Macroeconomics – Page 6 – The Aleph Blog

Redacted Version of the April 2016 FOMC Statement

Posted on 27 April 201627 April 2016 by David Merkel

Caption from the WSJ: Regulators don?t think it is the place of Congress to second guess how they size up securities. Fed Chairwoman Janet Yellen said recently that legislation would ?interfere with our supervisory judgments.? PHOTO: BAO DANDAN/ZUMA PRESS — PHOTO CREDIT: BAO DANDAN/ZUMA PRESS

Comments

Policy continues to stall, as the economy muddles along.
But policy should be tighter. Savers deserve returns, and that would be good for the economy.
The changes for the FOMC?s view are that labor indicators are stronger, and GDP and household spending are weaker.
Equities rise and bonds rise. Commodity prices flat and the dollar falls.
The FOMC says that any future change to policy is contingent on almost everything.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up much, absent much higher inflation, or a US Dollar crisis.

On a Letter from an Expatriate

Posted on 26 March 201627 March 2016 by David Merkel

Photo Credit: Liz West

A friend I haven’t heard from in many years?since he left the USA wrote me. He closed the letter in an unusual way, saying:

PS — USA has gone completely bonkers these days? or what the heck is going on over there? would love to pick your mind over a glass of wine. someday!

I’m not intending on writing on politics as a regular habit at Aleph Blog, and most of what I am going to say is economics-related, so please bear with me. ?Hopefully this will get it out of my system.

To my friend,

There are a lot of frustrated people in the US. ?Though you’ve been gone a long time, you used to know me pretty well; after all, I trained you on economic matters.

Let me give a list of reasons why I think people are frustrated, then explain how that affects their political calculations, and finally explain why they have mostly misdiagnosed the issues, and won’t get what they want regardless of who is elected.

The electorate is frustrated because:

Living standards have declined for the lower 80% of society.
Many people lost jobs, homes, pensions, etc., during the recent financial crisis… those assets are not coming back anytime soon. ?Much of the fault was theirs, but they don’t recognize that, preferring to blame others for their problems.
Many formerly attractive jobs are disappearing either due to technological change or offshoring (whether corporations or subsidiaries).
The economy muddles along, and economic policies that average people don’t understand dominate discussion. ?Many wonder if anyone is seriously trying to improve matters. ?They generally distrust the Fed.
It doesn’t seem to matter who gets elected, Democrat or Republican — the status quo remains because business interests support the Purple Party, which is the consensus of establishment Republicans and Democrats who duopolize politics in the USA.
Nothing good seems to happen in DC, and what few significant pieces of legislation have occurred in the Obama years have turned out to be bad (Obamacare) or useless (Dodd-Frank to the average person who doesn’t get it).
Immigration issues get short shrift, also trade issues.
Moral issues have basically disappeared from the political agenda in any classical form. ?Everything is pragmatic, geared to serve the Purple Party.
In general, the candidates are pretty lousy, and the moral tone of the campaign has been poor. ?That said, negative campaigning works, and the candidates that focus on being negative are doing better.

Now take a moment and think about what people do when they are desperate. ?In short, they take longer-shot chances than they would ordinarily take. ?They think:

“This person couldn’t be that much worse than what we have going now, and he sounds a lot different than the politicians that I have been hearing for so many years, ad nauseam. ?He talks about issues that affect my situation, and is not willing to mince words. ?He could be a LOT better than the status quo, which stinks. ?

So, the downside is limited, and the upside could be significant. ?I don’t care about the rough edges of this guy; the media always blows things out of proportion anyway, and helps foster the consensus candidates that never solve anything. ?So, I’m just going to hold my nose and vote for (fill in the blank).”

In my opinion, that’s why politics is nuts over here right now. ?Given the relative inability of the electorate to digest complex explanations, there are a lot of matters that they can’t understand, and as a result, regardless of who they elect, they won’t be happy.

Most of the economic and political problems stem from:

Technological change
Increasing returns to those that are smart versus those that are not
Not enough productive children being born
Attempts to improve the economy that don’t work
Gerrymandering
A diminishing consensus on what is right and wrong, and the proper role of government

The technological change is the most important factor, and explains why attempts to limit immigration or limit free trade won’t help. ?As a result of the internet, businesses can set up in many areas and benefit from the different aspects of each area — labor here, capital there, taxes way over there. ?Unless governments are willing to work together to limit this, and they?compete, they don’t cooperate here, this can’t be solved.

