In my last post on this topic, I went over the orthodox and unorthodox monetary policy responses to the crisis in the US.  Here were the orthodox options:

• Lower the Fed funds rate into lower positive territory.
• Offer language that says that the Fed Funds rate will be low for a long time.
• Buy more long-dated Treasury bonds.

And the unorthodox options:

• Lend directly to classes of private borrowers.
• Create negative interest rates for Fed funds.
• Debase the currency by expiration dates, lotteries, etc.

On orthodox policy: I’m not sure there is that much difference between Fed funds at 0.25% and 0.10%, except that money market funds will find themselves in further trouble, as yields are too low to credit anything. That the Fed will be on hold for a long time seems to be the default view of the market already, so an explicit declaration would likely prove superfluous.  On buying long-dated Treasury bonds, that will benefit the US Government by pseudo-monetizing the debt, but won’t help the real economy much.

Yes, some high-quality corporate and mortgage bond rates will be pulled down with it, but so will discount rates for liabilities.  The same applies to spending rules for endowments, and how much retirees can get if they go to buy an annuity.  The effects of QE are mixed at best, and on balance, might be depressing, not stimulating.  But what practical proof, if any, do we have that QE has ever worked?

We need policymakers to understand the bankruptcy of the theories they are working with.  So many macroeconomic models work with one interest rate.  But in the real world there are many rates, and duration and quality of lending make a huge difference in what rate is charged.  I would urge that every person who would be on the FOMC work at a buyside firm managing bonds and money market instruments.  Let them see how the markets really work, and it might disabuse them of their false neoclassical views of how the lending markets work.  Better still, if their P&L is less than the cost of capital, revoke their appointment.  It’s time to kick out the academics, with their failed ideologies, and let those who have worked in the markets successfully manage the economy.

Direct Lending

But then there are the unorthodox methods.  When Social Security came into existence, they argued over where the money would be invested.  It was decided that the only fair investment was in government bonds, because it was neutral.  Investing in other assets, like the S&P 500 would be unfair, because they would be favoring a sector of the economy.

The same argument applies to direct lending by the Fed, because it would smack of favoritism.   Going back to my last article, favoritism undermines confidence in the system, and makes people less willing to invest unless the government gives them an edge — cash for clunkers, $8,000 tax credit, etc.  We are Americans, after all.  Why buy from the retailer now, when you know that there will be another sale coming soon?  Economic policymakers should not rely on people to behave “as usual” when policy becomes unpredictable and unfair to the average person.

So I don’t see direct lending by the Fed, or buying high yield bonds, or offering protection on baskets of bonds as wise moves.  It may temporarily goose an area for a time, and make an area of the economy QE-dependent, or stimulus-dependent, but at best it is helping a few, while discouraging the rest.

Negative Fed Funds

I’ve been thinking about negative rates for Fed funds, and I think that they will have the following effects:

• Banks will drop their excess reserves at the Fed to zero, and vault cash (or its short-term debt equivalents) will increase.
• Banks will try to borrow from the Fed at negative interest rates, if they allow it, and just sit on the cash, park it in T-bills, Top-top CP — it’s free money, after all.  Of course, some point free money may be construed as valueless money, but that is another thing.

Required reserves are not a large percentage of liabilities.  Unless Fed funds goes deeply negative, it’s not going to affect bank profitability that much.  Banks may just view it as a cost of doing business, and pass it on to customers.

Destructive Creative Currency Debasement

With apologies to Schumpeter, who popularized the concept of creative destruction, I’ll try to define a new concept that is the opposite — destructive creativity.  Destructive creativity is when bureaucrats or regulators get too clever, and in an attempt to solve a lesser problem, end up creating a bigger problem.

I’ve heard proposals for further debasement of the currency via placing expiration dates on currency, or randomly canceling currency through lotteries based on the serial numbers on the bills.  The idea is that people will change their behavior: save less and spend more.

I can’t say that I can see every unintended consequence with these proposals, but according to Keynes, Lenin said, “The best way to destroy the capitalist system is to debauch the currency.”  These creative means of debasing the currency might do it.

Who gets to be the one holding the Old Maid card as expiry draws near.  How much time would be wasted scanning currency at registers as money is handed over and change is handed out?  Is the money cancelled or expired?  Close to expiration?  Quick, put it into the pile to give as change to the next customer.  There may be legal tender laws, but I can tell you that there would be fights over things like this.  Would all of the dollar bills used as a shadow currency overseas come trotting home?

If the Fed wanted to write its own death warrant, it should implement schemes like these.  The Fed is already viewed with enough skepticism by average people, that it wouldn’t take much to tip the scale from “Audit the Fed,” to “End the Fed,” where it gets replaced with the currency board tied to a commodity standard.

