Wall Street

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Why China is Holding All That Debt

What does it mean that China are making a lot of noise about the Federal Reserve’s loose monetary policy?

 Via Reuters:

A senior Chinese official said on Friday that the United States should cut back on printing money to stimulate its economy if the world is to have confidence in the dollar.

Asked whether he was worried about the dollar, the chairman of China’s sovereign wealth fund, the China Investment Corporation, Jin Liqun, told the World Economic Forum in Davos: “I am a little bit worried.”

“There will be no winners in currency wars. But it is important for a central bank that the money goes to the right place,” Li said.

At first glance, this seems like pretty absurd stuff. Are we really expected to believe that China didn’t know that the Federal Reserve could just print up a shit-tonne of money for whatever reason it likes? Are we really expected to believe that China didn’t know that given a severe economic recession that Ben Bernanke would throw trillions and trillions of dollars new money at the problem? On the surface, it would seem like the Chinese government has shot itself in the foot by holding trillions and trillions of dollars and debt instruments denominated in a currency that can be easily depreciated. If they wanted hard assets, they should have bought hard assets.

As John Maynard Keynes famously said:

The old saying holds. Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed.

But I think Keynes is wrong. I don’t think China’s goal in the international currency game was ever to accumulate a Scrooge McDuck-style hoard of American currency. I think that that was a side-effect of their bigger Mercantilist geopolitical strategy. So China’s big pile of cash is not really the issue.

Scrooge-McDuck

It is often said that China is a currency manipulator. But it is too often assumed that China’s sole goal in its currency operations is to create growth and employment for China’s huge population. There is a greater phenomenon — by becoming the key global manufacturing hub for a huge array of resources, components and finished goods, China has really rendered the rest of the world that dependent on the flow of goods out of China. If for any reason any nation decided to attack China, they would in effect be attacking themselves, as they would be cutting off the free flow of goods and components essential to the function of a modern economy. China as a global trade hub — now producing 20% of global manufacturing output, and having a monopoly in key resources and components — has become, in a way, too big to fail. This means that at least in the near future China has a lot of leverage.

So we must correct Keynes’ statement. Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed; owe him £1 trillion, and become dependent on his manufacturing output, and the position is reversed again.

The currency war, of course, started a long time ago, and the trajectory for the Asian economies and particularly China is now diversifying out of holding predominantly dollar-denominated assets. The BRICs and particularly China have gone to great length to set up the basis of a new reserve currency system.

But getting out of the old reserve currency system and setting up a new one is really a side story to China’s real goal, which appears to have always been that of becoming a global trade hub, and gaining a monopoly on critical resources and components.

Whether China can successfully consolidate its newfound power base, or whether the Chinese system will soon collapse due to overcentralisation and mismanagement remains to be seen.

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When Solar Becomes Cheaper Than Fossil Fuels

Solar power has been getting cheaper and cheaper:

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Current estimates suggest that solar might be as cheap as coal by the end of the decade, and half the cost of coal by the end of the next decade:

If the trend continues for another 8-10 years, which seems increasingly likely, solar will be as cheap as coal with the added benefit of zero carbon emissions. If the cost continues to fall over the next 20 years, solar costs will be half that of coal. These predictions may in fact be too conservative given that First Solar have reported internal production costs of 75 cents (46 pence) per watt with an expectation of 50 cents (31 pence) per watt by 2016.

When applied to electricity prices this predicts that solar generated electricity in the US will descend to a level of 12 cents (7 pence) per kilowatt hour by 2020, possibly even 2015 for the sunniest parts of America.

What does that mean? Cheap, decentralised, plentiful, sustainable energy production. This would be a massive relief to global markets that have been squeezed in recent years by the rising cost of oil extraction, which has been passed onto consumers. Falling energy prices — all else being equal — mean more disposable income to save and invest, or to spend.

Some will say that solar is inherently unviable due to the difficulty of storing energy. But huge advances have been made on that front in recent years, and improvements continue.

This — if it comes to pass — would be a basis for a period of strong growth. Independence from foreign oil. Independence from falling EROEI yields on conventional energy. A robust decentralised grid. A new sustainable energy supercycle — and new growth in other industries that benefit from falling energy costs. This has the potential to reverse so many of the negative trends we have seen emerge in recent years, and prove wrong the Malthusians who claim that humanity has over-extended itself and that the era of growth is over.

