The Fabled Greek Mega-Bailout

May 16, 2012

Aziz Economic History, Economics, Fixed Income, Inflation, International Relations, Musings, Philosophy, Politics , , , , , , , , , , , , , , 42 Comments

In a truly eyebrow-raising CNBC interview, Matthew Lynn alleges that Europe shall be saved! (As if by the grace of God!).

With Europe on the brink yet again Germany will act.

The Greeks can’t carry on with the austerity being imposed on them. No country can be expected to endure annualized falls in GDP  of 7 percent or more,” he said, “and 50 percent youth unemployment for years on end.

On Tuesday we learned that the Greek economy shrank by another 6.2 percent in the latest quarter. It simply isn’t acceptable” Lynn said.

But Germany and the rest of the EU could come up with a Marshall Aid-style package for Greece. Very little of the bail-out money so far has gone to the Greeks. It has all gone to the bankers.

Forget talk of a ‘Grexit’. There will be a mega-bail-out—a ‘Grashall Plan’—instead.

And when it happens, the markets will rally on the news.

Who else would publish this? (That’s a redundant question — who else, besides J.P. Morgan and maybe a few government agencies, wouldn’t have fired Jim Cramer after what he said about Bear Stearns?)

At various stages in the last two years everyone from China, to Germany, to the Fed to the IMF, to Martians, to the Imperial Death Star has been fingered as the latest saviour of the status quo. And so far — in spite of a few multi-billion-dollar half-hearted efforts like the €440 billion EFSF —  nobody has really shown up.

Perhaps that’s because nobody thus far fancies funnelling the money down a black hole. After Greece comes Portugal, and Spain and Ireland and Italy, all of whom together have on the face of things at least €780 billion outstanding (which of course has been securitised and hypothecated up throughout the European financial system into a far larger amount of shadow liabilities, for a critical figure of at least €3 trillion) and no real viable route (other than perhaps fire sales of state property? Sell the Parthenon to Goldman Sachs?) to paying this back (austerity has just led to falling tax revenues, meaning even more money has had to be borrowed), not to mention the trillions owed by the now-jobless citizens of these countries, which is now also imperilled. What’s the incentive in throwing more time, effort, energy and resources into a solution that will likely ultimately prove as futile as the EFSF?

The trouble is that this is playing chicken with an eighteen-wheeler. While Draghi might be making noises about “continuing to comply with the mandate of keeping price stability over the medium term in line with treaty provisions and preserving the integrity of our balance sheet” (in other words, not proceeding with the fabled “mega-bailout” even if it fractures the Euro),  we may well see a full-blown financial meltdown (and of course, the ramifications of that on anyone who is exposed to the European banking system) unless someone — whether it is the ECB, or the Fed, or the IMF — prints the money to keep the banks going.

There are really two layers to bailing out the insolvent nations: the real bailout is of the banks who bought the debt, and the insolvent nations are just an intermediary. Should the insolvent nations become highly uncooperative, it seems more likely that the insolvent nations will just be cut out of the loop (throwing their citizens into experiencing a forced currency redenomination, bank runs, and even more chaos) while policymakers continue to channel money into “stabilising” the totally broken global financial system — because we know for sure that a big disorderly default will likely cause some kind of default cascade, and that is something I am sure that (based on past form) policymakers will seek to avoid.

How close to the collapse we will come before the money gets printed is another matter.

Given that it is predominantly Germans who are in charge of Europe for the moment — with their unusual (at least in the West) post-Weimar distaste for Keynesianism —  it seems to me like we will see quite a lot of chaos (read: Euro exits) before the money printing begins in earnest. And the money printing may be far more ad hoc and decentralised than 2008 (read: The Fed may be on the hook for American exposure). Just as we have seen so far, the money will come at the last minute, and will just keep things ticking over rather than actually solving anything.

And ultimately, I think it is the social conditions — particularly unemployment levels — that matter more than whether or not the financial system survives. If the attendant cost of ad hoc bailouts (in the name of pretending to stick to the ECB mandate) is a continued depression, and continued massive unemployment and youth unemployment then politicians are focusing on the wrong thing.

The problem is that as conditions continue to fester and as solutions seem distant and improbable that Europe’s problems may become increasingly political. As the established (dis)order in Europe continues to leave huge swathes of people jobless and angry, their rage and discomfort will be channelled toward dislodging the establishment. As we have seen in Greece and France, that has already produced big lifts for both the Far Left and Far Right.

We already know, I think, that in Greece’s upcoming election the outsider parties will crush the establishment, with SYRIZA most likely emerging on top. A key metric for me in the next few weeks will be Golden Dawn‘s proportion of the vote.

Let’s not forget history:

Double or Nothing: How Wall Street is Destroying Itself

May 12, 2012

Aziz Economic History, Economics, Finance, Fixed Income, Inflation, Philosophy , , , , , , , , , , , , , , , 30 Comments

There’s nothing controversial about the claim— reported on by Slate, Bloomberg and Harvard Magazine — that in the last 20 years Wall Street has moved away from an investment-led model, to a gambling-led model.