This leaves aside ideas like expiring/canceling a certain amount of monies in savings or checking accounts.  After all, why stop with the paper money?  Move onto the blips that we transfer day after day, silently, quietly choking the economic well-being of people, making them feel less safe, less secure, more paranoid.  Would we set up checking/savings accounts in other currencies to avoid this trouble?  Would that even work, such that we would have to set them up in foreign countries, and access funds that way?  What’s that you say?  Exchange controls?  Destructive creation indeed.  To “solve” a smaller problem, a dud economy, create a much larger problem…

Want to kill the economy/country?  Taxation is one thing, confiscation is another.  There are more than enough people who have question marks in their heads over what the government is doing with monetary policy and stimulus.  Aggressive actions to debase the currency can turn those question marks in to exclamation points.

This has gone longer than I thought.  Time to hit publish, and I will finish this tonight.

11) I was surprised to read that there is not a perfect market in interest rate swaps.  They are so vanilla, but counterparty risk interferes.

12) There is always a skunk at the party, and who better than Baruch to dis bonds?  I half agree with him.  Half, because the momentum can’t be ignored entirely.  Half, because profit margins are wide.  But rates are low, and unless we are heading into the second great depression, stocks look cheap.  That’s the risk though.  Is this the second Great Depression? (Or the Not-so-great Depression that I have called it earlier.)

13) Housing is a mess.  The US government has been engaged in a delaying action on defaults, while calling it a rescue effort.  The sag in housing prices may lead to a recession.  The FHA is raising the costs of mortgages because their past loans have had too many losses.

14) Commercial Real Estate continues to do badly while some CMBS performs — no surprise that what is more secured does well.

15) The Fed gets whacked on its lack of transparency.  This could be a trend for the future.

16) In the current difficulties in the Eurozone, the ECB is beginning to suck in more bonds, presumably from peripheral Eurozone countries that are seeing their financing rates rise.  As central banks get creative, a simple question for currency holders becomes what backs the money?  It would seem to be governments, which will absorb losses if central banks generate them, and cover it with additional taxes or borrowing (some of which could eventually be monetized).  What a mess.

17) Bruce Krasting is almost always worth a read, and he digs up something that I had forgotten about how interest is credited on the Social Security Trust Funds.  It’s calculated this way:

The average market yield on marketable interest-bearing securities of the Federal government that are not due or callable until after 4 years from the last business day of the prior month (the day when the rate is determined). The average yield must then be rounded to the nearest eighth of 1 percent.

Krasting thinks that’s too high.  I think that is too low, given the true tradeoff that is going on here.  Think about it: when the government borrows from the SSTFs in a given year, a slice of the benefits incurred over that year don’t get “funded.”  The debt claim to back that should match the maturity profile of those future claims.  Medicare would have some short claims, Disability and Supplemental Security slightly longer, but Old Age Security develops most of the assets, and is a long claim.  Say the average person paying in is 40, and they will retire on average at 65.  That is a 25-year deferred claim that will last for maybe 20 years on average, with inflation adjustment.  The US offers no debt that is that long to back such a liability, so I would argue that the proper rate to use would be that of the longest noncallable debt offered by the Treasury.

But here would have been my second twist on this: they should have absorbed the longest marketable securities from the debt markets, and bought and held them.  That would have looked really ugly as the rates looked piddling against current interest costs.  But today, it would reflect the true costs of the borrowing from the SSTFs, and that cost would likely be greater than what was paid to the trust funds.  My guess is that the interest rate paid on the trust funds today would be higher than 5%, maybe higher than 6%, if a fair method had been used.

If there is enough interest, I could try to run the numbers, but the point is academic.  It would not change the total claims against the government plus SSTFs as a whole, but it might have changed the behavior of the government if it had tried to borrow on a long duration basis, competing for funds with private industry.  It would have revealed the true tradeoff earlier, and shown what a trouble we were heading for.

18) On retained asset accounts, this Bloomberg piece makes me say, “Yes, this is a big enough issue to deal with.”  For MetLife particularly, which has its own bank, it would be simple enough to set up a genuine bank account with all of the statutory protections involved.  If there are risks from forgery, that is big.  Even the risks of not being covered by the state guaranty funds is big enough.

My view is this: full cash payment should be the default, and a genuine bank account an option.  If you have one of these checkbooks now, and you want to minimize your risks, do this: write one check for the balance so that it is deposited in your bank account.  Simple enough.  You can protect yourself with ease here, even without legal change.

19) The yen will continue to rally until the Japanese economy screams.  Currency moves tend to last longer than we anticipate, and secular moves force needed economic changes on countries.

20) Consider what I wrote last week on long Treasuries:

I am not a Treasury bond bull, per se, but I am reluctant to short until I see real price weakness.  And some think that I am only a fundamentalist value investor.  With bonds, it is tough to catch the turning points, and tough to grasp the motivations of competitors.  Better to miss the first 10% of a move, than miss it altogether.

Now, I never expect to be right so fast, but with rates gapping lower on economic weakness — the 10-year below 2.5%, and the 30-year below 3.6%, I would simply say this: don’t fight it.  Let the momentum run.  Wait until you see a significant pullback in prices, and then short.  Don’t be a macho fool fighting forces much larger than yourself.  The markets can remain crazy for longer than you remain solvent.

