Wall Street

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Of Bitcoin & the State

Bitcoin is very much in ascendancy. While it has for over three years existed as a decentralised and anonymous electronics payments system and medium of exchange for online black markets and gambling, more attempts to integrate Bitcoin into the wider economic system — most notably the integration of Bitpay with Amazon.com — have brought Bitcoin to the attention of a wider segment of the population. Alongside this, the egregious spectacle of depositor haircuts in Cyprus, and the spectre that depositor haircuts might happen elsewhere seems to have spurred a great new interest in alternatives to bank deposits in particular and state fiat currency in general. Consequently, the price is soaring — pushing up above $140 per bitcoin at the time of writing. Of course, this is still far less than a single ounce of gold currently priced at $1572.

There are many similarities between Bitcoin and gold. Gold is cooked up in the heart of supernovae, and is therefore exceedingly rare on Earth. It has a distinctive colouring, is non-perishable, fungible, portable, hard-to-counterfeit, and even today so expensive to synthesise that the supply is naturally limited. That made it a leading medium-of-exchange and store of purchasing power. Even today, in an age where it has been eclipsed in practice as a medium-of-exchange and as a unit-of-account for debts by state-backed fiat monies, it remains an enduring store of purchasing power.

Bitcoin is an even more limited currency — limited by the algorithms that control its mining. The maximum number of Bitcoins permitted by the code is 21 million (and in practice will gradually fall lower than this due to lost coins). Gold has been mined for over 5000 years, yet there is still gold in the ground today. Bitcoin’s mining will be (in theory) complete in a little over ten years — all the Bitcoins that there will ever be are projected to exist by 2025. True, there are already additional new currencies like Namecoin based on the Bitcoin technology but these do not trade at par with Bitcoin. This implies that Bitcoin will have a deflationary bias, as opposed to modern fiat currencies which tend toward inflation.

Many people have been attracted to the Bitcoin project by the notion of moving exchange outside of the scope of the state. Bitcoin has already begun to facilitate many activities that the state prohibits. More importantly, Bitcoin transactions are anonymous, and denominated outside of state fiat currency, so the state’s power to tax this economic activity is limited. As the range of Bitcoin-denominated merchants grows, it may become increasingly plausible to leave state  fiat currency behind altogether, and lead an anonymous economic life online fuelled by Bitcoins.

So is Bitcoin really a challenge to state power? And if it is, is it inevitable that the state will try to destroy Bitcoin? Some believe there can only be one survivor — the expansive modern state, with fiat currency, central banking, taxation and redistribution, or Bitcoin, the decentralised cryptographic currency.

The 21st Century is looking increasingly likely to be defined by decentralisation. In energy markets, homes are becoming able to generate their own (increasingly cheap!) decentralised energy through solar panels and other alternative and renewable energy sources. 3-D printing is looking to do the same thing for manufacturing. The internet has already decentralised information, learning and communication. Bitcoin is looking to do the same thing for money and savings.

But I don’t think that conflict is inevitable, and I certainly don’t foresee Bitcoin destroying the state. The state will have to change and adapt, but these changes will be gradual. Bitcoin today is not a competitor to state fiat money, but a complement. It would be very difficult today to convert all your state fiat currency into Bitcoins, and live a purely Bitcoin-oriented life, just as it would be very difficult to convert into gold or silver and life a gold or silver-oriented life. This is a manifestation of Gresham’s law — the idea that depreciating money drives out the appreciating money as a medium of exchange. Certainly, with Bitcoin rampaging upward in price — (a trend that Bitcoin’s deflationary nature encourages — holders will want to hold onto it rather than trade it for goods and services. If I had $1000 of Bitcoin, and $1000 of Federal reserve notes, I’d be far more likely to spend my FRNs on food and fuel and shelter than my Bitcoin, which might be worth $1001 of goods and services (or at current rates of increase, $1500 of goods and services) next week.

Bitcoin, then, is emerging as a savings instrument, an alternative to the ultra-low interest rates in the dollar-denominated world, the risks of equities, and a recent slump in the prices of gold and silver which have in the past decade acted in a similar role to that which Bitcoin is emerging into. (This does not mean that Bitcoin is a threat to gold and silver, as there are some fundamental differences, not least that the metals are tangibles and Bitcoin is not).

This means that the state is far more likely to attempt to regulate Bitcoin rather than destroy it. The key is to make Bitcoin-denominated income taxable. This means regulating and taxing the entry-and-exit points — the points where people convert from state fiat currency into Bitcoin.