Information technology can make lower skilled workers far more productive, leading to a diminution of jobs in many sectors. ?This can happen anywhere — in banks, investment shops, factories, and restaurants. ?It works anyplace where you can turn 80%+ of a job into a set of rules. ?That can move jobs away from where they currently are to places where inexpensive labor can do the work.

In the short-run, this is a problem for many. ?In the long run, it will release labor to more valuable pursuits. ?That said, many older people will not be capable of retraining, and younger people will gain the opportunities if they are smart. ?the “know nots” are becoming “have nots.”

Part of this is payback for not studying enough in school, and/or studying topics that would eventually valuable in college. ?As I have said before, “Follow your bliss” is selfish and dumb. ?Real value comes, and society improves, from facilitating the bliss of others. ?The more people you make happy, the greater the rewards are.

Now, demographics are getting worse for most developing economies. ?Most economies do better when the fertility rate is over 2.1 — i.e., that population is growing. ?Typically that means that opportunities are growing. ?When working populations shrink, social benefit plans begin to collapse, and when populations shrink, countries lose vitality and creativity. ?We need youth to replenish its ranks to keep our societies healthy.

Note that efforts to fix fertility by offering tax incentives do not work. ?Once women are convinced it is not valuable to have kids, no reasonable amount of effort will change that.

As for economic policy, we are still running policy off of a model that assumes that debts are not high on order for policy to work. ?That is why continued deficit spending and abnormal monetary policy (QE & Zero or Negative Interest Rates) aren’t helping. ?Helicopter money?has its own issues.

Regardless of what happens to the presidency, Congress will remain the same because of gerrymandering. ?There’s only so much that even a good President can do if Congress is occupied by ideologues from both sides of the political spectrum.

Finally, the sides of the political spectrum are further apart because there is less consensus?on what is right and wrong, and the proper role of government. ?In some ways the internet facilitates this because you can filter out the arguments of those who disagree with you more easily. ?I set up my news sources so that I am always reading liberals and conservatives, as well as those that don’t fit well on the political map, but few others do.

And that, my friend, is why the political scene is nuts in the US now. ?There are a lot of disappointed and desperate people who are willing to try anything to get their prosperity back, even though none of the politicians can do anything that will genuinely help the situation.

It is a recipe for disaster, and absent an act of God, I don’t see anything that will change the attitudes rapidly. ?People across?the political spectrum are happily believing their own myths; it will take a lot of pain to puncture them all.

PS — I’ve given up alcohol. ?We’ll have to figure something else out if?we get together.

Laws are Only as Good as Enforcement

Posted on 25 March 201625 March 2016 by David Merkel

Photo Credit: Gerard Van der Leun || Personally, I would not have wanted my name on that law

This should be short. ?If you want more, you can read my old piece, “Who Dares Oppose a Boom?”

Laws are only as good as?those that enforce them. ?There was no lack of power in the hands of regulators prior to the financial crisis. ?There was a lack of willingness to use the power given, because regulators were discouraged by those above them from using the powers that they could use. ?That included both political appointees to high-level positions in the bureaucracy and Congressmen.

The real risk today is not that the laws are inadequate. ?Dodd-Frank has its flaws, and I didn’t like handing so many things over to committees, but with respect to banks, it is better than what we had previously. ?The risk is that regulators will once again not use the powers that they have, and be lax in enforcement.

I’ve argued before that state regulation of insurance is far superior to?federal banking regulation. ?There are several reasons for this:

Small-mindedness is good in regulation. ?Protect the downside, let the regulated suffer.
Actuaries have an ethics code. ?Their equivalent inside banks do not. ?Regulators do not. ?(Chartered Financial Analysts also have an ethics code, as an aside…)
It’s harder to corrupt 50 states than one federal regulator, particularly if you can choose that federal regulator.

Now, the next big problem may not be in the finance sector… I tend to think that we will see a major developed nation go through a crisis of its finances as the next crisis. ?But if there is a significant financial crisis, it will be because the regulators did not do their jobs, whether under outside pressure or not.