In the long term, this makes me pretty bullish. But unfortunately this is all still years away. Maybe five, maybe ten, maybe twenty years. We’re not out of the woods yet. Not for a long time.

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What Could Possibly Go Wrong?

Uber-bullishness is the order of the day in the markets. Last week I noted that the DJIA has climbed to a new post-2007 high. And now, the “fear index” VIX is hitting all-time lows:

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Popular commentators like Bill McBride are declaring the era of crisis to be almost over:

It looks like economic growth will pickup over the next few years. I’ve written about this before – a combination of growth in the key housing sector, a significant amount of household deleveraging behind us, the end of the drag from state and local government layoffs (four years of austerity nearing the end), some loosening of household credit, and the Fed staying accommodative (with a 7.8% unemployment rate and inflation below the Fed’s target, the Fed will remain accommodative).

While there has been recovery in metrics like industrial production, durable goods orders and GDP, the (artificially stimulated) euphoria in markets is probably strange news to consumers and workers and businesses and job seekers in the real economy. All the various measures of unemployment remain weak especially the employment-population ratio which is still deeply depressed. Private-sector debt remains dangerously high. Home prices are still depressed and foreclosures remain high. Consumer sentiment remains depressed. The financial sector continues to blunder from disaster to disaster. And there are lots of big geopolitical dangers still on the table — not least Japan-China and Iran-Israel.

This implies that the market has become dangerously euphoric, and that risk is being improperly priced.

The last time VIX fell to an all-time low and market-confidence hit an all-time high, it presaged a financial crisis. John Stoltzfus of Oppenheimer Asset Management writes:

We caution our readers about past periods of deflated volatility; the last time the VIX traded down to a new low, which occurred on 01/24/07, it rallied drastically in the following month. Approximately six weeks later on 03/05/07 the index had increased to 98.48%. By 08/16/07, less than eight months from the low, the VIX index was up 211.73%.

This time may not be so different.

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2008 Again?

The so-called recovery is built on sand, and as stock markets climb and climb, and more traders and investors turn bullish, we come ever-closer to a new 2008-style collapse.

Markets have already gone far, far higher than many expected on a drift of reinflationary central bank liquidity. Yesterday the DJIA hit a new post-2007 high:

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The same day, it was revealed that the big Wall Street banks are gambling again with billions and billions of dollars of clients’ funds. Goldman Sachs are back to pre-crisis-style profits. Again and again — from the LIBOR scandal, to MF Global, to the London Whale, to Kweku Adoboli — the financial sector has illustrated that it has learned very little from 2008, and is still practising many of the same hyper-fragile ponzi finance practices that led to the subprime bubble and the 2008 collapse.

Soaring markets, and soaring speculation. Big finance using loopholes to speculate bigger and harder. Mainstream financial journalists becoming more and more complacent about the “recovery”.

We’ve been here before. Isn’t repeating the same behaviour and hoping for different results the very definition of insanity? 

I don’t know exactly how the next crash will occur — although there are many potential ignition spots including a severe trade or energy shock, or a Chinese real estate and subprime meltdown, or a natural disaster, or a new Western financial crisis.  I don’t know when the next crash will occur, or how high the markets will climb before it does (DJIA 36,000 maybe? That would be hilarious).

But I know that if markets and regulators continue to repeat the mistakes that led to 2008, we will be back in a similar or worse hole soon.

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Ding Dong the Coin Is Dead

I laughed a lot when it was announced that Obama wasn’t going to mint a platinum coin and effectively render the debt ceiling obsolete. And not because I hope for or expect the USA to immediately and chaotically default. Not because I expect the Federal government to not raise the debt ceiling again.

I laughed a lot because the platinum coin was a very, very silly idea. I laughed a lot because there was no clue of any such event taking place. It was a pure myth talked into prominence by Business Insider for pageviews and advertising dollars, and by other bloggers who should have known better.

Bruce Krasting writes that the platinum coin was killed by foreign central banks who thought it would set a dangerous precedent, and ultimately by Ben Bernanke:

It was the Fed, in a message delivered by Bernanke, that caused Obama to back off on any consideration of the Coin. There might have been wiggle room in existing law to print a Coin, but there is nothing that says that the Fed had to take it. And Bernanke said, “No”. When Obama ditched the Coin, he did it because it was no longer an option. Bernanke took the option off the table. The WH statement makes it sound as it it was their decision, that’s just smoke and mirrors.