This is so-far the approach that the US Federal government has chosen to take:

The federal agency charged with enforcing the nation’s laws against money laundering has issued new guidelines suggesting that several parties in the Bitcoin economy qualify as Money Services Businesses under US law. Money Services Businesses (MSBs) must register with the federal government, collect information about their customers, and take steps to combat money laundering by their customers.

The new guidelines do not mention Bitcoin by name, but there’s little doubt which “de-centralized virtual currency” the Financial Crimes Enforcement Network (FinCEN) had in mind when it drafted the new guidelines. A FinCEN spokesman told Bank Technology News last year that “we are aware of Bitcoin and other similar operations, and we are studying the mechanism behind Bitcoin.”

America’s anti-money-laundering laws require financial institutions to collect information on potentially suspicious transactions by their customers and report these to the federal government. Among the institutions subject to these regulatory requirements are “money services businesses,” including “money transmitters.” Until now, it wasn’t clear who in the Bitcoin network qualified as a money transmitter under the law.

For a centralized virtual currency like Facebook credits, the issuer of the currency (in this case, Facebook) must register as an MSB, because the act of buying the virtual currency transfers value from one location (the user’s conventional bank account) to another (the user’s virtual currency account). The same logic would apply to Bitcoin exchanges such as Mt. Gox. Allowing people to buy and sell bitcoins for dollars constitutes money transmission and therefore makes these businesses subject to federal regulation.

Of course, the Bitcoin network is fully decentralized. No single party has the power to issue new Bitcoins or approve Bitcoin transactions. Rather, the nodes in the Bitcoin network maintain a shared transaction register called the blockchain. Nodes called “miners” race to solve a cryptographic puzzle; the winner of each race is allowed to create the next entry in the blockchain. As a reward for its effort, the winning miner gets to credit itself a standard amount, currently 25 Bitcoins. Given that Bitcoins are now worth more than $50 and a new block is created every 10 minutes, Bitcoin mining has emerged as a significant business.

If a lot of economic activity were to move totally into Bitcoin, then the state might react more aggressively, seeking to tax transactions within the Bitcoin network (which may or may not be technically possible given Bitcoin’s anonymous nature) rather than just at the entry and exit points. There are, of course, risks for those wishing to move their entire economic life into Bitcoin — not just Gresham’s law, but transaction risks (Bitcoin has no clearing house, so all transactions are uninsured), and the risk that Bitcoin will be superseded (perhaps via the cryptography being rendered obsolete by some black swan advance in processing power, mathematics or cryptography?)

This current boom, where awareness of Bitcoin is growing considerably and many more individuals are joining the network, may soon be over. It is inevitable that at some stage the number of profit-takers seeking to cash out of Bitcoin into a currency where they can spend their profits will exceed the number of new investors trying to buy Bitcoin. At that stage, the price will fall. Just how much it falls will impact to what extent Bitcoin establishes itself as a decentralised and trusted store of purchasing power.

The last consolidation phase in Bitcoin’s price — between 2011 and 2013 — was not overwhelmingly encouraging, as prices remained far below the 2011 peak for a long while:

bitcoin

Yet they remained far above the pre-2011 levels. And while the 2011 boom was marked by curious scepticism, this boom seems to be marked by the notion of decentralised virtual currency going viral. Due to this increased awareness, it is highly probable that Bitcoin will end 2013 above whether it started it, even if the present prices do not prove sustainable. Ultimately, Bitcoin has no fundamentals (P/E, EBITDA, cash flow, etc) and so is worth what people will pay for it. And as Max Keiser, an early champion of Bitcoin put it:

In my view, Bitcoin has a much better chance of being part of the future of money than Groupon ever did of being part of the future of commerce.

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Ben Bernanke Must Be Hoping Rational Expectations Doesn’t Hold…

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In the theory of rational expectations, human predictions are not systematically wrong. This means that in a rational expectations model, people’s subjective beliefs about the probability of future events are equal to the actual probabilities of those future events.

Now, I think that rational expectations is one of the worst ideas in economic theory. It’s based on a germ of a good idea — that self-fulfilling prophesies are possible. Almost certainly, they are. But expressed probabilities are really just guesses, just expressions of a perception. Or, as it is put in Bayesian probability theory: “probability is an abstract concept, a quantity that we assign theoretically, for the purpose of representing a state of knowledge, or that we calculate from previously assigned probabilities.”