To my readers: I am still in the process of blog repair.  I have heard from a few readers that I need larger type and more contrast.  I will fix that.  For now, use Ctrl-+ to expand the font.  I don’t want any of you going blind over me.

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Onto tonight’s topic: asset allocation.  So, we had a bad quarter for equities.  Not that I can predict things, but I pulled in my horns progressively over the last nine months, culminating in buying a bunch of utilities at the last portfolio reshaping.  I own mostly energy, insurance, utilities, and consumer nondurables stocks, with a little tech thrown in for fun.  At present, median P/E is around 9, and P/B around 90%, with strong balance sheets, and around 17% of the portfolio in cash.  I missed roughly half of the carnage of the last quarter, and this week, I put some money to work, cash falling by 1%.

So, when are equities cheap?  Next question: cheap relative to what?  It’s difficult to say when equities are absolutely cheap, but here are some ideas on cheapness:

• Stocks are absolutely cheap when they trade in aggregate at less than book value, or less than 8x trailing earnings.  Think of Buffett getting excited back in 1974.
• Stocks are relatively cheap to Baa bonds when the earnings yield of stocks plus 3.9% is above the yield on Baa bonds.  But this at present depends on very high profit margins continuing, and sales not shrinking, neither of which are guaranteed.
• When there is significant debt deflation going on, determining cheapness is tough.  Better to ignore the market as a whole, and focus on survivability/cheapness.  Aim at companies in necessary industries with relatively little debt, strong accounting practices, and cheap to earnings/book/sales.
• I don’t have a good metric for when equities are cheap/dear to commodities.  Ideas welcome.

With respect to bonds, credit spreads are not wide enough to make me yell buy, as I did in November 2008 and March 2009.  Beyond that, the spread on GSE debt and guaranteed mortgages is thin.  TIPS look attractive, as few care about inflation.  The US dollar has been strong lately, largely due to weakness in the Euro.  I would be light on non-dollar bonds for now.

What we have been experiencing is creeping illiquidity, where the prior stimulus from the Fed and US Government has been declining.  There isn’t enough private demand growth to drive the economy, because we need to pay off or compromise on debts.  Also, the private sector looks at the growing debts of the government, and gets concerned.  How will the government deal with it?  Higher taxes, inflation, default?  No good scenarios there.

When an economy is overleveraged, there are no good solutions.  If sales fall, then corporations will fire more people, and idle more capacity in order to maintain profits near prior levels.  High quality bonds do well, but stocks do poorly, until enough debts are paid of or compromised, and the economy can work without the fear of mass insolvency again.

I have written before on a new approach to asset allocation.  Broadly, I am looking at a system that:

• Considers the credit cycle first.  Great returns typically happen after credit spreads are wide, and are lousy after they are tight.
• Considers the slopes of the Treasury nominal and TIPS curves.
• Looks at the cash flow yield of all asset classes relative to history, relative to other asset class yields, etc.
• Factors in safety provisions for each asset class.  Stocks need the most, then junk bonds, then investment grade.
• Looks at the short-run and the long-haul returns of each asset class, attempting to analyze when the short run is way above or far below long-haul trends.

At present, I am still happy playing conservative, because I am less confident about debt deflation than most investors are now.  There will come a time to be much more bullish, but it will come after earnings decline, and firms have delevered still further.

Pardon the infrequency of posting.  I have been having internet issues.

1) A response to those commenting on my piece A Stylized View of the Global Economy: when I say stylized, is does not mean that every nation fits the paradigm, only that most do.  My view is that the debt overages will have to be liquidated, and there is no possible policy that can avoid it except large scale inflation.  Those looking for clever ways out of this bind will be disappointed by what I write.  When nations are heavily indebted their options decline, particularly when they don’t control their own currency.  For the US I say that we should have liquidated insolvent firms rather than bailing them out.

Also, read Falkenstein as he takes on the idea that stimulus spending works.  I have little confidence that the linear reasoning behind stimulus spending yields long-term economic benefits.

2) One blogger that I have some respect for, but have not mentioned often is Bruce Krasting.  He writes some good things on US social insurance programs. His recent post Social Security at Mid-Year highlighted what should shock many: we have hit the tipping point on Social Security.  From here on out it will be a drag on the federal budget.  Expect Congress to remove it from the federal budget.  It no longer aids the illusion of smaller deficits.  (What a cleverly hidden illusion.)

As he commented at the end of his article:

-SS is $2.5T of the $4.5T Intergovernmental account. I believe that this entire group is going cash flow negative. The IG account cost us ~$160 billion in interest last year, but some out there are pretending the IG account does not exist. An example of this is in the following link.

Sorry, U.S. Federal Debt Is NOT Approaching 100% Of GDP Anytime Soon

This kind of thinking is not only lunacy; it is dangerous.

And I agree.  There only two ways to look at the balance sheet of the US.  Look at explicit debt vs GDP, regardless of who is owed the debt.  Or, look at total liabilities vs GDP.  But never look at explicit debt not used to fund social insurance funds.  It is meaningless.  The total liabilities number tells the whole story.