This was exemplified by the failure of LTCM which blew up unsuccessfully making huge interest rate bets for tiny profits, or “picking up nickels in front of a streamroller”, and by Jon Corzine’s MF Global doing practically the same thing with European debt (while at the same time stealing from clients).

As Nassim Taleb described in The Black Swan this strategy — betting large amounts for small frequent profits — is extremely fragile because eventually (and probably sooner in the real world than in a model) losses will happen (and, of course, if you are betting big, losses will be big). If you are running your business on the basis of leverage, this is especially dangerous, because facing a margin call or a downgrade you may be left in a fire sale to raise collateral.

This fragile business model is in fact descended from the Martingale roulette betting system. Martingale is the perfect example of the failure of theory, because in theory, Martingale is a system of guaranteed profit, which I think is probably what makes these kinds of practices so attractive to the arbitrageurs of Wall Street (and of course Wall Street often selects for this by recruiting and promoting the most wild-eyed and risk-hungry). Martingale works by betting, and then doubling your bet until you win. This — in theory, and given enough capital — delivers a profit of your initial stake every time. Historically, the problem has been that bettors run out of capital eventually, simply because they don’t have an infinite stock (of course, thanks to Ben Bernanke, that is no longer a problem). The key feature of this system— and the attribute which many institutions have copied — is that it delivers frequent small-to-moderate profits, and occasional huge losses (when the bettor runs out of money).

The key difference between modern business models, and the traditional roulette betting system is that today the focus is on betting multiple times on a single outcome. By this method (and given enough capital) it is in theory possible to win whichever way an event goes. If things are going your way, it is possible to insure your position by betting against your initial bet, and so produce a position that profits no matter what the eventual outcome. If things are not going your way, it is possible to throw larger and larger chunks of capital into a position or counter-position again and again and again —mirroring the Martingale strategy — to try to compensate for earlier bets that have gone awry (this, of course, is so often the downfall of rogue traders like Nick Leeson and Kweku Adoboli).

This brings up a key issue: there is a second problem with the Martingale strategy in the real world beyond the obvious problem of running out of capital. You can have all the capital in the world (and thanks to the Fed, the TBTF banks now have a printing-press backstop) but if you do not have a counter-party to take your bets  (and as your bets and counter-bets get bigger and bigger it by definition becomes harder and harder to find suitable counter-parties) then you are Corzined, and you will be left sitting on top of a very large load of pain (sound familiar, Bruno Iksil?)

The obvious real world example takes us back to the casino table — if you are trying to execute a Martingale strategy starting at $100, and have lost 10 times in a row, your 11th bet would have to be for $204,800 to win back your initial stake of $100. That might well exceed the casino table limits — in other words you have lost your counter-party, and are left facing a loss far huger than any expected gains.

Similarly (as Jamie Dimon and Bruno Iksil have now learned to their discredit) if you have built up a whale-sized market-dominating gross position of bets and counter-bets on the CDX IG9 index (or any such market) which turns heavily negative, it is exceedingly difficult to find a counter-party to continue increasing your bets against, and your Martingale game will probably be over, and you will be forced to face up to the (now exceedingly huge) loss. (And this recklessness is what Dimon refers to as “hedging portfolio risk“?)

The really sickening thing is that I know that these kinds of activities are going on far more than is widely recognised; every time a Wall Street bank announces a perfect trading quarter it sets off an alarm bell ringing in my head, because it means that the arbitrageurs are chasing losses and picking up nickels in front of streamrollers again, and emboldened by confidence will eventually will get crushed under the wheel, and our hyper-connected hyper-leveraged system will be thrown into shock once again by downgrades, margin calls and fire sales.

The obvious conclusion is that if the loss-chasing Martingale traders cannot resist blowing up even with the zero-interest rate policy and an unfettered fiat liquidity backstop, then perhaps this system is fundamentally weak. Alas, no. I think that the conclusion that the clueless schmucks at the Fed have reached is that poor Wall Street needs not only a lender-of-last-resort, but a counter-party-of-last-resort. If you broke your trading book doubling or quadrupling down on horseshit and are sitting on top of a colossal mark-to-market loss, why not have the Fed step in and take it off your hands at a price floor in exchange for newly “printed” digital currency? That’s what the 2008 bailouts did.

Only one problem: eventually, this approach will destroy the currency. Would you want your wealth stored in dollars that Bernanke can just duplicate and pony up to the latest TBTF Martingale catastrophe artist? I thought not: that’s one reason why Eurasian creditor nations are all quickly and purposefully going about ditching the dollar for bilateral trade.

The bottom line for Wall Street is that either the bailouts will stop and anyone practising this crazy behaviour will end up bust — ending the moral hazard of adrenaline junkie coke-and-hookers traders and 21-year-old PhD-wielding quants playing the Martingale game risk free thanks to the Fed — or the Fed will destroy the currency. I don’t know how long that will take, but the fact that the dollar is effectively no longer the global reserve currency says everything I need to know about where we are going.

The bigger point here is whatever happened to banking as banking, instead of banking as a game of roulette? You know, where investment banks make the majority of their profits and spend the majority of their efforts lending to people who need the money to create products and make ideas reality?