Fly Away From Helicopter Money

Posted on 23 March 2016 by David Merkel

Photo Credit: Shiny Things || Apologies, this was the best I could find at Flickr with a Creative Commons License

Once I wrote a piece advocating helicopter money, and I called it?2300 Smackers. ?For those who were not reading me back during the bailout, you should know that I vociferously opposed it, and wrote a lot to encourage everyone to oppose it.

The?2300 Smackers?piece was meant to advocate giving the bailout to the American people, and not the banks. ?The piece would have been better if I had advocated limiting the money to debt reduction, but anyway…

Now we are in a situation where helicopter money is once again being advocated — surprising to me, in this Wall Street Journal article, which probably should be an editorial, by Greg Ip, someone I usually respect. ?This is what he advocates:

Helicopter money merges QE and fiscal policy while, in theory, getting around limitations on both. The government issues bonds to the central bank, which pays for them with newly created money. The government uses that money to invest, hire,?send people checks or cut taxes, virtually guaranteeing that total spending will go up. Because the Fed, not the public, is buying the bonds, private investment isn?t crowded out.

Unlike with QE, the Fed promises never to sell the bonds or withdraw from circulation the money it created. It returns the interest earned on the bonds to the government. That means households won?t expect their taxes to go up to repay the bonds. It also means they should expect prices eventually to rise. As spending and prices rise, nominal GDP goes up, so the debt-to-GDP ratio can remain stable.

If this sounds too good to be true, it?s because usually it is. Throughout history, governments that couldn?t or wouldn?t collect enough taxes to finance their spending resorted to the printing press, from the U.S. Confederacy in the 1860s to Zimbabwe in the 1990s. It?s why so many central banks, including the ECB, are prohibited from financing government deficits.

But just because monetizing the debt can cause hyperinflation doesn?t mean it must. In ordinary times, the Fed is continuously monetizing debt to create enough currency to lubricate the wheels of commerce. Between 1997 and 2007, before QE began, its holdings of government debt rose by $355 billion, and currency in circulation rose by a similar amount. In effect, the government borrowed and spent $355 billion and never has to repay it.

In that instance, the Fed only created as much currency as the public wanted. What if it created more, to finance government spending? Even that isn?t necessarily catastrophic. In his book ?Between Debt and the Devil,? which advocates helicopter money, the British economist Adair Turner cites Pennsylvania in the early 1700s, the U.S. Union government in the 1860s and Japan in the early 1930s as examples of governments that used monetary finance without triggering hyperinflation.

An even better example is World War II. The federal government had to borrow heavily to finance the war effort and the Fed helped by buying bonds to keep their yields from rising above 2.5%. Between 1940 and 1945, the Fed?s holdings of debt rose from $2.5 billion to $22 billion, an increase roughly equal to 9% of annual GDP. Though this only financed a fraction of the war, it was still debt monetization: most of those purchases proved to be permanent.

The war effort massively boosted nominal GDP. Initially, only part of that showed up as higher prices, thanks to wage and price controls. Most of it came through a stunning rise in real output, made possible by the economy?s depressed prewar state, a flood of women into the labor force and business innovation to meet the demands of war and the civilian economy. As wage and price controls ended, prices shot up 34% between 1945 and 1948. But then, inflation reverted to low single digits.

I would encourage Greg Ip, Adair Turner and anyone else who is interested to read the book?Monetary Regimes and Inflation?by Peter Bernholz. ?Even if there have been some times where monetizing debt has not led to inflation, the odds are really low that that happens historically. ?Why?

Well, when a government gets a new policy tool, they tend to use it until it stops working or blows something up. ?Seeming success leads to more use (think of trying to trade lower employment for higher inflation in the ’60s), and lack of success leads policymakers their economist lackeys to try more because they say it will work when you do enough of it (think of QE, spit, spit).

It’s kind of like knowing that you have a difficult time with self-control issues, and wondering if you should try a drug offered to you at a party (even alcohol). ?You shouldn’t want to take the risk. ?Upside is low, downside could be very high, and probabilities are tilted the wrong way also.