I don’t even think it got that far.

As I wrote last week:

I think all parties other than the pundits thought the idea was ridiculous and totally unpalatable. For both Obama and Boehner — and especially Bernanke — negotiating a settlement is far, far more attractive than the signals of fiscal disarray that would have been sent by minting the platinum coin. Not to mention that minting a platinum coin and depositing it at the Fed to avert the debt ceiling would have been open to serious legal challenge. Compromise was the order of the day in 2011, and on the fiscal cliff, and it will be the order of the day on the debt ceiling again.

The people who advocated for the platinum coin were mostly doing so because they don’t like compromise. They wanted their side to effectively steamroller the other side into total submission. Right or wrong, that’s not how politics works. A deal will be done. It may not be a deal that Krugman, or Weisenthal, or Boehner, or Obama or Ron Paul or the country in general really likes, though.

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The Interconnective Web of Global Debt

It’s very big:

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Andrew Haldane:

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

A mutual incendiary device sounds about right.

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Too Big To Jail

What’s worse than unjust and ineffective laws like the failed War on Drugs and the failed sanctions on Iran?

Unjust and ineffective laws that apply to ordinary folks, but not to banksters:

When the Justice Department announced its record $1.9 billion settlement against British bank HSBC last week, prosecutors called it a powerful blow to a dysfunctional institution accused of laundering money for Iran, Libya and Mexico’s murderous drug cartels.

But to some former federal prosecutors, it was only the latest case of the government stopping short of bringing criminal money laundering charges against a big bank or its executives, at least in part on the rationale that such prosecutions could be devastating enough to cause such banks to fail.

They say it sounds a lot like the “too big to fail” meme that kept big but sickly banks alive on the support of taxpayer-funded bailouts. In these cases, they call it, “Too big to jail.”

This stings. It should sting anyone who cares about the idea of equality in front of the law, anyone who cares about the basic rule of law, anyone who doesn’t want to see their society devolve into a festering pool of feudalism.

According to the most recent data, there were 197,050 sentenced prisoners under federal jurisdiction of which 94,600 were serving time for drug offenses.There were 1,362,028 sentenced prisoners under state jurisdiction of which 237,000 were serving time for drug offenses. That’s over 300,000 individuals serving time currently for drugs offenses, in addition to over one million currently on probation. Now I don’t agree with the War on Drugs at all. But big banks are deemed too “systemically important” to be held to the same standard as the huge and disproportionately black population of low-level drug users.

BlackPrisoners

If the Drug War laws don’t apply to the big banks — if Wall Street bankers who have broken the law can’t go to prison too — then how is incarcerating low-level drug users really much different to chattel slavery?

And not only do private prison companies pocket massive profits from the taxpayers’ purse for running the prisons, but prisoners are a pool of ultra-cheap indentured labour.

As Todd Curl notes:

Prisons in the United States used to be institutions of actual reform and rehabilitation. Men who entered a prison, would often learn a trade and have a usable skill to earn a legitimate living upon release. The recidivism rates have sharply increased as job and education programs within prisons–especially private prisons–have steadily declined. This is not to say that skills are not acquired in these private prisons, quite the contrary. In many of these private prisons, inmates are contracted as telemarketers, among other things, for many large corporations. These prisoners can earn as much as 75 cents an hour for their job–sometimes under 40 cents. What’s the payoff one might ask? For one, corporations get very cheap—third world cheap—labor that cannot unionize, cannot call in sick and cannot complain without fear of time added to their sentence or retaliation from guards who overworked and underpaid themselves, and risk losing their livelihood if an “uppity” prisoner refuses their indentured corporate servitude.

The War on Drugs is descending from tragedy into farce. Poor black drug users are fair game for the slave labour business. Rich Wall Street bankers who launder drug money? Nope.

In May I asked:

Have the 2008 bailouts cemented a new feudal aristocracy of bankers, financiers and too-big-to-fail zombies, alongside a serf class that exists to fund the excesses of the financial and corporate elite?

Only time will tell.