Sometimes widely-held or universally-held beliefs turn out to be entirely irrational and at-odds with reality (this is especially true in the investment industry, and particularly the stock market where going against the prevailing trend is very often the best strategy). Whether a belief will lead to a reality is something that can only be analysed on a case-by-case basis. Humans are at best semi-rational creatures, and expectations effects are nonlinear, and poorly understood from an empirical standpoint.

Mainstream economic models often assume rational expectations, however. And if rational expectations holds, we could be in for a rough ride in the near future. Because an awful lot of Americans believe that a new financial crisis is coming soon.

According to a recent YouGov/Huffington Post survey:

75 percent of respondents said that it’s either very or somewhat likely that the country could have another financial crisis in the near future. Only 12 percent said it was not very likely, and only 2 percent said it was not at all likely.

From a rational expectations perspective, that’s a pretty ugly number. From a general economic perspective it’s a pretty ugly number too — not because it is expressing a truth  (it might be — although I’d personally say a 75% estimate is rather on the low side), but because it reflects that society doesn’t have much confidence in the recovery, in the markets, or in the banks.

Why? My guess is that the still-high unemployment and underemployment numbers are a key factor here, reinforcing the idea that the economy is still very much in the doldrums. The stock market is soaring, but only a minority of people own stocks directly and unemployed and underemployed people generally can’t afford to invest in the stock market or financial markets. So a recovery based around reinflating the S&P500, Russell 3000 and DJIA indices doesn’t cut it when it comes to instilling confidence in the wider population.

Another factor is the continued and ongoing stories of scandal in the financial world — whether it’s LIBOR rigging, the London Whale, or the raiding of segregated accounts at MF Global. A corrupt and rapacious financial system run by the same people who screwed up in 2008 probably isn’t going to instill much confidence in the wider population, either.

So in the context of high unemployment, and rampant financial corruption, the possibility of a future financial crisis seems like a pretty rational expectation to me.

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Stocks Priced in Real GDP

Since the 1990s, priced in Real GDP the Dow Jones Industrial Average (as well as the S&P500) has been far above their 20th-century norm:

STockspricedinRealGDP

There is an unsurprising coincidence — as stock prices (and corporate profits) have soared above their historical norm, wage growth has been very stagnant. The economy has come to be tilted toward bankers, financiers, insurance brokers and away from wage-earners, manufacturers and artisans. 

Does that mean that as Hassett and Glassman projected in Dow 36,000, stock prices have climbed to a new plateau? Well, while it is impossible to say exactly what prices will do in future (nominal, or otherwise) the “new plateau” has been very much supported by the Federal Reserve, first by lowering rates and keeping them low:

DJIAFederalFunds

And second through expanding the monetary base by buying securities directly (Bernanke estimates a simulated interest rate decrease of 0.25% for each 250 billion dollars of quantitative easing):

DJIABASE

Each time stocks have turned cheaper, the Fed has stepped in and eased, and stocks have reversed upward.

Some might take that as a sign that stocks aren’t going to get much cheaper, because the Fed won’t let them get much cheaper. First under Greenspan, and second under Bernanke the Fed has succeeded at reinflating the bubble. But the secular trend is back toward the pre-1990s norm. Gravity is against the Fed. The Fed (to use a tired old metaphor) is Atlas, holding stock prices up on its shoulders. Will it be third-time unlucky for the Fed, hell-bent on wealth-effecting and financialising the US economy to prosperity?

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Whose Insured Deposits Will Be Plundered Next?

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According to Zero Hedge, it could be Spain:

 Spain, it would appear, has changed constitutional rules to enable a so-called ‘moderate’ levy on deposits.

New legislation in New Zealand suggests that depositor funds could be used to bail out banks there, too.

Far more worrying for American and British depositors though is this paragraph Golem XIV brings up from a joint Bank of England and FDIC paper from 2012 which points to the possibility of using deposit insurance funds to bail out illiquid banks:

The U.K. has also given consideration to the recapitalization process in a scenario in which a G-SIFI’s liabilities do not include much debt issuance at the holding company or parent bank level but instead comprise insured retail deposits held in the operating subsidiaries. Under such a scenario, deposit guarantee schemes may be required to contribute to the recapitalization of the firm, as they may do under the Banking Act in the use of other resolution tools. The proposed RRD also permits such an approach because it allows deposit guarantee scheme funds to be used to support the use of resolution tools, including bail-in, provided that the amount contributed does not exceed what the deposit guarantee scheme would have as a claimant in liquidation if it had made a payout to the insured depositors.