Does Jamie Dimon Even Know What Hedging Risk Is?

May 11, 2012

Aziz Finance, Fixed Income, Wall Street , , , , , , , , 44 Comments

From Bloomberg:

J.P Morgan Chief Executive Officer Jamie Dimon said the firm suffered a $2 billion trading loss after an “egregious” failure in a unit managing risks, jeopardizing Wall Street banks’ efforts to loosen a federal ban on bets with their own money.

The firm’s chief investment office, run by Ina Drew, 55, took flawed positions on synthetic credit securities that remain volatile and may cost an additional $1 billion this quarter or next, Dimon told analysts yesterday. Losses mounted as JPMorgan tried to mitigate transactions designed to hedge credit exposure.

Having listened to the conference call (I was roaring with laughter), Jamie Dimon sounded very defensive especially about one detail: that the CIO’s activities were solely in risk management, and that its bets were designed to hedge risk. Now, we all know very well that banks have been capable of turning “risk management” into a hugely risky business — that was the whole problem with the mid-00s securitisation bubble, which made a sport out of packaging up bad debt and spreading it around balance sheets via shadow banking intermediation, thus turning a small localised risk (of mortgage default) into a huge systemic risk (of a default cascade).

But wait a minute? If you’re hedging risk then the bets you make will be cancelled against your existing balance sheet. In other words, if your hedges turn out to be worthless then your initial portfolio should have gained, and if your initial portfolio falls, then your hedges will activate, limiting your losses. A hedge is only a hedge if it covers your position. That is how hedging risk works. If the loss on your hedge is not being cancelled-out by gains in your initial portfolio then by definition you are not hedging risk. You are speculating.

Dimon then stuck his foot in his mouth even more by claiming that the CIO was “managing fat tails.” But you don’t manage fat tails by making bets with tails so fat that a change in momentum produces a $2 billion loss. You manage tail risk by making lots and lots of small cheap high-payoff bets, which appears to be precisely the opposite of what the CIO and Bruno Iksil was doing:

The larger point, though, is I think we all know damn well what Jamie Dimon and Bruno Iksil were doing — as Zero Hedge explained last month, they were using the CIO’s risk management business as a cover to reopen the firm’s proprietary trading activities in contravention of the current ban.

Personally, I have no idea why the authorities insist on this rule — if J.P. Morgan want to persist with a hyper-fragile prop trading strategy that rather than hedging against tail risk actually magnifies risk, then there should be nothing to stop them from losing their money. After all, these goons would quickly learn to stop acting so incompetent without a government safety net there to coddle them.

The fact that Dimon is trying to cover the tracks and mislead regulators is egregious, but that’s what we have come to expect from this den of vipers and thieves.

The Treasury Bubble in One Graph

May 7, 2012

Aziz Economics, Fixed Income, Musings, Wall Street , , , , , , , , , , 43 Comments

What are the classic signs of an asset bubble? People piling into an asset class to such an extent that it becomes unprofitable to do so.

Treasury bonds are so overbought that they are now producing negative real yields (yield minus inflation):


That’s right, after taking into account inflation, many investors in treasuries are standing over a drain and pouring their money down it. 

And so America’s creditors are now getting slapped quite heavily in the mouth by the Fed’s easy money inflationist policies.

I propose (much, I am sure, to the consternation of the monetarist-Keynesian “print money and watch your problems evaporate” establishment) that this is a very, very, very dangerous position. And I propose that those economists who are calling for even greater inflation are playing with dynamite.

See, while the establishment seems to largely believe that the negative return on treasuries will juice up the American economy — in other words that “hoarders” will stop hoarding and start spending — I believe that negative side-effects from these policies may cause severe harm.

There is the danger of a bursting treasury bubble. What would happen if America’s creditors decide they want to liquidate their positions? After all, they’re getting slapped in the mouth , and the Fed is promising to continue with the zero interest rate policy until at least 2014.

And we know for sure that even before real rates on treasuries turned negative that China were selling:

The Fed has been picking up the slack, and will have to continue to do so for the forseeable future (the private domestic and international markets have no reason to increase purchases assets of with a negative real rate of return).

This means that to keep the Treasury’s interest payments low, the Fed will have to start printing more money, which brings us to the second danger: the danger of runaway inflation.

Bernanke might well believe he can do this without triggering runaway inflation. He might point to his track record of tripling the monetary base without triggering hyperinflation.

But inflation has stayed (relatively) low for one reason: the money he printed isn’t circulating. The primary dealer banks are holding the money as excess reserves. Can this last?

I doubt it. As I noted last month:

So, does the accumulation of excess reserves lead to inflation?

Only so much as the frequentation of brothels leads to chlamydia and syphilis.

Excess reserves are only non-inflationary so long as the banks — the people holding the reserves — play along with the Fed-Treasury game of monetising debt and trying to hide the inflation . The banks don’t have to lend these reserves out, just as having sex with hookers doesn’t have to lead to an infection.

But eventually — so long as you do it enough — the condom will break.

This trend of amassing excess reserves (done, lest we forget, as a stability measure to protect primary dealers against another shadow banking collapse) is closer to going to sleep upon a bed of dynamite. 

