Correction or Crisis?


After almost seven years of relative calm and stability, a stock market crash is finally upon us.

This is a very predictable crash stemming from a very widely known cause. Hundreds of analysts including myself — following the trail illuminated by Michael Pettis — have for a long time been banging on about a Chinese slowdown gathering an uncontrollable momentum, sending China into a panic, and infecting global markets.

What’s less clear yet is whether this is a correction or a crisis. My view is toward the latter, simply because confidence is fragile.  Once the animal spirits of the market turn negative, it takes a heck of a lot to soothe them. And the markets look increasingly spooked. The fear is rising. Last week I tweeted that I felt the risks of a new financial crisis are greater than ever.

The reasons why are simple: Western central banks have gone a bit nuts, and are trying to hike rates even though inflation is close to zero even after interest rates being at zero for seven years. And Western governments have gone a bit nuts (especially in the eurozone and Britain but also to a lesser extent in the United States) and are trying to encourage growth with austerity even though all the evidence illustrates that austerity is only a helpful policy in a booming economy, not in a slack one.

Those two factors weren’t too destructive in an economic situation where there was moderate economic growth. More like a minor brake on growth. Keep swimming forward, and sooner or later inflation will rear its head, and rates will have to be raised. But with a stock market crash and a growth downturn, and an unemployment spike, and deflation, things get very problematic very fast.

Let me explain how I think this plays out: interest rates are at zero. Inflation is almost at zero, and a stock market crash will only push that lower. Simply, this is the bottom falling out of the bottom. A crash here is like falling off the bicycle in spite of the Fed’s training wheels. Unconventional monetary policy has already been exhaustively tried, and central bank balance sheets are already heavily loaded with assets purchased in quantitative easing programs. Now the Fed’s balance sheet does not excessively concern me — central banks can print all the money they like to buy assets up to the point of excessive inflation. But will that be enough to reverse a new crash?

Personally, my doubts are growing. At the zero bound, I believe Keynes was right, and fiscal policy is the best answer. The post-2008 economic landscape has been defined by monetarists trying desperately to perfect new tools like quantitative easing to avoid outright debt-financed fiscal policy. But there have been problems upon problems with the transmission mechanisms. Central banks have succeeded at getting new money into the banking system. But the drip of that money into the real economy where it can do its good work and create growth, employment and prosperity has been slow and uneven. The recovery is real, but weak, even after all the trillions of QE. And it has left us vulnerable to a new downturn.

If the effects of the crash cannot be reversed with monetary policy, that leaves fiscal policy — that old, neglected, unpopular tool — to fight any breakouts of deflation or mass unemployment.

Or it leaves central banks to try really radical policies that emulate the directness of fiscal policy, like literally throwing money out of helicopters or OMFG.


The taper is finally here: What the Fed’s move means for the economy

Ben Bernanke, in his final press conference as chairman of the Federal Reserve, announced today that the central bank would be tapering asset purchases to $75 billion a month, down from $85 billion, which has been widely seen as a modest first step toward reducing the Fed’s outsized role in financial markets and the economy.

The move caught many economists by surprise — USA Today survey found that most economists polled said the Fed would maintain its current levels of quantitative easing, as the policy is known, before trimming down in January.

After the financial crisis in 2008, spooked investors started piling into low-risk assets like Treasuries, driving prices dramatically higher. The Fed’s aim in buying these assets was to take safe investments like Treasuries off the market, in order to encourage investors to take more risk and invest in higher-yielding and more productive ventures like stocks, equipment, and new employees.

The ultimate objective was more jobs, and more economic activity.


Can The Fed Taper?

The Taper Tapir

Back in June, I correctly noted that it was severely unlikely that the Federal Reserve would taper its asset buying programs in September. I based this projection on the macroeconomic indicators on which the Federal Reserve bases its decisions — unemployment, and inflation. The Federal Reserve has a mandate from Congress to delivery a monetary policy that results in full employment, and low and stable inflation. With consumer price inflation significantly below the Fed’s self-imposed 2% goal, and with the rate of unemployment relatively high — currently well over 7% — I saw very little chance of the Fed effectively tightening by reducing his asset purchases.