Of course, if deposit insurance money is used as a resolution tool to bail out a bank which then goes on to fail anyway (as we have already seen multiple times since 2008 — a bank receives a large liquidity injection, and goes onto fail anyway) depositors could end up moneyless.

As Golem XIV notes:

The new system makes the Deposit Guarantee fund available for use as bail out money.

The rationale is that if using your deposit guarantee fund for propping up the bank ‘saves’ the bank from collapse then you wouldn’t need that deposit guarantee would you? This overlooks the one lesson we have all learned from the bank bail outs of the last 5 years, that the bail outs are never, ever, ever, a one off. The first one fails to save the bank as does the second and third and and and.

So if I have read the above correctly – the new system raids the Deposit Protection scheme, gives it to the bank instead of you  and when that fails to save the bank…then what? The bank fails again and there is no money left in the Deposit Guarantee scheme.

Now, in the case of this kind of scenario actually happening, it seems probable that governments and central banks would try to replenish the deposit insurance fund. Whether the fund would be replenished to its full extent, or whether insured depositors would suffer an effective haircut remains to be seen.

These kinds of policy suggestions coming from governments and central banks are extremely worrying for depositors, because it implies that what is happening to Cypriot depositors and Cypriot banks could be forced onto British and American depositors. In a worst-case-scenario, criminally minded bankers (of which there seem to be many) could even use this provision to intentionally run off with deposits.

We know that the TBTF banking sector (or G-SIFI’s — global systemically important financial institutions — as they are now known) remains fragile, over-connected and dependent on insider advantages. That means that over the next few years, it remains possible that there could be another severe banking crisis in Britain or America or both.

Just what in the world do financial regulators think they are doing even implying that depositor guarantee funds could be used to bail out banks under such an eventuality? Such a recommendation — and the attendant possibility of insured depositor haircuts — could severely impact confidence in the banking sector, just as it has done in Cyprus. The possibility that insurance money may go down the toilet to bail out illiquid banks will make some uneasy to invest their money in the banks. If a severe banking crisis looms, it could lead to bank runs, just as is happening in Cyprus. The trend, if events in Cyprus and Europe continue to escalate, and if other jurisdictions do not take steps to protect depositors from banker greed, is toward depositors losing faith in the banking system, and seeking other stores of purchasing power — mattress stuffing, bitcoin, tangibles.

Essentially, if there is to be any confidence in the banking system, the possibility of depleting liquidity insurance funds to bail out banks needs to be taken off the table completely. The possibility of insured depositor haircuts needs to be taken off the table completely. If banks need bailing out, the money must not come from insured depositors, or funds designed to compensate insured depositors. If banks fail, the losers should be the uninsured creditors.

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There Is No Surer Way To Destroy A Banking System Than Giving Depositors A Haircut

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No, not that kind of haircut.

I’m talking about the kind of haircut where depositors lose a portion of their money. This can destroy confidence in a fractional reserve banking system, as depositors in other banks and other countries fear that they too might be forced to take a haircut, leading to mass withdrawals, leading to illiquidity. And — as part of an E.U. bailout of the Cypriot financial system this just happened in Cyprus:

Eurozone finance ministers have agreed a 10bn-euro (£8.7bn) bailout package for Cyprus to save the country from bankruptcy.

The deal was reached after talks in Brussels between the ministers and the International Monetary Fund (IMF).

In return, Cyprus is being asked to trim its deficit, shrink its banking sector and increase taxes.

For the first time in a eurozone bailout, bank depositors are facing a levy on their savings.

This attack on depositors will have clear implications for depositors and banks in other bailout-prone areas of the Eurozone — Spain, Italy, Greece, Portugal. If the EU is prepared to impose haircuts of up to 10% on depositors in Cyprus as part of a bailout package, which countries’ depositors will be forced to take a haircut next? Mattress-stuffing Cypriots will be 10% better-off than their compatriots with confidence in the banking system. Even if only 10% or 20% of bank customers in Spain choose to withdraw their funds, that has the potential to cause serious liquidity problems.