3) Spain is in trouble.  Their banks are borrowing a lot from the ECB, with no end in sight.   Perhaps that leads them to push for stress testing across all European banks.  Or, maybe things are so bad that the banks are identified with the sovereign credit, and both are tarnished.

4) Or consider the Eurozone as a whole: the system begs for debt relief, but the Euro and ECB are tough taskmasters.  The Euro has been an excellent successor to the Deutschmark in terms of preserving purchasing power, but perhaps purchasing power needs to be sacrificed in order to relieve debtors.  The ECB is steps away from monetizing the debts of its governments.  Perhaps they could preserve the Eurozone by destroying the value of the Euro.  Germany might not stand for it, but it has significant unfunded liability issues as well.

As with the US, unless there is a large inflation, debts will eventually have to be liquidated, whether through austerity or default.  There is no other way.  Austerity will have its costs, but unless debts are inflated away or defaulted, those are costs that must be paid.

5) Can pensions be cut?  The typical answer is no, but what if a state pays less than what was promised in inflation-indexed terms?  That is what is being tested.  I think that eventually states and municipalities will be forced into bankruptcy because they can’t make employee benefit payments, and still maintain minimal services to the populace.

6) Debtors prison.  I have mixed feelings here, because I think that those that can’t pay should not be put there for long, if at all.  Those that can pay but won’t, should go there.  Regardless, this is a trend, and those that think they can walk away from debts should think twice before doing so.  You may be setting yourself up for prison.

This is just another front in the war against those who can pay but won’t.  More lenders are suing those who won’t pay, and going after their assets.  My only surprise is that it has taken so long for this to happen.

7) Fannie and Freddie are a giant black hole.  It astounds me that there is any respect given to two companies that have lost massive amounts of money since their inception.  The US would have been better off without them, and will be better off with them in bankruptcy.  The US should not promote single family housing as a goal, because it cannot create the conditions where marginal people can be capable of financing housing on their own.

So, when some suggest one last bailout, I say, let them fail.  Cancel the common and preferred stocks, and fold the remainder into Ginnie Mae.

8 ) Occasionally, there are really dumb articles, like this one.  The time for debt was November 2008 through March 2009, when I recommended investing in junk bonds.  There is little reason to borrow now; valuations are relatively high, don’t take your life into your hands.

9) And, occasionally, smart articles, like this one.  If you are in a volatile profession, reduce your risks by investing in high quality bonds.  If you are in a safe profession, invest in stocks.  When I went to work for a hedge fund, the first thing I did was pay off my mortgage, so that I could take more risk, without worrying about getting kicked out of my house.

10) Felix Zulauf has generally been a bearish guy, and so has done well over the past decade.  But is he right now?  Will stocks revisit their March 2009 lows?  It is possible, but I lean against it.  We would need a situation where most of the developed nations decided to aim for recession and stay there a while.  I do not see that yet.

11) Is it is liquidity problem or an insolvency problem?  If you have to ask, it is usually insolvency.  Consider Richard Koo, and his thoughts on the matter.

12) Using the rubric of the “Tragedy of the Commons” Kid Dynamite points out how it sets up the wrong incentives if we bail out profligate states and municipalities.  As a part of my “new mormal,” it is no surprise to me that this is happening.  It should be happening, and will happen for at least the next five years.

13) Because of my employment agreement, I can’t tell you exactly what I know about the demise of Finacorp.  But I can tell you that the article cited is wrong.  Finacorp never carried an inventory of assets.  It only crossed bonds between buyers and sellers.  The failure of Finacorp occurred for far simpler reasons.

fed's balance sheet

The image above is borrowed from this blog post at The Wall Street Journal.  Here’s my main point: the Fed is not succeeding in reducing the size of their balance sheet.  They are happily letting it grow, buying more mortgage backed securities, more than are paying off or defaulting.   The Fed’s balance sheet is now at a record size.

I have argued in the past that the Fed is not likely to remove stimulus prematurely.  We have the bad providence that Ben Bernanke is Fed Chairman, and has the wrong view of the Great Depression, and also the wrong view of monetary policy.  He will leave rates low for too long, and buy long duration assets for the Fed, and be reluctant to sell them.

In absence of a commodity standard (which would be a very good thing), monetary policy should act to preempt high growth in debt.  If debt across the economy is growing at more than twice GDP growth rates that is a time to raise rates, and make it hard to borrow.  I realize at a time like now, this makes no sense, but had we adopted it in the 70s or 80s we would not have the present crisis.

In a fiat money/credit world, evil as it is, monetary policy is credit policy.  The issues become clear at the bust, but the prescriptions work best before the boom starts.

The Fed always delays trouble in the modern era.  Slow to tighten, quick to loosen.  No wonder that we built up a mountain of debt, because the Fed would always ride to the rescue of crises, but never let the pain settle in that would liquidate poor investments.