There exists another school of thought that also correctly noted that the Fed would not taper. This other school, however, believes that the Fed cannot ever taper and that the Fed will destroy the dollar before it ceases its monetary activism. This view is summarised by the Misesian economist Pater Tanebrarum:

While it is true that the liquidation of malinvested capital would resume if the monetary heroin doses were to be reduced, the only alternative is to try to engender an ‘eternal boom’ by printing ever more money. This can only lead to an even worse ultimate outcome, in the very worst case a crack-up boom that destroys the entire monetary system.

So the Misesian view appears to be that the Fed won’t stop buying because doing so would result in a mass liquidation, and so the Fed will print all the way to hyperinflation.

Since talk of a taper began, rates certainly spiked as the market began to price in a taper. How far would an actual taper have pushed rates up? Well, it’s hard to say. But given that banks now have massive capital buffers in the form of excess reserves — as well as a guaranteed lender-of-last-resort resource at the Fed — it is hard to believe that an end to quantitative easing now would push us back into the depths of post-Lehman liquidation. Certainly, in the year preceding the announcement of QE Infinity — when unemployment was higher, and bank balance sheets frailer — there was no such fall back into liquidation. What a taper certainly would have amounted to is a relative tightening in monetary policy at a time when inflation is relatively low (sorry Shadowstats) and when unemployment is still relatively and stickily high. Whether or not we believe that monetary policy is effective in bringing down unemployment or igniting inflation, it is very clear that doing such a thing would be completely inconsistent with the Federal Reserve’s mandate and stated goals.

Generally, I find monetary policy as a means to control unemployment as rather Rube Goldberg-ish. Unemployment is much easier reduced through direct spending rather than trusting in the animal spirits of a depressed market to deliver such a thing, especially in the context of widespread deleveraging. But that does not mean that the Fed can never tighten again. While the depression ploughs on, the Fed will continue with or expand its current monetary policy measures. Whether or not these are effective, as Keynes noted, in the long run when the storm is over the ocean is flat. If by some luck — a technology shock, perhaps — there was an ignition of stronger growth, and unemployment began to fall significantly, the Fed would not just be able to tighten, it would have to to quell incipient inflationary pressure. Without luck and while the recovery remains feeble, it is true that it is hard to see the Fed tightening any time soon. Janet Yellen certainly believes that the Fed can do more to fight unemployment. This could certainly mean an increase in monetary activism. If she succeeds and the recovery strengthens and unemployment moves significantly downward, then Yellen will come under pressure to tighten sooner. 

In the current depressionary environment, the hyperinflation that the Misesians yearn for and see the Fed pushing toward is incredibly unlikely. The deflationary forces in the economy are stunningly huge. Huge quantities of pseudo-money were created in the shadow banking system before 2008, which are now being extinguished. The Fed would have had to double its monetary stimulus simply to push the money supply up to its long-term trend line. Wage growth throughout the economy is very stagnant, and the flow of cheap consumer goods from the East continues. So Yellen has the scope to expand without fearing inflationary pressure. The main concerns for inflation in my view are entirely non-monetary — geopolitical shocks, and energy shocks. Yet with ongoing deleveraging, any such inflationary shocks may actually prove helpful by decreasing the real burden of the nominal debt. Tightening or tapering in response to such shocks would be quite futile.

Sooner or later, the Fed will feel that the unemployment picture has significantly improved. That could be at 5% or even 6% so long as the job creation rate is strongly growing. At that point — perhaps by 2015  — tapering can begin. Tapering may slow the recovery to some extent not least through expectations. And that may be a good thing, guarding against the outgrowth of bubbles.

Yet if another shock pushes unemployment up much further, then tapering will be off the table for a long time. Although Yellen will surely try, with the Fed already highly extended under such circumstances, the only effective option left for job creation will be fiscal policy.

Can Tightening Fight the Collateral Shortage?

Tyler Durden of Zero Hedge claims that any taper in QE will be a response to the collateral shortage — the fact that quantitative easing has stripped an important part of the market’s collateral base for rehypothecation out of the market. With less collateral in the market, there is less of a base for credit creation. The implication here is that quantitative easing is tightening rather than easing credit conditions. The evidence? Breakdown in the Treasuries market resulting in soaring fails-to-deliver and fails-to-receive:


Tyler notes:

Simply put, the main reason the Fed is tapering has nothing to do with the economy and everything to do with the TBAC presentation (rehypothecation and collateral shortages) and that the US is now running smaller deficits!!!