Whether or not this actually happens is another question — although with unemployment running high throughout the Eurozone, those with savings may be particularly wary of losing them. This decision — no matter how many times Draghi and Merkel and Barroso reassure the crowds — makes bank runs throughout the Eurozone much more likely as savers seek to avoid the possibility of a haircut by moving to cash or tangible assets.

And this madness was totally avoidable.

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Sparkassen — A De Facto Glass-Steagall?

Ed Miliband has a very good idea to break the British lending freeze:

Ed Miliband is to make his firmest commitment to a regional-based economic policy when he proposes a network of banks around the country responsible for providing capital to businesses in their locality.

The proposals, due to be unveiled in a speech to the British chambers of commerce, mark a further attempt to map out a different industrial policy, some of which has echoes of plans for a revival of city regions set out by the coalition adviser Lord Heseltine.

Miliband will say it is time to stop tinkering with the banks and recognise a wholly new system is needed.

He will say: “We do not just need a single investment serving the country. We need a regional banking system serving each and every region of the country. Regional banks with a mission to serve that region and that region alone, not banks that are likely to say no but banks that know your region and your business; not banks that you mistrust, but banks you can come to trust.”

I would not support politicians interfering with the financial sector if the British financial sector was a successful model. But the country is still hurting from its utter failure in 2008. Back then, Ed Miliband’s predecessor Gordon chose to bail out the banking system. Had the financial sector been allowed to fail, then a new model would have been forced to emerge. But that wasn’t the case. Now, politicians must take responsibility for putting the banking system on a life support system. The current government’s attempts at reform have not succeeded in revitalising the economy.

Miliband’s idea approximates the German model of Sparkassen — publicly owned regional banks:

Supporters of the local banks claim that in 2011 total loans by the Sparkassen stood at €322bn (£280bn), whereas the total loan stock of Germany’s large commercial banks was only €177bn (£153.5bn). Like Britain’s large banks, Germany’s large commercial banks cut credit during the financial crisis; lending fell by 10% between 2006 and the middle of 2011. In contrast, the Sparkassen increased lending by 17%.

On the surface, regionalisation may be helpful in that British banks have become over-centralised and disconnected from the interests of their local customers. This may be one factor that can explain why local, small and new businesses are struggling to get credit.

But this is an even better idea than Miliband may realise. Why? Because so long as the regional banks behave solely as depository and business investment institutions, and not as investment banks, insurance brokers, hedge funds, shadow banks, or proprietary traders, or any of the other highly interconnective and risky activities favoured by today’s supermarket banks — then such a system acts as de facto Glass-Steagall-style separation between the riskier privately-owned national and international-level commercial banks, and the regional level business investment and savings banks.

Such a system also echoes the recommendation made by Nassim Taleb, to nationalise the parts of the banking system that act as a public utility, and deregulate the rest so it is free to gamble, speculate, succeed and fail without significantly destabilising business lending, public savings, and the wider economy.

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Dow 36,000 Is Back

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In a testament to just how euphoric stock markets are right now, James K. Glassman the co-author of the fabled Dow 36,000 — a book published in 1999 that claimed that stock prices could hit 36,000 by as soon as  2002 (and which quite understandably is now available for just 1 cent per copy) — has written a new column for Bloomberg View claiming that he might have been right all along:

When we wrote our book, we expected that the stock market, as represented by the 30 blue chips of the Dow, would rise to 36,000 for two reasons.

First, investors had mistakenly judged the risk in stocks to be greater than it really was. Here, we drew from the work of Jeremy Siegel of the Wharton School of the University of Pennsylvania. He showed that, over long periods, stocks were no more volatile, or risky, than bonds.

We saw indications that the risk aversion of investors was declining — as we believed it should. Lower perceived risk would mean higher stock valuation measures: rising price-to- earnings ratios, for instance.

Second, we assumed that real U.S. gross domestic product, the main driver of corporate profit growth, would rise at 2.5 percent a year — a bit below the historic post-World War II rate, but still a decent clip. We warned, however, that small changes in growth rates could have big effects on stock prices.

What’s happened since 1999?

First, investors have become more frightened of stocks, not less — as reflected in a higher equity risk premium, the excess return that investors demand from stocks over bonds.

These fears may be perfectly reasonable. We wrote our book before the Sept. 11 attacks, the dot-com debacle, the 38 percent decline in stocks in 2008, the “flash crash” of 2010 that sent the Dow down 1,000 points in minutes, the Japanese tsunami and the euro crisis. There’s a good case to be made that, because of the instant interconnections wrought by new technology, unprecedented “black swan” events are increasing and markets are becoming more volatile as a result.

