil prices induced by fears of continuing political unrest in the Middle East, financial instabilities induced by the continuing debt crises on the periphery of the European Union, and the possibility of tightening by China to rein in inflation pressures and rein in an unbalanced and overheated economy.

Pausing QE would tend to raise interest rates, which is a situation that the financial system may not be ready to face. As Bill Gross asked: "Who will buy Treasuries when the Fed doesn't?" This raises the additional question of how high rates might go when the artificial foundation of QE II credit is removed. There is also the question of how well the economy and the financial system can withstand higher rates. The economy hardly seems robust enough to withstand sharply higher borrowing costs. The financial system gives appearances of having stabilized to some extent, but that leaves the question of how dependent is has become on the continuance of rock-bottom interest rates.

There is also a risk that fiscal austerity, induced by fears about government deficits, might actually worsen that situation. This is because the stabilization of the economy has been dependent on stimulus through growth in Federal expenditures. With reductions in Federal, state, and local budgets, there is a higher risk that growth will falter, and that lower economic growth will reduce tax revenues and increase the deficit.

Barbara Stevenson, Apple Vendor, 1933-1934.

All of this paints a picture of a financial and economic environment that is hardly appropriate for monetary tightening in the US. As noted above, recent economic news is not encouraging, and continuing signs of weakness could easily raise new fears of another recession. We have to wonder if QE would not need to be quickly resumed if this uncertain economic climate resumes a downward course.

Tightening to fight inflation runs the risk of undercutting the recovering economy, a situation which would place the Fed and Congress between a rock and a hard place with respect to policy choices. This could lead to a real dilemma for policy, that perhaps deficits cannot be reduced without further weakening the economy. Perhaps we should not be surprised to see such a dilemma, given that this country has seen decades of Fed policies and national budgets sending false signals to the markets that induced economic participants to misallocate resources into consumption rather than productive investment.

QE and the Markets

One of the best discussions about pausing QE that I have read was John Hussman's March 28 commentary. His argument is based on the fact that "the primary factor behind the market's recent advance has been speculation based on the belief, explicitly encouraged by Bernanke, that the Fed would provide a backstop for risk-taking." The implication for the markets is clear. If the Fed does not enter into another round of QE (and certainly if the Fed unwinds past QE), it risks an "an increase in risk aversion" and "a decline in speculative enthusiasm."

Given the momentum-like behavior of the markets, Hussman believes that investors have not priced in "the extent to which this [the market advance] has been reliant on various stimulus measures that are now drawing to a close." In fact, low market returns were almost guaranteed by the nature of QE. This is because by "increasing the stock of non-interest bearing money in the economy toward $2.4 trillion, all of which has to be held by somebody, the Fed has created a market environment that has raised the prices and lowered the returns on all competing assets." [My emphasis]

There is no way of knowing where the market will go in the short-term, but poor long-term returns are indicated by present market valuations. This is borne out by Hussman's quantitative models, which are definitely long-term and fundamental in their valuation approach. These models assume that "long-term growth in GDP and earnings will persist at the same roughly 6.3% peak-to-peak growth rate across economic cycles," which is the average rate observed over nearly the past century. Based on the level of stock valuations to normalized earnings, "our present 10-year total return estimate for the S&P 500 is only about 3.4% annually," and "the historical skew to these returns easily includes zero in the confidence interval."

Bill Gross's has warned that the end of QE will mean the end of the bull market in bonds and, as we discussed above, there is good reason to worry that the removal of extraordinary monetary accommodation may also drive down the prices riskier asset classes, like stocks and commodities. Whether we agree with all of these arguments or not, it is always a good time to review the asset allocations in our portfolios.

Not Yet the End of the Bull Market in Bonds

2011-03-22T10:30:00.008-04:00

PIMCO Total Return Eliminates Government Bonds

A couple of weeks ago there was considerable angst in the press over the announcement that the PIMCO Total Return Fund had totally eliminated its exposure to US government bonds during the month of January. Total Return raised its cash position by a corresponding amount.

In an interview on Yahoo Tech Ticker, PIMCO guru Bill Gross advised investors to stay clear of “bonds in dollar denominated terms” and to be “wary of higher interest rates going forward.” Bloomberg reported: "Gross believes that interest rates on U.S. Treasuries are way too low right now and that they will start going up when the Federal Reserve ends the current round of quantitative easing in June."

Should We Be Worried?

Well, if you believe that rates will rise precipitously when QE II ends, I don't blame you for selling bonds and going to cash. You might even believe, as Zero Hedge wrote, that the "cost of capital could go up by at least 150bps while input costs are rising, margins are compressing and liquidity drying up." In that situation, it might even make sense to "get the hell out of Dodge in all asset classes."

But is there reason to be so greatly worried about rising rates, especially at the end of QE II in June? I certainly agree that the US faces persistent, multi-year problems with interest rates and the dollar. However, it isn't exactly clear that we should have a particularly elevated level of worry about the purported forthcoming event "when the Federal Reserve ends the current round of quantitative easing in June," as Gross says we should. There are differing opinions about the market impact that the end of QE II may have, if it does end then, and we might profit by at least listening to some other opinions.

What Happened to Bond Yields the Last Time?

Cullen Roche, the author of the blog Pragmatic Capitalism, looked at Gross's track record and concluded: "I am not sure there is much, if anything, that we can read into this move by Mr. Gross. He has been talking about some form of bear market in bonds for over 10 years now." For example, ten years ago Gross wrote in 2001 "We are at the end of the secular bull market in bonds," which hardly turned out to be the case then.

Roche also pointed out that Federal Reserve history is against Gross's pronouncement that QE II will lead to a rise in bond rates. When QE I ended last year, and the Fed contracted its balance sheet, interest rates did the opposite of what Gross expected, that is, they dropped.

Of course, the Fed's move was advertised in advance, and bond yields did rise during much of the lead-up to the event. Also, the context is different this time. There is more public awareness now of the risks of a declining dollar, and attention to the growing US government debt has also increased in the past year. Perhaps it is best to admit that argument from a single anecdote is impossible, and not dismiss Gross's worries simply on that basis.

What Else Happened Last Time?

If we want to use historical analogies, the only time that the Fed previously cut back on a program of quantitative easing was last year. Interest rates fell after that cutback, but what else happened? A full examination of the historical record shouldn't be restricted to a single dimension, bond yields, even if that is the issue that Bill Gross focused on.

In John Maldin's latest column, he quoted from a list that was originally published by David Rosenberg. To quote those two, during the period from late April to late August last year, when the Fed contracted its balance sheet by 12 percent, the markets saw asset price changes that included the following:

The S&P 500 sagged from 1,217 to 1,064….

The S&P 600 small caps fell from 394 to 330….

Baa spreads widened +56bps from 237bps to 296bps…

CRB futures dropped from 279 to 267….

Oil went from $84.30 a barrel to $75.20….

The VIX index jumped from 16.6 to 24.5….

The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5….

The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%…

Among commodities, the exception to the overall decline was gold which "acted as a refuge at a time of intensifying economic and financial uncertainty" by rising to $1,235 an ounce from $1,140.

If the end of QE II follows the same pattern as the end of QE I, perhaps there is reason to worry about the short-term impact, because there were price drops across a wide range of asset classes. But the price declines last time did not include the one that Gross identified, namely a drop in bond prices.

The Difficulty of Interpreting History and Statistics

In his Yahoo Tech Ticker interview, Gross said that America's debt level is nearing a breaking point after years of reckless spending, and that we can no longer depend on foreigners for funding. A critical question, of course, is when the breaking point will arrive. Gross cited the work of Ken Rogoff and Carmen Reinhart in This Time Is Different when he said: “When a country reaches a certain debt level, confidence in that country’s ability to repay that debt becomes jeopardized.”

Now, we must be careful here, because timing is everything in investing. Certainly, high national debt levels can be dangerous, but has the US reached a critical level of debt? Do we expect the US to experience a major bond market dislocation this year, as Gross seems to imply?

The really big problem with Gross's appeal to Rogoff and Reinhart is of course that, when he refers to "a certain debt level," he is referring to average results over a sample of national experiences. Referring a a sample average is misleading. The outstanding aspect of the data used by Rogoff and Reinhart is the variability in the experiences of different nations with respect to the conditions under which they had difficulties paying their debts. There is no way of saying that a nation will default when it reaches a given level of debt, however one defines the debt.

Also, it is myopic to focus attention on only a single variable, the nation's level of debt (presumably as a fraction of gross economic product). Other factors are also critical in determining a nation's ability to pay its debts, including its level of economic activity, prospects for growth, currency convertibility, trade relationships with creditors, and many others. There are good reasons that US creditors are willing to tolerate present debt levels and that the US currently experiences interest rates that are low to moderate in historical terms over the maturity span of the yield curve.

In fact, predicting a nation's ability to repay its debt is not a matter than anyone can achieve with any certainty. Is there risk to the US dollar? You bet. Could the dollar fall more this year? Sure. But will American's ability to repay its debt suddenly end this year? There are risks, but QE II does not seem especially likely to be the trigger for a massive event.

Years, Not Months

Setting a time for a bond blowup is impossible, but the real problem is probably more likely to lie sometime in the next decade, not over the next few months. That is because the big problem is the current high level of US government debt and the likely future growth of that debt, seemingly without limit. Current budgets are heavily in deficit, and entitlement programs —Social Security, Medicare and Medicaid—are set to add ever-increasing burdens that will throw the budget even more into the red. Given the reluctance of politicians to raise taxes to pay for these programs, or to cut entitlements, the national debt seems fixed on a doomsday trajectory that will grow without bound until disaster strikes.

A chart at The Economist is a good place to see the proportion of GDP spent on entitlements and interest, compared with the proportion of GDP that the government is expected to raise in the form of revenues. The data come from the Congressional Budget Office's "alternative fiscal scenario", which is based on today's underlying fiscal policy but also incorporates some widely expected changes, such as an increase in the threshold for the alternative minimum tax rate. The expansion of entitlements to take up an ever-expanding proportion of the US budget is very striking.

The Economist pointed out that, according to this graph, entitlements and interest will absorb all government spending by 2025. Of course, a crisis will arise well before we reach that point. Not only will there be resistance to letting entitlements crowd other government programs, but the government budget will expand well before that time to comprise an unacceptably large percentage of our GDP. Other economic activity would be crowded out, but markets are certain to react well before that point to demand higher interest rates and pernicious currency exchange rates from the US. As confidence is lost in the US, the point will be reached where the economy falls into depression and the national debt cannot be serviced.

Clearly, the government debt situation poses a very big risk for bonds, interest rates, and the dollar. In this respect Gross and PIMCO seem perfectly on track in their warnings, although that still leaves the question of timing.

When will the crisis be seen in the markets? Hard to tell, but it seems more likely that the real trouble will be a few years off, say, in the latter half of this decade, rather than at the end of QE II, if it ends this summer. Of course, there are many uncertainties. Determined political action could lead to meaningful cutbacks in government spending, or unexpected economic growth could bring greater tax revenues to the government to reduce annual deficits. Whether a crisis occurs or not, half a decade seems a more plausible period of uncertainty for an American interest rate crisis than does a restricted period like the few months attending the end of QE II, whenever that event actually comes.

Bill Gross's Argument

Gross's stated position on QE II is much more alarmist than the aforementioned historical interpretations would seem to support. He reminded readers in his March letter that the Fed is currently buying about 70 percent of all new US government debt, and he then asked: "Who will buy Treasuries when the Fed doesn't?"

There is no argument with Gross's recognition that "Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets." Without this "handoff and stability" the private sector may indeed be unable to issue debt at the low yields and narrow credit spreads seen in the markets at present. It is difficult to disagree that this point.

As for the magnitude of the problem that the financial markets might experience if QE ends, we have Gross's estimate" that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%." Of course, in order to be really worried that QE II will end soon, you have to accept Gross's estimate of expected nominal GDP growth. Not everyone would agree that the economic prospect is so rosy.

Perhaps the biggest problem with Gross's alarm is that it posits an event that may not occur. Given the weakness of the economy and the reluctance of Congress engage in fiscal stimulation, it would seem more likely that the Fed will find it necessary to continue a policy of extraordinary monetary easing, rather than discontinue it. Current optimism about the economy seems overdone, and the Fed probably knows that.

There is no denying the existence of near-term risks, but the question is the magnitude of the risk and how it will evolve over time. Based on this analysis, risks to the dollar and Treasuries should rise as deficit difficulties increase over time. This isn't exactly the message of Gross's comments, but at least he has stated his arguments publicly, so that we can judge the extent to which we would like to share them.

The Down Staircase

2011-02-26T11:15:00.004-05:00

The Stairway to Poverty

Several times I’ve said in this blog that I don’t expect the imminent collapse of the dollar. This isn’t because I’m blind to the dollar’s fatal flaws, but because of the time required for the unfolding of this nation’s budgetary and economic problems, and because the dollar is only one of a number of troubled currencies of declining developed nations.

But I don’t want to give the impression that the dollar is safe. We know that the dollar is on an unsustainable trajectory, and its decline seems inevitable. It’s just that the path isn’t necessarily straight down, and the timing of the dollar’s decline is highly uncertain.

The Dollar Cascade

There is no doubt that the direction is down. Even Chairman Bernanke has said that the US needs to reduce debt, and that the process of deleveraging will involve high rates of bankruptcy and unemployment. In such a spare environment, low rates of economic growth will force governments and individual citizens to adjust their expectations and economic activities downward. Because governments and citizens do not willingly adjust their expectations to reduced circumstances, we cannot expect the process to be a smooth one.

Until the financial crisis hit, the risk of financial collapse because of rising levels of private and public debt was met with official denial. When collapse became imminent, the official response was a bailout of key financial players, a policy of rock-bottom interest rates, and quantitative easing – all temporary measures that left the underlying issues untouched. Private debt was partially transformed into public debt, but the debt remained. The system was stabilized temporarily, but this was only the first step in a multi-year process of deleveraging and economic adjustment.

For these reasons, I see the continuing decline of the dollar as a sequence of stair steps. After falling down a step, the US finds ways to arrest its decline partially and sustain itself at a lower level for a few years. Eventually, the pressure on the US (declining economic competitiveness, value of the dollar, political influence) builds up to a point that resistance gives way and we fall down another step. Over a period of decades, some of the steps may be small and others large and catastrophic. However long we may loiter on any single step, the direction is down.

Printing Money Is Not the Answer, It Is a Symptom

There is a school of thought, based on Modern Monetary Theory, that the US cannot become insolvent. The thesis is that the Fed is not monetizing the debt, and a truly sovereign currency can not be debased into hyperinflation. This position posits that the government does not print money, but rather pushes buttons to create amounts in bank accounts or remove amounts from bank accounts. The blog Pragmatic Capitalism has published a number of articles supporting this position, which might be summarized as: “a sovereign government with monopoly supply of currency in a floating exchange rate system has no solvency issue.”

In my opinion the main problem with discussions of this point of view is that they discuss the wrong problem. The real issues are this country's ballooning federal debt and its persistent negative balance of payments. Those are the main forces driving this country to penury, not monetary policy.

Easy monetary policy, however, exacerbates the problem because it distorts market prices, resulting is the allocation of resources into speculation rather than productive activities. Nevertheless, I was still interested to read a critique of modern monetary theory in a recent series of articles in another blog that I enjoy, Jesse’s Crossroads Café (Jesse Part 1, Jesse Part 2, Jesse Part 3). To quote Jesse, the critique might be summarized as “I can print money, therefore I can never go broke.”

A government with a monopoly supply of currency may remain solvent in the limited sense that it can pay its debts in its own currency, but that is such a myopic issue as to be meaningless. What is that currency worth in real terms? Not much, if that government’s debts expand without limit. If debt grows uncontrollably, no sovereign government can escape the consequences.

Theoretical solvency is a false issue if your currency declines against all others, and if everyone understands that the trend is going to continue indefinitely.

If debt grows uncontrollably, relative to the size of an economy, citizens and creditors will notice. What exchange rates will foreign trading partners demand, what interest rates will foreign creditors demand, and what rate of price inflation will domestic consumers experience? As Jesse put it: “The limit of the Fed's and Treasury's ability to create money is the value and acceptance of the dollar and the bond in market transactions.”

And at some point, after exchange rates, interest rates, and price inflation have escalated to the point that the people are mostly in penury, who will accept that currency in exchange for any service or real good? At that point such a government really does become insolvent.

The Runaway Fiscal Trajectory

The US and other advanced nations seem unlikely to take significant steps to bring their houses into fiscal order until catastrophe is staring them in the face, and by that time it will be too late. It may already be too late. Even holding social entitlements (such as Social Security and Medicare) at current levels (as a percent of GDP) may be insufficient, according to a study by the Bank of International Settlements.

Both monetary and fiscal policy now appear to be impotent, and there is an increasing risk that government policies may be unable to avoid financial collapse. As Charles Hughes Smith recently wrote in “Beyond the False Dawn: Global Crisis 2020-2022” in his blog Of Two Minds, the policy of easy money is a trap, because we cannot reverse it without catastrophe: “… the status quo is now addicted to unlimited flows of free money. If the flow continues, then inflation will destabilize it; if it's cut off, then rising interest payments will destabilize it.”

Although I mentioned inflation as a problem, this does not mean that every step forward will be inflationary. Government budget cuts, recession, and falling real income are among the strong deflationary forces that lie in our future at some point. Different steps on the down stairway will bring different conditions, whether inflationary and deflationary, whether in the price sense or the monetary sense. The overall direction is toward economic decline and monetary devaluation, however.

Despite political rhetoric, US fiscal policy is still on a runaway trajectory. Recently The Economist reported in its Daily Chart feature, "I O USA" that neither the Republicans or the Democrats are serious about the deficit:

“Both sides talk about cutting the deficit but are unwilling to risk losing voters by trimming the big budget items: pensions, Medicare, Medicaid and defence. Republicans, who were initially pushed to talk tough on cutting spending by the Tea Partiers, have backed away from what plans they had to take on entitlements since gaining control of the House.”

Stumbling Down the Stairs

At some point people will not accept dollars without a suitable discount, or else they will not accept them at all. I agree with those who argue that the dollar is already unstable and that the present conditions supporting the dollar are unlikely to continue forever. As Jesse stated: “the question is when markets will start putting pressure on governments, not if.”

Apparently, people are catching on to this idea. Mohammed El Erian recently commented ominously about the failure of the dollar to rise in reaction to the crisis in Egypt, Libya, Bahrain, and other countries in the Middle East (my emphasis):

"It is a warning shot to America that we cannot simply assume flight to quality, flight to safety. That people are starting to worry about the fiscal situation in the U.S., worrying about the level of debt and what they're hearing about states and municipalities. I would take this as a warning shot that we cannot assume that we will maintain the standing of the reserve currency as we have in the past."

It does not matter whether the US dollar is or is not the world's reserve currency, as long as the world has confidence in the dollar. Losing the dollar's status as the reserve currency does matter, however, because it signals that the world has recognized lost confidence in the US. It signals that our underlying problems of debt and lack of competitiveness have become unmanageable.

As recognition of the fiscal and economic problems of the US become widely accepted, there will be little to restrain the fall of our currency. The debt has been accumulated, the industrial system has been eroded, and government policies are not being meaningfully directed to remedy the fundamental problems underlying the crisis. This mantra quoted from Jesse’s Crossroads Café is an insightful comment on the need for new solutions:

“Both austerity and stimulus will falter in the mire of imbalanced, broken systems and corruption. The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained recovery.”

The Old Always

2011-01-23T17:11:00.002-05:00

The thing that hath been, it is that which shall be; and that which is done is that which shall be done; and there is no new thing under the sun.

Ecclesiastes 1:9

Last month, James Montier of GMO wrote a piece, In Defense of the “Old Always", questioning the concept of the "new normal" and what it means for the way we invest these days. Perhaps not surprisingly for a value investor, his conclusion was that there is nothing new under the sun and that "old always" value investing principles still apply. I especially liked his observation that the value investing concept of mean reversion still applies, contrary to what some "new normal" proponents have proposed.

What Is the "New Normal"?

Discussing the "new normal" is complicated by the variety of meanings that different writers have attached to the term. Perhaps the most common interpretation is that the "new normal" refers to the current period of low economic growth in the developed world and the likelihood that this period will continue for years. This interpretation makes a lot of sense, because low growth seems likely to be with us for years, thanks to the unsustainably high levels of debt in the private and public spheres. Indeed, the growing convergence of the developed and developing worlds makes it unlikely that the "old normal" economic proposition will return.

Is the "New Normal" in Investing Returns?

To other observers the "new normal" refers to a shift in investing returns from a distribution with thin tails and more likely outcomes close to the middle to a more uniform distribution with fat tails, or more frequent extreme outcomes. Bill Gross of PIMCO offered this interpretation in one of his monthly commentaries last year.

I find this "fat tail" interpretation very hard to give credibility to, because the world has experienced high variance outcomes in the financial markets historically and with a frequency that is much higher than has generally been appreciated. Bubbles, bankruptcies, and the ruin of old regimes have been fairly frequent companions of financial markets for centuries. With samples taken over long enough periods of time or across enough kinds of markets, financial returns have always looked non-normal with fat tails.

Joan Miro, Red Sun

Is the "New Normal" in Mean Reversion?

Another PIMCO manager, Richard Clarida, went even further and attacked the very basis of value investing, which is that one buys when a thing is cheap and sells when it is dear. Clarida wrote, “Positioning for mean reversion will be a less compelling investment theme in a world where realized returns cluster nearer the tails and away from the mean.”

Come on now, who could really believe that mean reversion is dead? Not only does this statement ignore the historical fact that extreme outcomes are not that rare, but it also makes the logical mistake of saying that high variance is inconsistent with the mean reversion. When markets go to extremes, they eventually revert to the mean and beyond, and patient value investors will profit if they wait for the bubble to burst. This increases the chances for profit when reversion occurs.

Mean Reversion Is Alive and Well

I have to agree with Montier when he says "the concept of the new normal confuses the distribution of economic outcomes (and forecasts thereof) with the distribution of asset markets ... From the perspective of mean reversion, fat tails help to create some of the best opportunities." Montier's letter also included a chart that illustrates his point very graphically.

History is littered with the remains of proclaimed, but unfulfilled, new eras. Exhibit 6 shows the long-run history for the Graham and Dodd P/E for the U.S. market. Over this time, we have witnessed some quite remarkable, and quite appalling, things – the deaths of empires, the births of nations, waves of globalization, periods of deregulation, periods of re-regulation, World Wars, revolutions, plagues, and huge technological and medical advances – and yet one thing has remained true throughout history: none of these events mattered from the perspective of value!

No One Says That It Is Going to Be Easy

None of this means that it is EASY to apply value principles to mean reversion. No one can predict the future, which means that no one knows when the top or the bottom will occur. You have to understand the investing world, and you need to apply valuation metrics, but is this possible today? Zero Hedge suggested that the metrics have changed:

Yet in a universe in which true asset fair value can no longer be derived, and all valuations are wrapped in the enigma of trillions of monetary and fiscal stimuli, whose stripping is virtually impossible in a world in which everything is centrally planned, we just may have entered... the non-"old always" zone.

I agree that it isn't easy to apply familiar valuation metrics when the Fed has flooded the market with liquidity, but I don't think that it is impossible. You just have to adjust your metrics so that they reflect the determining forces at work in a debt-laden world. If the government assumes private debt to attain financial stability, you need to attend to the political risks as well as the industry fundamentals. But mainly you need patience. I'll let Montier answer in his own words.

