Fixed Income

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The Origin of Money

Markets are true democracies. The allocation of resources, capital and labour is achieved through the mechanism of spending, and so based on spending preferences. As money flows through the economy the popular grows and the unpopular shrinks.  Producers receive a signal to produce more or less based on spending preferences. Markets distribute power according to demand and productivity; the more you earn, the more power you accumulate to allocate resources, capital and labour. As the power to allocate resources (i.e. money) is widely desired, markets encourage the development of skills, talents and ideas.

Planned economies have a track record of failure, in my view because they do not have this democratic dimension. The state may claim to be “scientific”, but as Hayek conclusively illustrated, the lack of any real feedback mechanism has always led planned economies into hideous misallocations of resources, the most egregious example being the collectivisation of agriculture in both Maoist China and Soviet Russia that led to mass starvation and millions of deaths. The market’s resource allocation system is a complex, multi-dimensional process that blends together the skills, knowledge, and ideas of society, and for which there is no substitute. Socialism might claim to represent the wider interests of society, but in adopting a system based on economic planning, the wider interests and desires of society and the democratic market process are ignored.

This complex process begins with the designation of money, which is why the choice of the monetary medium is critical.

Like all democracies, markets can be corrupted.

Whoever creates the money holds a position of great power — the choice of how to allocate resources is in their hands. They choose who gets the money, and for what, and when. And they do this again and again and again.

Who should create the monetary medium? Today, money is designated by a central bank and allocated through the financial system via credit creation. Historically, in the days of commodity-money, money was initially allocated by digging it up out of the ground. Anyone with a shovel or a gold pan could create money. In the days of barter, a monetary medium was created even more simply, through producing things others were happy to swap or credit.

While central banks might claim that they have the nation’s best democratic interests at heart, evidence shows that since the world exited the gold exchange standard in 1971 (thus giving banks a monopoly over the allocation of money and credit), bank assets as a percentage of GDP have exploded (this data is from the United Kingdom, but there is a similar pattern around the world).

Clearly, some pigs are more equal than others:

Giving banks a monopoly over the allocation of capital has dramatically enriched banking interests. It is also correlated with a dramatic fall in total factor productivity, and a dramatic increase in income inequality.

Very simply, I believe that the present system is inherently undemocratic. Giving banks a monopoly over the initial allocation of credit and money enriches the banks at the expense of society. Banks and bankers — who produce nothing — allocate resources to their interests. The rest of society — including all the productive sectors — get crumbs from the table. The market mechanism is perverted, and bent in favour of the financial system. The financial system can subsidise incompetence and ineptitude through bailouts and helicopter drops.

Such a system is unsustainable. The subsidisation of incompetence breeds more incompetence, and weakens the system, whether it is government handing off corporate welfare to inept corporations, or whether it is the central bank bailing out inept financial institutions. The financial system never learned the lessons of 2008; MF Global and the London Whale illustrate that. Printing money to save broken systems just makes these systems more fragile and prone to collapse. Ignoring the market mechanism, and the interests of the wider society to subsidise the financial sector and well-connected corporations just makes society angry and disaffected.

Our monopoly will eventually discredit itself through the subsidisation of graft and incompetence. It is just a matter of time.

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Liquidation is Vital

Many Keynesians really hate the concept of liquidationism. I’m trying to grasp why.

Paul Krugman wrote:

One discouraging feature of the current economic crisis is the way many economists and economic commentators — apparently ignorant of what went on over the last 75 years or so of macroeconomic debate — have been reinventing old fallacies, imagining that they were coming up with profound insights.

The Bank for International Settlements has decided to throw everything we’ve learned from 80 years of hard thought about macroeconomics out the window, and to embrace full-frontal liquidationism. The BIS is now advocating a position indistinguishable from that of Schumpeter in the 1930s, opposing any monetary expansion because that would leave “the work of depressions undone”.

Andrew Mellon summed up liquidationism as so:

The government must keep its hands off and let the slump liquidate itself. Liquidate labor, liquidate stocks, liquidate the farmes, liquidate real estate. When the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. A panic is not altogether a bad thing. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.

In light of the zombification that now exists in Japan and also America (and coming soon to every single QE and bailout-heavy Western economy) — zombie companies, poorly managed, making all the same mistakes as before, rudderless, and yet still in business thanks to government intervention  — it is clear that the liquidationists grasped something that Keynesians are still missing. Markets are largely no longer trading fundamentals; they are just trading state intervention and money printing. Why debate earnings when instead you can debate the prospects of QE3? Why invest in profitable companies and ventures when instead you can pay yourself a fat bonus cheque out of monetary stimulus? Why exercise caution and consideration when you can just gamble and get a bailout?