The heightened fears of investors are reflected in lower valuations. Currently, for example, the forward P/E ratio (based on estimated earnings for the next 12 months) of the Standard & Poor’s 500 Index is about 14. In other words, the earnings yield for a stock investment averages 7 percent (1/14), but the yield on a 10-year Treasury bond is only 1.9 percent — a huge gap. Judging from history, you would have to conclude that bonds are vastly overpriced, that stocks are exceptionally cheap or that investors are scared to death for a good reason. Maybe all three.

Explaining why Glassman and Hassett were wrong is simple. They believed that they had found a fundamental truth about how stocks should be valued — that stocks were really less risky than the market perceived them to be — and that the market would correct to meet their beliefs. The problem is that there is no fundamental truth about what stocks are worth. The fundamentals of a company are determined by profit and loss, but the market prices of stocks are created from the meeting of different parties with different subjective beliefs. A buyer of a stock at $10 might believe it will become worth $100, and the seller might believe it is really worth $5. The future performance of that stock will be determined by the future beliefs of market participants in light of the future performance of the firm. Market participants have for some reason always valued equities as a class within a certain P/E range:

P/E

With one exception — the peak during which Dow 36,000 was written — equities have traded roughly between 5 and 30 times earnings. That’s a large range.  Glassman and Hassett believed — and subsequently tried to convince markets — that they were pricing equities wrong, and that stocks should be priced at roughly 100 times earnings.  They failed. Markets just wouldn’t go there.

One significant issue with such predictions is that there are far too many unknown variables. They didn’t know future technology or energy trends. They didn’t know future geopolitical trends. They didn’t know future social or demographic trends. They didn’t know the shape or style of future financial markets. All of these trends are critical in determining market sentiment, and the financial, economic and material fundamentals that drive earnings. It was all a big extrapolation with a catchy-sounding number that they effectively pulled out of the air and dressed up in the false clothes of economic rigour. And the real economy — as Glassman candidly admits — just didn’t match up to their assumptions.

Glassman thinks that Dow 36,000 is attainable with a return to strong growth:

Let’s set investor fears aside for a moment. For investment gains over the long term, there is absolutely no substitute for faster economic growth.

To get it, we need policy changes that will create a better environment for businesses to increase revenue, profits and jobs: a rational tax system that keeps rates low and eliminates special deductions and credits; immigration laws that encourage the best and the brightest to move here and stay; entitlement reform to bring down costs and provide incentives for productive seniors to keep working; sensible environmental, workplace and financial regulation that allows entrepreneurship to thrive; a K-12 education system that boosts student achievement and holds teachers, administrators and politicians accountable …

Chime in and make your own list, because it’s time to focus on what counts in an economy: growth. Even with relatively high risk aversion (let’s say, what we have now), faster growth would significantly increase stock prices.

How fast can the U.S. grow? Four percent is attainable, but I’d settle for 3 percent. Get there quickly, and we’ll get to Dow 36,000 quickly, too.

Back in the real world, we have the opposite problem. Stocks are soaring, on the back of a very weak economy. In fact, the fact that Glassman is being given a platform again to talk about the possibility of huge future stock gains is probably testament to just how overvalued stocks are. The market has more than doubled since the trough in 2009 on the back of the idea that Bernanke will do whatever it takes. But that illusion could easily be shattered, because there are many kinds of negative shocks that central bankers cannot prevent or control. To justify present valuations in the next two years, we would need a significant uptick in American and probably also global growth. Instead we have what may be the biggest housing bubble in history, declining global growth, North Korean threats to start a nuclear war, and so on. And all the while the market is setting new nominal highs.

The uber-optimistic atmosphere permeating much of the financial press is frightening to me. The resurrection of the Dow 36,000 zombie is a symbolically significant event that likely signals much the same thing as it did first time around: a correction.

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This Time It’s Different 2013 Edition

A small note on the frankly hilarious news that the Dow Jones Industrial Average smashed through to all-time-highs.

First of all, while stock prices are soaring, household income and household confidence are slumping to all-time lows. Employment remains depressed, energy remains expensive, housing remains depressed, wages and salaries as a percentage of GDP keep falling, and the economy remains in a deleveraging cycle. Essentially, these are not the conditions for strong organic business growth, for a sustainable boom. We’re going through a structural economic adjustment, and suffering the consequences of a huge 40-year debt-fuelled boom. While the fundamentals remain weak, it can only be expected that equity markets should remain weak. But that is patently not what has happened.