Time is telling.

Once a certain segment of society becomes protected from criminal liability, that society has travelled a long way down the road to feudalism, to a caste system, to serfdom.

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Jamie

Warren Buffett wants to give Jamie Dimon a job:

On the Charlie Rose show [last month], Buffett was asked what kind of message it would send if President Obama picked Jamie Dimon or another Wall Street banker to succeed Timothy Geithner, who has expressed a desire to leave the post after Obama’s first term.

“I think he’d be terrific,” said Buffett, chairman of Berkshire Hathaway, about Dimon. “If we did run into problems in markets, I think he’d actually be the best person you could have in the job.”

Buffett added that Dimon would have the confidence of world leaders if he were appointed to the Treasury post.

Warren Buffett is one of America’s biggest bailout beneficiaries, having profited hugely from buying into firms whose assets were subsequently bailed out. Shortly after the crisis began in 2008, Warren Buffett loaned money to, and bought options from, Goldman Sachs, seemingly with the knowledge the bailout of AIG — a counterparty to which Goldman had massive, massive exposure — would take place.

Dimon as Treasury Secretary would intend more of the same. Dimon and Buffett and others like them believe in having their cake and eating it. They seem to believe that the U.S. taxpayer should provide a liquidity lifeline to their fragile and risky too-big-to-fail businesses, but without at the same time demanding any regulatory oversight to prevent too-big-to-fail banks from acting irresponsibly.

The Financial Times noted in 2011:

Jamie Dimon, chief executive of JPMorgan Chase, launched a broadside against financial regulation on Wednesday, warning that new capital rules could be “the nail in our coffin for big American banks”.

Regulators are negotiating international capital standards for the biggest banks but Mr Dimon said setting the new requirements too high, or allowing overseas banks to calculate their asset base differently, could disadvantage US banks and was already stifling economic growth.

If you want to set it so high that no big bank ever goes bankrupt … I think that would greatly diminish growth,” he told a US Chamber of Commerce conference. Too large a disparity in capital requirements between Europe and the US would mean “you’re pretty much putting the nail in our coffin for big American banks,” he said.

What this really amounts to is a lack of skin in the game. Big banks can gamble and speculate without remorse and without risk — if they win they keep the proceeds, and if they lose the taxpayer will pick up the pieces. This destroys the market mechanism, and any hope of self-regulation. Were lessons learned from 2008? If the antics of Corzine, Kweku Adoboli and the London Whale — just three big financial blowups in the last year — are any guide, big finance is acting just as irresponsibly and self-destructively as before the crisis.

Buffett and Dimon surely have in mind more cronyism, bailouts and free lunches, but the reality of the next four years and beyond may be very different indeed.

While it is impossible to predict exactly when the next crisis will emerge, the current slump in capital goods orders, the intractable debt overhang, and the general trend of ditching the dollar as a reserve currency do not look good. As one of the architects (both practically and ideologically) of the current mess, Dimon as Treasury Secretary would at least get all the blowback and blame when the bubblecovery finally implodes into a currency or supply chain crisis that cannot be bailed out through liquidity injections.

JamieCoyote

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Too Big To Understand

One thing that has undergone hyperinflation in recent years is the length of financial regulations:

Too Big To Understand

The Dodd-Frank regulatory hyperinflation crowds out those who cannot afford teams of legal counsel, compliance officers, and expansive litigation. Dodd-Frank creates new overheads which are no challenge for large hedge funds and megabanks armed with Fed liquidity, but a massive challenge for startups and smaller players with more limited resources.

As BusinessWeek noted in October:

The law requires Hedge Funds to register with the Securities and Exchange Commission, supply reams of sensitive data on trading positions, carefully screen potential investors, and hire compliance officer after compliance officer.

So, is this expansion in volume likely to improve financial stability? No — the big banks are bigger and more interconnected than ever, which was precisely the problem before 2008, and they are still speculating and arbitraging with very fragile strategies that can incur massive losses as MF Global’s breakdown and more recently the London Whale episode proves.

Andy Haldane laid out the problem perfectly in his recent paper The Dog and the Frisbee:

Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to understand and apply Newton’s Law of Gravity.

Yet despite this complexity, catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a Doctorate in physics. It is a task that an average dog can master. Indeed some, such as border collies, are better at frisbee-catching than humans.