It is also worth noting that in order for mean-reversion-based strategies to work, it is not required that the mean be realized for long periods of time, but that markets continue to behave as they always have, swinging pendulumlike between the depths of despair and irrational exuberance, or, from risk-on to risk-off. As long as markets display such bipolar disorder and switch from periods of mania to periods of depression, then mean reversion should continue to merit worth as an investment strategy.

Unstable Equilibrium

2010-12-10T15:41:00.036-05:00

Woodblock print by Utagawa Hiroshige

Freeze and Thaw

An increasing number of analysts are forecasting better time ahead for the economy and the stock market. Elaine Garzarelli daid on CNBC that there will be better economic growth and stock market performance next year as a result of the money put into action by QE II. PIMCO's Mohammed El-Erian also raised his US growth forecast for 2011, to between 3.0 and 3.5 percent from an earlier estimate of 2.0 to 2.5 percent, based on the prospect that Bush-era tax cuts will be extended for another two years. However, he added that further stimulus would be needed to sustain growth.

To be sure, not all of the optimism is US-centered or long-term. Byron Wien just came out with a warning that investors need to be invested in emerging markets, and he recommended a portfolio allocation that emphasizes emerging markets, high yield bonds, and hedge funds. Bill Gross just advised fixed-income investors to look to emerging markets like Brazil where they can earn an attractive real interest rate, rather than the pittance offered in the US.

Also, many structural factors are against the US in the longer term. Gross added: “The U.S. is being out-trained, out-educated and out- maneuvered in the global competition for employment.” About his forecast of higher US economic growth, El-Erian wrote: "Maintaining such a growth rate beyond 2011 requires additional measures to enhance competitiveness and achieve medium-term fiscal consolidation."

Risk Probabilities Remain Tilted Toward Recession and Deflation

Despite recent talk in the press about signs of an improving economy, a look at a broader range of evidence shows persistent and underlying economic weakness. Combined with underlying conditions, including high levels of debt in both the private and public sectors, the economic and financial evidence suggests that the way out of this country's troubles will be a long slog and fraught with risks.

Fed Chairman Bernanke said last Sunday that the economy is barely expanding at a sustainable pace and that it’s possible the Fed may expand bond purchases beyond the $600 billion announced last month to spur growth. “We’re not very far from the level where the economy is not self-sustaining,” Bernanke said in an interview broadcast yesterday by CBS Corp.’s “60 Minutes” program. “It’s very close to the border. It takes about 2.5 percent growth just to keep unemployment stable and that’s about what we’re getting.”

Indeed, this country is not alone in its troubles. Around the developed world, financial systems burdened by high levels of debt and stagnant economies are highly dependent on government policies for their maintenance. Certainly, the economies and financial systems of the US, EU, and Japan are supported only by extraordinary monetary policy, and errors in these countries' policies could have negative repercussions that would reverberate around the world. As Hugh Hendry says in his December 2010 Eclectica Fund commentary, "This is an environment rich in policy error contingencies."

Hendry also made the very practical point that serious dislocations can also present serious investment opportunities. In the spirit that our wealth is only as safe as our ability to prepare for an uncertain future, I'd like to review recent commentaries about these risks and uncertainties.

Is Santa Coming to Your House?

In case anyone thinks that the economy and financial system actually are making progress, he or she need look no farther than recent news headlines. As an example, consider the headlines from the news stories reprinted in The Automatic Earth blog, last Saturday, December 4, 2010:

Senate Republicans Defeat Reauthorization Of Jobless Aid, Tax Cuts

4 Million Americans Set To Lose Unemployment Benefits Even If Congress Passes Extension

Here Are The The AWFUL Details Behind Today's Big Jobs Report Miss

Value Sinking Fastest on Homes Priced Low to Start

Homes Prices are Plunging: Let's Talk About the Deficit

Distressed Homes in U.S. Sell at Biggest Discount in Five Years

The con of the century – Federal Reserve made $9 trillion in short-term loans to only 18 financial institutions. Since 2000 the US dollar has fallen by 33 percent. The hidden cost of the bailouts.

ECB bows to German veto on mass bond purchases

Angela Merkel warned that Germany could abandon the euro

The details within these stories are no better than the headlines. For example, consider the imbalance between good and bad news in this list of employment facts from the above-mentioned jobs report article:

1. First, the headline: Nonfarm payrolls barely move upward.

2. And the unemployment rate is now creeping up again.

3. Those unemployed for more than 15 weeks is now near 2010 highs.

4. And those unemployed for more than 27 weeks is moving higher.

5. The civilian employment ratio is back at the post recession low.

6. Civilian employment numbers have given up the past few months' gains.

7. The civilian participation rate is now at a new low.

8. Weekly hours have slipped as well.

9. Now, a look at the industries hardest hit: Manufacturing employment in non durable goods now below 2010 lows.

10. And durable goods manufacturing jobs don't look too much better.

11. Government jobs have dipped again, although only slightly.

12. Construction jobs remain low, and flat.

13. BRIGHT SIGN: Total private industry jobs are still moving higher.

He's Making a List

Maybe we can muddle through with a weak economy, or maybe not. For my part, I'm worried about all the risks we fact before (if ever) we get out of the woods. Pragmatic Capitalism made this point forcefully: "I still believe we are mired in a balance sheet recession that will result in below trend growth, deflationary risks and leaves us extremely vulnerable to exogenous risks that could exacerbate the current malaise."

If the current stagnant situation is being propped up only with extraordinary monetary policy, then surely the situation is actually quite fragile. A world delicately balanced between debt disaster and policy overreach must surely be fraught with numerous, serious risks. Niels Jensen, Managing Partner of Absolute Return Partners LLP listed 12 risk factors for the attention of readers of his latest Absolute Return Letter. Here are the risk factors, each accompanied by my own short exegesis:

High yield priced for perfection? Are spreads getting so tight that one could even talk of a bubble, and could that bubble burst, should the US (and/or European) economy fall back into recession?

The risk of double dipping. Just consider the economic news that I listed earlier.

The sinking ship of Japan. This refers to the high and growing level of government debt, the funding of which is endangered by an old and aging population.

Beggar thy neighbor mentality. Just consider administration talk of devaluing the dollar to increase exports (as if anyone needed our products), complaints from various emerging countries about manipulated interest rates in the US, and China's policy with the Renminbi.

Capital flows too hot to handle. We read every day about the risks of overheating in China and other emerging economies. Capital controls would damage both overseas investors and internal growth. Not imposing controls would risk high inflation and runaway bubbles in commodities and other assets.

Chinese inflation out of control? Although the leadership has said that it is considering price controls on food, lax monetary policy is pushing up prices of a variety of goods and assets.

Food inflation induced civil unrest. Based on the last food price peak in 2008, it may not be too much to expect civil unrest across Asia if food prices continue to climb.

Is India an accident waiting to happen? Although India is financing its external deficit with ease at present, due to the positive capital flows into emerging markets, tighter overseas monetary policies or a change in investor risk perceptions could endanger those flows.

European contagion and solvency risk. Current efforts to avert a crisis are just kicking the can down the road. Banks are in trouble, and the underlying solvency problems are not being solved by adjustments in liquidity.

Massive refinancing program. "This programme poses the biggest risk to my benign outlook for bond yields ...", because of the huge financing needs that are approaching, according to Jensen. Zero Hedge ventured that the problem is even bigger: "Simply put, it's not just fiscally-challenged nations in the eurozone that are suddenly being forced to address the threat posed by too much borrowing. Over the next 12 months, countries across the world, including the United States, will be looking to roll over approximately $10 trillion worth of debt."

Premature withdrawal of monetary support. Not only are the indebted peripheral nations of Europe dependent on continuous support, but the US economy is in danger if Congress follows through on Republican promises to rein in the Federal budget, seemingly without any consideration of the consequences.

Israel launching a pre-emptive strike on Iran’s nuclear facilities. The world is full of political-military risks, and this is just one risk that happens to be a current focus of attention.

I don't know if these are exactly the risks that I would focus on, but they serve to convey the general notion that the present unstable equilibrium could easily be disturbed and send the system sliding off into a new trough of worse conditions.

He's Checking It Twice

Naturally, David Rosenberg has taken his turn listing risks to economic recovery, and out of his list, I think that these two pose particular domestic threats next year:

Massive tightening in U.S. fiscal policy coming via spending cuts and tax hikes. This is the part of the macro forecast that is not given enough attention.

Many goodies will expire at the end of the year and question marks linger over whether they will be extended. These range from the Build America Bond program that subsidized municipal issuance, the Bush-era tax cuts, the extended/emergency jobless benefits, and the little-known Obama tax benefit called the Making Work Pay Credit.

Pragmatic Capitalism reviewed Rosenberg's list and added another domestic risk : "The one major risk that Rosenberg and the market is largely overlooking at this juncture is the housing double dip. This has the potential to be THE most important story of 2011. As I've previously explained, declining asset values are highly destructive during a balance sheet recession."

Tighter fiscal policy will do no good for the economy, and it also brings into question how much money the states might receive from the Federal government should states continue down their present road to budgetary crisis. In "Mounting Debts by States Stoke Fears of Crisis" The New York Times noted just a few examples of how bad the situation has become:

"The State of Illinois is still paying off billions in bills that it got from schools and social service providers last year. Arizona recently stopped paying for certain organ transplants for people in its Medicaid program. States are releasing prisoners early, more to cut expenses than to reward good behavior. And in Newark, the city laid off 13 percent of its police officers last week."

Given continued problems with the national economy, many states could be overwhelmed by debt in a few years, if they are not already at the brink of the precipice. Worries about Federal willingness to aid the states may not be mere fear mongering. The Times added: "Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones, much as the turmoil in Europe has spread from country to country."

Felix Rohatyn, the financier who helped save New York City from budget problems in the 1980s warned that while municipal bankruptcies were rare, they appeared increasingly possible. Mr. Rohatyn added that the imbalances are so large in some places that the federal government will probably have to step in at some point, even if that seems unlikely in the current political climate.

In noting the likelihood of legislative deadlock in 2011, David Rosenberg wrote:

Folks, we are on life support. We have been since 2008. Nothing will change in 2011. QE has been extended, the tax cuts will be extended, BABs and the Agency loan limits are being extended. The IV is full and inserted into the arm. The juice that is keeping us alive is still flowing. But make no mistake about this. Without the IV the lights will go out very quickly. 2011 is the last year for these extensions. When we wake up to the fact that we are alive only as a result of medicine we take on a daily basis there is going to be another “event”.

In the current political climate, we have to wonder what kind of price the Republicans might try to exact in exchange for eventual bailouts of the states. Breaking public employee unions would surely please the Republicans, but they might have to provoke a state bankruptcy crisis in order to get their way. Financial systems don't like crises, unfortunately.

In Wednesday’s NYT, David Leonhardt commented: “Mr. Obama effectively traded tax cuts for the affluent, which Republicans were demanding, for a second stimulus bill that seemed improbable a few weeks ago.” It seems likely that any resulting stimulus will be too little to make a difference.

It is to be hoped that the recent extension of tax breaks for the wealthy will prompt those who are often referred to as the "job creators" to get with it and start hiring. Given that the demand for goods from the masses is lacking, there is little reason for more hiring, but we can all hope. At least there are some modest increases in prospective hiring surveys for the first quarter of next year.

The Neighbors Have Been Naughty Too

David Rosenberg has a good way with words, so I'll let him express the nature of the risks with Europe:

"All these “rescue” packages in euroland really do is provide bridge financing — they do not resolve the underlying structural problems in these countries or the deflating asset values in bank balance sheets."

"The massive selloff in government bond markets, even in countries like Belgium and Italy (let alone Portugal and Spain), is a clear sign that the bond vigilantes are now targeting the supposedly stronger governments in the eurozone. These bond vigilantes are also speculating that the national purse will be needed to keep their banks afloat and the relentless widening in CDS spreads is an added suggestion from the markets that these governments may not have the resources to fully repay their creditors once they have moved to support their banking systems."

The Washington Post commented last Tuesday that bond markets are not the only worry with Europe: "A greater danger is that a full-blown debt crisis in Europe could put new pressure on the region's banks, tightening credit and potentially slowing growth in one of the world's largest economic engines. It could also send the euro plunging against the dollar, making the greenback stronger on world markets and undermining the efforts of the Obama administration to boost U.S. exports overseas."

In a guest editorial in Naked Capitalism, the author of Washington's Blog wrote: "...... by assuming huge portions of the risk from banks trading in toxic derivatives, and by spending trillions that they don’t have, central banks have put their countries at risk from default."

Nouriel Roubini put it this way, “So at some point you need restructuring. At some point you need the creditors of the banks to take a hit —otherwise you put all this debt on the balance sheet of government. And then you break the back of government—and then government is insolvent.” There remains the question of what kind of restructurings will take place, but Europe seems to be kicking the can down the road at present. The transfer of risks onto government balance sheets is already being reflected in the widening of sovereign credit default swaps.

Should there be a systemic breakdown in Europe, it could bring a banking crisis of the same kind that we saw in 2008. Banks in the US, Europe, and elsewhere could face sudden lack of liquidity if European banks take a hit. Investors on the whole are probably not prepared for such an event.

The Bond Vigilantes May Beat Santa to Town

CNBC reported Wednesday that Nouriel Roubini voiced concern over the compromise on extending tax cuts between President Obama and Republican Congressional leaders. Roubini said that the agreement could expose the US to bond vigilantes who will drive up bond yields. The Fed has kept short-term rates as rock-bottom levels to support the fragile economy, and an increase in bond yields could damage any chance of a recovery

Roubini said on Twitter: “Obama-GOP tax deal costs $900 billion over two years. US kicking the can further down the road. Are bond vigilantes starting to wake up?” Bond prices have fallen from the highs of a few weeks ago when speculators were anticipating the Fed's purchases under QE II, and renewed worries about US government debt levels could send Treasury prices even lower.

Worries about the debt positions of other advanced economies, which seem to be in even worse condition, might be a mitigating condition preventing any abrupt break in US bond prices. Nevertheless, given the seeming intractability of the debt problem, it would not be surprising to see recurring periods of worry about US debt levels over the next few years, accompanied by occasional declines in bond prices.

Progress on reducing the national debt will require both steady tax revenues and reduced budget expenditures. The weak economy will make progress on both fronts very difficult, since it will increase demands for fiscal and monetary intervention. As Jesse's Crossroads Cafe put it, "For a nation that is a net debtor, deflation is tantamount to suicide."

Despite criticisms of its monetary policies, the Fed seems unlikely to allow deflationary suicide anytime soon. In his CBS interview, Federal Reserve Chairman Ben Bernanke did not rule out buying more than $600 billion of bonds in further quantitative easing. Once the idea of an imminent QE III gets into the consciousness of Wall Street, we should not be surprised to see even more money piling into commodities, emerging markets, and other "risk" assets. Perhaps this time the weakness of Europe will help to support the dollar ... perhaps. A weaker dollar would help exporting industries in the US, if the Fed could engineer it.

According to the New York Times, financial markets have interpreted the tax cut deal, which was announced this week between the administration and Congress, as contributing to economic growth over the next couple of years but also increasing the federal deficit and raising borrowing costs. Higher borrowing costs would not help in funding extant debts, and the elephantine issue of reducing the federal debt is being pushed off to the future. Whatever happens on the fiscal side, the monetary side of policy seems likely to keep levitating financial asset prices. When that levitation will end it hard to tell, but at some point the bond vigilantes will likely have their say.

An increasing number of analysts is saying that it makes no sense for the Fed to keep monetary conditions so loose when the economy is enjoying growth in excess of 2 percent. They may have a point, because the bond market has responded to better growth prospects, and bond prices have declined recently. Given all of the risks that we have enumerated in this article, we have to wonder if that growth spurt will be short-lived.

Afterword

Pundits who make point predictions about the economy and the markets are absolutely foolish, because any alert observer will admit that the future is a swirling sea of variables. No one knows what is going to happen. On the other hand, we all need to protect our assets and prepare for the future. To do that, we need to consider a range of alternative futures and form judgments about their relative plausibilities. You can tell in which direction I think the probabilities are pointing.

The Beginning of the End

2010-10-29T13:48:00.018-04:00

The End of a Bull Market in Bonds

PIMCO's Bill Gross shook me up the other day with his October commentary. Bond investors do not like it when a bond guru writes that the Fed's announcement of renewed quantitative easing next Wednesday "will likely signify the end of a great 30-year bull market in bonds."

Whoa! I've been raking in easy if modest returns with a portfolio tilted toward high credit quality bonds. That's what you do in a debt deflation, isn't it?

"Safe Spreads"

Always prone to hyperbole, Gross softened the message toward the bottom of his commentary, when he said that PIMCO had no intention of suffering a bear market in bonds, and that they could maneuver around this little problem of no more bond bull. Specifically, he intends to invest in what he calls "safe spread" securities that offer higher yield "without taking a lot of risk" of inflation.

One example is emerging market debt with higher yields and non-dollar denominations, and another is high quality global corporate bonds. Gross added: "Even U.S. Agency mortgages yielding 200 basis points more than those 1% Treasuries, qualify as 'safe spreads'.”

You know, I wouldn't call a bond portfolio exactly safe it includes a lot of securities sensitive to highly correlated risks like currencies and emerging market economies. So, how does this square with the "end of a great 30-year bull market in bonds?" Well, with Gross we know that he likes to engage in a hyperbole and that he doesn't tell the whole story.

Bonds Are Not "Over the Cliff"

Gross appeared on Bloomberg Surveillance Thursday and was more nuanced in his explanations. By an end to the bond bull he means "not over the cliff" for the entire market but a recognition that "certain maturities can't go much lower." Two-year maturity Treasuries, for example, are yielding near the overnight rate. Not much opportunity for return there. He explained that Fed purchases make it mathematically impossible for bonds to do much better.

He also explained that "safe spreads" refer to securities that offer yield without being vulnerable to inflation expectations. This concern with inflation sensitivity seems an important point.

Gross added that he hasn't shortened the maturity of his Total Return portfolio, which is still in the vicinity of four to four and a half years. This is in contrast to Dan Fuss, who said on Bloomberg Surveillance the day before that he had reduced the average maturity of his Loomis Sayles portfolios.

Rather than reducing PIMCO's bond maturity, Gross has gone "to a space not vulnerable to inflationary expectations." A lot of securities are much less sensitive to inflation than are Treasuries, and he is focusing on the "safe space.".

It is interesting that Gross is concerned with vulnerability to inflation. Inflation is what the Fed is trying to achieve with QE, and with the suggested 2.5% inflation target. If PIMCO takes it seriously, perhaps there is a risk that they will succeed, or at least that investors will be spooked by the expectation.

Higher Rates in Three to Five Years

Another reason that Gross hasn't changed his portfolio's average maturity yet is that "the Fed isn't changing its target rate." So, he isn't expecting inflation soon, but apparently he thinks that it is a possibility sometime in his planning horizon. He believes that the Fed will tighten eventually.

The timing of inflation is influencing the maturities in his portfolio. Gross said that he is avoiding the 10-year Treasury because policy rates may go higher. The "safe maturities are five years and in, not five years and out." So apparently five years is approximately the horizon at which the Fed is expected to tighten. (I have no idea how anyone can predict if and when the Fed will tighten, but there it is.)

Gross reinforced this estimate of a five-year "safe" period when he said that CD investors could go out in maturity to three or four years. Five-year CDs might appeal a risk taker. Just to make it clear that he is willing to make a prediction, he added: "The Fed won't raise for three years, maybe four or five."

Stagflation Coming?

Given that the Fed is unlikely to restart the economy with monetary policy, it is natural to wonder why the Fed might raise rates within three to five years. The answer may be stagflation. If the Fed creates inflation through dollar devaluation or speculative bubbles, it would probably result in stagflation rather than ordinary wage-price inflation, given the likelihood that the economy will remain weak. Stagflation would be very negative for Treasuries. Rates would rise in general, and the Fed would have to follow.

It would take something very serious, like stagflation, to get the Fed to raise rates with the economy still weak. We have to wonder how badly higher rates would affect the economy and the servicing of US debt, which suggests that recovery through inflation is a self-limiting process.

No Inflation at Present

However, inflation risks are for the future and not the present, according to Gross. He sees even the low yields of short Treasuries as "safe" at the present time. "A two-year Treasury and a three-year Treasury only yield 37 to 60 basis points, but that's safe yield because the Fed isn't going anywhere."

Gross also suggested that the Fed may not be able to go much farther with monetary policy, and that fiscal policy will have to take over soon. "We've been willing to accept the lower yield in anticipation of a hand-off to federal officials maybe six months down the road." Gross didn't say, but this would be after newly elected Congressmen have taken office in what is expected to be a more Republican House. Given the likely stalemate in Congress, it is hard to understand exactly how this "hand-off" is to work.

Does This Mean Anything?

Gross loves to dampen his clients' expectations by expressing caution. A look at his past commentaries shows that he has called for the end of the bond bull before, only to be followed by huge bond rallies. Maybe this is another of those times, but on the other hand, maybe his remarks are justified and even prudent at this time. No one knows what the Fed is going to announce next week or the market reaction. The stakes of the anticipated QE II are huge, and it would make sense to hedge bond portfolios ahead of the meeting. Gross's comments aren't much at odds with the fears that most bond investors hold these days, and at least we have another plausible scenario for consideration.

We definitely need some scenarios to think about to protect our portfolios. Another PIMCO guru, Mohammed El Erian, also said this week that Federal Reserve purchases of Treasury securities likely will spur inflation, while leaving unemployment untouched.

Bond Risks and Opportunities

2010-10-23T15:47:00.018-04:00

"This was a great nation until the robo-signers came."

Following a run-up in response to prospects for further Fed asset purchases, the bond market has turned more cautious. Perhaps this caution is in response to prospects of an intensified round of currency devaluations, with its implications for domestic inflation, or maybe the advance was just getting ahead of itself. Let's look at what people are saying about bonds.

Portfolios Shift Out of Short Term Treasuries

On October 8 PIMCO's Bill Gross gave in interview on Bloomberg television, in which he described how the advance in parts of the Treasury curve had caused him to adjust his portfolios. I watched part of the interview of Bloomberg Surveillance, where Gross said the yields of 2-, 3-, and 4-year Treasuries are getting so low that alternatives are now preferable in terms of taking on a little more duration or credit risk in return for more yield. In fact, he found no advantage for 2-4 year Treasuries over the money market. Instead, traders are moving out to the "belly" of the curve, and Gross said they should buy 5-, 6-, or 7-year maturities if they buy Treasuries.

"Look, Timmie, Someone Spent a Dollar!"

This move seems consistent with the prevailing pubic view that the Fed has gone as far as is practical in lowering yields in the shortest maturities, and that we can expect to see the Fed gradually walk its way out the yield curve, lowering rates in longer and longer maturities until the curve is flat.

Seeing the End of the Bond Rally

Then on October 14 Bloomberg summarized an interview with Douglas Hodge, the COO of PIMCO, about recent changes in their portfolios. The basic message was a little stronger than Gross's earlier statements, and Hodge warned that the strong bond gains of recent months are unlikely to continue:

“From where we sit, it’s very hard to suggest there’s going to be that kind of price appreciation that we’ve seen in bonds over the last 12 to 24 months.”

“Even if the QE process is large and rates decline further, in our view we’re approaching the end of the bond market rally.”

Hodge reinforced Gross's earlier message about the portfolio implications, saying that “We have reduced our Treasury holdings, the lowest yielding instruments.” Hodge mentioned that increased positions included emerging markets, such as India, China, and Brazil, with infrastructure debt looking particularly attractive. They are buying high-quality corporate bonds in India and are making investments in China via the non-deliverable forward market.

"This meeting of the Federal Open Market Committee will come to order!"