But inflation is only the most obvious risk.

The greatest danger is illustrated here:

America — for most of last century exporter and creditor to the world now runs the biggest trade deficits the world has ever seen.

Let’s not forget that these creditors that U.S. monetary policy is now slapping in the face produce most of our consumption, much of our military hardware, and most of our oil. 

Of course, many neocons seem to believe that this position is sustainable; that America can slap her creditors in the face all she likes because she has thermonuclear weapons and can tell the rest of the world to go and bite the big one.

Not so fast.

As VeteransToday noted in December:

“Surprise, Surprise, Surprise”,  to quote Gomer Pyle. The secret spy mission to create photographic proof of Iranian nuclear intentions has gone horribly wrong.

China is the country of origin for many, many of the semiconductors used by the US Military. It was most likely that China provided the hardware with the secret backdoor that allowed the Iranians to seize control of the Stealth drone while the drone was on a secret CIA mission over Iran.

Working together, they captured a state of the art US Military stealth aircraft.

What this means to all US Military personnel serving anywhere in the world? It means that control of any electronics system in any type of platform, can be seized and used against the military that launched it.

I don’t doubt America still has great technological and infrastructural advantages over her Eurasian creditor rivals. But do we really want to test the limits of our power? Do we really want to try and provoke a trade war with China and the other Eurasian nations (who of course are testing the petrodollar reserve to its limits by creating their own reserve currency agreements) by obliterating the value of their dollar-denominated assets?

So now we know, beyond a shadow of doubt that U.S. Treasuries are in a historic bubble.

We know that to some degree the Federal Reserve and Ben Bernanke are guilty of stoking up this program by buying U.S. Treasuries (artificial demand) and thus constricting supply. We know that this is screwing America’s creditors who happen to produce a lot of America’s consumption, components, military hardware, energy and resources. We know that these nations are using increasingly violent rhetoric regarding their relationship with the United States (Putin for instance described America as a parasite), and are activating agreements to ditch the dollar as the reserve currency.

Do we really want to continue in this vein? Do we really want to continue screwing our creditors by forcing them to accept negative real rates on their investments? Do we really want to risk the inflationary impact of continuing to print money to monetise debt (and hiding the money in excess reserves, thereby temporarily hiding the inflation). Do we really want to find out if all those Chinese semiconductors in our military hardware have backdoors that allow America’s enemies to shut down American military hardware?

I’d call that playing dice with the devil.

Paul vs Paul: Round #2

May 4, 2012

Aziz Current Affairs, Economic History, Economics, Federal Reserve, Fixed Income, Inflation, Philosophy, Politics, Wall Street , , , , , , , , , , , , , , , , 19 Comments

Bloomberg viewers estimate that Ron Paul was the winner of the clash of the Pauls. But that is very much beside the point. This wasn’t really a debate. Other than the fascinating moment where Krugman denied defending the economic policies of Diocletian, very little new was said, and the two combatants mainly talked past each other.

The real debate happened early last decade.

To wit:

Readers are free to make up their own minds who won that one.

And so, round two. Krugman wants more inflation; Paul is scared of the prospect. From Paul’s FT editorial yesterday:

Control of the world’s economy has been placed in the hands of a banking cartel, which holds great danger for all of us. True prosperity requires sound money, increased productivity, and increased savings and investment. The world is awash in US dollars, and a currency crisis involving the world’s reserve currency would be an unprecedented catastrophe. No amount of monetary expansion can solve our current financial problems, but it can make those problems much worse.

Or, as Professor Krugman sees it:

Would a rise in inflation to 3 percent or even 4 percent be a terrible thing? On the contrary, it would almost surely help the economy.

How so? For one thing, large parts of the private sector continue to be crippled by the overhang of debt accumulated during the bubble years; this debt burden is arguably the main thing holding private spending back and perpetuating the slump. Modest inflation would, however, reduce that overhang — by eroding the real value of that debt — and help promote the private-sector recovery we need. Meanwhile, other parts of the private sector (like much of corporate America) are sitting on large hoards of cash; the prospect of moderate inflation would make letting the cash just sit there less attractive, acting as a spur to investment — again, helping to promote overall recover.

Ron Paul believes that inflationary interventions into the dollar economy will have unpredictable and dangerous ramifications. Paul Krugman believes that a little more inflation (although he forgets that by the old measure of CPI inflation is already running at 9%, far higher than his supposed target) will spur economic activity and decrease residual debt overhang. Krugman seems to give no credence to the prospect of inflation spiralling out of hand, or of such policies triggering other deleterious side-effects, like a currency crisis.

The prospect of a currency crisis is a topic I have covered in depth lately: as more Eurasian nations ditch the dollar as reserve currency, more dollars (there are $5 trillion floating around Asia, in comparison to a domestic monetary base of just $1.8 trillion — the dollar is an absurdly internationalised currency) will be making their way back into the domestic American economy, and that this may have a steep inflationary impact. Additionally, many of the deflationary pressures that existed in 2008 or 2009 (e.g. shadow bank deleveraging) aren’t there anymore.