We need fewer banks, fewer homebuilders, and fewer auto companies.  But guess what we bailed out?  We bailed out the very things that were the least productive in our economy, and taxed those more productive to do so.  Monstrously dumb.

So when the market corrects because there has been no effective change in economic policy that would allow for elimination of bad debts, and shrinkage of bloated industries, we should not be surprised.  Government stimulus can only do so much.  The markets incorporate the stimulus, and they move on.  Those stimulated gain, and taxpayers/moneyholders lose, but the markets move on.

In the two-dimensional Fed where they offer credit to banks, and buy long assets as well, the Fed can’t be considered to be tight when the Fed funds rate is under 1/4%, and they are still sucking in long duration paper.  The Fed is engaged in an operation to support asset prices, which may fail when goods prices begin to show some life, regardless of whether the CPI agrees or not.

Monetary policy needs an anchor like gold, and people need to stop looking to the government for prosperity; the government can do little to achieve prosperity, aside from laying down a consistent set of rules.  Prosperity is in the hands of the culture, and productive cultures that take on little debt will tend to be prosperous.

And Now For Something Slightly Different

While I’m on the topic of monetary policy, what if the money markets are beginning to run ahead of the Fed?  Look at this:

Money markets rising?

There are 3 components to the Treasury-Eurodollar [TED] spread:

1. The orange line is the LIBOR slope: 3 month US Dollar [USD] LIBOR minus overnight USD LIBOR.  LIBOR is a rate that banks will supposedly lend to each other at unsecured for short amounts of time.  As the LIBOR slope gets higher, banks are less willing to lend to each other.
2. The yellow line is the Overnight LIBOR gap: it is overnight USD LIBOR minus the Fed funds target.  This measures how much banks need overnight money through sources outside of Fed Funds.
3. The green line is called the Fed spread: it is the Fed funds target minus 3 month T-bills.  It measures how tight Fed policy is versus the ability of the US government to fund itself on the short end.

Now the current move is small, so far.  Banks are showing slightly more need for funding versus Fed funds, and since the crisis in the Eurozone intensified, the costs of borrowing longer in the Eurodollar market have risen.  But there isn’t the grab for safety, when T-bills go to zero, at least, not yet.  And contrast the last year with the last five years:

money markets panic

Panics aren’t pretty. They also start small.  I’m not saying that this must turn into a money markets panic, but only that it is possible.  There is a budding distrust in the Eurodollar lending markets, and that could spill into the short term lending markets in the US, though the effect should be less than in the Eurozone, where distrust is building across national borders.  Many banks implicitly say, “Better to have assurance regarding getting our money back if we need it, than be at the mercy of another nation’s laws.  Who knows if this grand experiment of the EU and the Euro will really last?”

Two Experiments

The Euro is an experiment, but so is unbacked paper money.  Both are undergoing a lot of stress at present; it will be interesting to see if either survives.

I’ve never been a huge fan of the Eurozone, as longtime readers know, and as this old piece indicates.  When times are volatile simplicity is rewarded and complexity punished.  Hard guarantees are favored over softer implied commitments.  Simple funding structures are favored when times get tough.  What then, to make of the humongous bailout plan proposed by the Eurozone, and aid proffered by the ECB?

First, it is by no means certain that all of the Eurozone governments will cooperate with the agreement.  It is not in the interest of most Eurozone countries to agree with the aid package.  Better to use the money at home and support debtors and banks at risk of failure, than support those that do not elect you.  With some countries, lending money to Greece on these terms may prove unconstitutional.

Second, providing liquidity to profligate nations does not tend to ease them onto “the straight and narrow,” but rather delays or prevents their adjustment to orthodox finance.  They accept the liquidity easily, but don’t easily return it.  The debt problem gets bigger through a rescue/bailout, leading to a bigger problem to solve later.

Third, multiparty agreements or multiple bilateral agreements are inherently less stable than simple bilateral agreements.  The more agreements that need to be upheld, the greater the probability of failure.

Fourth, making the ECB buy Eurozone government debt means that the Euro is only as hard as the debt that they buy.  Given the political pressure, it is more likely that they buy Spanish debt than German debt, and Greek debt than Dutch debt.

Fifth, it sends the wrong message other profligate nations, saying that there is someone to catch them if they fall.  Far better to kick one nation out of the Eurozone, and make the others take notice.  Is there something about being in the Eurozone that prevents intelligent judgment from taking place?

Sixth, it does not solve the problem that banks are increasingly less willing to lend across national boundaries.  No surprise; they see the same things that I am seeing, and are demanding a high risk premium to lend to other nations that may eventually default.

Seventh, it does not affect the ability of Eurozone governments to run large deficits in any significant way.  Yes, hey may make promises today, but what if they face domestic political issues later.  Who will they listen to, the Eurozone, or the local electorate?

Eighth, the ability of governments to modify pension and other entitlement promises is limited, which limits their willingness to comply with fiscal restraints.

Ninth, so you want to defend the Euro?  Go ahead.  Sell dollar-denominated debt and buy Euro-denominated debt.