Seeing Increasing Credit Risks

In an email to Bloomberg, Bill Gross described the strategy underlying these portfolio changes, which involves much more than simply moving out the Treasury yield curve:

“Pimco Total Return currently is employing what we call a ‘safe spread’ strategy, which seeks to identify sovereign countries best able to handle a new normal global economy that envisions slower growth and therefore increasing credit risks in fixed-income markets.”

Perhaps PIMCO is expecting the Fed to keep the world's financial bubble primed through eternal quantitative easing. As ridiculous as that sounds, maybe we should consider the possibility that the Fed is not going to let the US slip back into recession, no matter the inflationary consequences.

He also remarked that this has definite implications for portfolio allocation: It looks like they are moving gradually away from the US to where the growth and improving creditworthiness may lie. This would be a good strategy if the emerging markets are not hurt when the economy of the developed world again takes a dive, which seems likely at some time in the next few months or years. Unfortunately, emerging economies like China are still extremely dependent on their more developed customers.

"The printing press is out of control!"

The worrying part of these pronouncements is that Gross's email emphasized the "increasing credit risks in fixed income markets" in a world of low growth. They still have a lot of their portfolio in the low growth US, but the percentage of the money there has been gradually reduced in recent months, particularly in the Treasury component. Many people are worried that high government debt problems will eventually catch up with the US and other advanced economies, and it would appear that PIMCO is starting to adjust its portfolios incrementally in that direction.

Buying Mortgage Backed Securities

If you look at PIMCO's most recent portfolio statistics, the message is a little different from that given by Hodge. Bloomberg published an article an article about this just the past week. You see that they still have large amounts of Treasuries, but the relative mix has been shifting in the past few months in favor mainly of mortgage-backed securities, which are the largest category in their funds (and which Hodge did not mention). Increases in emerging markets were much smaller. This move is quite consistent with Bill Gross's statement that Treasury yields are so low as to be unrewarding in some parts of the curve, and that it is necessary to look elsewhere. Apparently their thinking is that, with the US government backing them, agency-issued MBS offer more yield reward with only little more risk than Treasuries.

"These oddballs are ruining the neighborhood."

There is another, more speculative issue with MBS. The general press is that QE II will focus on purchasing Treasuries somewhere out the curve, extending the flattening of yields that has already occurred at the short duration end. However, the Fed may have reasons for including considerable amounts (a billion or so) of MBS in QE II, especially now that there is a crisis brewing with rotten MBS that the big banks sold to investors at the height of the mortgage boom. With so many investors pressing the banks to make good on their agreements to buy back such rotten MBS, there is some increased level of risk to the survival of some of the big banks, and the profitability of others. The Fed may want to help the banks get rotten stuff off their balance sheets sooner rather than later, so as to avoid another possible financial crisis. Just maybe we might see some mortgage backed securities included in the Fed's asset purchases during QE II.

Timing the End of the Bond Bull

Bloomberg published a worrying article on October 21. It reported that Mark Kiesel, global head of corporate bond portfolios at PIMCO, said in a CNBC television interview that he sees interest rates going higher. He also said that PIMCO is increasing its stakes in investment grade companies. There was no word about whether this was a cyclical or secular rise.

"Is this the food stamp line?"

Other PIMCO pronouncements convey a different slant and suggest that the bond bull still has some chances of continuing in their opinion. Just prior to Kiesel's comments, a senior VP of PIMCO, Tony Crescenzi, said on Bloomberg television that bonds will suffer only when bankers start to lend money and when businesses and individuals ask for loans. Further, a "Keynesian endpoint" will really come only when all major economies "max out" their balance sheets. Given the likelihood that this event is some years in the future (albeit highly uncertain), the time for bond suffering is evidently not just around the corner.

The Risk of a Liquidity Trap

Perhaps a more serious threat to bonds is the threat posed by the Fed itself. Or, more properly, the threat is that the financial crisis has only been patched over, and could arise again to drag the economy and the financial system down in a deflationary liquidity trap.

This past weekend's New York Times carried an article on the dangers that the Fed sees with deflation, which the article referred to euphemistically as "persistently low inflation." It is widely expected that the Fed will respond to this risk by attempting to lower long term interest rates. It is also expected that the Fed will do this by announcing of another asset purchase program -- QE II -- at its meeting in November.

The problem may be worse than generally appreciated until recently. Charles L. Evans, president of the Chicago Fed, said plainly at a recent conference that the economy is in a "liquidity trap." He announced his support for a strategy known as “price-level targeting,” in which the Fed would permit inflation to run at higher-than-normal rates in the future to make up for inflation being lower than desired today. In other words, Evans was proposing inflation targeting.

"Don't pull on your leash, Timmie."

Evans did not say how the Fed would accomplish this at a time when no one wants to spend money, and it seems unlikely that ordinary monetary policy (or asset purchases) could do this. However, even an official Fed statement saying that it is targeting higher inflation rates would raise considerable fears in the bond market that the Fed might embark on reckless actions. Unfortunately, such actions would be self-defeating to the Fed's goals of keeping credit easy and cheap.

The Risk of Repressive Monetary Policy

Many commentators have commentated on the likely fruitlessness of further quantitative easing, which raises the question of what happens next. Maybe it is just idle speculation, but some of these commentators raised the possibility that the Fed will eventually be forced to turn to more repressive measures to force people to spend their money. By "repressive" they mean such things as motivating banks to charge their depositors for holding funds at the bank, rather than giving them interest on deposits. (Perhaps the Fed would charge a fee for holding banks' required reserves.) This means that the Fed would force negative short-term interest rates on the public and business.

There's nothing like seeing your money disappear before your eyes to motivate people to convert their money into real things, like cars, houses, or gold bullion. Would this restart the economy? It seems doubtful. But it would get money moving. Money would flee the country and go to places that have saner central banks.

"We'll get those lazy bums off Social Security and Medicaid!"

Repressive monetary policy seems unlikely from today's perspective. The majority of observers seem to think that the Fed will simply continue with QE until it debases the dollar, and the recent drop in the dollar seemed to be tied to that worry. That would be another way of targeting inflation, which gets us back to the stopping problem of when to sell bonds and dollars ... and presumably buy gold and wheat.

Betting on the Inevitable

Not everyone is convinced that the Treasury bull is over. Gary Shilling, for example, still expects years of a deflationary environment and a continuing Treasury rally at the long end of the curve. David Rosenberg of Gluskin-Sheff has a similar view. Rosenberg believes in deflation, and he remarked in a recent newsletter that, despite all of the Fed's intervention, consumer prices have continued to fall, and core inflation is at four-decade lows. His reasoned:

"Therefore, it would make sense to assume that once we get pass this bump in the form of a weaker U.S. dollar and surging commodity prices, the risks of deflation will intensify again."

"Right now, the long bond yield provides a 150 basis point premium over 10-year Treasury notes at the price of taking on nearly nine extra years of modified duration. Sounds like a handsome trade-off ... a 3% real yield still looks fairly attractive from our lens."

"This wll give us exactly 3% inflation."

The Prospect of Fiscal Prudence Next Year

A problem with the deflationary argument is that many forces point to a different environment next year: That's when questions of fiscal austerity will start to come to the fore, and when we can expect real discussion of how to cut back on the US fiscal deficit. If this results in fiscal prudence, we can look forward to a slowing economy but perhaps also to a relaxing of worries about government debt, which could be good for the dollar and the long bond. On the other hand, if a Republican win in the elections should produce a political stalemate, there arises the prospect of a Congress unable to do much to reduce the fiscal deficit. A continuation of the present trajectory of budget deficits would heighten worries about the US, weaken the dollar and the bond, and raise again the specter of increasing inflation.

What to make of this dichotomy? One point of view is to go with the inevitable. What is the most inevitable, unstoppable force affecting our society today? Why, it's the faltering economy. And what is ailing the economy? Why, it's debt, of course. It is hard to argue with trillions of dollars in debt (manifested in foreclosures, unemployment, and budget cutbacks) as an inevitable force. Particularly when the deleveraging of the consumer sector has hardly begun, and when banks are still constrained by bad debts. Driven by the weight of all this debt on our collective backs (and by its political masters), what else can the Fed do than feed the asset bubble until it bursts ... again?

"They bought it. Only billionaires can vote, now."

A Night on Bald Mountain

2010-10-02T21:23:00.004-04:00

Bald Mountain in Fantasia

A Mountain of Debt

In his latest monthly commentary, Bill Gross of PIMCO warns that there is no way back to the "good old days" of high returns in investing. Decades of double-digit returns were made possible because easy credit provided more money than could be put to productive uses in the real economy, but the credit bubble has burst. The bursting of the debt bubble means that days of easy credit are over, and it will be many years before debts are paid off or defaulted sufficiently for better days to return. This is the New Normal that PIMCO has adopted as its mantra.

As harsh as the New Normal sounds, I think that PIMCO does not go far enough. I would add that the buoyant economy we experienced ever since the end of World War II has never been normal. It was based on special circumstances and can never be the same. A generation of Credit Excess was preceded by centuries of Good Luck for America and the West. There is no way to get back to the "old normal," and the economy will never be the same.

Satan Contemplates the Mortal World

The Fantasy of Normalcy

Why can the economy never be the same? We had a long run of good luck in the US, and our luck seems to have run out. It's right there in our history. We exterminated entire peoples to conquer an entire continent and exploit its resources, we were in the right place to be beneficiaries of multiple industrial revolutions, our industries were relatively unscathed by global conflicts, and then we prospered even more by refitting the bombed-out industries of a war-broken planet. No wonder we believed in "progress."

The problem now is: Those advantages are gone. Information and capital can flow anywhere instantly. Former colonial subjects and former slaves of Communist ideology are no longer exploited but are now investing their sweat in modernization and increasing competition. They want the good things and they are willing to work for them. There is no more monopoly market for America or the West to exploit.

About three decades ago, when America started to find the going more difficult, we didn't scale back our inflated expectations. Instead, we clung to our outsized expectations and financed current consumption by borrowing from the future. In fact, our government encouraged borrowing by instituting a policy of easy credit. Citizens responded, used their housing ATMs, and piled up debt. It was an unsustainable process and the mortgage-credit-finance bubble was the terminal phase.

Satan Spreads the Seeds of Evil

Our only hope now is to get through the debt mess and -- probably after decades -- get back to a growing, sustainable economy. We are far from creditworthy now, and our competitors continue to grow lot more capable. There are no "good old days" to go back to.

Illusion Has Replaced Reality

No, the debt load does not mean that America is doomed, but it suggests that many or most of us are bound to be disappointed that our outsized expectations are not satisfied.

Debt is too high, and trust is too low to restart the economy. Time is the only real solution to deleveraging, but government and the people have no patience. QE will not work, and it will raise the level of risk to our national credit and currency, but the Fed will proceed anyway. Illusion has replaced reality in the minds of the policy makers.

The Spirits of the Dead Rise on All-Hallows Eve

A Declining Dollar and a Lower Standard of Living

In his latest monthly PIMCO commentary, Bill Gross pointed out that the economy is mired in the deflationary process of debt deleveraging and is likely to stay there for years. Quantitative easing (QE) is the Fed's attempt to jump-start a moribund economy by igniting a process of inflation. (More precisely, they want to bring about price inflation by increasing the velocity of money in an already inflated monetary base.)

After some years, price inflation should reduce the real value of debts to a more manageable level. The problem with inflating our way out of debt is that America will have to pay a very painful price:

"And the most likely consequence of stimulative government policies that strain to get us there will be a declining dollar and a lower standard of living."

If the dollar is worth less, we are poorer. We would have to cut back on what we import from the rest of the world, but rises in exports would be of little importance, because we export so little. A country that has invested so little in productive technologies would stand little chance of expanding the scope of its exports. Such lazy countries suffer a declining standard of living.

Gross's point of view isn't the only one with credibility, but the alternatives are also depressing. There are other kinds of "soft default," such as reneging on promised social entitlements. There are also ways that governments can "stick it" to creditors, such as revoking the terms of existing debt securities (perhaps converting inflation indexed securities to fixed rates). None of it would be pleasant.

Mere Toys in Satan's Power -- Satan Increases the Velocity of Money

Terminal Competitive Devaluation

As SoGen's Albert Edwards mentions in a recent report,

"Our economists made a very interesting point in the Economic News, 17 Sept. They believe the BoJ's actions may be the start of a more general period of competitive devaluation; with the US authorities tacitly allowing the US dollar to decline in an environment of QE2 (no wonder gold looks so perky!)."

According to Edwards, there is good precedent for using currency devaluation as a tool to combat presistent deflation, and good indications that the Chairman of the Federal Reserve, Mr. Bernanke, has considered devaluation seriously as a policy tool. In his 2002 speech Deflation: Making Sure "It" Doesn't Happen Here, he said:

“The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt."

"Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange … there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation."

Not that I necessarily agree, but Zero Hedge interpreted Bernanke's statements very liberally as "the blueprint for the endgame," meaning that a competitive round of international currency devaluation will soon be upon us:

"Hence Bernanke openly stated back in 2002 that the end game, especially when all else fails (fiscal deficit too high and QE shown to be impotent), is to print money to drive down the dollar. This is default in all but name. Investors ignore this at their peril."

I have no idea of whether or not the Fed can actually bring about currency devaluation and inflation, but there are ominous signs. As a likely program of QE II approaches, the dollar has been declining and gold has been rallying. Now, noted investment managers such as Bill Gross are warning of inflation and currency devaluation in our future.

Satan, Like the Fed, Can Extinguish His Creations

On the other hand, bonds are still performing well. They need to, because the Fed is enforcing low rates to keep banks solvent, to let debtors refinance, and to let the Federal government roll over its debt at affordably low rates. The strong dollar has been a big help in doing this. It is also fortunate for the US that no country wants to endanger its exports by letting its currency rise against the dollar. Since the dollar started sliding recently, countries around the world have intervened to weaken their currencies and maintain their export competitiveness.

If the Fed promotes currency devaluation, it will be walking a tightrope between driving down the dollar (to cheapen our debt) and keeping the dollar strong (so that we can afford to roll over our debts). Something will have to give.

Maybe the currency game is not a total standoff. As Edwards put it:

"The good news is that this is not the zero sum gain that most commentators suppose. For if all central banks are printing money to drive their currencies downward, exchange rates may not change, but the money supply does. It is easier for the US to "guide" down the dollar with its burgeoning current account deficit, and to the extent bond yields rise as foreigners back away, the Fed will just keep printing money to hold them down!"

So, maybe the US really can devalue the dollar relative to other currencies, at least those that are not pegged. In that case, there would be all those "printed" dollars waiting to enter the real economy and, if the velocity of money increases, the eventual inflation in prices. That is what Edwards argues.

Of course, there are problems with this scenario. To get inflation, individuals and businesses would have to want to borrow and spend, and it would take a lot of devaluation for that to happen (which hardly seems in the cards now that Congress has caught the austerity bug). Not that I doubt the ability of politicians and bureaucrats to make mistakes, but it is hard to imagine an environment that would encourage much additional spending, short of some kind of currency crash or bond panic.

Maybe a really repressive Fed policy (like incentivizing banks to charge negative interest on deposits) could do the trick, but that would have risks too. Another problem is that devaluation would not help against currencies that are pegged to the dollar. In fact, modest dollar devaluation would make China even more competitive against the rest of the world, as long as the dollar-yuan decline wasn't so great as to price them out of the commodities markets.

What Will Dawn Reveal?

The Fed has already responded to the slowing economy with one round of extraordinarily accommodative monetary policies, and they seem ideologically inclined to try it again. Extraordinary policies can be risky -- and we had better think hard about that risk.

The End Game -- Doomed Souls Return to Satan

What about the risks of accomplishing another round of QE? Zero Hedge wrote that $1 trillion of Treasury purchases a year (as widely expected) means that the Fed will be purchasing nearly all of the net debt that the Treasury will issue this year. That means the Fed will be financing all of the Treasury's debt issuance, which might raise a few eyebrows, because the Fed would actually be monetizing the debt. Will anyone lose confidence in the US as a result? I don't know, but it sounds strange.

The most popular view in the media is that QE II will cause nearly all asset classes to rise in price, but will have only a very minor and transitory effect on the real economy. This is a very short term point of view. In contrast, Edwards takes a very extreme but more serious view. He believes that citizens of the mature Western economies are being pinched to the point of social unrest, and that the inflation resulting from competitive currency devaluation could be the breaking point: "what do devaluation, high unemployment, inequality and food prices spell? C-H-A-O-S."

I hope that everyone had a good time!

Despite worries about social trends, I certainly do not see social chaos affecting the US anytime soon. Rather than some kind of social chaos, the risks at present seem more tilted toward policy mistakes. Politicians do have a way of catering to the base needs of their constituents, no matter the long-term consequences.

Perhaps devaluation and inflation are future risks, but I am not sure if they can affect us greatly in the near term. For the near-term future, disinflation and economic stagnation seem more likely to continue as the dominant forces, but the destabilizing risks posed by QE II are worth contemplating very seriously.

Happy Halloween!!!

Bonds, Bubbles and Busts

2010-09-06T22:17:00.006-04:00

A Bubble in Treasuries?

Is there a bubble in Treasuries? This question has recently been discussed by nearly every financial commentator on the web and in the press, with both sides having amassed convincing but conflicting arguments. Value investor James Montier of GMO had something interesting to say about this question in his blog recently. You would expect a value type like Montier to warn that Treasuries are overvalued compared to historical norms, and you would be right. The only trouble is that I'm not sure that I agree, and I'm not sure that his argument is even a valid value judgment is today's situation.

In his blog Behavioural Investing Montier published an article on August 31 titled "Bond Bubble - a sterile debate on semantics," which asked : "The issue shouldn’t be whether bond are a bubble or not, but rather are bonds a good investment or not?" Using Ben Graham's definition of an investment as an operation that promises "safety of principal and a satisfactory return," Montier proceeded to estimate the return from Treasuries over the next ten years, so as to see if that return would be in some sense "satisfactory."

Are Bonds a Good Investment or Not?

To do this, Montier estimated the three components of return -- the real yield, expected inflation and an inflation risk premium -- for 10-year Treasuries over the next ten years. He estimated the real yield as 1%, based on the yield of 10-year TIPS. For expected inflation, the inflation swap market implies 2% over the next ten years; alternatively, the nominal bond yield minus the TIPS yield implies 1.5%. For the inflation risk premium, which is a way of accounting for uncertainty in future inflation, he used 0.5%, which is the upper range of current estimates. This implies a return of 4% annually under "normal" inflation conditions. Montier upped the estimate of longer term average 10-year Treasury yields to the 4%-5% range because he questioned whether the current market real yield of 1% is really a "fair price," and because the longer UK experience with inflation linked bonds suggests a somewhat higher number.

Montier's conclusion is "In the ‘Normal’ state of the world bonds sit at close to equilibrium, say 4.5%." The implication is "The current 2.5% yield on the US 10 year bond is clearly a long way short of this." In contrast, a Japanese outcome for the US over the next ten years would have rates around 0%-1%, and an inflationary outcome would have yields around 7.5% (with inflation at 5%).

Montier interpreted these numbers as saying that "In essence, the market is implying a 70% probability that the US turns Japanese." Maybe 2.5% Treasuries are attractive if you are certain that the US is becoming Japanese, but that is a lot to assume. A rise in yields even to the long-term average level implies some losses.

A Satisfactory Return?

I think that we knew this already, at least in a qualitative way, before Montier published his calculations. We already knew that T-bonds are overpriced according to historical metrics. We understand that an all-out bet on Treasuries at this point is risky, but we also know that all-out bets on other asset classes are also risky. Montier did not address the right question.

The problem is that Montier is arguing on the basis of the range of Treasury bond prices over the limited history of those securities. That history is limited in time extent and in the range of conditions that were sampled. It is not an average over an infinite sequence of all possible financial histories going through all possible states of the world. In other words, it is a sample average, not a known parameter. The values and frequencies seen over the recent past were dependent on the unique and contingent conditions pertaining during exactly that period of time. Why should we assume that the future will be like the past?

Today's financial state is highly peculiar in the US. It is a state of high indebtedness occurring at the end of a period of easy credit and overconsumption. If we look over longer periods of time than Montier examined, we see that periods of excess are regularly followed by periods of sub-par growth and financial crisis. We have examined the work of Reinhart and Rogoff in this blog before. We place much more weight on several centuries of world financial history than we do on the limited history of the past few decades of a peculiar and distinctly American era.

Bubbles are followed by busts, and long term averages can be violated for a considerable period of time. Excessive debt weighs down with an inexorable burden that has to be worked off over time. As a result, the "long term" average may not re-emerge for a long time. I don't think that any Roman descendants are waiting on their British estates for the legions to return from over the channel.

The Only Things That Really Matter in Investing Are Bubbles and Busts

Montier's colleague Jeremy Grantham suggested how to frame problems of this sort in the GMO Quarterly Letter of April 2010. In an article titled "Friends and Romans, I come to tease Graham and Dodd, not to praise them" he wrote on some potential disadvantages of Graham and Dodd-type investing. Grantham attacked the "preposterous belief" that all information is embedded in securities prices and that bubbles and busts can be ignored. Grantham said, in fact, that "I am at the other end of the spectrum: I believe that the only things that really matter in investing are the bubbles and the busts."

In support of this belief, Grantham presented a variety of statistics illustrating that even such "standard" stock valuation criteria as the price-to-book ratio come in and out of fashion, and can over-perform or under-perform over extended periods of time. To extrapolate a little from Grantham's examples, we are already familiar with the work of Reinhart and Rogoff and other historical studies showing how financial crises spawn more crises and are regularly followed by extended periods of sub-par economic growth.

Grantham quotes from Securities Analysis: "Undervaluations caused by neglect or prejudice may persist for an inconveniently long time … and the same applies to inflated prices caused by over enthusiasm or artificial stimulants.” Graham adds: "If ever we were living in a world of artificial stimulus, it is now."

When there is no bubble or bust around, "if you keep your nose clean, you will probably keep your job," by which he probably means that prudent value principles are usually the best investing guide. During bubbles and busts, however, the usual value principles may not be the best way to go. He exhorts: "But when there is a great event, that’s the time to cash in some of your career risk units and be a hero." The end of the age of credit excess certainly qualifies as a great event in my book.

A Margin of Safety

Should we base investment decisions on recent historical distributions or on the dynamics of bubbles and busts? Where does the margin of safety lie? If we take Grantham's advice, "the only things that really matter in investing are the bubbles and the busts." If you are living in a bust, maybe the future consists of something other than a statistical sample of the recent past. Maybe you should think seriously about the life cycles of bubbles and busts.

Treasuries look dangerously over-valued to our eyes, but our eyes have been trained by lifetimes spent in a credit-crazed culture worried about inflation. It is not surprising that, since Montier's article, the yield has fluctuated from 2.50% to 2.70%. Howewever, if we are in a debt deflation, supported by extraordinary government intervention, maybe there is a better than average chance that Treasury yields will stay low for longer than Montier suggested. It also helps that a contraction in private debt issuance has made room for expanded government issuance without a backup in yields. Or maybe the economy will come back and tank bonds. There is no sure thing here.

Whatever the eventual outcome, there is much more to the Treasury bond situation than a simple comparison to historical average yields. Past returns are no guarantee of future results.

A Stochastic Stopping Problem

2010-08-15T20:38:00.000-04:00

Police stand guard outside the entrance to New York's closed World Exchange Bank, March 20, 1931

How safe are Treasuries? Won't Treasuries fall when enough people start worrying about the ability of the US to finance its national debt? I recently read an article in Capital Gains and Games saying "the bond market today is exhibiting no worries about the deficit or federal borrowing at all" and "there is little or no concern on Wall Street about the government’s borrowing, either short- or long-term." In other words, the article says that we should have confidence in the markets to price risk.