So what is the secret of the dog’s success? The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. For studies have shown that the
frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant. Humans follow an identical rule of thumb.

Catching a crisis, like catching a frisbee, is difficult. Doing so requires the regulator to weigh a complex array of financial and psychological factors, among them innovation and risk appetite. Were an economist to write down crisis-catching as an optimal control problem, they would probably have to ask a physicist for help.

Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators, some with a Doctorate in physics. Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities. No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.

So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity.

Big, messy legislation leaves legal loopholes that clever and highly-paid lawyers and (non-) compliance officers can cut through. Bigger and more extensive regulation can make a system less well-regulated. I propose that this is what the big banks will use Dodd-Frank to accomplish.

I predict that the regulatory hyperinflation will make the financial industry and the wider economy much more fragile.

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The Icelandic Success Story

Emotionally, I love Iceland’s financial policies since the crash of 2008:

Iceland

Iceland went after the people who caused the crisis — the bankers who created and sold the junk products — and tried to shield the general population.

But what Iceland did is not just emotionally satisfying. Iceland is recovering, while the rest of the Western world — which bailed out the bankers and left the general population to pay for the bankers’ excess — is not.

Bloomberg reports:

Few countries blew up more spectacularly than Iceland in the 2008 financial crisis. The local stock market plunged 90 percent; unemployment rose ninefold; inflation shot to more than 18 percent; the country’s biggest banks all failed.

This was no post-Lehman Brothers recession: It was a depression.

Since then, Iceland has turned in a pretty impressive performance. It has repaid International Monetary Fund rescue loans ahead of schedule. Growth this year will be about 2.5 percent, better than most developed economies. Unemployment has fallen by half. In February, Fitch Ratings restored the country’s investment-grade status, approvingly citing its “unorthodox crisis policy response.”

So what exactly did Iceland do?

First, they create an aid package for homeowners:

To homeowners with negative equity, the country offered write-offs that would wipe out debt above 110 percent of the property value. The government also provided means-tested subsidies to reduce mortgage-interest expenses: Those with lower earnings, less home equity and children were granted the most generous support.

Then, they redenominated foreign currency debt into devalued krone, effectively giving creditors a big haircut:

In June 2010, the nation’s Supreme Court gave debtors another break: Bank loans that were indexed to foreign currencies were declared illegal. Because the Icelandic krona plunged 80 percent during the crisis, the cost of repaying foreign debt more than doubled. The ruling let consumers repay the banks as if the loans were in krona.

These policies helped consumers erase debt equal to 13 percent of Iceland’s $14 billion economy. Now, consumers have money to spend on other things. It is no accident that the IMF, which granted Iceland loans without imposing its usual austerity strictures, says the recovery is driven by domestic demand.

What this meant is that unsustainable junk was liquidated. While I am no fan of nationalised banks and believe that eventually they should be sold off, there were no quick and easy bailouts that allowed the financial sector to continue with the same unsustainable bubble-based folly they practiced before the crisis (as has happened throughout the rest of the Western world).  

And best of all, Iceland prosecuted the people who caused the crisis, providing a real disincentive (as opposed to more bailouts and bonuses):

Iceland’s special prosecutor has said it may indict as many as 90 people, while more than 200, including the former chief executives at the three biggest banks, face criminal charges.

Larus Welding, the former CEO of Glitnir Bank hf, once Iceland’s second biggest, was indicted in December for granting illegal loans and is now waiting to stand trial. The former CEO of Landsbanki Islands hf, Sigurjon Arnason, has endured stints of solitary confinement as his criminal investigation continues.

That compares with the U.S., where no top bank executives have faced criminal prosecution for their roles in the subprime mortgage meltdown. The Securities and Exchange Commission said last year it had sanctioned 39 senior officers for conduct related to the housing market meltdown.

Iceland’s approach is very much akin to what I have been advocating — write down the unsustainable debt, liquidate the junk corporations and banks that failed, disincentivise the behaviour that caused the crisis, and provide help to the ordinary individuals in the real economy (as opposed to phoney “stimulus” cash to campaign donors and big finance).

And Iceland has snapped out of its depression. The rest of the West, where banks continue to behave exactly as they did prior to the crisis, not so much.