Now to his credit, Greg Ip ends his piece like this:

Another obstacle?is the institutional separation between monetary and fiscal policy. That separation exists for a good reason: Central banks were granted independence so that they would not become the printing press for feckless politicians. The Fed was uncomfortable?doing the Treasury?s bidding during World War II and dates its de facto independence to the end of the arrangement in 1951. In 2013, Treasury was advised to sell the Fed a platinum coin to get around the statutory debt ceiling. Treasury dismissed the idea as a dangerous violation of Fed independence.

Tampering with this long-standing separation should not be done lightly. For the U.S., which is at close to full employment and in no imminent danger of deflation, the tradeoff hardly seems worthwhile. But there may be times, and countries, when it is. Monetary finance isn?t riskless, Mr. Turner?says, but the alternatives may be worse: stagnation and deflation, or perpetually low interest rates that fuel dangerous bubbles: ?The money finance option should not be excluded as taboo.?

No, money finance?should be taboo. ?Monetary history is replete with examples of where it ended very badly, and with few examples of success.

You know my opinion here. ?It would be far better as a society to get the government out of the macroeconomic policy business, except to regulate banks tightly as they are the source of systemic risk, and let the economy endure booms and busts. ?We won’t have perpetually low interest rates unless the government interferes, as they have done recently and during the Great Depression. ?If anything, government policy has amplified our booms and busts, and makes the present situation worse.

That said, we are going to take some pain from the present economic difficulties, it is just a question of what pain we will get because of too much debt. ?It could be inflation or more debt deflation. ?There could be defaults on government debt or considerably higher taxes. ?I can’t tell what the government will try to do, but whatever it will be, it will be painful.

Thus, diversify and prepare. ?You could do worse than the permanent portfolio idea. ?Consider it.

Redacted Version of the March 2016 FOMC Statement

Posted on 16 March 2016 by David Merkel

Comments

Policy continues to stall, as the economy muddles along.
But policy should be tighter. Savers deserve returns, and that would be good for the economy.
The changes for the FOMC?s view is that GDP, inflation, and labor indicators are stronger, and business fixed investment weaker.
Equities rise and bonds rise. Commodity prices rise and the dollar falls.
The FOMC says that any future change to policy is contingent on almost everything.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up much, absent much higher inflation, or a US Dollar crisis.

Trying to Cure the Wrong Disease

Posted on 5 March 2016 by David Merkel

Catch the caption from the WSJ for the above picture:

Regulators don?t think it is the place of Congress to second guess how they size up securities. Fed Chairwoman Janet Yellen said recently that legislation would ?interfere with our supervisory judgments.?

Regulators are not required by the Constitution, but Congress, perverse as it is, is the body closest to the people, getting put up for election regularly. ? Of course Congress should oversee financial regulation and monetary policy from?an unelected Federal Reserve. ?That’s their job.

I’m not saying that the Congressmen themselves understand these things well enough to do anything — but that’s true of most laws, etc. ?If the Federal Reserve says they are experts on these matters, past bad results notwithstanding, Congress can get people who are experts as well to aid them in their decisions on laws and regulations.

The above is not my main point, though. ?I have a specific example to draw on: municipal bonds. ?As the Wall Street Journal headline says, are they “Safe or Hard to Sell?” ?For financial regulation, that’s the wrong question, because this should be an asset-liability management problem. ?Banks should be buying assets and making loans that fit the structure of their liabilities. ?How long are the CDs? ?How sticky are the deposits and the savings accounts?

If the maturities of the munis match the liabilities of the bank, they will pay out at the time that the bank needs liquidity to pay those who place money with them. ?This is the same as it would be for any bond or loan.

If a bank, insurance company, or any financial institution relies on secondary market liquidity in order to protect its solvency, it has a flawed strategy. ?That means any market panic can ruin them. ?They need table stability, not bicycle stability. ?A table will stand, while a bicycle has to keep moving to stay upright.

What’s that you say? ?We need banks to do maturity transformation so that long dated projects can be cheaply funded by short-term savers. ?Sorry, that’s what leads to financial crises, and creates the run on liquidity when the value of long dated assets falls, and savers want their money back. ?Let long dated assets that want debt financing be financed by REITs, pension plans, endowments, long-tail casualty insurers, and life insurers. ?Banks should invest short, and use the swap market t aid their asset liability needs.

