Skewering Muppets

Jan Hatzius of Goldman Sachs is calling a major recovery after 2013:

What can we expect in coming years? If our estimates and assumptions are correct, 2013 is likely to be a more extreme version of 2010-2012, with a bigger positive private sector impulse that is offset by a bigger negative public sector impulse but still leaves growth around trend. But we expect the net impulse to turn positive in subsequent years, assuming that 2013 marks the peak rate of fiscal contraction. By 2014-2015, the decline in the ex ante private sector balance should be contributing around 11⁄2 percentage points to the overall growth impulse, but we currently assume that fiscal policy will subtract only 1⁄2- 1 percentage point, for a net impulse of 1⁄2-1 point. This ought to be a recipe for clearly above-trend growth.

His forecast looks like this:

Impulses

His model is one of sectoral balances.

financial-balances

He writes:

…an update of our financial balances model suggests that growth is likely to improve starting in the second half of 2013. Homebuilding looks set to recover strongly, the corporate sector should start to spend a larger share of its cash flow, and the personal saving rate will probably edge down a little further.

In very simple language, Hatzius is forecasting a recovery because he believes that the current trend is away from private sector deleveraging toward releveraging.

This approach is deeply, deeply flawed. Why? Total debt as a percentage of GDP is still ridiculously elevated. There has been very little deleveraging in total:

TCMDO/GDP

How can the private sector releverage from here? The costs of a high debt load make growth very difficult, as Irving Fisher and later Hyman Minsky showed. This huge outgrowth of debt is totally unsustainable. It has taken trillions of quantitative easing and bailouts to just sustain the present bloated debt load. And Hatzius’ model is predicting that we will soon be growing from taking on more?

This is transparent bullshit (unless you’re either a sucker or a shill), and I am sure Goldman’s traders will reap great reward betting against this advice just as they reaped great reward betting against worthless subprime junk last time round (another reason why banks that trade should never be in the business of advising clients, but that absurd conflict of interest is another story for another day). Win on the way up, win on the way down, and take a bailout if you lose.

The economy is stuck in a Catch-22. The high debt load is strangling growth, but growth is the one thing that can significantly reduce the size of the debt load. Right now, we are experiencing a slow deleveraging of a fragile economy as opposed to the quick and brutal deleveraging we would have seen had the market been allowed to clear in 2008.

There will be no return to the kind of debt-driven growth Hatzius is forecasting before the unsustainable debt is either liquidated, forgiven or (hyper-)inflated away. Until then, it is Japan all the way for America.

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Japan’s Adult Diaper Boom

Japan’s population has gotten so old that diaper manufacturers are selling more adult diapers for incontinent seniors than they are baby diapers. According to Bloomberg:

Unicharm Corp’s sales of adult diapers in Japan exceeded those for babies for the first time last year.

This is because Japan’s population is getting older and older:

This is a pronounced trend all over the developed world. As people live longer and as fertility rates fall, there is a proportionately a larger and larger population of elderly retirees being supported by a proportionately smaller and smaller population of young workers paying taxes and interest on debt.

Governments of countries with ageing populations have a few choices. First, they could relax immigration laws so that working-age immigrants can enter the country, work and pay taxes to support the domestic elderly population (Japan has some of the tightest immigration laws in the world). Second, they could change the tax code or legal framework to incentivise a higher birthrate (for instance, tax breaks per child). Third, they could raise the retirement age (or at least provide incentives to keep an ageing population in work).

Another option is to hope for a miracle. But that doesn’t have a history of working out very well.

George Osborne & Big Banks

The Telegraph reports that George Osborne thinks big banks are good for society:

The Chancellor warned that “aggressively” breaking up banks would do little to benefit the UK and insisted the Government’s plans to put in place a so-called “ring fence” to force banks to isolate their riskier, investment banking businesses from their retail arm was the right way to make the financial system safer.

“If we aggressively broke up all of our big banks, I am not sure that, as a society, we would benefit from it,” he said. “We don’t have a huge number of banks, sadly, large banks. I would like to see more.

His comments came as he gave evidence to the parliamentary commission on banking standards where he was accused of attempting to pressure members into supporting his ring-fencing reforms.

“That work has been accepted, as far as I’m aware, by all the major political parties. We are now on the verge of getting on with it,” he said.

Several members of the Commission have argued in favour of breaking up large banks, including former Chancellor, Lord Lawson.

This is really disappointing.

Why would Osborne want to see more of something which requires government bailouts to subsist?

Because that is the reality of a large, interconnective banking system filled with large, powerful interconnected banks.

The 2008 crisis illustrates the problem with a large interconnective banking system. Big banks develop large, diversified and interconnected balance sheets as a sort of shock absorber. Under ordinary circumstances, if a negative shock (say, the failure of a hedge fund) happens, and the losses incurred are shared throughout the system by multiple creditors, then those smaller losses can be more easily absorbed than if the losses were absorbed by a single creditor, who then may be forced to default to other creditors. However, in the case of a very large shock (say, the failure of a megabank like Lehman Brothers or — heaven forbid! — Goldman Sachs) an interconnective network can simply amplify the shock and set the entire system on fire.