Unfortunately, Mellon and his counterparts at the 30s Fed were the wrong kind of liquidationists — they could not heed their own advice and leave the market be. Ironically, the 30s Fed in raising interest rates and failing to act as lender-of-last resort drove the market into a deeper depression than was necessary (and certainly a deeper one than happened in 1907) and crushed any incipient recovery.

Liquidation is not merely some abstract policy directive, or government function. It is an organic function of the market. As the stunning bounce-back from the Panic of 1907 shows — especially when contrasted against the 1930s — a  market liquidation on the back of a panic avoids a depression. Prices fall as far as the market deems necessary, before market participants quickly come back in into the frame, setting the market on a new trail toward growth. For without a central bank, asset-holders who want to maintain a strong economy and growth (in 2008, that probably would have meant sovereigns like China and Arabia) have to come in and pick up falling masonry as lenders of last resort.

Under a central banking regime (especially a Bernankean or Krugmanite one committed to Rooseveltian Resolve) all expectations fall onto the central bank.

My own view is not just that liquidation is vital. It is that the market mechanism is vital. Without their own capital as skin in the game, central bankers are playing blind. The pace of the liquidation and the pace of the recovery should be dictated by market participants — in other words, by society at large — not by the whims of distant technocrats. Society has more skin in the game. The Great Depression was not a crisis of too little intervention — it was a crisis of too much well-intentioned intervention.

As we are learning in our own zombie depression, a central bank doing the opposite of the 1930s Fed and reinflating may solve the problem of debt-deflation, but it causes many of its own problems — zombie banks, zombie corporations, zombie markets, corporate welfarism, and the destruction of the market mechanism.

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The World Before Central Banking

In today’s world, there are many who want government to regulate and control everything. The most bizarre instance, though — more bizarre even than banning the sale of large-sized sugary drinks — is surely central banking.

Why? Well, central banking was created to replace something that was already working well. Banking panics and bank runs happen, and they have always happened as long as there has been banking.

But the old system that the Fed displaced wasn’t really malfunctioning — unlike what the defenders of central banking today would have us believe. Following the Panic of 1907, a group of private bankers led by J.P. Morgan successfully bailed out the system by acting as lender of last resort. The amount of new liquidity disbursed into the system was set not by academics like Ben Bernanke, but by experienced market participants. And because the money was directed from private purses, rather than being created out of thin air, only assets and companies with value were bought up.

The rationale of the supporters of the Federal Reserve Act was that a central banking liquidity mechanism would act as a safeguard against such events, to act as a permanent lender-of-last-resort backed by government fiat. They wanted something bigger and better than a private response.

Yet the Banking Panic of 1907 — a comparable market drop to both 1929 or 2008 — didn’t result in a residual depression.

As the WSJ noted:

The largest economic crisis of the 20th century was the Great Depression, but the second most significant economic upheaval was the panic of 1907. It was from beginning to end a banking and financial crisis. With the failure of the Knickerbocker Trust Company, the stock market collapsed, loan supply vanished and a scramble for liquidity ensued. Banks defaulted on their obligations to redeem deposits in currency or gold.

Milton Friedman and Anna Schwartz, in their classic “A Monetary History of the United States,” found “much similarity in its early phases” between the Panic of 1907 and the Great Depression. So traumatic was the crisis that it gave rise to the National Monetary Commission and the recommendations that led to the creation of the Federal Reserve. The May panic triggered a massive recession that saw real gross national product shrink in the second half of 1907 and plummet by an extraordinary 8.2% in 1908. Yet the economy came roaring back and, in two short years, was 7% bigger than when the panic started.

Ben Bernanke, widely seen as the pre-eminent scholar of the Great Depression thought things would be much, much better under his watch. After all, he has claimed that he understood the lessons of Friedman and Schwartz who criticised the 1930s Federal Reserve for continuing to contract the money supply, worsening the Great Depression; M2 in 1933 was just 72% of its 1929 peak.

So a bigger crash and liquidation in 1907 allowed the economy to roar back, and continue growing. Meanwhile, in today’s controlled, planned and dependent world of central liquidity insurance, quantitative easing and TARP, growth remains anaemic four years after the crash. Have the last four years proven conclusively that central banking — even after the lessons of the 1930s — is inferior to the free market?