I don’t disagree with this. The ultra-low rate environment (that is still an ultra-low rate environment in spite of the small spike in Treasuries since murmurs of the taper began) on everything from Treasuries to junk bonds is symptomatic of a collateral shortage. Quantitative easing may ease the base money supply (as an anti-deflationary response to the ongoing deflation of the shadow money supply since 2008), but it tightens the supply of collateral.

The evidence on this is clear — expanding government deficits post-2008 did not bridge the gap in securities issuance that the financial crisis and central bank interventions created:


The obvious point, at least to me, is that it seems easier and certainly less Rube Goldberg-esque to fight the collateral shortage by running bigger Federal deficits until private market securities issuance can take its place. Unfortunately quantitative easing itself is something of a Rube Goldberg machine with an extremely convoluted transmission mechanism, and fiscal policy is not part of the Fed’s mandate.

But I am not sure that tightening can fight the collateral shortage at all. The money supply is still shrunken from the pre-crisis peak (much less the pre-crisis trend) even after all the quantitative easing. Yes, many have talked of the Federal Reserve inflating the money supply, but the broadest measures of the money supply are smaller than they were before the quantitative easing even started. This deflation is starting to show up in price trends, with core PCE falling below 1% — its lowest level in history. Simply, without the meagre inflation of the money supply that quantitative easing is providing, steep deflation seems highly likely. I don’t think the Fed can stop.

Why Does Anyone Think the Fed Will Taper?

Simon Kennedy of Bloomberg claims:

The world economy should brace itself for a slowing of stimulus by the Federal Reserve if history is any guide.

Personally, I think this is nutty stuff. In enacting QE3, Bernanke made pretty explicit he was targeting the unemployment rate; the “full-employment” side of the Fed’s dual mandate. And how’s that doing?

fredgraph (21)

It looks like its coming down — although, we are still a very long way from full employment. And a lot of that decrease, as the civilian employment-population ratio insinuates, is due to discouraged workers dropping out of the labour force:

EMRATIO_Max_630_378 (1)

Moreover, of course, quantitative easing — substituting zero-yielding cash into the money supply for low-yielding assets — is about the Federal Reserve attempting to reinflate the shrunken money supply resulting from the collapse of shadow intermediation in 2008. And the broad money supply remains extremely shrunken, even after all the QE:

And the bigger story is that America is still stuck in a huge private deleveraging phase, burdened with a humungous debt load:

Japan, of course, tapered its stimuli multiple times at the faintest whiff of recovery. Bernanke and Yellen will be aware of this.

Much more likely than abandoning stimulus is the conclusion by the next Fed chair — probably Yellen — that the current transmission mechanisms are ineffective, and the adoption of more direct monetary policy, including helicopter money.

No Investment is an Island


A Chinese woman from Kunming is attempting to sue the Federal Reserve for debasing the dollar:

A woman in Kunming, Yunnan province, is trying to sue the United States central bank after discovering that the real value of the US$250 she put in an account in 2006 had shrunk by 30 per cent.

She claims it was a result of the Federal Reserve issuing too much money.

Her attorney, her son Li Zhen , called the lawsuit “litigation for the public good” which aimed to stop the Fed from continuing its quantitive easing policy and promote people’s awareness of their rights.

This is a quite bizarre claim. If I buy and hold a currency or instruments denominated in that currency, I try to understand the mechanisms through which the market price (or my subjective valuation) of that asset could increase or decrease. In buying dollars, market participants tacitly accept the actions of the United States government and the Federal Reserve system. They tacitly accept that dollars (and implicitly, dollar-denominated instruments) are freely reproducible in either cotton-linen blend, or as digital currency in accordance with the Federal Reserve’s mandate, which includes a definition of price stability of 2% inflation (reduction in purchasing power as measured by the CPI-U) per year.

This is true with other liquid media, as well as less liquid assets like land, companies and capital goods. With gold and silver, future market prices are dependent on the actions and subjective expectations of gold miners and market participants. How much gold will they bring to the market? How much will they dig up out of the ground? To what extent will future market participants desire to hold and own gold? These are the questions one must implicitly answer in buying or selling gold.

The same is true for seashells, Bitcoin, Yen, Sterling, Euro. The differences are in physical characteristics, and the web of social interactions around them. All currencies and liquid assets are built on social interaction. The future viability of any currency or asset is dependent upon a complex web of social interactions.