Tenth, so where is the enforcement mechanism?  What will keep Eurozone governments from breaking the agreement?  Whether borrower or lender, the call from the local electorate is stronger than that of European unity.  Those calls head in opposite directions.

Economic systems are the result of cultures.  Where there is little cultural agreement, the economic system will be unstable, as will be governmental action.

No, this is not another “Rules” post.  But this is a post about the Eurozone and Japan today.  Japan faces trouble, but there is cultural agreement on what should be done, so there is no great crisis today, though the demographics may force issues eventually.

The Eurozone does not publicly recognize that there are large disagreements over what economic policy should be.  In the countries that are in economic trouble, there are many that push their governments to spend more on them, forcing the governments to borrow more.  This is particularly true of the unions.

My view of unions is that they slowly kill whomever they serve.  Industries with high unionization die eventually.  Countries that support unions die slowly as well.

Unions introduce inflexibility into the economic process which has a huge cost, eventually.  Greece is controlled by its unions.  They are willing to seek their own prosperity even if it leads to the destruction of the nation.  They don’t think the nation will be destroyed, but think that there are parties in power that hold back value from them, and they must be opposed, deluded fools that the unions are.

But there is a bigger problem for the Eurozone.  What do they do about Portugal, Ireland, Spain, and maybe Italy?  Yeah, the Eurozone could rescue Greece, but could it rescue Spain?  The answer is simple, NO.  But rescuing Greece discourages Spain from taking hard actions.

There is a lot of moral hazard involved in rescuing countries in the Eurozone.  Far better for nations to rescue banks that have lent to Greece, Portugal, Ireland, Spain, Italy, etc.  From what I have read, Europeans don’t exist.  Nations exist around a common culture and language.  Nations in Europe exist, and many act against the concept of a Eurozone.

Both positively and negatively, one can say that the Eurozone can’t make everyone into Germans.  The Germans exercised discipline that other nations would not.  Because of the size of Germany, and those allied with them in the Eurozone, the Euro is a hard currency, harder than many cultures/nations with lower labor productivity would like.

Why is the Euro weak?  Because the present crisis has relegated it to the status of an experiment.  Wondering over how Eurozone obligations will be repaid is an issue outside the Eurozone.  There are solutions, but they are painful — 1) let Greece become a state of Germany.  Not happening. 2) Let the Eurozone pour money into Greece; I’m sure they will reward you by adopting austerity measures, not. 3) Let Greece default, and then, let the Eurozone attempt to ameliorate it.  It will be difficult, and I doubt that debts to Greece will be settled at over 40% per Euro.

The major trouble is that banks in countries with relatively orthodox finances have lent to countries with liberal finances.  Well, who else could have done it, but the banks making the loans are in a fix because their health is subject to the creditworthiness of those that they lent to, which should be no surprise, but we forget.

Thus the big crisis in Europe is really over the soundness of the banking sector.  Rather than bailing out nations in trouble, far better to bailout your own banks that made bad loans, and let the profligate nations fail.  Remember, the Eurozone was not a promise to support profligate nations, but an effort for responsible nations to share a common currency.  If nations are not responsible, it is not the responsibility of the other Eurozone nations to subsidize them.

Do you want to save the Eurozone?  Save it by protecting your own banks, and letting profligate nations fail.  You will end up with a “hard” Eurozone of nations that are not profligate, and can live up to the demands of a strong currency.  The Eurozone exists without the UK.  It can exist without Greece, Portugal, Spain, Italy, and Ireland.

Subsidies don’t work, and that is what the loans to Greece are.  The Greeks will just suck them in, and continue their unruly fracas over who gets what.  Far better to let Greece fail, and scare marginal nations to clean up their acts.

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I don’t write this because I want the US Dollar to prosper because of a failure of the Euro.  Hey, I want credible alternatives to the Dollar, because it is at best the best of a bunch of sorry currencies, and I am not ready to sign on to the cult of Gold.  I like gold as a currency, but am not crazy about it as an investment.

My view is that the Euro can exist even after the failure of nations that leave the Euro, and that Euro obligations could still be enforced on defaulting nations because of the large amount of commerce inside Europe.

My advice to European statesmen, including those that share my surname, is to focus on your national interests.  The Eurozone is too vague to matter to those who elect you.  Focus on protecting your banks, rather than those the banks have lent to, which would waste money.

I did not ask for this book, but I am glad the publisher sent it to me for free.  There is a lot of concern over inflation in the present era, but not a lot of structured thought about what drives inflation.

This book takes the long term perspective, and looks at the wide array of monetary arrangements, and analyzes which arrangements produced more or less price inflation.  The author shows that there is generally an inflationary bias in all currencies.  Currencies that are backed by precious metals tend to experience less inflation, but many governments using such currencies debase the metals or clip the coins.  That said, it does restrain inflation, because inflating a  metallic-based currency takes a lot of work.

To have significant inflation, one must have unbacked paper money.  The same is true of defaults in bonds.  In order to have a crisis, much debt must be issued relative to the assets and earning power of the companies.  The debt is not backed by sufficient repayment capacity, and thus there are some defaults.