Certainly, Bernanke’s response to 2008 has been superior to the 1930s Fed — M2 has not dropped by anything like what it did from 1929:


Industrial production has not fallen by as significant an amount as 1929, nor has homebuilding. And there are many other wide-scale economic differences between 1907 and 2008 in terms of the shape of the economy, and the shape of employment, the capital structure, and the wider geopolitical reality. But the bounce-back is still vastly inferior to the free-market reality of 1907. I think there are greater problems to central banking, ones of which Friedman, Schwartz and Bernanke were unaware (but of which Rothbard and von Mises were acutely aware).

Does central banking retard the economy by providing liquidity insurance and a backstop to bad companies that would not otherwise be saved under a free market “bailout” (like that of 1907)? And is it this effect — that I call zombification — that is the force that has prevented Japan from fully recovering from its housing bubble, and that is keeping the West depressed from 2008? Will we only return to growth once the bad assets and bad companies have been liquidated? That conclusion, I think, is becoming inescapable.

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Debt is Not Wealth

Here’s the status quo:


These figures are staggering; the advanced nations typically have between three and ten times as much total debt as they have economic activity. In the United Kingdom — the worst example — if one year’s economic activity was devoted entirely to paying down debt (impossible — people need to eat and drink and pay rent, and of course the United Kingdom continues to add debt) it would take ten years for the debt to be wiped clean.

But the real question is why? Why are both debtors and creditors willing to build a status quo of massive unprecedented debt?


From the side of the creditors, I think the answer is the misconception that debt is wealth. Debt can be used as collateral, or can be securitised and traded on exchanges (which itself can become a form of shadow intermediation, allowing for a form banking outside the accepted regulatory norms). To keep the value of debt high, and thus keep the debt illusion rolling along (treasury yields keep falling) central banks have been willing to swap out bad debt for good money. But debt is not wealth; it is just a promise, and in today’s world carries huge counter-party risk. Until you convert your debt-based promissory assets into real-world tangible assets they are not wealth.

From the side of the debtors, I think the answer is that debt is easy. Why work for your consumption when instead you can take out a home equity loan or get a credit card? Why buy the one car that you can afford when instead you can buy two with debt?

But there is another side in this world: the side of the central planners. Since the time of Keynes and Fisher there has been an economic revolution:

Deflation has effectively been abolished by central banking.  And so we get to where we are today: the huge and historically unprecedented outgrowth of debt. Deleveraging necessitates economic contraction, which produces the old Keynesian-Fisherian bugbear of debt-deflation, which the central planners abhor. So they print. Where once deflation often made debts unrepayable, and resulted in mass defaults, liquidation and structural transformation, today — thanks to money printing — debtors get their easy lunch of cheap debt, and creditors get their pound of flesh, albeit devalued by the inflation of the monetary base. It has been a superficially good compromise for both creditors and debtors. Everyone has got some of what they want. But is it sustainable?

The endless post-Keynesian outgrowth of debt suggests not. In fact, what is ultimately suggested is that the abolition of small-scale deflationary liquidations has just primed the system for a much, much larger liquidation later on. Bad companies, business models and practices that might otherwise not have survived under previous economic systems today live thanks to bailouts and money-printing. This moral hazard has grown legs and evolved into a kind of systemic hazard. Unhealthy levels of leverage and interconnection that once might have necessitated failure (e.g. Martingale trading strategies) flourish today under this new regime and its role as counter-party-of-last-resort. With every rogue-trader, every derivatives or shadow banking blowup, every Corzine, every Adoboli, every Iksil, comes more confirmation that the entire financial system is being zombified as foolish and dangerous practices are saved and sanctified by bailouts.

With every zombie blowup comes the necessity of more money-printing, and with more money-printing to save broken industries seems to come more moral hazard and zombification. Is that sustainable?

Already, central bankers are having to be clever with their money printing, colluding with financiers and sovereign governments to hide newly-printed money in excess reserves and FX reserves, and colluding with government statisticians to hide inflation beneath a forest of statistical manipulation. It is no surprise that by the BLS’ previous inflation-measuring methodology inflation is running at a much higher rate than the new:

Worse, in the modern financial world, we see an unprecedented level of interconnection. The impending Euro-implosion will have ramifications to everyone with exposure to it, and everyone with exposure to those with exposure to it. Not only will the inflation-averse Europeans have to print up a huge quantity of new money to bail out their financial system (the European financial system is roughly three times the size of the American one bailed out in 2008), but should they fail to do so central banks around the globe will have to print huge quantities of money to bail out systemically-important financial institutions with exposure to falling masonry. This is shaping up to be a true test of their prowess in hiding monetary inflation, and a true test of the “wisdom” behind endless-monetary-growth fiat economics.