Thus, there is no need for the Fed to be worrying about muni market liquidity. ?The problem is one of asset-liability matching. ?Once that is settled, banks can make intelligent decisions about what credit risk to take versus their liabilities.

In many ways, our regulators learned the wrong lessons in the recent crisis, and as such, they meddle where they don’t need to, while neglecting the real problems.

But given the strength of the banking lobby, is that any surprise?

They Can’t Help You

Posted on 4 March 2016 by David Merkel

Before I start this evening, I want to add one follow-up to last night’s piece on Berkshire Hathaway. ?My summary was that it wasn’t a great year, and the profit margins are likely to shrink in insurance, because BRK is being conservative there. ?So why do I still own it for my clients and me?

BRK is trading maybe 8% over the level at which it would begin buying back stock. ?Even in a pessimistic year, I expect BRK’s book value to rise to the level that triggers the buyback. ?Thus, I think the floor for the stock is pretty close below me, and there is a decent possibility that Buffett could do some things with the cash that are even better than buybacks, especially if the market falls into bear territory.

It is positioned well for most market environments, even one where insurance gets hit hard. ?BRK is “the last man standing” in any insurance crisis — they have the ability to prosper when other companies will have their capital impaired, and can’t write as much business as they want.

That’s why I own it.

Long BRK/B for my clients and me

=-=-=-=-=-=-=-=-=-=-=-=-=-=-

Onto tonight’s topic. ?This is partially spurred by an article at Bloomberg.com entitled?Angry Americans: How the 2008 Crash Fueled a Political Rebellion. ?There was one graph that crystallized the article. ?Here it is:

Incomes have not improved for the bottom 80% of Americans over the last decade. ?Before I go on, recognize that the income distribution is not static. ?The same people are not in each decile today, as were in 2006. ?Examples:

Highly skilled students in a field that is in demand graduate and get jobs that pay well.
Highly skilled immigrants?in a field that is in demand come to the US?and get jobs that pay well.
Less skilled people who relied on the private debt culture to keep getting larger no longer have jobs that pay well in finance, construction, real estate, etc.
Workers and businessman who expected the commodities and crude oil boom to go on forever have seen their prospects diminish.
Some people have retired and their income has fallen as a result.
Layoffs have come in some industries because many people did not realize that they were lower skilled workers, and as such the work that they did could be automated or transferred to other countries.
Manufacturing continues to get more efficient, and we need fewer jobs in manufacturing to produce the same output (or more). ?This is true globally; manufacturing jobs are being reduced globally.
Technology firms that apply the advantages of the internet gain value, while legacy firms lose value. ?Whole classes of goods go away because they are replaced, and in other cases, some firms find that they can’t price their products to make a decent profit, while other firms can.
Some effects are demographic, like mothers ceasing work to raise children, or industries with a lot of older workers becoming uncompetitive because their pension plans are too expensive to fund.
Divorce usually ruins the prospects of the wife, if not the husband.
Throw in death, disability, substance abuse, and serious diseases.
And more…

Thus there is a lot of reason to look at the graph and not say, “The rich are getting richer,” but, “Those who are getting rich today are doing so faster than those who were getting rich back in 2006.”

My life is even an example of that… I make less than 30% of what I was making in 2006. ?On an income basis, I’ve gone from the top of the graph to the middle. ?I’m not upset, because I’m debt free, and manage my finances well. ?I’m grateful to have my own little firm, and every client that I have.

Resentment

That said, many feel that the comfortable life that was theirs has been denied to them by forces beyond their control. They think that shadowy elites want to turn previously well-off people into modern serfs.

It’s a tempting thought, because most of us don’t like to blame ourselves. ?Myself included, we all make mistakes. ?Here is a sampling:

Did we make a bad decision in the industry in which we chose to work? ?The particular firm?
Did we choose a bad field of study in college? ?Rack up too much student loan debt?
Did we borrow too much money at the wrong time? ?(Remember, debt is always a risk. ?If you don’t know that, you shouldn’t borrow money.)
Did you make bad decisions regarding your assets, and get too greedy or fearful at the wrong times?
Did you spend too much during your good years, and not save enough for the future?
Did you not buy the insurance that would have protected you from the disaster that hit you?
Throw in relationship errors, etc.