I don’t really know how much of this is to do with the Fed’s inflationary policies, and how much is to do with the United States’ role as global hegemon coming to an end. I tend to think that the dollar hegemony has always been backed by American military force, and with the American military overstretched and its funding increasingly debt-fuelled, the dollar’s role is naturally threatened. If America can’t play the global policeman for global trade, why would the dollar be the currency on global trade?

However it must be noted that America’s creditors do believe that their assets are threatened by the Fed’s inflationism.

As the Telegraph noted last year:

There has been a hostile reaction by China, Brazil and Germany, among others, to the Federal Reserve’s decision to resume quantitative easing.

Or as a Xinhua editorial put it:

China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets.

Probably, the egg of American imperial decline came before the chicken of the recent inflationism, but that inflationism certainly has the capacity to worsen the problems rather than lessen them. After all, if America’s consumption-based economy is dependent on China’s continued exportation, and Krugman is advocating slamming creditors (i.e. China) by inflating away their debt-denominated financial assets, then surely Krugman’s suggestions imperil the already-fragile trans-Pacific consumer-producer relationship?

And this is a crucial matter — there is nothing, I think, more crucial than the free availability of goods and resources through the trade infrastructure, which is something that Krugman’s policies seem to endanger.

As commenter Thomas P. Seager noted yesterday:

[The situation today] is directly analogous to the first Oil Shock in 1973. In the decades prior, the US had been a major oil producer. However, efficiency gains and discoveries overseas resulting in an incrementally increasing dependence of foreign petroleum. Price signals failed to materialize that would caution policy makers and industrialists of the risks.

Then, the disruption of oil supplies from the Middle East caused tremendous economic dislocations.

Manufacturing is undergoing the same process. The supply chain disruption from the Japanese earthquake and Tsunami was merely a warning shot. Imagine if S Korean manufacturing were taken off-line for any length of time (a plausible scenario). The disruption to US industry would be catastrophic.

In the name of increased efficiency, we have introduced brittleness.

Time will tell which Paul is right. But I know where I stand.

The Truth About Excess Reserves

April 21, 2012

Aziz Current Affairs, Economic History, Economics, Federal Reserve, Fixed Income, Inflation, Politics, War , , , , , , , , , , , , , , , , , 44 Comments

Tyler enquires about excess reserves:

While the current iteration of the Fed, various recent voodoo economic theories, and assorted blogs, all claim that excess bank reserves are never an inflationary threat, it is precisely two Federal Reserve chairmen’s heretic claims that reserves will light an inflationary conflagration, that forced then president Truman to eliminate not one but two Fed Chairmen, and nearly result in the “independent” Federal Reserve being subsumed by the Treasury to do its monetization and market manipulation/intervention bidding. Which then begs the question: who is telling the truth about the linkage of reserve accumulation to inflation — the Fed of 1951, or every other Fed since, now firmly under the control of the Treasury-banker syndicate?

This is of course a live question. Excess reserves are at never-before-seen levels:


That’s right — throughout the postwar period, banks have almost always lent out all the way up to the reserve requirement.

So, does the accumulation of excess reserves lead to inflation?

Only so much as the frequentation of brothels leads to chlamydia and syphilis.

Excess reserves are only non-inflationary so long as the banks — the people holding the reserves — play along with the Fed-Treasury game of monetising debt and trying to hide the inflation . The banks don’t have to lend these reserves out, just as having sex with hookers doesn’t have to lead to an infection.

But eventually — so long as you do it enough — the condom will break.

As soon as banks start to lend beyond the economy’s inherent productivity (which lest we forget is around the same level as ten years ago) there will be inflation.

So, will they?

I think that would mean biting the hand that has fed them. The financial complex owes a great deal to the Fed for bailing them out in 2008, and throwing a pig’s ear of slush money their way in 2009 and 2010 in the form of QE. Like any Fat Tony, Bernanke commands the allegiance of his minions. But even the most enduring mafia bosses sometimes get shot. There is no status quo that a black swan cannot shatter.

But there are greater inflationary risks (which also, we must note, may set alight the inflationary potential of the excess reserves). A severe oil shock — caused by (say) Iran closing the Strait of Hormuz, something that America, NATO and the UN seem totally set upon — is one. So too could be a global trade shock caused by a regional war — there are lots of danger zones (North Korea, Pakistan, Iran, Syria, Egypt, Libya, Lebanon, etc, etc, ad infinitum).

And how about the return of some of the trillions of dollars now floating around Asia?


As more Asian nations ditch the dollar for bilateral trade, more dollars will end up getting dumped back into the American market. (Paul Krugman says this is a good thing. Nope.)

So while the amassing of excessive reserves perhaps does not pose quite the same inflationary risk as collapsing reserve currency status, I think it is safe to say that while the 00s securitisation bubble was akin to juggling dynamite, this trend of amassing excess reserves (done, lest we forget, as a stability measure to protect primary dealers against another shadow banking collapse) is closer to going to sleep upon a bed of dynamite. 