In fact, it has been engineered that way. Bernanke has been explicitly targeting equities, hoping to trigger a beneficent spiral that he calls “the wealth effect” — stock prices go up, people feel richer and spend, and the economy recovers. But with fundamentals still depressed, this boom cannot be sustained.

There are several popular memes doing the rounds to suggest, of course, that this time is different and that the boom times are here to stay, including the utterly hilarious notion that the Dow Jones is now a “safe haven”. They are all variations on one theme — that Bernanke is supporting the recovery, and will do whatever it takes to continue to support it. Markets seem to be taking this as a sign that the recovery is real and here to stay. But this is obviously false, and it is this delusion that — as Hyman Minsky clearly explained last century — is so dangerous.

There are many events and eventualities under which throwing more money at the market will make no difference. Central banks cannot reverse a war, or a negative trade shock, or a negative production shock, or a negative energy shock simply by throwing money at it. And there are severe limits to their power to counteract financial contractions outside their jurisdiction (although in all fairness the Federal Reserve has expanded these limits in extending liquidity lines to foreign banks). Sooner or later the engineered recovery will be broken by an event outside the control of central bankers and politicians. In creating a false stability, the Federal Reserve has actually destabilised the economy, by distorting investors’ perceptions.

But, of course, some analysts think that this time really is different. Here’s a chart from Goldman showing the S&P500 by sectoral composition:

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The implication here is clear — with no obvious sectoral bulge like that of the late 1970s, the tech bubble, and the financial bubble — there is no bubble. But what if the bubble is spread evenly over multiple sectors? After all, the Federal Reserve has been reinflating Wall Street in general rather than any one sector in particular.

Wall Street leverage is, unsurprisingly, approaching 2007 levels:

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Is this the final blowout top? I’m not sure. But I would be shocked to see this bubble live beyond 2013, or 2014 at the latest. I don’t know which straw will break the illusion. Middle eastern war? Hostility between China and Japan? North Korea? Chinese real estate and subprime meltdown? Student debt? Eurozone? Natural disasters? Who knows…

The wider implications may not be as bad as 2008. The debt bubble has already burst, and the deleveraging cycle has already begun. Total debt is slowly shrinking. It is plausible that we will only see a steep correction in stocks, rather than some kind of wider economic calamity. On the other hand, it is also plausible that this bursting bubble may herald a deeper, darker new phase of the depression.

With every day that the DJIA climbs to new all-time highs, more suckers will be drawn into the market. But it won’t last. Insiders have already gone aggressively bearish. This time isn’t different.

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Save Our Bonuses!

With the British economy in a worse depression than the 1930s , bank lending to businesses severely depressed, and unemployment still high, a sane finance minister’s main concern might be resuscitating growth.

Prime Minister David Cameron And Chancellor George Osborne Ahead Of A Critical Week At The Leveson Inquiry

George Osborne’s main concern, however, are the poor suffering bankers:

Chancellor George Osborne flies to Brussels later determined to water down the European Parliament’s proposals to curb bankers’ bonuses.

But EU finance minsters in the Economic and Financial Affairs Council (Ecofin) are expected to approve last week’s proposals.

They include limiting bonuses to 100% of a banker’s annual salary, or to 200% if shareholders approve.

The City of London fears the rules will drive away talent and restrict growth.

Mayor of London Boris Johnson has dismissed the idea as “self-defeating”. London is the EU’s largest financial centre.

On Monday, a spokesman for Prime Minister David Cameron said: “We continue to have real concerns on the proposals. We are in discussions with other member states.”

But Mr Osborne’s bargaining power may be weakened further by Switzerland’s recent decision to cap bonuses paid to bankers and give shareholders binding powers over executive pay.

Now, I couldn’t care less about bonuses or pay in a free industry where success and failure are determined meritocratically. It is none of my business. If a successful business wants to pay its employees bonuses, then that is that business’s prerogative. If it wants to pay such huge bonuses that it puts itself out of business, then that is that business’s prerogative.

But the British financial sector is the diametrical opposite of a successful industry. It is a forlorn bowlegged blithering misshapen mess. The banks were bailed out by the taxpayer. They do not exist on the merits of their own behaviour. Two of the biggest are still owned by the taxpayer.  So I — as a taxpayer and as a British citizen — have an inherent personal interest in the behaviour of these banks and their employees.