Such confidence in the markets is totally wrong, I believe. Market prices fluctuate over time, and attitudes toward risk change over time. Today's markets prices only tell us what participants believe today. Sure, from today's perspective, with the Fed buying Treasuries and the economy heading lower, it looks profitable to hold Treasuries. But today's market conditions won't last forever, and we need to ask "When will these conditions end?"

The condition of the fixed income markets is hardly normal today. The Fed has bought nearly a trillion dollars of mortgage-backed and other securities in order to keep interest rates down and to encourage markets to operate. Other governments buy Treasuries to meet their currency and interest rate goals. Governments buy for policy reasons, and they will sell for policy reasons.

Other market participants buy Treasuries for their own reasons. Sovereign risk troubles in Europe have pushed huge amounts into the dollar for safety, and US bankers also need safety and park their funds in Treasuries. When the Fed guarantees easy monetary conditions and the economy is weakening, it is only logical that money managers shift their money into Treasuries. But these are all short-term perspectives. When the risk-safety equation changes, money managers will shift out of Treasuries and into whatever offers safety or return at that time.

This is a familiar situation: Three years ago commodities were high and climbing. Five years ago housing prices were high and climbing. Fifteen years ago, internet stocks were starting their climb. Eighty-one years ago, stocks had reached a "permanently high plateau". People lost fortunes believing that the prevailing conditions would continue indefinitely.

Many people feel that Treasuries are a good buy today, and it sure looks profitable, but this is short-term thinking. No serious investor plans to hold long or intermediate Treasuries to maturity. They hold for today and they have plans that define when they will sell. It hasn't been long since we heard the slogan "Now is the best time to buy a house." It hasn't been long since people bought "good" stocks and planned to hold them forever. These were mere slogans serving the purposes of narrow interests.

John Singer Sargent, Orestes Pursued by the Furies (mural, 1921), Boston Museum of Fine Arts

Economic indicators look weak, and the Fed is telegraphing the intent to keep monetary conditions extremely accommodative. How long will these conditions continue, and how will Treasury investors know when they should sell? How can they avoid getting caught in the last-second stampede for the exit?

All of you operations research types will recognize this as a stochastic stopping problem -- we get a reward for investing in Treasuries as long as the environment is disinflationary and accommodative, but we lose a whole lot if we still hold Treasuries when the Final Trump sounds. Although there is a world of contingent risks, the predominant controlling factors are in fact very few. The stopping problem is a bet on what politicians and the Fed will do.

Formulate a payoff function and a risk curve, and then answer me this: How much should we bet on Treasuries, and when should we sell?

NOTE: In classical times Greeks and Romans did not speak the name of the Furies out loud, lest they attract the Furies' attention. It was considered more prudent to refer to "the Friendly Ones" or a similar euphemism. Perhaps the Fed is now in the position that saying anything at odds with an accommodative monetary policy is like shouting out the true name of the Friendly Ones.

What's in Store for QE II?

2010-08-04T13:07:00.001-04:00

There has been much talk in recent days of policy changes that the Fed might make at its meeting next week. Such talk has heightened in the wake of last week's statements by St Louis Fed President James Bullard that there is a need for more quantitative easing, and Chairman Bernanke's warnings not to tighten policy too soon. The Fed's balance sheet has been contracting as its portfolio of securities gradually matures, taking badly needed money out of the struggling economy. Another round of QE might reverse or compensate for this trend.

Given the likelihood that QE will impact my portfolio in one way or another, I decided to check out recent news stories for a small sample of what other market watchers anticipate.

Option: Stop the MBS Roll-Off

An article in the WSJ "Fed Mulls Symbolic Shift" predicts that the latest plan is for the Fed to use proceeds from maturing mortgages on its books to buy Treasuries. Paul Sheard, chief global economist of Nomura Securities, also published a note guessing that this would be the Fed's move (as reported in The Telegraph).

The Fed has a lot of mortgage-backed securities on its books from its previous QE program, and as these securities mature the proceeds remain at the Fed and the amount of easing achieved through the mortgage purchase program gradually falls. This amounts to a gradual tightening process that the economy hardly needs right now. "Buying new bonds with this stream of cash from maturing bonds—projected at about $200 billion by 2011—would show the public and markets that the Fed is seeking ways to support economic growth."

Giving some support to the option is that Charles Plosser, president of the Federal Reserve Bank of Philadelphia, said in an interview last week that he was open to reinvesting proceeds from maturing mortgage bonds into Treasury securities.

Option: Roll Off the SFP Program

A different guess was put forth by Barclay's Joseph Abate, who believes that the Fed will allow the Supplemental Financing Program to roll off, which would free up the $200 billion that the Treasury holds on its books for that program. According to Zero Hedge, Abate thinks that this would have a bigger impact than merely letting $10 billion a month of MBS roll off the Fed's books, which he thinks would be too gradual to have little impact on rates.

Recall that the SFP consists of a series of special Treasury bill auctions, the proceeds of which are maintained in a Fed account in order to drain reserves from the banking system, so as to offset the reserve impact of other Fed lending and liquidity initiatives. Abate's suggestion was that the Treasury will roll off the SFP by ending the 56-day Bill auctions, thus pushing almost 200 billion dollars into the banking system in only 56 days.

As for impact, Abate thinks that the disappearance of SFB would likely push bill and repo rates well into the single digits, without needing to buy additional securities, and it would then allow the natural attrition of the Fed's portfolio to slowly proceed, as had been the intention when the economy was expected to do better. Some commentators have referred to this option as QE Lite.

QE Is Just a Way to Inflate Asset Prices

The prospect of renewed QE has not been entirely popular. One of the critics has been PIMCO's Bill Gross who said on Bloomberg that QE cannot be very effective since it is just a shuffling of financial assets, and that it would inflate asset prices more than consumer prices. These are valid criticisms, but of course, maybe rising asset prices are what the Fed wants. Chairman Bernanke has said that a rising stock market would be a big help to the economy -- even thought that is kind of like getting the cart in front of the horse.

Gross also repeated his criticism of whether the US can get out of debt by issuing more debt. As much as I poke fun at Gross on occasion, he is right on target there.

Who Benefits?

Any extension of the Fed's earlier asset purchase program will just stimulate the markets to buy up more of the riskier assets. None of this gets into the real economy. Because banks need to control risk , they aren't lending. New money stays with the banks, who will continue to speculate in ways that will merely levitate asset prices -- bonds, stocks, commodities, etc.

This is good for the financial elite who profit from this speculation. Of course, we taxpayers are the ones stuck with paying the interest on those Treasury securities and making good on losses from all the other asset purchases that have propped up asset prices and forced interest rates so low that leveraged speculation is nearly free.

According to a comment to a related Zero Hedge article: "Our government and the federal reserve run a massive Ponzi scheme. Take from the bottom and transfer to the top. Been going on for 30 years. ... the only people who keep ahead of inflation are those that benefit from cheap credit and leverage. The great majority loose."

The financial elite don't even have to wait for the Fed to act. By telegraphing its intentions, the Fed has given the highly leveraged speculators another chance to score "as the market attempts to front run the Fed in buying up Treasuries."

The Fallout

The Fed is betting that the US can grow its way out of its debt mess, and it sees QE II as a way to move the economy forward again. In other words, they think that more debt can get us out of debt. Does anyone else believe this idiotic idea? Worthless debts must be written off and the losses recognized before the US can start on the road to healthy growth again.

Those in power can become blind to the truth. In his book Collapsed, Jared Diamond gives good examples of societies that have adapted to crisis and societies that have failed to adapt to crisis. The failures that Diamond uses as his examples either misunderstood the nature of the crisis, recognized it too late, or chose to ignore it. It is fair to say that the last group were arrogantly wedded to the status quo -- sort of like the US financial oligarchy. Maybe the Fed should read Collapsed.

The Bottom Line

As much as I enjoy Marc Faber's commentary, I don't take seriously his warning that investors avoid bonds, and that the US is at the edge of "the final crisis." Not yet anyway, because the US still has an economy, is still viewed as credit-worthy, and because in the developed world, the US is still the best of a bad lot of heavily indebted nations. But the day of crisis could come eventually. But maybe later.

We need to consider about what the Fed does next, after QE II fails to stop the US from falling deeper into recession. This may happen sooner than some anticipate. Private forecasters generally expect real GDP to grow by an annual rate of about 2¾% in the second half of 2010. If the picture deteriorates and they forecast growth falling below 2%, which seems increasingly likely, the Fed would be more likely to act in a way that could alarm some holders of US securities.

To get an idea of what might follow in the future, we will need to pay attention to what the Fed does this time, and to the markets' reactions to this coming round of QE.

Shared Sacrifice

2010-07-13T14:32:00.006-04:00

Edward Hopper, Railroad Sunset, 1929.

A Prolonged Economic Slump

With the recently renewed concern that the economy is faltering, a number of writers have been hazarding guesses at how the debt crisis may eventually resolve itself in the context of an economic downturn. Especially interesting are the recent writings of David Rosenberg, Bill Gross, Niall Ferguson, and Edward Chancellor, which contain a number of common threads on this topic.

These threads combine to make a scenario that differs from some of the more extreme forecasts, in that it does not necessarily sound like a complete disaster for the US -- no deflationary spiral, out-of-control inflation, or currency crash. Just a prolonged economic slump driven by austerity and the rebuilding of balance sheets.

Fiscal Prudence Means Shared Sacrifice

David Rosenberg, Chief Economist at Gluskin Sheff, makes the argument for a prolonged economic slump in a recent Globe and Mail opinion piece. According to Rosenberg, fiscal prudence is taking over at the individual and government levels. Without credit or spending to fire the economy, it will limp along with some degree until balance sheets are sufficiently repaired to bring growth again. This will take time. He bases this scenario on the assumption that the US population is sufficiently shocked from the debt crisis to change its economic behavior permanently:

"It is reasonable to assume that the economic behavior of the population in general, and the baby boom cohort in particular, is on the precipice of a dramatic change, as Main Street has enough understanding of the situation to start to take action to get its balance sheet in order."

He assumes that the economy does not fall apart in a deflationary collapse, allowing debts eventually to be paid off enough that economic growth can begin again -- although it may take some time:

"Most likely, what happens next is that the credit collapse proceeds on the back of a severe form of the “savings paradox,” resulting in a prolonged economic slump. The good news is that it will ultimately lead to a balance sheet rebuilding process, both at the household and government level, that can sustain the next secular economic expansion."

That doesn't sound too bad, because he says that the US will avoid total catastrophe, like debt default, currency collapse, or hyperinflation. However, working down debt will require fiscal austerity by everyone in society, which will not be a pleasant experience for the participants:

"In the meantime, an enormous amount of shared sacrifice will be required." (My emphasis.)

Individuals can rebuild their balance sheets by sacrificing consumption if they have incomes. A problem is that employment will continue to suffer as government will be unable to substitute for private spending:

"Initially, we can expect to see less government, fewer entitlements and higher taxes. ... Less government will require balanced budgets and this will contribute to continued stress in the job market, at least for a while."

Not only consumption, but entitlements will be cut back:

"Currently, the seeds are being sown for a radical restructuring of entitlements. ... Across the nation, sweeping changes are taking place as pension trustees and legislatures push for higher monthly contributions to pension plans, a later retirement age and lower annual cost-of-living adjustments for current and retired workers."

Cutting back entitlements will force much of the population to cut back spending and save:

"Out of necessity, the boomer population will be pursuing a strategy of working longer, saving more and reducing their debt obligations in order to secure a comfortable retirement lifestyle, while at the same time the public sector moves in the very same direction toward fiscal probity."

This of course guarantees the the downturn is prolonged. One has to wonder how boomers can work longer and save for retirement if there are no jobs for them. One also has to wonder how the unemployed, the disabled, and the elderly are going to survive if entitlements are cut to the bone. The payoff for all that suffering could well be that it buys enough economic and financial stability for the US to dig itself out of the hole:

"... what we could well be in for is a prolonged period of price stability or modest deflation. It is reasonable to assume that a resumption of strong GDP and earnings growth in the future and a resumption of inflation and appropriate inflation investment strategies will have to await the end of the rebuilding phase as it pertains to the household and government balance sheets."

Harry Sternberg, Builders, 1935-36.

The Lenders of Last Resort Are Out of Money

The latest monthly commentary latest monthly commentary by PIMCO's Bill Gross supports important parts of Rosenberg's scenario. Part of PIMCO's New Normal is the notion that the advanced world has run out of funding sources with which to restart economic growth. If not even sovereigns can lend, economies will remain subdued and there will be "low total returns on investment portfolios" until debts are paid down.

"Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened."

Shared Sacrifice Includes Default on Unfunded Liabilities

Harvard history professor Niall Ferguson also sees the US as avoiding an inflationary outcome, but he foresees problems with the deleveraging process. In fact, he does not see how the US can work off its debt without some kind of default.

The problem, he says, is that extreme debtors have rarely been able to grow their way out of debt in the past, and the conditions that allowed the rare historical case (like Britain after the Napoleonic wars) just don't pertain now. (We aren't the beneficiaries of a new industrial revolution.) This leaves inflation or default.

"Right now there is no sign of inflation. We have monetary contraction at an alarming rate, and zero inflation in terms of core CPI, so the option of inflating this debt away doesn't seem to be there right now. What you are left with is therefore default."

This could but doesn't necessarily have to include outright default to bondholders. Ferguson doesn't mention it, but we will later discuss a point of view saying that US outright default on its debt is very unlikely, given the past situations where this has occurred. Ferguson suggests this kind of default:

"And I think it is a fair bet that US will default at least on the unfunded liabilities of Social Security and Medicare at some point in the foreseeable future."

So we have another voice suggesting that the solution will include the dismantling of social programs. This would be part of the American people's if there is a prolonged slump.

No Default, but Bond Yields Are at Risk

GMO analyst Edward Chancellor has written a very interesting paper on the dynamics of extreme sovereign debt loads, which also contains a very interesting comparison to the current debt cycle. Given the historical preconditions for default, Chancellor concludes that the "US is not on the verge of a default." The US has carried high debt loads in the past and not defaulted outright, and it has the advantage that its debts are denominated in its own currency (although a lot of debt is foreign-owned). He agrees with the other forecasts in this respect, although not in others.

Chancellor thinks that "inflation is more likely than default in the US" because "public finance is a ponzi scheme." This makes the current environment of low government bond yields a very risky one for the bonds of the advanced economies:

"Under only one condition - that the world follows Japan's experience of prolonged deflation - do they offer any chance of a reasonable return. But this is not the only possible future. For other outcomes, long-dated government bonds offer a limited upside with a potentially uncapped downside. As investors, such asymmetric pay-off profiles don't appeal to us."

Despite this admirable risk aversion, Chancellor is self-contradicting in one respect. First, he says that US debt can be paid off only if interest rates remain low. Then he says that inflation is the likely outcome, and that bond prices will suffer then. He glosses over the implications for servicing the interest and rolling over maturing US sovereign debt (and private debt) if rates rise. Perhaps this contradiction is an honest reflection of the impossibility of forecasting, but the contradiction also masks the ugliness and unpredictable instability of debt servicing under rising yields.

Such uncertainties reflect real risks in future outcomes. Even if we end up in a deflationary economic slump, there is no guarantee that it will provide a smooth ride with price stability or mild deflation all the way to recovery.

Thomas Hart Benton, Mine Strike.

How the Sacrifice Will Be "Shared"

The "shared sacrifice" is really a "soft default" on entitlements, which are seen by the financial elite as mere promises of hippie liberal governments. However, so-called entitlements are in fact the foundation of life planning for a good part of the US citizenry. Such promises include essential components of a retirement plan, including program like Social Security and Medicare, which many people have already paid for during their working lives. If people have paid for Social Security and Medicare during their entire working lives, and planned their retirements based on these payments, they don't look at those programs as "soft" entitlements. In fact, they deferred consumption in order to pay for these insurance programs, and they planned the course of their lives around them.

Rosenberg says that boomers will work longer, in order to save for retirement. How are they to do this when there are no jobs? They are hardly likely to work longer when they have no jobs in the first place. They will just languish in poverty and illness until sinking away to an early death. That is the "shared burden" that Rosenberg is really writing about.

Not everything will be sacrificed. You can be sure that zero-interest money will continue to flow to banks, who will use that money to engage in more speculation and provide bonuses to their most "productive" parasites.

Sacrificeing to Pay Down the Debt

There are many ways of achieving "soft default" on the programs that the common people have worked so long for. In the case of Medicare and Social Security, the government can raise age limits, reduce inflation indexing, phase in benefits over longer periods, index to individual net worth, or other tricks.

At the local level, education, public safety, and other basic services are already being sacrificed in order to avoid raising taxes. State governments have already started cutting back on essential social and health services such as meals for shut-ins, family crisis centers, and higher education. There are many more elements of civilized life that the elites will find a way to cut.

Don't forget tax policy. The elites will be sure that unearned income (economic rent) is taxed at lower rates than earned income. If taxes on earned income are raised, what do they care? If you complain, you are just opposing the wonderful capitalist system that rewards risk taking. Never mind if you invest your life and effort in training and labor, and then end up supporting the rich with your taxes.

This is only one, alternative scenario, but perhaps it is what the elites of the developed nations are hoping for. It is easy to believe that their cries for "austerity" are really calls for "soft default" in the form of fewer entitlements. After all, the financial elites managed to default on the losses that the banks suffered in the wake of the mortgage crisis due to their greed and incompetence. The taxpayers shouldered that burden. Why stop there?

The "prolonged deflationary slump" has a lot going for it as a plausible scenario for the future of the US, but it assumes that the US taxpayer can pay down much of the private and public debt loads. Unless the US frees itself of the financially-driven bubble economy grows and restores a foundation for real, organic growth with employment and income growth, the slump may turn into something worse.

Changing Treasuries for CDS

2010-07-05T10:29:00.004-04:00

Natori Shunsen: Nakamura Utaemon as Hanako in Musume Dojoji. In this kabuki dance-drama Hanako changes costumes several times, including instantaneous onstage costume changes matching the character's movements. Just before the change, an onstage assistant removes basting strings holding together layers of costume.

As you probably know, PIMCO's Bill Gross has in recent months given changing and contradictory views on the attractiveness of US Treasury securities. Late last year, he wrote that US debt was to be avoided because of rising debt levels and declining ability to service the debt load. In contrast, in the past few weeks news stories indicated that PIMCO had changed course and increased holdings of US Treasuries as being more credit-worthy and offering less interest rate risk than the sovereign bonds of the more developed European nations.

These stories did not explain the time horizon of this shift in PIMCO's allocations -- whether it reflected some fundamental shift in the attractiveness of US debt, or rather a reflection of the relative attractiveness of the US in reaction to the sovereign debt crises on the periphery of the European Union. PIMCO clarified an important part of this issue in a recent commentary published on its website.

It turns out that PIMCO is insuring the sovereign debt of G-7 nations rather than buying their bonds outright. PIMCO does this by writing credit default swaps on the sovereign debt of these nations, by which PIMCO collects premium payments from the counterparties and promises to indemnify them should they suffer default by the issuers.

This means that PIMCO is not exposed to the interest rate risk on G-7 bonds, but it is betting that the G-7 nations will not default on their sovereign debt.

This seems a neat way of separating interest rate risk from default risk.

This also implies that PIMCO is serious when it predicts that increasing debt loads will lead to higher interest rates on the bonds of the developed nations. This also implies that PIMCO is serious in believing that the risk of default is very low among the G-7 nations.

This still leaves room for a lot of market upsetting conditions to come, including ballooning debt and falling bond prices, and for personally unpleasant conditions, such as higher taxes and reductions in government services due to fiscal austerity.

This Is Fiscal Austerity: California Sacrifices the Old, the Disabled, the Children of the Poor

2010-05-19T18:12:00.004-04:00

To solve its budget crisis, California has decided to dismantle programs that preserve the lives and health of its most helpless citizens.

Faced with a fiscal deficit that totals 20% of its annual budget, Governor Schwarzenegger decided that the best path to austerity was to cut support for those who cannot defend themselves. The trouble is that, because the Federal government also contributes money, court judgments have prevented California from going through with attempts to scale back these programs. So, the Terminator proposed a budget that will do away with the programs entirely.

The programs eliminated include home healthcare for the elderly and disabled, a nearly $2-billion program that serves 440,000 Californians, and the Healthy Families program, which uses federal money to help provide health insurance for about 900,000 low-income children.

As the San Jose Mercury noted last week, more single mothers and their children will be homeless and hungry, more mentally ill people will be in jail, more old people will be forced into nursing homes. In California, no one will look after poor children while their parents work, look after shut-ins, buy food for low-income seniors, of take in the homeless.

These are the kinds of actions and consequences that reveal where the values of our country's supercilious voters and politicians really lie. These are the kinds of values that put to the lie to the self-righteous rhetoric of "value" obsessed electorates.

Rather than bear the consequences of their own past foolishness, the politicians and the vast bulk of the electorate will simply shift the punishment onto the helpless. Presumably, the electorate and their leaders will have no trouble ignoring the suffering that they cause now, any more than they were troubled by their past foolishness.

Maybe citizens should be more concerned about how fiscal austerity is implemented.

Do they think that today's poor are the only losers? Think again, because there are more jobs to be lost, and more homes to be foreclosed.

Do they think that fiscal austerity is only for other states or other countries? Think again, because California isn't the only state in budget trouble, and Greece isn't the only Western country in budget trouble.

Painful fiscal austerity should soon be coming to more states. Just hope that it is not coming to your home.

We Will Defend the Euro Whatever It Takes

2010-05-11T09:34:00.002-04:00

Last weekend, European Commission President Jose Manuel Barroso said: "We will defend the euro whatever it takes."

This was after French President Nicolas Sarkozy and German Chancellor Angela Merkel announced that Europe will set up an intervention mechanism to calm markets rattled by the Greek debt crisis, and stave off any attack against weakened nations whose financial systems are at risk. Sarkozy and Merkel also said laid out a plan to defend the euro against "speculators", which led to Barroso's statement.

This is just a stopgap, and it does nothing to eliminate the underlying problems -- low productivity of southern European nations, high debt loads all over Europe, unrealistic social commitments, higher growth in the rest of the world. If it takes $1T at this initial stage of the crisis, what will it take later? What will they do when the next southern European country reaches crisis stage? If the ECB has to buy government bonds, they are just monetizing debt (while holding toxic assets). The underlying problems will remain, which raises the risk that eventually debts will be defaulted or inflated away, and that the EU will face some kind of political rearrangement in the future.

"Whatever it takes"? The real problems are just being postponed.

The China Real Estate Bubble

2010-04-12T21:20:00.008-04:00

Jim Chanos Interview

You probably know that Kynikos Associates Ltd and its founder, Jim Chanos, are shorting property developers and building suppliers in China. In an interview that will soon air on the Charlie Rose Show, Chanos provided some information on the Chinese property bubble, as well as a contrarian opinion on the Renminbi.

According to Chanos, China needs to keep up the pace of property investment because up to 60 percent of its gross domestic product relies on construction. "They can’t afford to get off this heroin of property development. It is the only thing keeping the economic growth numbers growing." Chinese state and local governments are among the most leveraged to property-related borrowings among all government entities around the world. Chanos also said that the bubble may start to burst perhaps later this year or in 2011.

How the Property Collapse May Play Out

Most observers probably expect the property bubble to collapse and result in a banking crisis, although others remain optimistic that China can mop up the effects of any financial bubble without ill effects. Chanos said that China will "ultimately" have to nationalize a lot of the bad loans from the property bubble, and that its foreign currency reserves will be "one asset" available to clean up the banking system. It would be useful to know more about how the collapse will play out, however.