Economics for the Muppet Generation

April 19, 2012

Aziz Economic History, Economics, Federal Reserve, Fixed Income, Humour, Inflation, Musings, Politics , , , , , , , , , , , 40 Comments

Mark McHugh of Across the Street provides a succinct summation of the problem America faces:

McHugh continues:

  • From 1947 to 1974 US income per capita grew more than National debt per capita 25 times.
  • In the last 30 years, National debt per capita has grown more than income per capita 24 times.
  • The last time income per capita grew more than national debt per capita was 2001.
  • Ben Bernanke arrived at the Federal Reserve in 2002.

So simple, even a muppet can understand what the problem is, right?

Not exactly. We know what the problem is: national incomes aren’t rising, even while we get deeper and deeper into hock trying to maintain our standard of living. We know that this pattern is totally unsustainable; unless incomes rise, that debt will become increasingly impossible to service. What is less clear is the cause of this stagnation.

So what changed between 1990 and 2005 that led the nation debt per capita to so quickly overtake national incomes per capita?

While I am mindful that correlation does not necessarily imply causation, that data fits pretty beautifully. The explanation for this trend would be that as America has become more and more consumptive, and less and less productive that more and more capital went offshore to pay for consumption, and thus less and less contributed to the national income, even as Bernanke ponied up trillions in new reserves, and even as the shadow banking system created trillions in pseudo-money.

So where’s America’s money?

Here:


So is this a criticism of free trade? Should America have been more protectionist of her industries and her domestic manufacturing? Not necessarily; what the Washingtonian elites refer to as “free trade” is heavily subsidised. The status quo that Washington has made seems to heavily favour China and disfavour America. Imports from China are subsidised by American military largesse; every dollar America pushes into its military-industrial complex pushes shipping costs like insurance a little lower. So while labour costs in the Orient are naturally cheaper (due to population density, and development level), that doesn’t necessarily mean that Chinese goods are naturally cheaper in the American market. Under a genuinely free system — where America was not subsidising shipping costs — would made-in-America be more competitive compared to Chinese goods? Would China have built up a less  mountainous supply of American cash? I think so.

Bernanke vs Greenspan?

March 23, 2012

Aziz Economic History, Economics, Fixed Income, Guest Post, Wall Street , , , , , , , , , , , , , , , 18 Comments

Submitted by Andrew Fruth of AcceptanceTake

Bernanke and Greenspan appear to have differing opinions on whether the Fed will monetize the debt.

Bernanke, on behalf of the Federal Reserve, said in 2009 at a House Financial Services Committee that “we’re not going to monetize the debt.“

Greenspan, meanwhile, on Meet the Press in 2011 that “there is zero probability of default“ because the U.S. can always print more money.

But they can’t both be true…

There is only 0% probability of formal default if the Fed monetizes the debt. If they refuse, and creditors refuse to buy bonds when current bonds rollover, then the U.S. would default. But Ben said the Fed will never monetize the debt back on June 3, 2009. That’s curious, because in November 2010 in what has been termed “QE2″ the Fed announced it would buy $600 billion in long-term Treasuries and buy an additional $250-$300 of Treasuries in which the $250-$300 billion was from previous investments.

Is that monetization? I would say yes, but it’s sort of tricky to define. For example, when the Fed conducts its open market operations it buys Treasuries to influence interest rates which has been going on for a long time — way before the current U.S. debt crisis.

So then what determines whether the Fed has conducted this egregious form of Treasury buying we call “monetization of the debt?”

The only two factors that can possibly differentiate monetization from open market operations is 1) the size of the purchase and 2) the intent behind the purchase.

This is how the size of Treasury purchases have changed since 2009:

Since new data has come out, the whole year of 2011 monetary authority purchases is $642 billion – not quite as high as in the graph, but still very high.

Clearly you can see the difference in the size of the purchases even though determining what size is considered monetization is rather arbitrary.

Then there’s the intent behind the purchase. That’s what I think Bernanke is talking about when he says he will not monetize the debt. In Bernanke’s mind the intent (at least the public lip service intent) is to avoid deflation and to boost the economy – not to bail the United States out of its debt crisis by printing money. Bernanke still contends that he has an exit policy and that he will wind down the monetary base when the time is appropriate.

So In Bernanke’s mind, he may not consider buying Treasuries — even at QE2 levels — “monetizing the debt.”

The most likely stealth monetization tactics Bernanke can use — while still keeping a straight face — while saying he will not monetize the debt, will be an extreme difference between the Fed Funds Rate and the theoretical rate it would be without money printing, and loosening loan requirements/adopting policies that will get the banks to multiply out their massive amounts of excess reserves.

If, for example, the natural Fed Funds rate — the rate without Fed intervention — is 19% and the Fed is keeping the rate at 0%, then the amount of Treasuries the Fed would have to buy to keep that rate down would be huge — yet Bernanke could say he’s just conducting normal open market operations.

On the other hand, if the banks create money out of nothing via the fractional reserve lending system and a certain percentage of that new money goes into Treasuries, Bernanke can just say there is strong private demand for Treasuries even if his policies were the reason behind excessive credit growth that allowed for the increased purchase of Treasuries.