Central bankers have shirked the historical growth cycle consisting both of periods of growth and expansion, as well as periods of contraction and liquidation. They have certainly had a good run. Those warning of impending hyperinflation following 2008 were proven wrong; deflationary forces offset the inflationary impact of bailouts and monetary expansion, even as food prices hit records, and revolutions spread throughout emerging markets. And Japan — the prototypical unliquidated zombie economy — has been stuck in a depressive rut for most of the last twenty years. These interventions, it seems, have pernicious negative side-effects.

Those twin delusions central bankers have sought to cater to — for creditors, that debt is wealth and should never be liquidated, and for debtors that debt is an easy or free lunch — have been smashed by the juggernaut of history many times before. While we cannot know exactly when, or exactly how — and in spite of the best efforts of central bankers — I think they will soon be smashed again.

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Enter the Swan

Charles Hugh Smith (along with many, many, many others) thinks there may be a great decoupling as the world sinks deeper into the mire, and that the dollar could be set to benefit:

This “safe haven” status can be discerned in the strengthening U.S. dollar. Despite a central bank (The Federal Reserve) with an avowed goal of weakening the nation’s currency (the U.S. dollar), the USD has been in an long-term uptrend for a year–a trend I have noted many times here, starting in April 2011.

That means a bet in the U.S. bond or stock market is a double bet, as these markets are denominated in U.S. dollars. Even if they go nowhere, the capital invested in them will gain purchasing power as the dollar strengthens.

All this suggests a “decoupling” of the U.S. bond and stock markets from the rest of the globe’s markets. Put yourself in the shoes of someone responsible for safekeeping $100 billion and keeping much of it liquid in treacherous times, and ask yourself: where can you park this money where it won’t blow up the market just from its size? What are the safest, most liquid markets out there?

The answer will very likely point the future direction of global markets.

Smith is going along with one of the most conventional pieces of conventional wisdom: that in risky and troubled times investors will seek out the dollar as a haven. That’s what happened in 2008. That’s what is happening now as rates on treasuries sink to all-time-lows. And that’s what has happened throughout the era of petrodollar hegemony.

But the problem with conventions is that they are there to be broken, the problem with conventional wisdom is that it is there to be killed, roasted and served on a silver platter.

The era of petrodollar hegemony is slowly dying, and the assumptions and conventions of that era are dying with it. For now, the shadow of that old world is still flailing on like Wile E. Coyote, hovering in midair.

As I wrote last week:

How did the dollar die? First it died slowly — then all at once.

The shift away from the dollar has quickly manifested itself in bilateral and multilateral agreements between nations to ditch the dollar for bilateral and multilateral trade, beginning with the chief antagonists China and Russia, and continuing through Iran, India, Japan, Brazil, and Saudi Arabia.

So the ground seems to have fallen out from beneath the petrodollar world order.

Enter the Swan:

We know the U.S. is a big and liquid (though not really very transparent) market. We know that the rest of the world — led by Europe’s myriad issues, and China’s bursting housing bubble — is teetering on the edge of a precipice, and without a miracle will fall (perhaps sooner, rather than later).

But we also know that America is inextricably interconnected to this mess. If Europe (or China or both) disintegrates, triggering (another) global default cascade, America will be stung by its European banking exposures, its exposures to global energy markets and global trade flows. Simply, there cannot be financial decoupling, not in this hyper-connected, hyper-leveraged world.

And would funds surge into US Treasuries even in such an instance? Maybe initially — fund managers have been conditioned by years of convention to do so. But how long  can fund managers accept negative real rates of return? Or — much more importantly — how long will the Fed accept such a surge? The answer is not very long at all. Bernanke’s economic strategy has been focussed  on turning treasuries into a losing investment, on the face of it to “encourage risk-taking” (or — much more significantly — keep the Treasury’s borrowing costs cheap).