Several Years of Sub-Par Growth

A good source is a recent article by Michael Pettis, Who Will Pay for China's Bad Loans, which argues that China will have a heavy price to pay for its excessive investment in the property sector, but not in the form of a banking collapse. Pettis is worth listening to as an expert on Chinese financial matters, in view of his position as a professor at Peking University’s Guanghua School of Management, and a Senior Associate at the Carnegie Endowment for International Peace.

Pettis says that we can learn a lot from the situation a decade ago when China had a huge surge in non-performing loans, the cleaning up of which was to cost China 40% of GDP. Although China paid a very high price for this earlier banking crisis, that price came not in the form of a banking collapse but rather in the form of a collapse in consumption growth. GDP growth was trimmed by several percentage points as households cut back consumption and raised savings in response to government policies. Money transferred from the household sector to the banks served to fund very low lending rates and to guarantee sufficient bank profitability to rebuild capital, avoiding a banking crisis.

Because at that time US leverage was rising and the world growing quickly, the cost of the collapse in consumption was easily masked by China’s surging trade surplus. Today, however, the US and the rest of the developed world are deleveraging rather than leveraging up. If China cannot rely on growing exports, the only acceptable alternative will be to increase household consumption. The problem is, as Pettis says: "But since growth in household consumption has always been constrained by the growth in household income, it may be unreasonable to expect a surge in consumption when households are also required to clean up another sharp increase in non-performing loans."

Pettis's conclusion is that the price China pays for the present bubble may be several years of below-average growth.

Implications for the Renminbi

Despite recent widespread anticipation of an upward revaluation of the Renminbi, it is possible that a collapsing property bubble could lead to a decline in the value of the Chinese People's currency in dollar terms. In another report of the interview Chanos was quoted as saying: "Chinese exports aren't the problem here. And what if it turns out that by having to nationalize lots and lots of real estate bad debts, the RMB is devalued." It is interesting that the latest month's data from China did show that the trade balance has deteriorated sharply, although this announcement was, just incidentally, immediately prior to talks with Treasury Secretary Timothy Geithner about exchange rate and trade issues.

Property Debt Continues to Increase

In an online article for China International Business, former Morgan Stanley analyst Andy Xie described the massive size of the property bubble and how destabilizing it is socially for land to continue be so unaffordable as to slow the growth of the middle class. An interesting takeaway is that the bubble may continue to build, and that it will be very difficult to predict the timing of the collapse. "The bubble can still continue because China's banking system has plenty of liquidity – thanks partly to hot money and because local governments have many levers to channel bank liquidity into the market. But the longer the bubble lasts, the more damage it will do to the economy."

Collateral Damage

It is hard to imagine how a country can avoid financial collapse when it has incurred so much debt for so many unproductive assets. In fact, China has been over-investing in fixed assets of all kinds, including industrial capacity, for some time and not just housing property. The problem is that many firms in the US and other developed countries are involved in sectors throughout the Chinese economy, which makes one wonder: Which firms will suffer the most, and how far will the damage go?

Cyclical Upturn within a Structural Decline

2010-04-05T13:17:00.002-04:00

There is an interesting presentation from the Economic Cycle Research Institute (ECRI) indicating that the US economy has been recovering from the Great Recession and suggesting that the recovery may continue for a while.

They suggest that, from a cyclical perspective, we are about to see higher inflation, more employment, and higher levels of economic activity. This does not sound good for bonds in the near future.

There is an interesting divergence between this good news about the immediate future of the economy and implications for the longer term. The presentation includes several decades of economic data series indicating that the magnitude of US economic recoveries has been declining for a number of decades, and that economic volatility is declining (less difference between peaks and troughs). This means that the US economy is spending a greater proportion of the time in a state of economic contraction or at very low levels of economic activity.

ECRI suggests that unemployment may have peaked for this cycle, but the news on employment is not totally happy. The shortening of the expansion phase of the cycle has some sobering implications, including: Job growth during this expansion, if it continues, is unlikely to compensate for the jobs lost during the recession. ECRI's indicators also suggest that inflation is increasing, which would not bode well for bonds.

Changing topics to the stock market, the stock market looks expensive now, and the prospects for very mild growth do not bode well for improved valuations. For a good source of information on that topic, John Hussman's weekly commentaries contain useful perspectives, as well as references to other sources of information on stock market valuation.

Bill Gross Says Bonds Have Seen Their Best Days

2010-03-28T17:39:00.004-04:00

But First He Recommends Some Bonds

In his April 2010 letter PIMCO’s Bill Gross advised how to select among the bonds of sovereign issuers. Then he turned around and said in a radio interview that bonds have seen their best days. Not only did he advise both for and against bonds, but his bond allocation consisted of nothing more than a set of binary choices dependent on so many unknowns as to make the advice useless. If you’re still interested, here is a summary of what Gross had to say.

Sovereign Debt Classification

Because of the rising risk of default (and related debt problems), Gross says that the main objective in fixed income investing should be capital preservation. Sovereign debt of developed nations is usually a good place to be for preservation, but the problem today is that the governments of developed nations still need to substitute for their private sectors. This means that they will all need to continue creating debt, but not all can do this without falling into a debt crisis. Gross used a series of two sieves to classify countries into tiers according to their capability to take on more debt:

Sieve #1

The first sieve assesses whether a country has the ability to escape a debt crisis by creating even more debt. Gross condensed this issue into three questions:

1. Can a country issue its own currency and is it acceptable in global commerce?

2. Are a country’s initial conditions (outstanding debt, structural deficit, growth rate, demographic balance) moderate and can it issue future public debt as a substitute for private credit?

3. Can a country’s central bank be allowed to reflate via low or negative real interest rates without creating a currency crisis?

Not surprisingly, Gross answered all of these questions in the negative for Greece, and he suggested that the answers are mostly negative for the other Southern European debtors. More surprisingly, he answered in the positive for the United Kingdom, which he expects to avoid a debt crisis, despite the nation being on PIMCO’s “don’t invest” list.

Sieve #2

Even if a nation seems likely to avoid a near-term debt crisis and passes the first sieve, it may not necessarily be a good investment candidate, because it may yet issue so much debt as to produce inflation and a depreciating currency. This would obviously reduce the return on the nation’s bonds and could in a severe case cause it to fall into a debt trap. Gross classifies the UK in this group.

In contrast, Gross passed the US on both sieves, albeit only conditionally on the second. He suggested that the US debt load may be manageable because of its favorable demographics and growth potential, but that the situation merits close monitoring. His concern is that Treasury issuance may in the future grow to the point that it overwhelms demand, given that “the Congressional Budget Office estimates that the present value of unfunded future social insurance expenditures (Social Security and Medicare primarily) was $46 trillion as of 2009, a sum four times its current outstanding debt.”

Where Gross Advises Investing

As his allocation strategy, Gross would restrict investments to the sovereign debt of countries that pass these tests – escape a debt trap, reflate their economies, and suffer no severe consequences like runaway inflation or currency devaluation. He included investments in both the front end and back end of the yield curve (short or long maturity) depending on whether the nation seems likely to experience reflation or debt deflation.

Specifically, he advised front end investments in countries like the US and Brazil that are likely to experience successful reflation, and back end investments in countries like Germany and “core Europe” that can withstand potential debt deflation. Elsewhere, Gross has been recommending the debt of countries such as Germany and Canada that have low deficits.

Another consideration is the risk of rising interest rates as quantitative easing is eventually reversed and the world economy reflates. Whenever this happens (no telling when), Gross believes that the prudent way of boosting yield will be by sacrificing credit quality rather than by extending duration.

So Long and Thanks for All the Fish

Gross added one caveat: The validity of his recommended strategy depends on the continuing stability of the world economic and financial system. “Spreads in appropriate sovereign and corporate credits are a better bet as long as global contagion is contained. If not, a rush to the safety of Treasury Bills lies ahead.” (Italics mine.)

In other words, if you buy the recommended foreign securities and the world recovers (save for a few smaller countries, I suppose), you have a chance of surviving with your scalp still attached. If you buy the recommended foreign securities and the world falls apart, that’s just too bad because you should have kept your portfolio exclusively in long Treasuries. How nice of Gross to provide us with a strategy whose execution depends on the binary outcome of an uncertain future event, “global contagion is contained”. Thanks for all the deep insights, Bill.

No wonder the performance of the Total Return Fund was only at the 54-th percentile last year.

Bonds Have Seen Their Best Days

Given that Gross has just written a letter advising a fixed income investing strategy, you might think that he is bullish on bonds. You might also be mistaken, because Gross said in a March 26 Bloomberg radio interview that “bonds have seen their best days.” A rising interest rate environment is an “argument to not own as many” bonds.

He added that the U.S., Japan, and other nations will have to sell record amounts of bonds, which will eventually lead to inflation. Although Gross did not specify the timing, it looks like the three decade long bond bull really is ending -- sometime.

No wonder PIMCO has been moving into equity investing.

PIMCO’s Advice to “De-Risk”

In the April edition of his US Credit Perspectives PIMCO Managing Director Mark Kiesel provided a perspective that somewhat unifies these seemingly disparate viewpoints into a more coherent, near-term strategy: De-risk fixed income portfolios by upgrading credit quality.

The rationale for this advice was a combination of both short-term and long term risks. In the short term, the current support of the world economy through accommodative fiscal and monetary policies seems likely to end, as the developed nations unwind their stimulus programs and face the prospect of fiscal tightening. In the case of the US, for example, policy support of the economy “will likely fade” in the second half of 2010. The long-term risk is the growing government debt loads of the developed nations.

Because spreads are currently tight between high and low credit quality bonds, this provides an opportunity to upgrade: “As a result, investors should take advantage of the tighter credit spreads and focus on de-risking their portfolios in order to prepare for the increasing long-term secular headwinds stemming from the growing deterioration in public sector balance sheets in many developed economies.”

At least Kiesel's message lies somewhere in a reasonably risk-sensitive middle ground somewhere between the rhetorical extremes in Gross's various messages.

Mohammed El Erian on the Likelihood of a Chaotic Outcome

2010-03-14T18:22:00.003-04:00

Mohammed El Erian's recent article in the Financial Times, "How to Handle the Sovereign Debt Explosion", may offer us a glimpse into the PIMCO CEO's thinking about the outcome of the debt crisis. He makes six points, which individually seem totally obvious. When you get to the sixth point, however, you get a definite picture of his thinking about the general nature of the outcome.

Point 1. The current financial crisis is best stated as a generalized deteriorization in the balance sheets of nations throughout the developed world.

No surprise here.

Point 2. The deterioration of public finances is reducing the relevance of "conventional classifications," such as the difference between advanced and emerging economies.

No surprise here. A growing number of the former now have poorer economic and financial prospects than a growing number of the latter.

Point 3. The advanced countries will adjust somehow, but the real questions are whether the adjustment will be orderly or disorderly, its timing and collateral impact.

Yes, we really would like to know that!

The orderly option is a " combination of growth and a willingness on the part of the private sector to maintain and extend holdings of government debt". This will be difficult because of "high unemployment, muted growth dynamics, persistently large deficits and regulatory uncertainty".

He says something else here that seems totally obvious but will become more relevant when we get to Point 6. "Countries will thus be forced to make difficult decisions relating to higher taxation and lower spending. If these do not materialise on a timely basis, the universe of likely outcomes will expand to include inflating out of excessive debt and, in the extreme, default and confiscation." Italics are mine.

Point 4. Governments will impose solutions by diverting resources internally. Because all advanced countries are in trouble, solutions that depend on other countries will be scarce.

If they can't grow their way out of the crisis, governments have to reduce spending and/or raise taxes. Reducing spending won't be easy, because constituencies will be bitterly disappointed at the loss of entitlements, deteriorating services, long-term unemployment, and other results of austerity. Raising taxes will bring conflict with the rich, put another burden on the middle class, and discourage business. Given the partisan standoff in Congress, it will not be easy to do any of this in the U.S.

Point 5. For the same reason, any government's attempt at getting its own fiscal house in order will be complicated by the actions of other countries.

El Erian does not elaborate, but examples could be competition in the bond markets, trade barriers, currency devaluation, or stresses in organizations like the EU.

Point 6. The deterioration in the finances of the major advanced countries is "not sufficiently well recognized." Further, "We should expect (rather than be surprised by) damaging recognition lags in both the public and private sectors."

I don't know if the problem is really "not sufficiently well recognized." Other than that, it is hard to disagree with him, because governments are hardly accustomed to dealing decisively with novel situations until disaster is upon them.

Even if the problem is recognized in a timely fashion, "history suggests that it is not easy for companies and governments to overcome the tyranny of backward-looking internal commitments." This is another good point, because entitlements, partisanship, special interests, and the complexity of modern society all act to deflect any government actions, let alone one that is sufficiently extreme to be effective.

Uptake. Point 6 seems to be the crux of El Erian's argument. As he said in Point 3, if decisions are not made in a timely fashion, "the universe of likely outcomes will expand to include inflating out of excessive debt and, in the extreme, default and confiscation." Given Point 6, he does not expect timely decisions, which suggests a good chance of a chaotic outcome -- inflating out of debt, default, and confiscation.

If we want to survive the financial crisis and maybe even prosper, we need a mental framework that will help us think about the world realistically and productively. Maybe El Erian's framework seems totally obvious to you, or maybe you disagree with it. I think that we need to consider strategies to cope with possible chaotic outcomes like inflating out of debt, default, and confiscation.

More Rogoff: Painful Austerity, Market Shockwaves

2010-02-24T09:38:00.004-05:00

Woodblock print by Utagawa Hiroshige

As a follow-up to yesterday's post here are more details of the remarks by Kenneth Rogoff at the Tokyo forum. According to Bloomberg, Rogoff said after the speech that the U.S. is likely to tighten monetary policy before cutting government spending, sending “shockwaves” through financial markets.

He does not see the U.S. as coming to grips with its budget deficit immediately. “The U.S. is in a state of paralysis in its fiscal policy,” he said. The IMF has forecast that by 2011 gross borrowings will amount to the equivalent of 99.5 percent of annual economic output for the U.S., 94.1 percent for the U.K., and 204.3 percent for Japan.

Rogoff said that investors around the world will eventually demand higher interest rates to lend to countries that have heavy debt loads, including the U.S. In his scenario, the U.S. government will delay any efforts to contain the deficit until Treasury yields reach around 6 percent to 7 percent. Fiscal discipline won't be imposed until soaring bond yields trigger “very painful” tax increases and spending cuts, he said.

“When they start tightening monetary policy even a little bit, it’s going to send shockwaves through the system.”

“Clearly the dollar is going to go down against the emerging markets -- there’s going to be concern about inflation and the debt.” He said that currently the dollar is being propped up by concerns about the euro zone's ability to withstand the deteriorating finances of member nations like Greece.

Oddly, in the audio of his remarks, Rogoff argued that the "main event" is over and that the situation is "not that bad" now, despite a deep recession and long recovery. His data indicate that stock prices recover remarkably well following a deep financial crisis and return to their former peak within two or three years. Rogoff did hedge this view, however, saying that government debt will be a huge problem, and it will be challenging to extricate from stimulation.

In Europe, he expects Greece will eventually be bailed out by the IMF rather than the European Union. Although he expects the EU to provide a bridge loan, he believes that it won't be enough in the long run. “The more they suck in Greece, the lower the euro goes, because it’s not a viable plan.”

As mentioned yesterday, Rogoff is co-author with Carmen M. Reinhart of the book This Time Is Different, a study of eight centuries of financial crises.

Rogoff: Several Countries to Default, U.S. to Cut Spending

2010-02-23T13:24:00.005-05:00

Thomas Hart Benton, Score Another for the Subs

In an earlier post this blog discussed This Time Is Different by Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University, who gleaned a number of general lessons from eight centuries of financial crises.

This blog has also discussed several pundits, including Bill Gross and Bill Mauldin, who both extrapolated from Reinhart and Rogoff's work to form their own conclusions about the course the present financial crisis.

Now, Rogoff has spoken out and said that ballooning public debt is likely to force several countries to default and the U.S. to slash spending.

Speaking at a forum in Tokyo Rogoff said that after a major financial crisis the world usually sees "a bunch of sovereign defaults, say in a few years. I predict we will again." Without predicting who would default, he did say that European countries such as Greece and Portugal will “have a lot of troubles.” He also said that Japanese fiscal policy is “out of control.”

Another of the outcomes predicted by Rogoff is higher interest rates.

In his view, the rich, developed nations will be able to cope with the crisis without defaulting, but will pay a price. Although it is hard to call the timing, “In rich countries -- Germany, the United States and maybe Japan -- we are going to see slow growth. They will tighten their belts when the problem hits with interest rates. They will deal with it.”

In addition to co-authoring This Time Is Different, Rogoff is a former chief economist at the International Monetary Fund and a member of the Group of Thirty, a panel of central bankers, finance officials and academics headed by former Federal Reserve chairman Paul Volcker. With a complex system such as global finance, it seems prudent to include historical precenents when contemplating how the debt crisis may play itself out.

Inevitable Collapse

2010-02-20T21:21:00.111-05:00

Jean Antoine Watteau, Gilles, 1718.

Today I would like to comment on recent reports issued by Societe General's Albert Edwards, a former colleague of Jean Marie Eveillard and James Montier, other value-minded strategists who have moved on to other organizations. Because Edwards seems to be perpetually on the extremely pessimistic side, his reports should perhaps be received with a degree of critical caution. After all, we should be examining every side of the debate over global indebtedness, and not dwell exclusively on pessimistic views.

On the other hand, Edwards is of interest precisely because he is extreme. He cites debt-to-GDP statistics as pointing toward extreme market events. Others have cited similar statistics and suggest that debt growth cannot continue, and some have been quite blunt, albeit without being quite as direct about the consequences as Edwards is. When you strip away some of Edwards's alarming language, you find that, lurking underneath, there remains a worrying and deteriorating situation for the world's advanced nations.

Competitive Devaluation Looms

Lacking the Societe Generale reports themselves, we will have to rely on quotes from two articles by Tyler Durden in the Zero Hedge blog. The first of these is pretty well summed up in its title: Timing The Exit As Competitve Devaluation Looms; Is The Euro 25% Overvalued? More Thoughts From Albert Edwards.

As for current conditions, Edwards intreprets leading indicators as signaling that China and other emerging markets have topped out, and that the U.S. and other advanced economies are soon to follow. He does not follow the interpretation of many others, that rises in economic indicators signal more positive surprises.

He thinks that the Euro is too strong and inflation too low given the prospect an impending European slowdown, and the the dollar/Euro exchange rate should fall by 25%. "The end game for the Ice Age was always competitive devaluation and the US and UK have embraced this strategy to revive growth and export their own domestically generated deflationary impulses." Now it's the Euro that needs to devalue. At least he doesn't see the U.S. as being prone to longer-term stagnation to the extent that demographically-challenged Japan is, given that "the US demographic outlook shows a continued expansion of the working age population through this century."

The Breakup of the Eurozone

Edwards's view of the ultimate outcome of the debt situation is summed up in the title of a related post: Albert Edwards: At 500% Net Liabilities To GDP, It Is Too Late To Prevent The Collapse Of The G-7; Greece Is Irrelevant, We Are All Now Insolvent. Starting with Europe, he believes that the debt problems of Portugal, Ireland, Greece, and Spain (the PIGS) will bring about "the inevitable break-up of the eurozone." This is because "the root problem for the PIGS is lack of competitiveness within the eurozone," brought on by "years of inappropriately low interest rates." The resultant inflation, double digit current acount deficits, and weak growth mean that "the PIGS public sector deficit will inevitably remain large."

Ivan Aivazovsky, The Shipwreck, 1871

Pressure to reduce these budget deficits by tightening fiscal policy "will not be tolerated by the electorates in these countries. Unlike Japan or the US, Europe has an unfortunate tendency towards civil unrest when subjected to extreme economic pain."   The breakup of the eurozone will then follow from "another of Europe's unfortunate tendencies -- the emergence of small extreme parties to take advantage of any unrest."

No Way Out But Default

As we know by now, the U.S. and U.K. also face the prospect of especially stern fiscal policies to reign in their budget deficits, which Edwards quantifies as "structural (cyclically adjusted) general government deficits of almost 10% of GDP (according to the OECD)."   He becomes particularly pessimistic when he looks at government debt including unfunded liabilities, for which "most governments are already insolvent with debt to GDP ratios closer to 500% of GDP instead of around 100% for most G7 countries . It is too late." Moving on to individual countries, "Greek total net liabilities (on and off balance sheet) to GDP are 800%! EU: at 470%, the US, at over 500%. There is no way out but default."

Is It Really This Severe?

This range of liabilities-to-GDP sounds severe, but how severe is it really? We have to consider differences between "official" debt accounts (on balance sheet) and total net liabilities, which include unfunded liabilities (off balance sheet). We are of course familiar with the problems that private firms have encountered when suddenly faced with the unexpected need to pay for unfunded off balance sheet liabilities, such as those hidden in special vehicles or counterparty liabilities.

However, in this case we are talking about government liabilities. We are also talking about future liabilities, generally those owed to citizens, on the basis of promises and expectations about entitlements.  Such entitlements include, of course, promises like Medicare, Medicaid, and Social Security. We do not know how such promises may be amended in the future, nor the ability of the taxpayers or the willingness of creditors to fund those promises. We do not know how much the citizenry may amend its expectations, nor the political will of the leadership to enforce fiscal discipline. Such future unfunded liabilities are therefore uncertain in magnitude and, to some extent, fungible.

Equally important, we don't know how well the U.S. and other nations will be able to grow their economies.  Growth seems scarce in the developed world, and growth is necessary to raise government revenue.

Other Statistics, Other Opinions

This blog has recently discussed a number of viewpoints about the debt situation and has cited the supporting statistics such as debt-to-GDP ratios. For example, Bill Gross includes the U.S. in the "Ring of Fire", his name for the set of advanced countries that are at risk of exceeding a 90% ratio of public debt to GDP. That is the point at which he considers a country at risk of suffering a 1% decrement in its economic growth rate. Gross does not say in his public statements what he thinks the chances are that the process will lead to a U.S. default or runaway inflation, but he does think that the situation bodes poorly for U.S. fixed income.

A different metric is the ability to make interest payments on debt. Former U.S. Comptroller General David Walker recently said: "Within 12 years…the largest item in the federal budget will be interest payments on the national debt." As interest payments squeeze out other budget items, something will have to give, and at some point in the next few years a choice will be made between default and fiscal austerity. Speaking at the same forum on fiscal reform, Federal Reserve Bank of Kansas City president Thomas Hoenig said that having the Fed print more money to purchase the mounting debt would lead to an inflation-induced financial crisis.

How Will It Play Out Politically?

In the case of Greece, we are now seeing an immediate reaction and the potential of confrontation over the need for fiscal discipline. Who knows? Perhaps Edwards has a point about the potential for extreme political reactions and fissures appearing with the EU.

Scene from Nosferatu (F. W. Murnau, 1922)

In the U.S., however, the outcome is far, far from obvious. Some want to continue stimulus, and others demand immediate fiscal discipline to avoid eventual insolvency and default. The debate is vociferous and, unfortunately, there is every appearance of a stalemate persisting in Congress.

Edwards has no such uncertainties about the political process: "The trouble is that, as the private sector debt unwinds, there is no political appetite to allow GDP to decline to its "correct" level as this would involve a depression. So burgeoning public sector deficits and Quantitative Easing are required to maintain the fig-leaf of continued prosperity."

Edwards also has no such uncertainties about the outcome. According to him, "there really is no way out that does not trigger a major market-moving upheaval."