Maybe Bernanke means he will not monetize a particular part of the debt that was being referred to in the video. Again, though, he could simply hide it under an open market operations 0% policy or encourage the banking system to expand the money supply.

Whatever the case, if you ever hear Bernanke say “the Federal Reserve will not monetize the debt” again, feel free to ignore him. When he says that, it doesn’t necessarily mean he won’t buy a large quantity of Treasuries with new money created out of nothing.

Remember, Greenspan says there’s “zero probability of default” because the U.S. can always print more money. Does Greenspan know something here? There’s only zero probability if the Fed commits to monetizing the debt as needed. If Greenspan knows something there will be monetization of the debt, even if Bernanke wants to call it something else.

Nassim Taleb’s Big Idea: Transforming Debt Into Equity

February 25, 2012

Aziz Current Affairs, Economic History, Economics, Fixed Income, Politics, What is Money? , , , , 40 Comments

I have mentioned, in passing, the possibility of transforming debt into equity as a solution for many of the troubles in the global financial system.

I borrowed the idea from Nassim Taleb and Mark Spitznagel, who floated it in 2009. It is unfortunate that the idea has not yet been taken very seriously. There are probably two reasons for this: firstly Taleb and Spitznagel never fully fleshed it out, and secondly because the political and media punditry don’t really recognise the graveness of the present situation. Largely it is hoped that we can muddle through; radical solutions tend to get left on the shelf.

It is my view that it is much better to fix the system in a fundamental way, rather than clobber together solutions piecemeal. The latter approach has been the norm — from the bailouts of Greece and euro austerity, to the bailout of AIG and the wider financial system, to quantitative easing and LTRO, to Obama’s stimulus package — the focus has been on keeping a system that is falling apart at the seams from crumbling completely into dust.

So what is the problem that governments fear so hugely?

As we learned a long time ago, big defaults on the order of billions don’t just panic markets. They congest the system, because the system is predicated around the idea that everyone owes things to everyone else. The $18 billion that Greece owes to the banks are in turn owed on to other banks and other institutions. Failure to meet that payment doesn’t just mean one default, it could mean many more. The great cyclical wheel of international debt is only as strong as its weakest link. This kind of breakdown is known as a default cascade. In an international financial system which is ever-more interconnected, we will soon see how far the cascade might travel.

The concept of too big to fail — and thus the justification for all the bailouts — comes out of these default cascades; if a default were to trigger such a cascade, the cycle of payments would break down. Thus, the logic goes, if a bankruptcy would break the system, then the government should step in and prevent that bankruptcy. Thus, the system can continue operating. Alas, this is the road to a zombie economy. If bad companies can succeed just as easily as well-run ones, then the market mechanism is rendered meaningless. Why innovate and create when instead you can run on government largesse? Why seek efficiency when inefficiency gets you cash just as easily? Furthermore, this government largesse starves new businesses of opportunities and cash. Every dollar taxed to pay for bailouts is a dollar that could have instead been invested in a startup. And every juggernaut that is saved is a hole in the marketplace that could instead have been filled by a new and better company.

The problem then, is the huge overhanging cyclical structure of debt and interest. In a free market — without bailouts and largesse — it would have collapsed into the sand long ago. That would have been painful and contractionary, but after the storm there would have been aggressive new growth; without the debt overhang, new lending would have been easier. There would be holes in the market to fill. But governments have determined that it must be saved, that there is no alternative to this strange mess.

It is not good enough to imagine a new beginning, either. For we already have this mess, and we have to get out of it. A route out — toward a place where the system is no longer so fragile. If we ignore the mess, our route out of it will be messy — systemic collapse, currency crises, trade breakdown, war or worse.

Now, I believe that the most significant factors in robustifying society are economic, as opposed to financial. The West’s greatest fragilities stem not from its weak financial system, but from its energy dependency and susceptibility to energy costs (for example, the financial crisis in 2008 might never have been so severe had there been such a huge spike in energy costs), its deteriorating infrastructure, and its imperial largesse (the cost, the blowback, the shortage of manpower). Simply, if America and the West were fuelled by decentralised domestic energy production (e.g. solar), and decentralised local production and resource extraction, the ululations of the global financial system would be irrelevant to the common people.

But, in reality, we live in a globalised and interdependent system. So anything that might robustify the financial system would be welcome.

Here’s what Taleb and Spitznagel originally wrote:

The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to gross domestic product that we had in the 1980s. This does not sit well with globalisation. Our view is that government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.

Our analysis is as follows. First, debt and leverage cause fragility; they leave less room for errors as the economic system loses its ability to withstand extreme variations in the prices of securities and goods. Equity, by contrast, is robust: the collapse of the technology bubble in 2000 did not have significant consequences because internet companies, while able to raise large amounts of equity, had no access to credit markets.

Second, the complexity created by globalisation and the internet causes economic and business values (such as company revenues, commodity prices or unemployment) to experience more extreme variations than ever before. Add to that the proliferation of systems that run more smoothly than before, but experience rare, but violent blow-ups.

The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers. 