As Andrew Haldane wrote in 2009:

Interconnected networks exhibit a knife-edge, or tipping point, property. Within a certain range, connections serve as a shock-absorber. The system acts as a mutual insurance device with disturbances dispersed and dissipated. But beyond a certain range, the system can tip the wrong side of the knife-edge. Interconnections serve as shock-ampli ers, not dampeners, as losses cascade. The system acts not as a mutual insurance device but as a mutual incendiary device.

Daron Acemoglu (et al) formalised this earlier this year:

The presence of dense connections imply that large negative shocks propagate to the entire fi nancial system. In contrast, with weak connections, shocks remain con fined to where they originate.

What this means (and what Osborne seems to miss) is that large banks are a systemic risk to a dense and interconnective financial system.

Under a free market system (i.e. no bailouts) the brutal liquidation resulting from the crash of a too-big-to-fail megabank would serve as a warning sign. Large interconnective banks would be tarnished as a risky counterparty. The banking system would either have to self-regulate — prevent banks from getting too interconnected, and provide its own (non-taxpayer funded) liquidity insurance in the case of systemic risk — or accept the reality of large-scale liquidationary crashes.

In the system we have (and the system Japan has lived with for the last twenty years) bailouts prevent liquidation, there are no real disincentives (after all capitalism without failure is like religion without sin — it doesn’t work), and the bailed-out too-big-to-fail banks become liquidity sucking zombies hooked on bailouts and injections.

Wonderful, right George?

The Emperor is Wearing No Clothes

As I’ve covered in pretty excruciating depth these past few weeks, the Euro in its current form is sliding unrelentingly into the grave.

Some traders seem pretty excited about that eventuality.

Why? There’s plenty of money to be made killing the Euro, (just like there was plenty of money to be made in naked-shorting Lehman brothers to death):

Markets are ruled right now by fear. Investors: the big money, the smart money, the big funds, the hedge funds, the institutions, they don’t buy this rescue plan. They know the market is toast. They know the stock market is finished, the euro, as far as the Euro is concerned they don’t really care. They’re moving their money away to safer assets like Treasury bonds, 30-year bonds and the US dollar.

I would say this to everybody who’s watching this. This economic crisis is like a cancer. If you just wait and wait thinking this is going to go away, just like a cancer it’s going to grow and it’s going to be too late.

This is not a time to wishfully think the governments are going to sort this out. The governments don’t rule the world. Goldman Sachs rules the world. Goldman Sachs does not care about this rescue package, neither do the big funds.

A few points:

“They’re moving their money to safer assets like Treasury bonds, 30-year bonds and the US dollar.”

Safer assets like the US dollar? Sure, that’s what the textbooks tell you has been the safest asset in the post-war era. But are they really safe assets? On dollars, interest rates are next to zero. This means that any inflation results in negative real rates, killing purchasing power. Let’s have a look at the yields on those “super-safe” 30-year bonds:

At 2.87%, and with inflation sitting above 3.5% these are experiencing a net loss in purchasing power, too. Yes, it’s better than losing (at least) half your purchasing power on Greek sovereign debt, or watching as equities tank. But with the virtual guarantee that stagnant stock markets will usher in a new tsunami of QE cash (or better still, excess reserves) expect inflation, further crushing purchasing power.” 

“The governments don’t rule the world. Goldman Sachs rules the world. Goldman Sachs does not care about this rescue package, neither do the big funds.” 

Well Goldman Sachs are the ones who convinced half the market to price in QE3. And they’re also making big noise demanding action in the Eurozone. I’m not denying Goldman don’t have massive power — or that they are ready and willing to book massive profits on Eurozone collapse. But — like everything in this crooked and corrupt system — they are vulnerable to liquidity crises triggered by the cascade of defaults that both myself and Tim Geithner (of all people) have talked about over the past week.

Of course, we all know that as soon as that tidal wave of defaults start, global “financial stabilisation” packages will flood the market to save Goldman and J.P. Morgan, and anything else deemed to be “infrastructurally important”, and survivors will take their pick of M&A from the collateral damage.

And kicking the can down the road using the same policy tools that Bernanke has been using for the past three years (i.e., forcing rates lower and-or forcing inflation higher) will result in harsher negative real rates — making treasuries into an even worse investment. Eventually (i.e., soon) the institutional investors — and more importantly (because their holdings are larger) the sovereign investors — will realise that their capital is rotting and panic. In fact, there is a great deal of evidence that China in particular is quietly panicking now. The only weapon Bernanke has is devaluation (in its many forms) — which is why he has been so vocal in asking for stimulus from the fiscal side.  

And — in spite of the last week’s gold liquidation, as China realised long ago — the last haven standing will be gold. Why? Because unlike treasuries and cash it maintains its purchasing power in the long run.

The Emperor is wearing no clothes.