A fiat currency in and of itself, is not sufficient to create hyperinflation.  Hyperinflation only happens when the government finances itself by printing money with abandon.

The book further distinguishes itself by explaining situations where foreign currencies come in to act as shadow currencies inside nations.  Further, the book describes how inflationary situations end.  One constant is that people quickly analyze where purchasing is declining, and seek stability through metals or relatively stable fiat currencies.

One strength of the book is that at the end of each chapter, the author summarizes all of the main points.  I recommend this book.

Quibbles

The book is not dry, but it has a distinctly academic feel.  Not everyone will take to the book easily.

Who would benefit from this book?

Economists would benefit from the book, and also those that like reading about the history of inflation.  Few things truly change in History; the names may change, but we make the same mistakes.

For those who want to buy the book, you can buy it here: Monetary Regimes And Inflation: History, Economic And Political Relationships.

Full disclosure: Though I get books for free from publishers, I burn time to read books in full, and write reviews that are balanced.  Those entering Amazon through my site and buying anything will end up sending me a small commission, but they will not pay more in order to do that.

Many of you have heard of the blog Naked Capitalism, and its pseudonymous writer, Yves Smith.  Well, she has written what I regard as an ambitious book, ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.  It is ambitious for several reasons:

• It tries to be comprehensive about all aspects of the crisis.
• It digs deeper than most, analyzing flaws in economic and financial theories that underpinned the errors of the crisis.
• It looks at the political angle of how laws and regulations were subverted, while alleging conspiracy probably too much, when ordinary greed in the open and stupidity could cover the causes of the crisis.

There is a tension between capitalism and democracy.  We don’t like to talk about it, but it is there.  Property rights are human rights, and should be protected.  Governments often determine that certain contracts are not valid on public policy grounds.  (I.e., gambling, prostitution, arson, assassins, etc.)

Democracies also do not like rivals for power.  If business gets too big, to the point where it is influencing the decisions of the government, democracy fights back.  I write this as one who would err on the side of property rights rather than democracy.  Property rights are a direct descendant of the eighth commandment, “You shall not steal,” whereas the form of government of any nation is a thing of relative indifference.  Many nations have different ways of ruling themselves.  It is not yet proven that democracy is the best form of government.  Personally, I think it is more prone to corruption than most governmental forms.  But it has the advantage of motivating the people.

I draw the line when businesses use political power to exclude rivals.  It is one thing to be really clever, and dominate your market, like Google.  It is another to have a natural monopoly like the old AT&T, before technology obsoleted them.  But it stinks to have a system where major financials, who have nothing of patentable value, hold the nation hostage, saying “Bail us out or the financial system fails.”

I argued against the bailouts, as did Yves, but the government caved under the asymmetry of “Heads we win, Tails you lose.”  It came up tails for all of us.

Yves digs deeper than many critics.  She questions the assumptions of the economics profession,with its gloss of pseudo-science.  She pokes at the questionable assumptions underlying much of finance theory.   She looks at those who got it right regarding the crisis, and were marginalized as a result.  Where I differ is that there isn’t necessarily a conspiracy behind unwillingness to listen to discordant theories.  Academic guilds ignore researchers who question their closely held beliefs, regardless of the truth of the matter.  They know that it couldn’t be true, and the outsider doesn’t really understand their discipline.  I do not charge them with ill intentions, but stupidity.

What I really appreciated about the book was its willingness to challenge academic economics and finance.  She did it well, but left little in her wake as to what to look to as a substitute.  The willingness of economics to engage in pretend games with high level math is ridiculous.  If we restarted economics from scratch today, whether mathematical or not, it would not look like much of the sterile games that are played in leading economic journals.  Ask the question: how many benefit outside the economics profession from what is written in economic journals.  Answer: precious few.

I have many more things to say about this book, but this review is long enough as it is.  Let me say that there are few books that I have marked up as much as this one.

Quibbles

I do not go in for conspiracy theories.  Usually, most evil can be performed outside of darkness; people still don’t notice for the most part.

Yves should have spent more time on the enablers of the crisis — yield hogs.  You can’t buy protection on a company that you think will die, unless there is a yield hog out there that wants extra income that they think they are getting for free.  AIG was the largest of them, but by no means the only one.

She complains a bit much about “free markets.”  Aside from trading with the enemy, why should trade be constrained?  Why should I try to take away the property rights of my neighbor?  Beyond that, suppose you are right.  Where would you draw the lines?  It is one thing to criticize, and quite another to propose new policy.  Personally, I make an effort that when I suggest that something be demolished, that I recommend something else to take its place.  It is easy to be a critic, but hard to be a builder.

Who would benefit from this book:

Most people would benefit from the book, if they read it realizing that the things that happened do not require that parties conspired to make this happen.  Those who would especially benefit include economics and finance professors; they need the criticism.

If you want to buy the book, you can buy it here: ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.