The strongest advantage, though, goes unmentioned. Systematically transforming debt into equity would end the problem of financial entities being too big to fail, as failure would no longer lead to a breakdown in the debt cycle. This is because insolvent positions would simply default to a majority-minority equity position, and — if the debtor’s equity position were high enough, say about 33% — liquidation could be avoided.

A huge philosophical problem is that such a complete transformation would alter (violate?) a huge number of existing contracts. It would be a top-down and coercive solution, and that is always open to legal challenge. Furthermore, curtailing the issuance of debt means curtailing the freedom of society and individuals to enter into any contract seen fit.

But the larger picture is rather intriguing — in a world where all debt has become equity, there is no such thing as a default, because an equity position is one of ownership, and thus a claim on future earnings.

Simply, lending would be done through lenders buying a share in a person or company’s or government’s future earnings, rather than through creating debt. Loan contracts could still be structured precisely the way they are today. But, as Taleb and Spitznagel insinuate in saying that “banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity”, lenders would have much more of an incentive to assist in the development of their equity position, as this would surely be the best way to get back their initial investment. And — as an equity position, rather than a cast-in-stone lending contract — terms could be far more easily renegotiated.

Of course, this new system would surely pose a whole new universe of challenges and moral and regulatory quandaries, not least the moral and philosophical problems of government effectively banning debt-based lending.

But, if we are looking to avoid the moral hazard of bailouts, and the dangers of default cascades, the architects of the global financial system — including banks themselves, who could of their own volition choose to cease debt-based lending, and adopt equity-based lending — could do much worse. While systematically transforming debt to equity is too difficult and controversial (not least for contractual reasons), we must remember that in a purely free-market, all of those debt-based lenders would have gone bust a long time ago.

The Inevitability of Default?

February 22, 2012

Aziz Economics, Fixed Income , , , , , , , , , , , 19 Comments

From Buttonwood:

While Greece continues to inch its way towards a [now completed] deal with its EU partners, the creditors of a much-larger debtor, the US government, appear to be untroubled. Ten-year Treasury bonds still yield just 2%. But the issue of how the US addresses its long-term fiscal problems is, as yet, unresolved. A series of papers from the Mercatus Centre at George Mason University in Washington DC, called “Tipping Point Scenarios and Crash Dynamics” attempts to address the issue.

Perhaps the most provocative paper comes from Jeffrey Rogers Hummel who reasons that default is virtually inevitable because a) federal tax revenue will never consistently rise much above 20% of GDP, b) politicians have little incentive to come up with the requisite expenditure cuts in time and c) monetary expansion and its accompanying inflation will no more be able to close the fiscal gap than would an excise tax on chewing gum. Most controversially, he argues that ”the long-term consequences (of default), both economic and political, could be beneficial, and the more complete the repudiation, the greater the benefits.”

Why does he take this view? Allowing for the Treasuries owned by the Fed, the trust funds and foreigners, total default could cost the US private sector about $4 trillion. In contrast, the fall in the stockmarket from 2007 to 2008 cost around $10 trillion. In compensation, however, the US taxpayer would no longer have to service the debt; their future liabilities would be lower.

It’s nice to know I’m not just one lone voice in the wilderness.  But I think most readers already knew most of this. There is significant empirical evidence that when the problem is excessive debt, neither austerity nor inflation are sufficient tools to really reduce the debt. Austerity tends to bring the problem to a head, while inflation tends to kick the can down the road, but neither approach really addresses the real problem of debt saturation. If we want real debt erasure, we need measures that really erase debt.

And of course, default would be beneficial beyond the reasons cited by Hummel. In a system where money is created through credit expansion, when the system is suffering from debt saturation, removing a large amount of the debt offers a relief, because lenders can take on more lending. Default would also almost certainly lead to a full liquidation of the system and a clear-out of the dark clouds of shadow banking securitisation, and the complex web of derivatives that currently render a whole swathe of the financial system as “too big to fail”.

Cataclysmic failure would open a whole new world of possibilities for reform. One possibility is the return of Glass-Steagall-style separation between investment and retail banking, and a complete ban on complex derivatives contracts. This is the more statist approach, but given the relative success of such a system in the post-war years it is certainly better than the status quo of unrestrained credit creation, where humungous bubbles appear to be the norm.

Another possibility is the end of credit-based money, and the return of full-reserve banking, or a gold standard. This would significantly weaken the possibility of future credit bubbles like the 2000s housing bubble and its ongoing corollary the shadow banking and derivatives bubbles. Of course under such a system growth would likely be slower, too, but more sustainable.

And there is nothing morally wrong with default. Investors in government debt should do their due diligence, and be aware that for all the political bleating and obsequious promises from politicians, ratings agencies and Warren Buffet there is always a risk of default with sovereign debt. And not just default by debasement. Debt is only ever as good as its issuers ability to generate sufficient revenues.

There was never any guarantee that this era of unrestrained credit creation, globalisation, job migration and American imperialism could go on forever. Now that the calculus for default — that it is cheaper for America default than to not — it is only a matter of time. It might be tricky negotiate politically, but things can be worked out.

For there is another motivation, too. If America postpones her default for twenty more years, creditors might demand that she repay it in renminbei or gold.

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