All of this suggests a global crash or proto-crash will be followed by a huge global money printing operation, probably spearheaded by the Fed. Don’t let the Europeans fool anyone, either — Germany will not let the Euro crumble for fear of money printing. When push comes to shove they will print and fiscally consolidate to save their pet project (though perhaps demanding gold as collateral, and perhaps kicking out some delinquents). China will spew trillions of stimulus money into more and deeper malinvestment (why have ten ghost cities when you can have fifty? Good news for aggregate demand!).

So Paul Krugman will likely get something much closer to what he claims to want. Problem solved?

Nope. You can’t solve deep-rooted structural problems — malinvestment, social change, deindustrialisation, global trade imbalances, systemic fragility, financialisation, imperial decline, cultural stupefaction (etc, etc, etc) — by throwing money at problems. All throwing more money can do is buy a little more time (and undermine the currency). The problem with that is that a superficial recovery fools policy-makers, investors and citizens into believing that problems are fixed when they are not. Eventually — perhaps slowly, or perhaps quickly — unless the non-monetary problems are truly dealt with (very unlikely), they will boil over again.

As the devaluation heats up things will likely become a huge global game of beggar thy neighbour. A global devaluation will likely increase the growing tensions between the creditor and debtor nations to breaking point. Our current system of huge trade imbalances guarantees that someone (the West) is getting a free lunch , and that someone else (the Rest) is getting screwed. Such a system is fundamentally fragile, and fundamentally unstable. Currency wars will likely give way to economic wars, which may well give way to subterfuge and proxy wars as creditors seek their pound of flesh, and debtors seek to cast off their chains. Good news, then, for weapons contractors and the security state.

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Is China Really Liquidating Treasuries?

The news that China has become the first sovereign to establish a direct sales relationship with the U.S. Treasury (therefore cutting out the middleman and bypassing Wall Street ) raises a few interesting questions.

From Reuters:

China can now bypass Wall Street when buying U.S. government debt and go straight to the U.S. Treasury, in what is the Treasury’s first-ever direct relationship with a foreign government, according to documents viewed by Reuters.

The relationship means the People’s Bank of China buys U.S. debt using a different method than any other central bank in the world.

The other central banks, including the Bank of Japan, which has a large appetite for Treasuries, place orders for U.S. debt with major Wall Street banks designated by the government as primary dealers. Those dealers then bid on their behalf at Treasury auctions.

China, which holds $1.17 trillion in U.S. Treasuries, still buys some Treasuries through primary dealers, but since June 2011, that route hasn’t been necessary.

The documents viewed by Reuters show the U.S. Treasury Department has given the People’s Bank of China a direct computer link to its auction system, which the Chinese first used to buy two-year notes in late June 2011.

The biggest Chinese outflows in U.S. Treasuries occurred in the months following the establishment of this relationship:

Which begs the question for some analysts — was China really selling? Or was China stealthily buying direct from the U.S. Treasury (unrecorded) and selling back into Wall Street (recorded)?

Well, according to the Treasury, the Treasury International Capital data seeks to record foreign holdings of U.S. securities, not just the flows, and given that the Treasury was the seller in these direct transactions (and so obviously was aware of them) there’s no reason to believe that they wouldn’t include any such direct outflows in the data. That suggests very strongly that yes, China really was selling.

And maybe the real reason that the Treasury offered China direct access (thus cutting out the middleman and offering China cheaper access than ever) was precisely because China was selling, and because the Treasury was concerned about the effect on rates, and wanted to give China some incentive to keep buying. As Jon Huntsman noted in a 2010 cable leaked by Wikileaks, the PBOC has felt pressured to keep buying, and as various PBOC officials have hinted in recent months, China is actively seeking to convert out of treasuries and into gold. And that makes sense — treasuries are yielding ever deeper negative real rates. People holding treasuries are losing their purchasing power. No wonder the treasury is willing to cut Wall Street out of the deal.

And it isn’t like the Treasury would have taken this move lightly — cutting Wall Street out of the equation is a slap in the face to Wall Street.

This raises a much more interesting question — now that the PBOC has effectively been upgraded to primary dealer status, would the Fed start buying treasuries directly from the PBOC in order to manage rates downward and prevent a spike in Treasury borrowing costs should China choose to quicken the pace of a future liquidation, potentially bursting the treasury bubble?

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The Fabled Greek Mega-Bailout

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.

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 system liquid.

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 post-Weimar distaste for monetary expansion —  it seems to me like 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:

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Double or Nothing: How Wall Street is Destroying Itself

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?

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Does Jamie Dimon Even Know What Hedging Risk Is?

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.

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The Treasury Bubble in One Graph

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.