In an ideal world, I would have let the banks go to the wall. The fact that the financial system is still on life support almost five years after the crisis began tells a great story. It’s not just that I don’t believe in bailing out failed and fragile corporations (although I do believe that this is immoral cronyism). The excessive interconnectivity built up over years prior to the crisis means that the pre-existing financial structure is extremely fragile. Sooner or later, without dismantling the fragilities (something that patently has not happened, as the global financial system today is as big and corrupt and interconnective as ever), the system will break again. (Obviously in a no-bank-bailout world, other action would have been required. Once the financial system had been allowed to fail, depositors would have to be bailed out, and a new financial system would have to be seeded and capitalised.)

But we do not live in an ideal world. We have inherited a broken system where the bankers (and not solely the ones whose banks are owned by the taxpayer — all banks benefit from the implicit liquidity guarantees of central banks) are living on taxpayer largesse. That gives the taxpayer the right to dictate terms to the banking sector.

Unfortunately, this measure (like many such measures dreamed up arbitrarily by bureaucrats) is rather pointless as it can be so very easily gamed by inflating salaries. And it will do nothing to address financial sustainability, as it does not address the problem that led to the 2008 liquidity panic — excessive balance sheet interconnectivity (much less the broader problems of moral hazard, ponzification, and the current weakened lending conditions).

But, if it is a step toward a Glass-Steagall-style separation of retail and investment banking — a solution which would actually address a real problem, and one advocated in the Vickers report — then perhaps that is a good thing. Certainly, it is not worth picking a fight over. The only priority Osborne should have right now is creating conditions in which the private sector can grow sustainably. Unlimiting the bonuses of the High Priests of High Finance has nothing whatever to do with that.

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Of Krugman & Minsky

Paul Krugman just did something mind-bending.

KrugMan-625x416

In a recent column, he cited Minsky ostensibly to defend Alan Greenspan’s loose monetary policies:

Business Insider reports on a Bloomberg TV interview with hedge fund legend Stan Druckenmiller that helped crystallize in my mind what, exactly, I find so appalling about people who say that we must tighten monetary policy to avoid bubbles — even in the face of high unemployment and low inflation.

Druckenmiller blames Alan Greenspan’s loose-money policies for the whole disaster; that’s a highly dubious proposition, in fact rejected by all the serious studies I’ve seen. (Remember, the ECB was much less expansionary, but Europe had just as big a housing bubble; I vote for Minsky’s notion that financial systems run amok when people forget about risk, not because central bankers are a bit too liberal)

Krugman correctly identifies the mechanism here — prior to 2008, people forgot about risk. But why did people forget about risk, if not for the Greenspan put? Central bankers were perfectly happy to take credit for the prolonged growth and stability while the good times lasted.

Greenspan put the pedal to the metal each time the US hit a recession and flooded markets with liquidity. He was prepared to create bubbles to replace old bubbles, just as Krugman’s friend Paul McCulley once put it. Bernanke called it the Great Moderation; that through monetary policy, the Fed had effectively smoothed the business cycle to the extent that the old days of boom and bust were gone. It was boom and boom and boom.

So, people forgot about risk. Macroeconomic stability bred complacency. And the longer the perceived good times last, the more fragile the economy becomes, as more and more risky behaviour becomes the norm.

Stability is destabilising. The Great Moderation was intimately connected to markets becoming forgetful of risk. And bubbles formed. Not just housing, not just stocks. The truly unsustainable bubble underlying all the others was debt. This is the Federal Funds rate — rate cuts were Greenspan’s main tool — versus total debt as a percentage of GDP:

fredgraph (18)

More damningly, as Matthew C. Klein notes, the outgrowth in debt very clearly coincided with an outgrowth in risk taking:

To any competent central banker, it should have been obvious that the debt load was becoming unsustainable and that dropping interest rates while the debt load soared was irresponsible and dangerous. Unfortunately Greenspan didn’t see it. And now, we’re in the long, slow deleveraging part of the business cycle. We’re in a depression.

In endorsing Minsky’s view, Krugman is coming closer to the truth. But he is still one crucial step away. If stability is destabilising, we must embrace the business cycle. Smaller cyclical booms, and smaller cyclical busts. Not boom, boom, boom and then a grand mal seizure.