Full disclosure: The publisher sent me the book for free.  I spent several hours reading it in full.  If you enter Amazon through my site and buy anything, I get a small commission (6-7% typically).  But, your costs don’t rise versus going to Amazon directly.  I have avoided doing a “tip jar” because I would rather people benefit from the books I review, while allowing Amazon to pay me indirectly.

As I looked over the carnage that was the bond market yesterday, I was reminded of my piece 17 months ago called Broken….  But as I read that, I said to myself, “Who are you kidding?  Yes, things were bad today, but nothing like when the bond market was falling apart out of fear of corporate credit risk.”

True enough, but I found yesterday disturbing.  Why?

1) Increasing chatter of troubles in the Eurozone, given Fitch’s downgrade of Portugal, and an increased insistence that Greece will not be bailed out, leading to a drop in the Euro.  Many say that it is impossible that the EU would not prop up Greece, but consider the German mindset here.  They traded their hard Deutschemarks for Euros.  They expect a hard Euro.  Their view is that if you want the benefit of being in the Euro, you must behave like Germans.  Anything else would be profoundly unfair — benefits come to those who have discipline.  There are two alternative views of what it means to be in the Eurozone, and they can’t be reconciled.  At most, one of those views will survive.  I think the German version is more likely.

My view is by no means the consensus, but without Germany on board, there is no Greek bailout.  The IMF is too small to truly help Greece.  If Greece were to default, it would harm banks in Europe, but it is a lot cheaper to help local banks than to help Greece.  That makes me a little bullish on the Euro, because if Greece defaults and leave the Eurozone, it sends a warning to other profligate nations, and leaves the core of the Eurozone stronger.  Beyond that, vacations in Greece would become the rage, as they would be very cheap, even including the frictions of exchanging Euros into “New Drachmas.”

Here’s a 12-month graph of the Euro:

My view is that the Euro will weaken further if they bail out Greece, and rally if they don’t.  Guess which the Germans will choose?  They will favor a strong Euro, even if it means shrinking the Eurozone.

2) I want to find the guy(s) who taught me when I was a young and impressionable mortgage bond manager (age 38, I came to the game late) that swap spreads could not go negative; sorry, it ain’t true.  John Jansen used to complain about the 30-year swap spread, but now we are negative at 10 and 7 years as well, and 5 years is not far away at +7 basis points.

But why?  If swap yields represent the levels that AA banks fund at, then how can they yield less than a AAA government?

Here’s my answer, though there are other good ideas to consider.  As a corporate bond manager, I underweighted two names that I really did not like, GE and AIG.  Though AAA, they traded as if they were single-A, and they had a lot of debt outstanding.  I always felt they were too levered, and that the rating agencies were giving them too much credit for being big.  Having run the GIC desk of a small well-capitalized insurer, with lower ratings, less leverage, and a higher ROE than other larger competitors, I was/am biased against firms with bad credit profiles that get good ratings only because they are big.  That they could fail is not conceivable.  Please ignore that AIG did fail, and that GE Capital would have failed in late 2008 or early 2009 without the TLGP.  The US Government played favorites, ignoring CIT, Advanta and others.

But, it is inconceivable the the US Government would fail.  That said it is issuing a lot of debt, and it is hard to absorb it all, so yields have to widen.  Very highly rated corporates offer some diversification, so they trade at lower yields than the behemoth that needs more and more liquidity.  Look at the lousy 5-year auction yesterday.  The Street is choking on Treasury paper.

The move in Treasury yields was large, but not overwhelming, maybe 98th percentile in severity:

3) Then there was the move in mortgage bond yields.

Up 15 basis points, near the Treasury move, but much more than the move in swaps, which are closer to how mortgages fund.

Looks like about a 10 basis point move, which means mortgages cheapened by 5 basis points or so.  That’s big!

Further, there was the change in the MOVE [Merrill Option VolatilityEstimate] index.  Think of it as the VIX for Treasury securities.  Up considerably:

All of this is somewhat panicky in terms of feel.  Is this a turning point? If it is, how much steeper can the curve get, or will the Fed genuinely tighten?

4) On a day like this, where things are falling apart, it does not help to hear Bill Gross say that he likes stocks over bonds.  I know, this is not nearly as serious as the above three, but I agree with him, weakly.  Bonds don’t have much upside here.  Large cap high quality stocks, which are a decent proportion of the S&P 500, still seem cheap.  Maybe that is true only in a relative sense, but I will stick with Jeremy Grantham here.

Here are two more wrap-ups of the day:

• Some Warning Signs, If You Look Closely
• Debt Fears Shake Markets

Summary

Be careful.  We live in a world where few governments are following orthodox rules of finance.  Indebted governments may turn to inflation, or higher taxation, or default.  At present, there is no decided answer to what will likely happen.  Governments are still trying to figure it out, hoping that some marginal nation like Greece will choose a course of action that tells them what or what not to do.  In a sense, we are waiting for some entity to make a bold move that changes the game, and then others will decide whether to do that, or, the opposite action.  Until then, keep your powder dry, and be nimble.