Users and holders of Bitcoin today have an extraordinarily precise timetable for future monetary production — with Bitcoin, the great uncertainty lies in whether people will choose to use Bitcoin or not, and whether or not governments will try to outlaw it. For modern state-backed fiat currencies, there are legislatively-defined price stability targets designed to regulate monetary production, although the actions of central bankers and macroeconomists may surprise many holders of the currency. The power of the state also matters; a collapse of a state usually spells doom for any fiat currency it has issued.

When we buy something as a store of purchasing power, we enter into an implicit contract with ourselves to accept the currency risks and counterparty risks associated with it. That is our due diligence. Purchasing dollars and then complaining that the Federal Reserve is debasing them is incoherent. No investment is an island, insulated from risk. It is the same as purchasing gold before Columbus sailed to the Americas and complaining when conquistadors brought back huge new supplies of gold that diluted the money supply. The discovery of huge new gold supplies is part of the risk in holding gold, just as quantitative easing is part of the risk in holding dollars.

Junkie Recovery

A bad jobs report that left headline unemployment above 8% — and much worse when we dig under the surface and see that the real rate is at least 11.7%, if not 14.7% or an even higher figure when we take into account those who have given up looking and claimed disability — has made QE3 seem like an inevitability for many analysts.


U.S. Treasuries rallied on Friday after a weaker-than-expected August U.S. jobs report boosted hopes that the Federal Reserve would buy more bonds to help shift the economy into a gear that could create higher employment.

Goldman Sachs:

We now anticipate that the FOMC will announce a return to unsterilized asset purchases (QE3), mainly agency mortgage-backed securities but potentially including Treasury securities, at its September 12-13 FOMC meeting. We previously forecasted QE3 in December or early 2013. We continue to expect a lengthening of the FOMC’s forward guidance for the first hike in the funds rate from “late 2014” to mid-2015 or beyond.

Jim Rickards:

Fed easing on Sept 13th is a done deal.

Nouriel Roubini:

Quite dismal employment report confirming anemic US economic growth. QE3 is only a matter of when not whether, most likely in December.

Gold has shot up, too, the way it has done multiple times when the market has sensed further easing:

The thing I can’t get my head around, though, is why the Federal Reserve are even considering a continuation of quantitative easing. Here’s why:

If the point of the earlier rounds of quantitative easing was to ease lending conditions by giving the financial system a liquidity cushion, then quantitative easing failed because the financial system already has a huge and historically unprecedented liquidity cushion, and lending remains depressed. Why would even more easing ease lending conditions when the financial sector is already sitting on a massive cushion of liquidity?

If the point of the earlier rounds of quantitative easing was to discourage the holding of treasuries and other “safe” assets (I wouldn’t call treasuries a safe asset at all, but that’s another story for another day) and encourage risk taking, then quantitative easing failed because the financial sector is piling into treasuries (and anything else the Fed intends to buy at a price floor) in the hope of flipping assetsto the Fed balance sheet and eking out a profit.

If the point of quantitative easing was to provide enough  liquidity to keep the massive, earth-shatteringly large debt load serviceable, then quantitative easing succeeded — but the “success” of sustaining the crippling debt load is that it remains a huge burden weighing down on the economy like a tonne of bricks.  This “success” has turned markets into junkies, increasingly dependent on central bank liquidity injections. After QE3 will come more and more and more easing until the market has either successfully managed to deleverage to a sustainable level (and Japan’s total debt level as a percentage of GDP remains higher than it was in 1991, even after 20 years of painful deleveraging — so there is no guarantee whatever that this will occur any time soon), or until central banks give up and let markets liquidate. Quantitative easing’s “success” has been a junkie recovery and a zombie market.

As I see it, the West’s economic depression is being directly caused by an excessive total debt burden — just as Japan’s has been for twenty years; the bust occurred on the back of a huge outgrowth of debt and coincided with the beginning of a painful new era of deleveraging. And the central bank response has been to preserve the debt burden, thus perpetuating the problems rather than allowing them to clear in a short burst of deflationary liquidation as was the norm in the 18th and 19th centuries.

Central banks have been given ample opportunity to demonstrate the effectiveness of reflationism. And yet economic activity remains depressed both in the West and Japan.