Payback Time

I agree with Edwards about what has happened to get us here: "Ultimately economic prosperity over the past decade has been a sham: a totally unsustainable Ponzi scheme built on a mountain of private sector debt. GDP has simply been brought forward from the future and now it's payback time. "

But I just don't have his one-sided conviction about the future. He sees the inevitability of collapse. I believe that there are too many uncertainties to say. Maybe the U.S. will just cut back on entitlements, people will suffer, and the country will muddle through and emerge a shell of its former self. There is no way to know the outcome more precisely. Not at present.

However, as governments run into budget problems, it does seem likely that people will run from one asset to another as their perceptions of safety change over time. In the very near future, it seems likely that people will continue to flee to the dollar. At some point another alternative may appear, and maybe that event is what we need to watch for.

Prediction is a perilous business, and Edwards mentions that his former colleague, James Montier, derides the notion of investing on the basis of forecasts as they inevitably prove so inaccurate. Agreeing that prediction of markets and economies goes beyond prudence, I will avoid agreeing with anyone how the debt crisis will play out.

But something extreme is going to happen. At a recent forum on budget reform, Former director of the Congressional Budget Office, Rudolph Penner warned: "The American people today are not remotely prepared for the changes that are necessary." This is something that I can agree with. If political stalemate continues, and the debt situation deteriorates, Americans may be stunned by the magnitude of the changes about to take place.

Thure de Thulstrup, The anarchist riot in Chicago : a dynamite bomb exploding among the police. From: Harper's weekly. Vol. 30 , no. 1534 (May 15, 1886)

The Sea of Fog

2010-02-13T18:01:00.012-05:00

Caspar David Friedrich, Wanderer above the Sea of Fog, 1818.

The prevalent view about US debt problems, at least as I interpret recent guru predictions, is that a rendezvous with disaster lies a number of years in the future, say 5 to 10 years. The most visible media gurus -- Taleb, Roubini, Faber -- appear to expect the process to culminate in the free printing of dollars accompanied by rampant inflation and a worthless dollar before the U.S. defaults on its debt. More immediately, many are predicting rising bond yields this year as the Treasury struggles to fund the growing federal debt.

These are not the only viewpoints being presented in the investment community, however. Also, what will be the nature of the path that the world economy traverses in the next few years, default or not?

An interesting scenario is that the immediate future will bring deflation rather than inflation, accompanied by low interest rates and a strong dollar. Longer term, perhaps stretching over years, interest rates may rise, as government bailouts and debt loads increase in scale. Given the importance of the debt question, and uncertainty about the way forward, I decided to give space to deflation-oriented viewpoints today.

David Malpass: Rolling Recovery

Having read a few sensible things from David Malpass of Encima Global, I decided to look further into his concept of a "rolling recovery". Despite his unintuitive conclusions, he agrees with the commonly held view that the U.S. in on the road to debt disaster and must take immediate steps to rein in federal spending. In a recent Forbes article titled "The High Cost of the U.S. Budget" he and Eric Singer wrote that the administration's budget puts the country on a path to danger in just a few years' time:

When a country goes past owing 100% of its nominal GDP in publicly held debt, as this budget schedules us to do by 2020, there is danger.

Although he does not predict the outcome, Malpass sees the path to 2020 as punctuated by occasional emergencies of varying magnitudes, a process that he calls a "rolling recovery". That's the long term. As for this year, his "Economic Outlook for 2010" predicts that the wind-down of emergency stimulus will affect asset prices like this:

Currencies should strengthen relative to commodities as emergency stimulus stands down.

Emergency stimulus has distorted both sides of the inflation/deflation barbell trade – commodities, bonds and foreign stocks all up big, esp. in dollar terms. They should soften or retrace as stimulus slows.

His February 11 letter at Encima Global, "Rolling Debt Crises -- Where They Lead", expects the global economic recovery to gain strength but be "marked by rolling debt crises – Iceland, GM, Dubai, Greece, California. Stronger sovereigns will extend debt guarantees and subsidies to some but not all of the distressed debtors." The result will be crises for those who cannot be sustained but a gradual process of recovery for the world as a whole:

The trend to government umbrellas is unsustainable, but I think the upward bias in global output and consumption -- including innovation, hard work, and tens of millions of Chinese, Indians and others moving from subsistence agriculture to the cash economy – is strong enough to push the problems into the future.

Malpass's scenario is that big bail-outs will produce different outcomes in the short-run and the long-run:

... expanding the too-big-to-fail umbrella – will be pro-growth in the short run.

In the longer-run, however, the process moves even more of the global economy away from market principles. This gradually undercuts the capital allocation process.

He expects growth in the U.S. this year, but the growth in government debt will have a price:

Bond yields should rise in the U.S. and Europe when as it becomes clearer that the trend is toward guarantees and bailouts, not bankruptcy. Insurance against deflation (part of the value of Treasuries and bunds) is less valuable if Germany chooses to guarantee Greece.

In the longer run, however, governments can only take on so much debt, and they will have to draw the line between those who can be supported and those who cannot:

Governments will try to draw the line between which countries and companies can win their protection and which can’t. The U.S. has many large banks that are too-big-to-fail, but thousands of smaller ones that can be digested by the FDIC and are outside the umbrella. I expect a similar sorting process for municipalities and small countries in Europe.

So, he does not predict immediate debt doom, but a longer-term malaise:

Cyclical and secular growth helps float distressed debt for a while. Guarantees save other debt. It probably works in the short run, but the longer-term result is bigger government, a poorer allocation of capital around the world, and slower long-term growth.

Hugh Hendry: Japanese Malaise

Hugh Hendry of Eclectica is hugely optimistic about the dollar and U.S. Treasuries. Zero Hedge reported this strategy as Hendry stated it at the recent Russian Summit of hedge fund leaders: "I am hugely intellectually bullish on Treasuries. I am long." The most contrary part of his strategy is that it is long-term.

He admits that this is against the majority views: (1) that the end of QE will result in higher bond yields, and (2) that a successful reflation of the economy would produce inflation:

I fear the end of QE, the money funds are making on the [curve], I am aware of the issuance, I am aware that the States is going to have to sell $2.5 trillion of this stuff. ... I think there is a lesson in Japan.

The precedent of Japan suggest that if you allow leverage in your society to breach a certain level, let's call it 200 or 230% of GDP, then what happens is monetary policy doesn't work, fiscal policy doesn't work. ... prices are falling and look set to fall further.

Hendry gives more of his reasoning about a strong dollar and strong Treasuries in the Eclectica November 2009 letter, which is probably best read at at this address. He believes that dollar devaluation has already happened and hence won't contribute to future inflation. The dollar is not going to decline versus major competitor currencies:

I keep hearing that a dollar devaluation would help matters. I agree; it has. Let me say it again; we have already had the devaluation. That is what the last five years were all about. Now with China rebuilt, and the trade deficit in full retreat (note the -47% contribution from net exports to China's GDP growth in the first 9 months of this year), there are less dollar bills being exported overseas to ungrateful recipients. ... Is it really inconceivable that the dollar could now strengthen?

Regarding US Treasuries, he agrees with those who say that they offer poor long-term prospects:

... not an adequate return for lending your money to the profligate United States for 30 years. I agree wholeheartedly. ... I do not propose that anyone adopt a buy-and-hold policy for the next thirty years in bonds. However, a nominal rate of 4.5% might prove very profitable over the coming year should breakeven inflation expectations head south again.

So, he may well switch positions at some time, but for now he thinks that the U.S. domestic market will take up the slack in demand from overseas:

... a lower Chinese trade surplus will eliminate a very large source of Treasury buyers at a time of burgeoning supply. ... However, it is our contention that US savings are heading north over the months and years to come. And an America that saves is an America that does not run a current account deficit. It is an American that can finance its own spending domestically.

As a consequence the Chinese surplus is set to fall further and ... their demand for Treasuries will continue to shrink. Now this is potentially a huge headache owing to the massive projected American budget deficits for this year and next ....

Many observers might disagree with Hendry and argue that U.S. consumer is too highly leveraged to do much saving of any kind, and that institutional investors cannot take up all of the slack. However, Hendry seems to think that the risk of default will force policy decisions that keep rates low:

Now remember I have been describing a positive macro scenario: a world in which low interest rates make the debt load manageable and that we muddle through with lower growth rates in nominal GDP. ... my opponents (see Ferguson et al.) believe that government bond yields are going much higher. ... It is my contention that the leverage of the economy is only tenable if interest rates stay low ...

He says, even if things get bad and bond rates rise, the problems will first appear in other nations' sovereign debt. He proposes Japan as the major domino to fall first:

But first, it may require the spectacle of seeing Japan implode and so we have been actively positioning the Fund to profit from such a scenario. As many of you know, the fiscal situation in Japan is rapidly rising out of control. ... the ratio of public debt to GDP is guaranteed to rise further. It is currently 196% of GDP with the IMF estimating that it will rise to 234% by 2014.

... we have been active buyers of corporate debt default swaps. We find it remarkable that one can insure highly leveraged utilities at 23bps despite their considerable yen debt.

Gary Shilling: Still Bearish, Still Right

Shilling has been bearish and on the side of deflation for so long that I hesitate to mention him, but he deserves credit for recommending this profitable asset allocation for a long time. In one of his recent Forbes columns he cited the pinched consumer and an expectation of a rising savings rate both as reasons to continue liking Treasuries, and he added a recommendation for growing dividend stocks in the staples sector.

Caspar David Friedrich, The Sea of Ice, 1823-24.

Like a Meteor Streaming in the Wind

2010-02-11T12:21:00.045-05:00

Him the Almighty Power
Hurld headlong flaming
from th' Ethereal Skie
With hideous ruine and combustion down
To bottomless perdition, there to dwell
In Adamantine Chains and penal Fire,
Who durst defie th' Omnipotent to Arms.

John Milton, Paradise Lost, Book I

Don't try to defy the capital markets. Added to the likes of Marc Faber, Nissim Taleb, and Nouriel Roubini, we now have predictions of U.S. hyperinflation and/or debt default from Niall Ferguson, the Harvard economics professor and author of The Ascent of Money.

Niall Ferguson

As reported in Zero Hedge, Ferguson took note of an environment that he thinks will remain positive for the dollar for a number of months:

For the world’s biggest economy, the US, the day of reckoning still seems reassuringly remote. The worse things get in the eurozone, the more the US dollar rallies as nervous investors park their cash in the “safe haven” of American government debt. This effect may persist for some months, just as the dollar and Treasuries rallied in the depths of the banking panic in late 2008.

As we know, however, the situation is deteriorating:

Even according to the White House’s new budget projections, the gross federal debt in public hands will exceed 100 per cent of GDP in just two years’ time. This year, like last year, the federal deficit will be around 10 per cent of GDP. The long-run projections of the Congressional Budget Office suggest that the US will never again run a balanced budget. That’s right, never.

Because those are long run projections, it seems that Ferguson is talking about fiscal trends that may take years to play out. These are the kinds of trends discussed in a book that I have written about often here, This Time Is Different, a study of eight centuries of financial crisis by Carmen Reinhart and Kenneth Rogoff. The current fiscal situation looks likes it fits the pattern. Higher bond yields have so far been avoided through the purchase of Treasury securities by the Federal Reserve and the Peoples Republic of China, but that situation is about to change:

Explosions of public debt hurt economies in the following way, as numerous empirical studies have shown. By raising fears of default and/or currency depreciation ahead of actual inflation, they push up real interest rates. Higher real rates, in turn, act as drag on growth, especially when the private sector is also heavily indebted – as is the case in most western economies, not least the US.

Ferguson argues that GDP growth and inflation will lead to a situation in which the debt load will eventually become unsupportable.

But now the Fed is phasing out such purchases and is expected to wind up quantitative easing. Meanwhile, the Chinese have sharply reduced their purchases of Treasuries from around 47 per cent of new issuance in 2006 to 20 per cent in 2008 to an estimated 5 per cent last year. Small wonder Morgan Stanley assumes that 10-year yields will rise from around 3.5 per cent to 5.5 per cent this year. On a gross federal debt fast approaching $1,500bn, that implies up to $300bn of extra interest payments – and you get up there pretty quickly with the average maturity of the debt now below 50 months.

The Elite Will "Preserve" the System

Ever the optimist, Zero Hedge commented "our political and financial leaders will do everything in their power, even sacrifice the population, to prevent the collapse of the system." There are lots of indirect ways of sacrificing the population fiscally and monetarily, but a direct way would be to confiscate 401k accounts in order to support Treasury securities. To do this, as some speculate, the contents of 401k accounts would be forcibly converted into annunities. Annuities backed by what? Why, by Treasuries, which a bankrupt federal government would have in unending abundance. After punishing savers with low interest rates, and saddling everyone with a monstrous national debt, why not?

Marc Faber

While discussing catastrophic predictions, we might as well hear from a cheery "Dr Doom" interview on CNBC, U.S.-Europe Will All Default on Their Debt: Marc Faber. He said, in fact, that the governments of every developed economy will eventually "all have to print money before they default", citing as reasons for his prediction both unfunded future liabilities and current debt-to-GDP ratios. The U.S. will reach this state "within ten years."

Faber isn't totally pessimistic, because he is "relatively optimistic" about stocks going up, and he referred to stocks and gold as two as the best safe havens.

Afterword

In Paradise Lost the "meteor streaming in the wind" is the glittering ensign of the fallen angels, Satan's unrepentant pride. Perhaps in its pride America too will remain fiscally unrepentant and defy the markets until they hurl the dollar down to hideous ruin and combustion.

Beneath Lilacs

2010-02-09T10:28:00.248-05:00

This post could be titled "The New Economy" or "The Perversity of Rent Seeking Behavior", but I prefer a title that brings to mind an image of sitting under blooming lilacs and contemplating how much more pleasant life would be if generations of politicians hadn't thrown our futures away with a ruinous public debt.

The Work of Nations

In 1991, before he had become President Clinton's Secretary of Labor, Robert Reich published The Work of Nations, in which he described an increasingly globalized world and the the impact that this world was having on society and the workforce. At a time before these changes were quite as widespread as they are today, Dr. Reich described how information technology and global wage arbitrage enabled global wage arbitrage, enabling workers in emerging nations to compete with workers in the more advanced economies. As Dr. Reich predicted, wage arbitrage brought about a convergence of wages across borders, within different job categories, and a stratification of wages according to the scarcity and demand for each type of labor, within national borders. One outcome of this process was to increase the divergence in economic outcomes across the labor force within the developed nations. It was well established even before the time of Reich's writing that the less skilled, less educated members of the advanced societies were suffering lower wages and lower employment because of international competition and increasing mechanical and information productivity.

Roll Back the Enlightenment

Economic statistics demonstrate a long-term trend to greater inequality in American society, with a widening gap between rich and poor. Wealth is being concentrated into fewer and fewer hands, and the rising debt loads of the past thirty years or so have greatly depleted the wealth and the ranks of the middle classes. This increasing inequality may look like nothing more than the inevitable results of greater global competition, greater financial complexity, or the folly of overconsumption, but there are yet other forces at work that threaten to continue the trend toward inequality and to drive it to barbaric extremes.

In an interview in 2008 the economist Michael Hudson said: "The economy has polarized to the point where the wealthiest 10 percent now own 85 percent of the nation’s wealth. Never before have the bottom 90 percent been so highly indebted, so dependent on the wealthy. From their point of view, their power has exceeded that of any time in which economic statistics have been kept."

About the wealthiest members of our society Hudson said: "You have to realize that what they’re trying to do is to roll back the Enlightenment, roll back the moral philosophy and social values of classical political economy and its culmination in Progressive Era legislation, as well as the New Deal institutions."

He feels that the move is a deliberate attempt to transform society fundamentally to their advantage, no matter the consequences to everyone else: "So what you find to be a violation of traditional values is a re-assertion of pre-industrial, feudal values. The economy is being set back on the road to debt peonage. The Road to Serfdom is not government sponsorship of economic progress and rising living standards, it’s the dismantling of government, the dissolution of regulatory agencies, to create a new feudal-type elite."

By the way, there is more than one "Road to Serfdom". Hayek's book of that title described one, undeniable route, which is the socialist state. Hudson's interview describes another route, which is feudal domination by a conservative, exclusivist elite. Both routes lead surely to serfdom and must be defended against.

New Feudalism

Although "rolling back the Enlightenment" sounds like an extreme view, there are identifiable forces working on the world to transform the economic and social system in a pre-industrial direction, as discussed in an article by Parag Khanna last year in Foreign Policy. In "The Next Big Thing: Neomedievalism," Khanna pointed out a seeming incongruity, that globalized financial systems have spread economic crisis around the world at a time when increased corporate and local concentration of power may be dragging us all back to a more localized, feudal condition. He called this state of affairs "a new Middle Ages".

The argument begins with the observation that: "The state isn't a universally representative phenomenon today, if it ever was. Already, billions of people live in imperial conglomerates such as the European Union, the Greater Chinese Co-Prosperity Sphere, and the emerging North American Union, where state capitalism has become the norm. But at least half the United Nations’ membership, about 100 countries, can hardly be considered responsible sovereigns. Billions live unsure of who their true rulers are, whether local feudal lords or distant corporate executives."

Given the weak positions of many nation states, "This diffuse, fractured world will be run more by cities and city-states than countries. ... Today, just 40 city-regions account for two thirds of the world economy and 90 percent of its innovation. ... Add in sovereign wealth funds and private military contractors, and you have the agile geopolitical units of a neomedieval world. Even during this global financial crisis, multinational corporations heavily populate the list of the world's largest economic entities ..."

We wonder if America will be dominated increasingly by feudal elites, corporations, or new transnational organizations. Or maybe this is the wrong analogy with the Middle Ages, which saw some remarkable progress in many spheres of European life, and which were perhaps even more remarkable in other parts of the world. The medieval world in Europe was one of city-states, local military strongmen, and the loose international network of the church. In contrast, China developed national commerce under the Sung dynasty, and then a universal (if foreign ruled) state under the Mongol Yuan dynasty.

A Predatory Financial Sector

In the western world, government's role in finance has been shrinking for hundreds of years as new financial enterprises and instruments have been developed -- banks, bonds, insurance, stock markets, bonds, futures contracts, etc. Economies and governments benefited as new financial institutions directed capital flows to where they were needed.

Any system can be perverted, however, and in recent decades financial activity has comprised a growing percentage of gross product -- but with no corresponding contribution to economic efficiency or growth. Heaven knows, economic stability has certainly been sacrificed to financial interests.

The Rent Seekers

The financial sector and the elite clientele that it serves have been looking for new ways to maintain and increase their wealth. This includes influencing legislators and bureaucrats to pave the way for more effective rent-seeking behavior. In economics, rent seeking is the capturing of "economic rent" (income) by means other than economic transactions or the creation of economic value added. That is, rent seeking requires manipulating the rules of the economy or exploiting special relationships, e.g., getting the government to regulate commerce in a way that effectively confers a monopoly advantage. Other examples would be getting control of public resources or charging "fees" rather than usurious rates of interest.

As "real" economic activity wanes (from foreign competition or economic depression), you can be sure than rent seeking behavior will increase among the privileged. They have to maintain their life styles, after all, and poor peons can't afford the lobbyists and corporate attorneys. The growing role of government in financial affairs, in the wake of the credit bust, is sure to provide even more fertile grounds for nefarious rent seeking.

You can be sure that this does not bode well for new "real" economic activity. People are always trying to get something for nothing.

My Brother Is Coming with Many Fremen Warriors

The intent has been to confine this post to known trends and to obstain from conspiracy theory, but you will of course have to consider for yourself whether this story is realistic or other-worldly. Should it say beneath lilacs or Bene Tleilax?

List of graphics:

Photograph of lilacs
Harry Sternberg, Bethlehem Steel in Moonlight, 1937
Jean-Honore Fragonard, The Reader, c. 1770-1772
Page from Les Tres Riches Heures du Duc de Berry
Otto Dix, Machine Gunners Advancing, from Der Krieg, 1924
Close up of Alia in Dune (David Lynch, 1984).

U.S. Credit Rating at Risk

2010-02-03T13:52:00.004-05:00

El Greco, The Annunciation

As I Was Saying ...

I just wrote a post warning that the U.S. debt is at risk of becoming unsustainable. Immediately after, along came a news story warning that the crisis may be even closer than we imagined. Zero Hedge reports "Moody's Sees US Rating Under Pressure After $3.8 Trillion Budget", and they quote the report:

The ratios of general government debt to GDP and to revenue are deteriorating sharply, and after the crisis they are likely to be higher than the ratios of other Aaa-rated countries.

If the current upward trend in government debt were to continue and become irreversible, the rating could come under downward pressure. The trend and the outlook would be more important than any particular level of debt.

The italics are mine. As Zero Hedge asks: "IF it becomes irreversible?"

Dollar No Longer the Safe Refuge?

The article says that, if trends continue, the U.S. ratios of debt to GDP and debt to revenue will be HIGHER than the ratios of other Aaa-rated countries. Many people have been counting on the U.S. being in no worse position than other advanced economies, and they have been allocating assets as if the dollar will remain strong relative to the Euro, Yen, Pound, etc. Maybe that is not a good assumption. Those are flawed currencies, but the dollar is flawed too. Maybe Treasuries will tank as rates rise on the sovereign debt of all these indebted countries.

MSN Money added this tidbit: "Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the Aaa government bond rating." This means, that in the absence of an economic miracle, we can expect (a) deflationary pressures from higher taxes and lower expenditures, (b) higher deficits, or (c) a ratings downgrade of the U.S. Or maybe all of these.

An Actor? We Move on the Word of an Actor?

That's what Martin Sheen (as General Lee) said in Gettysburg, after receiving a scouting report on the Army of the Potomac. We all know that the credit rating organizations are corrupt liars, and no one believes them anymore. They proved that they will do anything, utter any lie to make a buck. If one of those sycophants comes this close to impugning the credit rating of the U.S., there must be a real problem with our credit. You would be justified to complain that this crisis has been obvious for so long that it isn't news anymore.

When and What to Do

Whenever a ratings agency issues a more directly worded warning, you can be sure that the Treasury market and the dollar will tank immediately. When it gets so bad that a Treasury auction finally fails, it will be too late to act.

What to do about it? Short Treasuries? Buy gold and foreign currencies? I lean more toward stockpiling guns, food, and ammo.

When to act? It seems a little early to act against the dollar, given the problems of Europe, Japan, and the U.K., whose problems are likely to benefit the dollar. With weak economies weighted down by heavy debt loads, it also seems early to short Treasuries. When the day will come is hard to tell.

The U.S. Budget Deficit

2010-02-02T13:25:00.003-05:00

Walker Evans: Truck and Sign, 1930.

Walker Evans Archive, The Metropolitan Museum of Art.

The federal budget deficit is larger than thought, and it is becoming a national-security threat.

The National Security Threat

The Wall Street Journal reports that the Federal government will borrow one of every three dollars it spends this year. The problem is that U.S. citizens cannot lend the money, because they save so little. Much of the money will have to be borrowed from foreign countries.

"We've reached a point now where there's an intimate link between our solvency and our national security," says Richard Haass, president of the Council on Foreign Relations and a senior national-security adviser in both the first and second Bush presidencies. "What's so discouraging is that our domestic politics don't seem to be up to the challenge. And the whole world is watching."

The Journal listed four ways that such a severe budget deficit threatens America's national security:

It makes America vulnerable to foreign pressures. Because half of America's debt is in the hand of foreigners, a foreign central bank could put pressure on the U.S.
By accepting vendor financing from China, we are conferring a lot of financial leverage to them in particular.
Long-term national-security budgets are put at risk. Debt service will crowd the defense budget.
The American model is being undermined before the rest of the world.

To this list I would add the following ways that the growing national debt harms national security:

America is saving so little that it is not able to invest in the human resources, plant and equipment, etc. needed to increase productivity and build a competitive position in a modernizing world.
The U.S. will become less socially stable as debt service crowds out social programs. Citizens will become desperate, angry, and more prone to take extreme solutions.
The resulting brittleness of U.S. systems will amplify the impact of any future terrorist attacks, resource scarcity, environmental change, inflation, war, or other adverse events.

The last bullet could be expanded into a number of issues. Living standards will decline because the Federal budget will be unable to afford the social safety net that US citizens have already paid for and are depending on: Social Security, Medicare, Medicaid. Support for already stretched cities and states will wither. Essential city and state services (roads, schools, police, fire, etc.) will have to be sacrificed. Benefits for the unemployed will be cut. Increased tax loads will discourage businesses, increase unemployment, and squeeze impoverished citizens even harder. As America sinks, its disappointed citizens will see other areas of the world gain improving living conditions. They will see "progress" fail in the U.S. and succeed elsewhere.

Otto Dix, Stormtroops Advancing under Gas, etching and aquatint, 1924.

Growing Deficit Estimates

In "White House to Paint Grim Fiscal Picture" Reuters reports that the budget deficit is larger than previously believed. According to the White House's Office of Management and Budget, the deficit for the current fiscal year will be significantly higher than the $1.35 trillion figure forecast by the nonpartisan Congressional Budget Office last week.

Despite the President's proposal of a three-year freeze on some domestic programs to save $20 billion next year and $250 billion over the coming decade, that will not be enough to get deficits down permanently to the 3 percent of gross domestic product that most economists consider sustainable. Deficits will still average roughly 4.5 percent of GDP over the coming decade, according to the White House estimate. That's not all.

What happened to the entitlement problem that we have been expecting for some time? It's still coming. Deficits are expected to rise again toward the end of the decade due to the increasing cost of retirement and healthcare programs as the "baby boom" generation retires. If we cannot bring the current deficit problems under control, we will be utterly swamped when the deficit is hit by the coming wave of baby boomer retirements.

Where to put the blame? Despite the criticism of President Obama and his administration, most of the fiscal mess has been inherited from the previous administration of Republican George W. Bush, who cut taxes and created an expensive prescription drug-benefit while pursuing wars in Iraq and Afghanistan.

Blame also falls on Bush for the shortfall in tax revenues to fund the budget. It was his administration whose monetary policies provided the loose money for the housing bubble, and it was his administration whose laissez regulatory policies failed to rein in the investment banks and mortgage companies. The shortfall in revenues during the resulting depression is putting cities, states, and the Federal government further in the red.

Unsustainable Debt Levels

Bert Dohmen wrote a sobering piece last month in Forbes about "Trillions of Troubles Ahead" for U.S. debt. He quotes his colleague Rob Arnott that "at all levels, federal, state, local and GSEs, the total public debt is now at 141% of GDP. That puts the United States in some elite company--only Japan, Lebanon and Zimbabwe are higher."

In adddition, household debt is 99% of GDP and corporate debt is 317% of GDP ("not even counting off-balance-sheet swaps and derivatives") -- both being the highest in the world. Adding those to government debt at all levels, "our total debt is 557% of GDP."

Dohmen warns: "The interest on the debt will consume all the tax revenues of the country in the not-too-distant future. Then there will be no way out but to create more debt in order to finance the old debt."

The article likens the situation of the U.S. to Japan, which has the highest debt-to-GDP level (227%) of any industrialized country. Japan's recession has lasted for 19 years now and the stock market is down 75% from the 1990 high. As bad as things have been for Japan, they could get worse. Japan's demographics will make it more dependent on foreign creditors in the future, and Fitch has warned about a potential downgrade of Japan's debt. This is not a good precedent for spendthrifts like the U.S.

Fundamental Valuations and Forecasts

2010-01-30T17:50:00.010-05:00

GMO's 7-Year Forecast by Asset Class

Jeremy Grantham of GMO has long been one of my favorite asset managers and financial commentators because of his value-based approach, his long-term investment horizon, and his warnings about fads, national debt, and growing asset bubbles. The GMO January Letter is interesting for its 7-year forecast of annualized returns by asset class.

Seven Lean Years

The forecast begins with the prospect that a continuing Fed policy of low interest rates will promote another speculative asset bubble, again endangering the economy and the financial system. This bubble may boost stock prices in the near term but the bubble will eventually burst.

Grantham believes that the economy faces what he calls "Seven Lean Years", because "after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios ..."

The US stock market is already overpriced, but it may continue advancing and become even more overpriced, Grantham believes. He estimates that the Standard and Poors 500 index is worth only about 850 but becuse of Fed policy may go to around 1200 before declining.

Expected Returns by Asset Class

He considers the "high quality" component of the US stock market to be "relatively cheap", however. I don't know GMO's criteria for high quality, but investment strategists commonly use criteria such as a good balance sheet, cash flow, decent current valuation, and good business prospects, as is the case as with a subset of US consumer staples companies. Except for managed timber, other assets are overpriced relative to history -- international equities a little so, fixed income very much, and cash extremely so. I've included GMO's chart of forecast annualized 7-year real returns by asset class.

Note that the chart includes no other commodities than managed timber, nor any other real estate. GMO's long run inflation assumption is 2.5% per year. International equities are ex-Japan. Note also that there is a wide band of uncertainty around the central estimates.

In case the chart above is not legible, here are the 7-Year Asset Class Return Forecasts: US equities: large cap 1.3%, small cap 0.5%, high quality 6.8%. International equities: large cap 4.7%, small cap 4.6%, emerging 3.9%. Bonds: US government 1.1%, international government 1.3%, emerging 2.1%, inflation indexed 0.8%, US Treasuries (30 days to 2 years) -0.6%. Managed timber 6.0%.

Risks in This Environment

The most salient feature of this chart for investment strategies is that expected returns are much lower overall than historical averages. In this environment, GMO feels that professional managers, being more concerned with comparison to their peers than with absolute returns, will be "seduced into buying equities because cash is so painful." The problem with that approach is that "Equity markets almost always peak when rates are low,so moving in desperation away from low rates into substantially overpriced equities always ends badly."

GMO Investment Strategy

GMO's solution to this dilemma, Grantham says, is to only slightly underweight international equities, but "tilted to quality", because the EAFE index is priced not far below historical norms. The rest of their portfolio is in fixed income, despite the meager expected return, although they do not specify the composition within fixed income. The equity allocation will be slowly reduced, however, if the equity markets continue to advance.

PIMCO's Ring of Fire

In contrast to GMO's expectations for asset classes, Bill Gross's recent PIMCO commentary discusses investment prospects across countries. As explained in "The Ring of Fire", Gross's approach seems to be based in part on fundamental valuation methods, as GMO's is, although he uses a different set of metrics more suited to fixed income.

Gross finds similarities between PIMCO's New Normal and a book that I have written of in earlier commentaries -- a study of eight centuries of financial crisis titled This Time Is Different by Carmen Reinhart and Kenneth Rogoff. PIMCO's thesis is that financial crises are followed by a process of deleveraging (shifting debt from the private to the public sector) which reduces economic growth and lowers returns on investment for a protracted period. PIMCO categorizes countries as red, yellow, or green based on public sector debt and the public sector budget deficit, both as percentages of GDP.

In PIMCO’s chart “The Ring of Fire”, the most vulnerable countries are shown in red. "These red zone countries are ones with the potential for public debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yellow and green areas are considered to be the most conservative and potentially most solvent, with the potential for higher growth."

PIMCO Investment Strategy

The conclusion that Gross draws is the difference "between emerging and developed economic growth, forecasting a much better future for the former as opposed to the latter." His investment strategy divides assets into growth, emerging markets fixed income, and developed markets fixed income:

Growth assets (as well as currencies) should be allocated to developing countries that are less levered and less prone to asset bubbles. "Look, in other words, for a savings-oriented economy which should gradually evolve into a consumer-focused economy. China, India, Brazil and more miniature-sized examples of each would be excellent examples."
Fixed income assets should be allocated to emerging countries when the opportunity occurs. However, reduced liquidity and less developed financial markets (e.g., property rights) make the emerging economies less appealing for fixed income, which means that "most bond money must still look to the “old” as opposed to the new world for returns."
Most fixed income assets should be allocated to a carefully selected subset of the developed nations, but the large, traditional bond markets should be avoided -- Japan because of demographics and the need for external financing, the US because of deficits and entitlements, Europe because of the debts of nations on the southern tier, and the UK because of its high debt. His top preference is Canada because of its fiscal balance and conservative banks, which did not participate in the housing crisis. His second choice is Germany "the safest, most liquid sovereign alternative, although its leadership and the EU’s potential stance toward bailouts of Greece and Ireland must be watched".

This is a much different strategy than GMO's, which does not give so much weight to emerging market equity and allocates to fixed income only grudgingly, but it is useful to see the investment world sliced and diced in different directions.

Woodcuts by Gustave Baumann (1881-1971), known for his work in Santa Fe, New Mexico and his depictions of the southwest

Back in Michigan

2010-01-29T21:15:00.002-05:00

Here I am, emerging from a kiva in the ruins of a pueblo at Pecos National Historical Park, New Mexico. As you can see, I am leaving no source unexamined in the quest to understand the repricing of global financial assets. More on the topic of asset valuation later, as I re-acclimate to the Michigan winter.

The Fate of Debtors

2010-01-24T11:10:00.002-05:00

Late last year I wrote a commentary titled "Eight Centuries of Financial Crises" about the book This Time Is Different—Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth Rogoff. I felt that this book would be of particular value to today’s investors because it analyzes the differences and similarities of over 250 financial crises in 66 countries over the past eight centuries. Today I would like to discuss lessons that other observers have drawn from that book and the application of those lessons to the current financial crisis. The findings are especially timely as the Fed appears headed toward an exit from quantitative easing, and as the US, Japan and Europe face the prospect of funding extremely heavy debt loads in the coming year.

Sources

These thoughts appeared in The Big Picture blog, in the weekly commentary of John Mauldin titled "Thoughts on the End Game". The majority of the post reproduced the fourth quarter 2009 review and outlook written by of two of Mauldin’s colleagues, Van Hoisington and Dr. Lacy Hunt.

Based on the book This Time Is Different, all of these commentators conclude that the outcome of the present process of deleveraging will be an era of deflation, continued low interest rates, and outperformance of US Treasury securities compared to alternative investments. Now, this is not a point of view that I necessarily subscribe to, but we should take a look at the evidence and the arguments.

Five Lessons

Hoisington and Hunt abstracted five lessons from This Time Is Different concerning today’s financial predicament. I’ve quote these five lessons in bold and added my own comments:

First, financial imbalances occur when aggregate domestic debt is excessive relative to income, regardless of whether the government or private sector is accumulating the debt. Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased saving.

Ever since the 1970s, I’ve heard politicians justify their pet programs and dismiss complaints of rising Federal debt, saying that critics “don’t understand” how government finance works. After all, they said, “we owe the debt to ourselves” and it all balances out in the end. What liars! Domestic debt does matter, no matter who the creditor is. If you are crushed by debt, you cannot obtain the credit needed to grow your business or support your family. You have to cut spending and pay down your debts, even if you don’t enjoy your reduced standard of living. Unfortunately, our collective debts are getting more unsupportable. That’s where we are now as a nation.

Second, whether the domestic debt is externally or internally owed is not as critical as the excessiveness of the debt.

So, politicians were lying when they said that it didn’t matter that we owe our debts to ourselves. Domestic debt does matter, and the size of the debt is the critical parameter.

Third, government actions, even involving sizeable sums of money, are far less helpful than they appear. As the book states, “Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.”

Rather than “reigniting” the economy, government stimulus will have only temporary effects. The underlying debts will remain and they will continue to act as a drag on the economy. The “green shoots” will wither once stimulus runs out, and we will face years of high unemployment, constrained spending, and recessionary economic conditions.

Fourth, Reinhart and Rogoff cover countries in debt crisis with a host of different conditions, such as growth and age of population, political regimes, technology status, education, and other idiosyncratic features. Nevertheless, economic damage as a result of extreme over-leverage has remarkably similar results, whether the barometer of performance is economic output, the labor markets, or asset prices.

It isn’t different this time. Debt crisis ends badly.

Fifth, further increasing leverage to solve the problem only leads to greater systemic risk and general economic underperformance.

Systemic risk is what precipitated this crisis. It is totally self-defeating to try to kick start economic activity by prompting banks to lend and consumers to borrow, because high debt levels brought down the system in the first place. The Federal government is only exacerbating the problem by running up astronomical debts trying to solve the crisis, and placing our financial system at even greater risk. Low interest rates help people finance their debt loads and speculate in the financial markets, but low interest rates will end someday, at a time when the bubble is even larger.

The Deflationary Outcome

There is much widespread debate today as to whether the current crisis will end up in inflation or deflation. In their book, Reinhart and Rogoff presented evidence that major debt crises have deflationary outcomes. In their quarterly commentary, Hoisington and Hunt extrapolated to conclude that interest rates will remain low for an extended period and say: “We are buyers and holders of long term U.S. Treasury debt.”

Comments

This is a sobering conclusion, but we must be cautious when interpreting historical cases. There are still important questions to answer, of which only a few are: Wouldn’t outcomes be different when countries lacked a well developed domestic credit system, such as banks and bond markets? Doesn’t a transition to fractional reserve banking confer enough flexibility to make a difference? What about the introduction of central banks? What about the effects of markets for securitized mortgages, consumer credit, accounts receivable, and credit default risk?

For example, colonial Spain defaulted on its debts numerous times, but that was when Spain depended for financing on marketing its plentiful supply of New World silver rather than a domestic system of commercial credit, as was developing in other parts of west Europe. Germany had budget problems after the Great War but didn’t experience hyperinflation until the victors forced the payment of reparations and limited the country’s options to printing the money.

The overall pattern of crises may appear similar over a long period of history, yet occurrences and outcomes may differ in essential details that matter critically. Details do matter, and we must exercise some caution in our interpretations. I can only advise reading the book, at a minimum. Fortunately, Reinhart and Rogoff go into more detail in This Time is Different than I can do justice to in this space.

As I said earlier, I don’t necessarily agree with all of this, but I also believe that historical precedents should be included in our deliberations when analyzing something as complex as the world financial and economic system.

Between Scylla and Charybdis

2010-01-14T19:09:00.002-05:00

A number of Wall Street investment banks are calling for a positive year in the US stock market, and many others are calling for a good first half of the year, followed by a weak second half, as the Fed cuts back on its easing. As suspect as Wall Street’s pronouncements may be (who would believe Goldman Sachs?), it must be admitted that the Fed’s accommodation is a very friendly environment for the markets, and a tighter stance would likely end the good times.

Although many commentators say that they are expecting a tighter Fed policy this year, when we look more closely, there is a variety of viewpoints about likelihood and timing. Let’s look at three opposed viewpoints : (1) a declining stock market due to Fed exit, which is the prevalent viewpoint, (2) a prolonged market advance because the Fed finds it impossible to exit, and (3) a new financial bubble in commodities (triggering another economic downturn) once it is understood that the Fed cannot exit.

A Fed Exit in 2010

Bill Gross of PIMCO is one of the most vocal and most visible proponents of the view that the Fed will cut back on quantitative easing this year. As described in his January 2010 commentary, Gross summarized his view this way:

If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of “exit strategies,” during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector.

If, in 2009, PIMCO recommended shaking hands with the government, we now ponder “which” government, and caution that the days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries.

… 2010 will likely witness an attempted exit by the Fed at the end of March, and perhaps even the BOE later in the year.

The reason that 2009 was so dominated by the government sector was the extraordinary amount of fiscal and monetary stimulus, including:

… the global innovation known as “quantitative easing,” where central banks and fiscal agents bought Treasuries, Gilts, and Euroland corporate “covered” bonds approaching two trillion dollars … the Fed and the Bank of England (BOE) alone expanded their balance sheets (bought and guaranteed bonds) up to depressionary 1930s levels of nearly 20% of GDP.

The reason he believes that this stimulus must end in 2010 is that:

… the check writing is ultimately inflationary and central bankers don’t like to get saddled with collateral such as 30-year mortgages that reduce their maneuverability and represent potential maturity mismatches if interest rates go up.

Now, however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance.

Despite the Fed’s apparent plans, Gross thinks that the exit from quantitative easing will not be so graceful:

Our fiscal 2009 deficit totaled nearly 12% of GDP and required over $1.5 trillion of new debt to finance it. … foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve. Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds.

Although Gross doesn’t say so explicitly, the implication is that, in the absence of further Fed purchases, the market for Agency mortgages will be, to say the least, weak. Also, given that PIMCO and other funds have already loaded up on Treasuries, the US may face problems selling the new Treasury issuance that will be coming to market in 2010. Higher interest rates on mortgage securities and Treasuries would discourage investors, businesses, and consumers, providing strong headwinds against stock and bond markets and the economy.Putting this all together, Gross is predicting a “double whammy” resulting from (1) heavy debt loads in the “spendthrift” nations and (2) the withdrawal of government support from the financial markets:

Gross doesn’t see the Fed exit strategy as the only problem. Like others, he feels that budget deficits already incurred will be a drag on both the economy and the Treasury securities market for years to come. Interestingly, he quantified the impact:

Various studies by the IMF, the Fed itself, and one in particular by Thomas Laubach, a former Fed economist, suggest that increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases – perhaps as much as 25 basis points per 1% increase in projected deficits five years forward.

Using 2007 as a starting point and 2014 as a near-term destination, the IMF numbers show that the U.S., Japan, and U.K. will experience “structural” deficit increases of 4-5% of GDP over that period of time, whereas Germany will move in the other direction. Germany, in fact, has just passed a constitutional amendment mandating budget balance by 2016.

Putting this all together, Gross sees a "double whammy" of debt loads for many nations plus the end of easy fiscal and monetary policies:

If these trends persist, the simple conclusion is that interest rates will rise on a relative basis in the U.S., U.K., and Japan compared to Germany over the next several years and that the increase could approximate 100 basis points or more.

… the shifting of private investment dollars to more fiscally responsible government bond markets … in 2010 and beyond.

Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009.

I recommend looking at Gross’s commentary for the chart comparing the deficits and debt levels of a number of large economies. It is fascinating that PIMCO is quantifying the impact of the US budget deficit in terms of bond pricing relative to more prudent countries.

Also, it is interesting to compare Gross’s statements to those of another PIMCO executive, Mohammed El Erian. In Fortune’s 2010 investment guide, El Erian expressed great doubts about the US economy’s ability to sustain any kind of recovery this year. That’s hardly the right environment for Fed tightening, but maybe PIMCO thinks that the Fed has run out of ammunition. Credit rating agencies have warned that the US must cut back spending or else risk a downgrade.

No Fed Exit in 2010

The RGE Monitor, Nouriel Roubini’s website recently published an article that argued against any tightening during 2010. The core of their prediction was:

But we expect carry trades to resume in 2010 as policy rates stay at or near zero in the major economies and inflation leads to further EM and commodity-country rate hikes …. We expect the Fed to stay on hold throughout 2010 ...

This is a complete turnabout for Roubini, since not long ago he was writing about the danger that accommodative monetary policies would fuel a continued carry trade on the US dollar and fuel dangerous bubbles in financial markets around the world.

Perhaps Roubini has a point about near zero rates. With unemployment running around 10%, will the Fed dare to tighten ahead of the November midterm elections? With fiscal stimulus running out in the second half of the year, monetary tightening may be out of the question.

In contrast to Roubini, Gross’s prediction is based on Fed and Administration expectations of a self-sustaining economy (do we believe that?) and the supposition that the Fed is being forced to clean up its own balance sheet. Given the extent to which much of the world is dependent on the US economy, it hardly seems likely that anyone would encourage the Fed to tighten when the economy is at best fragile. Thewarnings of Fitch et al. hardly matter compared to the stances taken by the central bankers of the world.

No Fed Exit and a Commodities Bubble

In "Roubini v. Gross on Outlook for 2010", Yves at the Naked Capitalist blog points out that if Roubini is correct and the Fed does not tighten in 2010, the markets will create their own organic problems. The reasoning is that continued accommodation will encourage risk-seeking trades (carry trade in the US dollar) that will push money into “hot” assets. In this view, the most dangerous recipient of these flows is commodities. As we saw during the last oil bubble, rising commodity prices produce a drag on the economy – a drag that 2010’s fragile economy can hardly afford.

Warnings about rising commodity prices are already appearing in the press, such as this recent article this recent article in the Wall Street Journal, and a growing global asset price bubble is depicted on the latest cover of The Economist. There is some justification for these warnings, because the valuation of the US stock market is approaching historical highs on fundamental measures, and a number of emerging stock and real estate markets are looking overheated. As we have seen during the past decade, inflating bubbles can persist for a quite some time before they burst.

Negative feedback from a slowing economy would eventually burst the bubble – but damage would already have been done to both the economy and financial markets.

The Fundamental Problems Remain

I don’t know which, if any, of these views will turn out to be correct, but the Fed is in a dilemma. Despite massive quantitative easing last year, the underlying problems weren’t solved, they were only postponed. We still have heavy public and private debt loads, banks holding impaired financial assets, and unaffordable home prices. Remove the lax monetary and fiscal policies and the financial markets will dry up, credit will tighten, and the economy will suffer. Continue the laxity and money will flow where it can find a return, into bubbles, not into the basic US economy.

Whether the Fed tightens or not in 2010, the financial markets and the economy are still caught between the Scylla of crushing debt and the Charybdis of unbridled speculation.

Merry Christmas

2009-12-24T17:14:00.003-05:00

More Profits, Less Welfare

2009-12-13T22:02:00.002-05:00

Lucienne Bloch, Land of Plenty, woodcut, ca 1935. Lucienne Bloch was in the WPA and worked with muralist Diego Rivera in the 1930s.

While Congress is working on half-measures to reform the US system of health insurance, I ran across these news stories about how our health care and welfare systems are working. We always hear myths about America's systems of health and welfare: You can depend on health insurers to protect your health. Anyone can get the medications that they need. America wouldn't let children go hungry. The reality is anything but.

Aetna Is Forcing 600,000-Plus to Lose Coverage in Effort to Raise Profits

In a third-quarter earnings conference call, officials at Aetna announced that the health insururer is planning to force up to 650,000 clients to drop their coverage next year in order to raise to meet profit expectations. They predicted that the company would lose between 300,000 and 350,000 members next year from its national account as well as another 300,000 from smaller group accounts. Aetna's third quarter earnings were up 26 percent year over year, but if they price more families out of insurance, they can do better.

Unburied Bodies Tell the Tale of Detroit -- A City in Despair

Things are bad in Detroit. The murder rate is soaring. The school system is in receivership. The city treasury is $300 million short. The city cannot reliably provide rubbish collection and other basic services. Thousands of houses are abandoned. Entire shopping districts lie boarded up. Auto manufacturing plants have been abandoned for years.

Can it get worse? It just did. People are dying from their poverty, and not even receiving burials.

In June, the $21,000 annual county budget to bury Detroit’s unclaimed bodies ran out. Many there cannot affort to bury their family members, and the city managed to provide burial in the past. Now that the city is in financial straits, the bodies are piling up in the morgue now.

What has alarmed medical examiners at the mortuary is that most of the dead died of natural causes. It is evidence, they believe, of people who could not afford medical insurance and medicines and whose families can now not afford to bury them.

Many people cannot afford health insurance ... and they are dying because of it. Does anyone doubt that the US needs national health insurance for all the people?

The Safety Net Is Failing Needy Americans

Four organizations -- The Institute for Policy Studies, the Center for Community Change, Jobs With Justice, and Legal Momentum -- have released a study showing how the nation's social welfare system is failing millions of Americans during the Great Recession, just as the need is greatest. Here are highlights from Battered by the Storm: How the Safety Net is Failing Americans and How to Fix It.

Temporary Assistance to Needy Families (TANF) is supposed to be our nation’s last line of defense against falling into the depths of poverty.

Yet this program is so deeply inadequate that by 2008, the number of needy children receiving TANF fell to only 22 percent. Under the pre-“welfare reform” system of Aid to Families with Dependent Children (AFDC) in 1995, 62 percent of poor children were benefiting. Eligibility criteria are set at sub-poverty levels in some states, making poor children ineligible, and barriers such as lack of childcare and lack of access to employment have further kept poor children from receiving desperately needed economic assistance that a system such as TANF should provide.

The food stamp program is doing better, because it has responded to growing need by reaching more households. Sadly, the average monthly benefit per person is only about $100. The report asks: "How can our children be happy, healthy, and adequately nourished on that?"

The reason for this human misery lies in the political trend of the past 30 years that has benefitted the wealthiest Americans while reducing wages and increasing poverty for the rest. With the onset of the Great Recession, we are seeing more poverty and likelihood of reprecussions for years to come.

Henri Matisse, Icarus

Eight Centuries of Financial Crises

2009-12-03T10:06:00.012-05:00

Thomas Hart Benton, The Departure of the Joads, 1940. Oil painting commissioned by 20th Century Fox to advertise their film production of John Steinbeck's novel, The Grapes of Wrath.

As behavioral economists know well, humans suffer from biases that cause them to overweight the present and the recent past in their reasoning. If one's biases have been based on a period of good economic times, it is not surprising that many will be unprepared and suffer greatly during a general crisis. Those wanting to place the present financial crisis in a long-term historical context may wish to read a fascinating, recently-released study from the National Bureau of Economic Research -- This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, by Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University. Quotes of some of the key findings, with my comments:

We find that serial default is a nearly universal phenomenon as countries struggle to transform themselves from emerging markets to advanced economies.

The current crisis is nothing unique, because disruptive financial crises have occurred from time to time over the centuries. Maybe it is prudent to live one's life as if financial and economic disaster is a real possibility (like avoiding massive debts, saving money, etc.).

Major default episodes are typically spaced some years (or decades) apart, creating an illusion that “this time is different” among policymakers and investors.

People have limited memories and tend to treat the recent past as "normal". Those living in good times will hardly be prepared for extreme adverse events, unless they consciously review the historical record.

We also confirm that crises frequently emanate from the financial centers with transmission through interest rate shocks and commodity price collapses.

In other words, the current crisis is highly typical. Problems started in US and spread to the rest of the world. Within the US, the crisis started in the financial centers, including the large mortgage brokers and investment banks, spread into markets for securitized mortgages and credit default swaps, and snowballed into problems for Main Street and the entire nation. A lack of proper regulatory oversight permitted critical financial institutions to operate without consideration to risk management and precipitate a massive crisis.

Our data also documents other crises that often accompany default: including inflation, exchange rate crashes, banking crises, and currency debasements.

Just because US hasn't experienced inflation, exchange rate crashes, or currency debasements yet, we can't ignore these possibilities. Conditions are still in place for the crisis to morph into new phenomena. Debt is being transferred from the financial system to the balance sheet of the Fed. Most private debt (home mortgages, commercial real estate, credit cards, etc.) has hardly been touched yet. There is a distinct risk that more crises could come soon.

The authors looked in particular detail at the years 1800 to 2006, where the data are the most complete:

Aside from the current lull, one fact that jumps out from the figure are the long periods where a high percentage of all countries are in a state of default or restructuring.

Countries are connected financially, now as in the past. We should be on the lookout for further breakdowns as the crisis spreads and strains build on weak points throughout the world. East European countries have built huge debts with West European banks. Will this be the next place to crack?

Serial default on external debt—that is, repeated sovereign default—is the norm throughout every region in the world, even including Asia and Europe.

Soverign default isn't just possible, it is common. Countries like France and Spain have defaulted multiple times in the past. In view of the problems faced by a number of governments around the world (not just the US), we should be prepared for more shocks to come to the financial system.

Our extensive new dataset also confirms the prevailing view among economists that global economic factors, including commodity prices and center country interest rates, play a major role in precipitating sovereign debt crises.

If you have been worrying about these kinds of risks, you weren't off the mark. Despite worries about the long-term sustainability of the US debt, there are many other countries around the world where sovereign risks are greater and more immediate. Whenever central banks raise short-term interest rates in anticipation of economic recovery, there will be countries and corporations that will be unable to withstand the shock.

Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.

Capital mobility is one of the hallmarks of the present era of globalization. However, our world has undergone earlier eras of globalization, accompanied both by capital flows and episodes of financial crises. In fact, the present era's flows of instantaneous information seem pale in their impact, compared to the flow of material goods loosed on the world by industrialization and the age of steam in the nineteenth century. We are not unique, and we would do well to consider the lessons of past crises.

Yet, the government’s gain to unexpected inflation often derives at least as much from capital losses that are inflicted on holders of long-term government bonds.

The US response to the financial crisis seems to have done little but increase the risks of new bubbles. Is anyone worried that the US might try to inflate its way out of its debt problems? Is anyone worried about a bubble in US Treasuries? Of course they are.

Watteau, The Embarcation for Cythera, 1717. Cythera is one of the Ionian islands and in antiquity was site of a shrine to Aphrodite. Watteau is playing on a popular notion viewing Cythera as a fictional place where the power of love eliminated petty conflicts and people could live harmoniously and engage in amorous pursuits. This idea followed the humanist views of the age of reason, whereby human beings were seen as perfectable and capable of achieving greater happiness. In the midst of this dreamy optimism, the lower classes lived desperate lives under the thumb of the aristocracy. In the painting, the elegantly attired rich await their departure for Cythera. After their departure from the dust bowl, the Joads faced desperation, disillusion, and rejection.

Caryatids

2009-11-05T21:30:00.015-05:00

Porch of the Caryatids, the Erectheon, Athens (author's photo)

Architecturally, a caryatid is a female figure acting as a column to hold up a structure. In a more figurative sense, I can't help thinking how much these caryatids on the Acropolis remind me of the American people. Our special burden isn't architectural, of course. It is debt, public and personal.

For some of us the burden is immediate and acute. The fallout of the financial crisis has left many unemployed, buried in debt, and foreclosed or at risk of foreclosure. States and cities are going broke as their tax base has withered. The elderly who lived prudently and saved their money are being punished by a financial system that keeps savings interest rates low, but quickly loans funds to speculators.

As for the rest of America, those not being crushed by debt, most of us are probably not overly worried about debt. But that may be a mistake. Since the start of the 21st century, Federal government debt has been rising due to lax fiscal policy, tax breaks for the rich, subpar economic growth, funding endless wars, and many other reasons, political and economic. Most recently, bailouts of our reckless financial sector ballooned the Federal debt to previously unimaginable levels that should give us all pause for our futures. Meanwhile, a recession has reduced the tax base from which to pay for the ballooning national debt. Even as economic growth shifts overseas, policies to renew economic growth seem lacking.

Now that the national debt is ballooning, and the economic capacity to service the debt is declining, our creditors seem to be growing increasingly worried. If they come to believe that they won't be paid back anything close to 100 cents on the dollar, they may look elsewhere to invest. That dollar could tank, interest rates rise, and the resultant defaults send the economy into a deep depression.

Rodin transformed the architectural convention of the female form supporting weight in the Fallen Caryatid Carrying Her Stone. In her fatigue, the caryatid can no longer support her weight. As she is crushed under the stone, what is going through her head?

Those who have lost jobs, homes, or lifetime savings know what it is like to support a weight too heavy to endure. The rest of us should care, because we are all caryatids now.

Fallen Caryatid Carrying Her Stone, Auguste Rodin, Musee Rodin, Paris

No American Dream without Social Mobility

2009-11-01T08:22:00.014-05:00

The American Dream

Income disparities in America have been growing for years as the very rich got richer and the rest of society stagnated economically. But the American Dream is till alive, isn't it? You can still advance based on your abilities and not your family background, can't you?

It's All Based on Social Mobility

We like to think of America as a land of opportunity, where anyone can succeed no matter how rich or poor he or she starts out in life. Unfortunately, America does not compare well to other advanced countries when it comes to the basic precondition for the American Dream, social mobility. There are many advanced countries where the social rank of a child's family means a lot less than it does in America for that child's educational achievement and chances of future economic advancement.

New Data from the OECD

Now comes a report from the Organization for Economic Cooperation and Development examining social mobility in the advanced economies. Orsetta Causa and Asa Johansson, the authors of Intergenerational Social Mobility, find that there are many advanced countries where the economic conditions of a child's family mean a lot less than they do in America for that child's future educational achievement and economic advancement in life.

What They Found

The influence of parental background on individual earnings varies widely across OECD countries, but low mobility across generations, as measured by a close link between parent’s and children’s earnings, is particularly pronounced in the United Kingdom, Italy, the United States and France. Mobility is higher in the Nordic countries, Australia and Canada.

The influence of parental socio-economic status on students’ achievement in secondary education is particularly strong in the United States, France and Belgium, while it is weaker in some Nordic countries, as well as Korea and Canada.

Inequalities in secondary cognitive skills are likely to translate into inequalities in post-secondary educational achievement and subsequent wage inequality in the labour market.

The Role of Social Policy

According to the report, any measure that reduces inequality will make it easier for individuals to break free of the constraints of their backgrounds. More progressive income taxation and higher short-term unemployment benefits were found to be helpful. Both were associated with a looser link between parental background and outcomes for children's cognitive skills and wages. If children are to succeed based on their own merits, they need equal access to the means of self-help.

Good for Economic Growth

Not only is social mobility fair, but it can be good for all of society. The report points out "the ability of an economy to continuously allocate human resources to their best use can have important effects on economic performance". The better the opportunity to succeed on your own merits, the better your skills will be employed in the economy. By understanding how economic growth and equal opportunity are mutually supporting, we can design policies to encourage both.

Worrying Trends in Income Inequality

With the gap between rich and poor growing so rapidly, it is no surprise ifthe American Dream is fading. A 2008 OECD report found that this trend is persistent and getting worse rapidly. (See Growing Unequal? Income Distribution and Poverty in OECD Countries, Country Note: United States.) The trend goes back to the 1970s, but since 2000, income inequality has increased rapidly.

Rich households in America have been leaving both middle and poorer income groups behind. This has happened in many countries, but nowhere has this trend been so stark as in the United States.

The distribution of earnings widened by 20% since the mid-1980s which is more than in most other OECD countries. This is the main reason for widening inequality in America.

As a result, the United States is the country with the highest inequality level and poverty rate in the OECD, with the exception of Mexico and Turkey. Just consider the data: "The average income of the richest 10% is US$93,000 US$ in purchasing power parities, the highest level in the OECD. However, the poorest 10% of the US citizens have an income of US$5,800 US$ per year – about 20% lower than the average for OECD countries."

We Need to Overhaul Social and Economic Policy

No one wants his or her children at a disadvantage in life merely because they lack the advantages available to the rich. However, as the 2008 OECD report notes: "Redistribution of income by government plays a relatively minor role in the United States." Unless we design policies to increase social mobility, we will continue to underuse our society's human resources and suffer sub-par growth. Meanwhile, other nations are growing quickly, and their people are reaping the benefits.

We aren't a third world country -- not yet -- but we can do better. After all, we still see outselves as a world leader, and maybe we can act like a leader. Social stratification is growing in America, and we must act to reverse the trend if we are to preserve the American Dream.

Bush Exploited the Common People to Make the Rich Richer

2009-10-31T16:03:00.011-04:00

As the Global Sociology blog notes, "stratification happens when the tax regime favors the transfer of wealth to the top". After years of growing income disparity between the rich and the rest of America, surely the federal government wouldn't exacerbate the problem would it? Well if it was the Bush administration, the answer is "yes".

The tax cuts sponsored by President George W. Bush lapse at the end of next year. Those cuts will have saved individuals, and cost the government, $2.34 trillion, according to The New York Times. Unfortunately, not every individual benefitted equally.

As the table above shows, a full 61.6% of the Bush tax cuts went to the top 20% of wage earners! Only 1.3% went to the bottom 20% of wage earners, and only 7.6% went to the next 20%. If you were in the middle quintile of US wage earners, you received about 11.8%, or about half of your "fair share".

This was income redistribution at its worst. The rich were in power, and their greed knew no limits. No wonder so many Americans have felt for years that their country is in danger of becoming another banana republic, because under Bush it sure looked like this country was dominated by an oligarchy of inherited wealth.

No, the right wing cannot justify the cuts as economic stimulus. Economic progress was stalled for years under Bush, and the majority of Americans are worse off than they were at the start of the decade. As the facts show, the tax cuts were nothing more than a scheme to transfer wealth to the rich, pure and simple.

Not only were benefits distributed unfairly through society, but reduced taxes mean reduced Federal tax revenues. You and I and everyone else in American with an income (if they are lucky enough to have one) is still paying off that deficit with our taxes now.

Fortunately, Bush's unfair tax cuts are lapsing now, but more will be needed to reverse the trend toward greater social stratification in America. Let's hope that America can get back on the path to social justice and economic growth for everybody.

Investing in America's Future

2009-10-30T21:29:00.022-04:00

The Problem is Waste

A frequent theme on this site is that today's financial crisis lie is the direct result of a longstanding misallocation of resources into unproductive ends. Current consumption, larger houses, etc. were preferred to savings and investment in the future, even if families and governments buried themselves in debt.

What the President Said

In "American Blew It, Will Obama?", we quoted the President's realistic State of the Union Speech about the incredibly short-sighted policies that led us into this mess:

In other words, we have lived through an era where too often, short-term gains were prized over long-term prosperity; where we failed to look beyond the next payment, the next quarter, or the next election.

Despite years of waste, maybe we could have muddled through if it hadn't been for the kleptocratic policies promoted by the preceding administration. As the President said:

A surplus became an excuse to transfer wealth to the wealthy instead of an opportunity to invest in our future. Regulations were gutted for the sake of a quick profit at the expense of a healthy market. People bought homes they knew they couldn’t afford from banks and lenders who pushed those bad loans anyway.

What We Said

Not only did these policies weaken the American middle class, but the diversion of precious resources away from more fundamental investments left the nation less competitive economically. As we pointed out in "Mis-Allocated Resources":

One of the issues brought to the fore by the present financial crisis is the extent to which America's productive capacity has been hollowed out. . . . Houses, shopping malls, internet concept stocks -- all were bubbles that wasted billions of dollars that could have funded productive, forward-looking activities.

In other words, we borrowed against our futures through leveraged speculation rather than investing in basics like R&D, training the workforce, etc.

New Support from the Financial Mainline

It seems that the mainline financial community is coming to agree with this point of view. In his latest monthly commentary, "Midnight Candles", PIMCO's Bill Gross cited some statistics compiled by his organization:

The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades.

Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services.

A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually.

We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds.

Putting a compounding computer to this 1.3% annual outperformance for 50 years, produces a double, and leads to the conclusion that the return from all assets was 100% (or 15 trillion – one year’s GDP) higher than what it theoretically should have been.

In other words, by leveraging up in stocks and other paper assets, we deleveraged our GDP, and by a huge amount.

The Only Solution

To repair America's decline, we must get at the root cause -- misdirection of resources. We can't continue to emphasize the financial sector of the economy. We must invest in the things that will make us productive, which are human potential, intellectual property, and productive capacity. This is the only path to a future that will benefit all the American people.

The Barbarous Relic -- "I Just Buy It"

2009-08-18T20:50:00.014-04:00

John Maynard Keynes, whose ideas have such an important place in modern macroeconomics, referred to gold as a "barbarous relic" in his 1924 work Monetary Reform and in a 1944 speech to the House of Lords. With the decline of the gold standard for currencies, one might think that gold is little more than a "barbarous relic", having little interest to any but jewelers, electronics fabricators, and commodity futures traders.

Yet with the decline of the gold standard for currencies, the modern world faces a situation in which central banks can create their fiat currencies at will. In the wake of the financial crisis, they have been doing a lot of that lately. If new dollars, euros, etc. are not consumed in acts of deleveraging, as they have been to some extent so far, currency holders (like you and I) may start to become concerned that their dollars, euros, etc. will become worth less relative to real things that are less easy to create. In other words, they may worry that the necessary inputs to their lives and their industries -- energy, food, metals -- will become more expensive in monetary terms.

Perhaps this is why gold the "barbarous relic" attracts interest today and often seems to trade on the basis of perceived risk rather than on the basic supply and demand, or interest rates that determine carring costs for future delivery. But given such a tenous perception as risk, would anyone want to hold gold as a significant portion of his portfolio for very long? When perceived risk is such a personal matter, what complicated strategy would one need for deciding when to buy and when to sell? For most of us, gold seems too risky itself to hold with confidence.

If we look at Commodity Online, we see that famed investor Jim Rogers said of gold "If it goes down I'll buy some more, and if it goes up I'll buy some more. I periodically buy some gold. I don't have a method to it. I just buy it."

If one thinks that recent price ranges for gold are far below future prices, then he does not need a complicated strategy for buying and selling: "If it goes down I'll buy some more, and if it goes up I'll buy some more."

So, there you have a strategy for accumulating and holding gold as a hedge for the loss of value of the currencies and other financial assets created by mere humans. The strategy is insensitive to fluctuations in price: "I periodically buy some gold. I don't have a method to it."

The deflationary forces of a deep recession give little indication of future inflation, especially as so many people are saving their dollars and buying US Treasury securities for safety now. Indeed, Treasury prices seem insensitive to the impending flood of issuance. That is the present, however. If you think that the world's reserve currency, the US dollar, will be worth much less in the future, you might want to consider other assets, such as gold, and a trading strategy. Gold -- "I just buy it".

Health Care in the US -- Inefficient and Discriminatory

2009-08-17T21:28:00.016-04:00

No Public Option. President Obama has apparently taken the "public option" for US health care off the table -- in other words, whatever health care reform the Obama administration is able to engineer, it won't be a public program providing universal care with the Federal government as single payer.

Who Wins, Who Loses. The big health care business special corporate interests must be greatly relieved. With the help of their right-wing ideologues, they have finally paid off enough members of Congress to get their way. The American people are the real losers, because the system will not get the fundamental reform that it requires.

Why We Need Health Reform. If you need more evidence that the US health system is in need of fundamental reform, just consider the above chart from the World Health Organization, comparing the health of citizens of the US, UK, France, and Singapore. It shows how poorly the US health system performs relatively to other advanced nations.

The systems compared by WHO. The health systems in the UK and France are publicly funded, universal, and government run. The US system is half public and half private, where no one is guaranteed health coverage. The Singapore system is another part-public, part-private hybrid system, where the government provides most care for those who are least economically advantaged, and costs are variously shared between the government and the rest of the population.

Effectiveness. The US has the lowest life expectancy of the countries compared. This is no surprise, because there is little promotion of disease prevention, little outreach to those who are in chronic need, and little attention to promoting healthy life styles and good health practices. It is easy to conclude that, given the rich resources available, the US system is not effective at promoting and delivering good health.

Efficiency. Of the countries compared, the US expends the highest percentage of its GDP on health care. It is easy to see that the US system is highly inefficient at delivering health.

Equity. In the US, only 10% of non-Hispanic whites are without health insurance. 16.8% of Asians, 19.5% of blacks, and 32.1% of Hispanics are without health insurance. If the statistics divide so strongly along ethnic lines, it is clear that the US system is highly unequal.

Why the Right Opposes Health Reform. Health reform isn't welfare for the rich, that's why. Billions for Wall Street? No problem. Never mind that government programs are paid for by the people's taxes and are supposed to be for the public good. Billions for the public good? If it really helps the people, it's "socialism". Socialism for the rich is ok here.

Why Public Options Are Vilified. Ever notice how Americans say that they encourage entrepreneurial risk taking, but they only consider the upside of the risk? Rich entrepreneurs are wonderful, but if you take a risk and fail, obviously you didn't try hard enough. In fact, you are so lazy and stupid that you no longer deserve the right to life and liberty. No health care for you. Not that it's their fault, but neither do your kids. It is convenient to have people to blame.

Why Vested Interests Call It "Socialism". Powerful vested interests are trying to use twisted rhetoric to set the terms of the health care debate, and right-wing ideologues are happy to play along. It is very convenient for the powerful to taint public health systems as doctrinally "socialist", because they think that they can divert the American people from discussing the real issues at stake. If no one compares the economic and health benefits of alternative systems of organization, they won't notice how inefficient and unequal our current US system is. There really are alternatives to our inefficient, unequal system.

Why We Need a Public System. The only way to reduce health-care costs is to to provide health care consumers with the power to negotiate costs with their doctors, hospitals, drug companies, and others who provide the goods and services. This means a system of sufficient scale and create an authority that will enable private insurers to negotiate effectively ... or else let the Federal government do the negotiating itself. And the only way to promote freedom, equality, and opportunity in the US with an affordable system is to have a public health care system that provides care for all of us.

No Exit

2009-07-24T19:42:00.026-04:00

Not the financial Terminators, we hope

Mr Bernanke's Testimony. In Congressional testimony last week, Federal Reserve Chairman Ben Bernanke tried to put to rest the widespread concerns that the Fed has no "exit strategy" from the unprecedented degree of monetary easing and fiscal stimulus currently underway. Many commentators seem greatly relieved by the Chairman's testimony, which identified many of the monetary tightening mechanisms in the Fed's arsenal. Others were not impressed.

The Fed's Tightening Mechanisms. The Fed's inventory of assets includes short-term Treasury bills, which it can sell in order to soak up excess any excess liquidity in the hands of the public and thereby reduce inflationary pressures. The Fed can also encourage banks to hold excess funds (and not loan them to the public) by raising the interest rate that it offers member banks on overnight deposits. These kinds of tightening mechanisms are well known, and it is remarkable that so many observers seemed to be reassured by the Chairman's testimony.

Near-Term Deflationary Pressures. It is true that there is little apparent risk of inflation in the US in the near term. Deflationary forces are likely to persist for some months, or longer, for many reasons. Levels of debt are very high and money entering the financial system is being used for deleveraging and not for real economic activity. Overseas holders of US Treasuries are interested in supporting their own economies by keeping their currencies low relative to the dollar, so as to encourage exports. Debtors are defaulting in increasing numbers, and levels of economic activity are still declining.

Disciples of Bush asleep at the switch again!

Long-Term Debt Problems. Despite the near-term comfort, there are very real long-term risks. The off-balance sheet obligations of Medicare, Medicaid, Social Security, and other programs are huge and growing. The US shows little political will to prevent the train wreck that will occur when runaway promises threaten to turn into a runaway debt load.

Debt Reduction Problems. To make things worse, the economy may stay weak for years, making it even harder to pay for the financial bailouts, let alone pay for expensive social programs. What if the economy is still weak when the interest load starts to become unbearable for the US? Would the Fed defend the dollar by soaking up excess liquidity and risk sending the US into another depression? A depression is hardly the time to raise interest rates.

The Financial Terminator? California's current budget problems may be a forwarning of things to come for the US as a whole. There are clear imbalances in the state's long-term obligations and its ability to fund them. However, the state's supposed budget "solution" fails to cut costs or raise taxes enough to solve the long-term imbalances already built into the system.

The similarities to the growing budget burdens of the US are worrying for the US dollar. Like an army of financial Terminators, creditors do not treat spendthrift debtors kindly.