The truth is, changes in technology, and to a lesser extent demography, affect the entities that we work in, and affect our personal economics as a result. ?There are some politicians blaming immigrants for our problems, and that’s not a major source of our difficulties. ?Most people don’t want to do the work that unskilled immigrants do, and skilled immigrants get hired when there aren’t enough people seeking those positions.

There is a need for retraining, but even that has its difficulties, as technology is changing rapidly enough that more areas may face job reductions. ?Again, this is a global thing. ?Those that think that?making trade less free will help matters are wrong. ?It’s not trade; it’s technology.

Some think that matters can be fixed by changing government taxes and spending. ?That would only help limitedly, if at all. ?Businesses and people can move to other countries. ?In an era of the internet, many more things can move than ever did previously.

Now, if the developed ?countries collaborated to unify tax policies, some of that would end. ?But cheating under such a regime is too tempting, just as Indiana and Wisconsin try to attract businesses to move out of Illinois. ?The relatively healthy governmental entities have advantages that allow them to prosper at the expense of the sick ones.

You’re Going to be Disappointed

Politicians live to promise. ?I can tell you right now that not one of the surviving candidates for President has a realistic proposal that could be voted up by the next Congress or the buyers in the US Treasury market. ?It’s all airy-fairy… just as most politicians have been since we stopped running balanced budgets.

I would encourage you therefore to look at your own situation and resources soberly, and assume that the next government will do nothing better for you than the current one. ?All of the main drivers of what could improve matters for the middle class are outside the power of any individual government, so plan your own situation accordingly and adjust your economic expectations down. ?After all, there is no place in the world that can promise its people prosperity. ?Why should the USA be any different in this matter?

A World Deep in Debt…

Posted on 27 February 2016 by David Merkel

Photo Credit: Friends of the Earth International || Note: the above is just a photo to illustrate a point. I do not endorse debt cancellation under most coircumstances — Photo Credit: Friends of the Earth International || Note: the above is just a photo to illustrate a point. I do not endorse debt cancellation under most circumstances. ?I do support debt-for-equity swaps to delever the system.

Debt, debt, debt…?debt is kind of like a snowflakes. ?A single snowflake is a pretty star, but one quintillion of them is a horrendous mess. ?In the same way, most individual debts are reasonable and justifiable, but when debt becomes a pervasive part of the economic system, the second order effects kick in:

As fixed claims grow relative to equity claims, the economy becomes less flexible, because many are counting on the debts for which they are creditors to be paid back at par.
Economies that are heavily indebted grow slower.
Central banks following untested and dubious theories like QE and negative interests rates try help matters, but end up making things worse. ?(Gold would be an improvement. ?Just regulate the solvency of banks tightly, which was not?done in cases where?the gold standard failed.)
Political unrest leads to dubious populism, and demands for debt cancellation, and a variety of other quack economic cures.
The most solvent governments find high demand for their long debt. ?Long-dated claims raise in value as inflation falls along with monetary velocity.

Thus the mess. ?Bloomberg had an article on the topic recently, where it tried to ask whether and where there might be a crisis. ?I’ve argued in the last year that we shouldn’t have a major crisis in the US over domestic debts. ?There are a few areas that look bad:

Student loans
Agriculture loans
Corporate debts to speculative grade companies that are negatively affected by falling crude oil and commodity prices.
Maybe some auto loans?

But those don’t add up to a debt market in trouble as when residential mortgages were on the rocks.

But what of other nations and their debts, public and private?

Tough question.

That said, the answer is akin to that for a corporation with a tweak or two. ?It’s not the total amount of indebtedness versus assets or income that is the main issue, it is whether the debts can continue to be rolled over or not. ?A smaller amount of debt can be a much larger problem than a bigger amount that is longer. (point 2 below)

Take a step back. ?With countries there are a variety of factors that would make skeptical about their financial health:

Large increases in indebtedness
Large amounts of short-term debt
Large amounts of foreign currency-denominated liabilities (also true of the entire Eurozone — you don’t control the value of what you will pay back)
A fixed, or pseudo-fixed exchange rate (versus floating)
A weak economy, and
Debt and/or debt service to GDP ratios are high

The first point is important because whatever class of debt increases the most rapidly is usually the best candidate for credit troubles. ?Debt that is issued rapidly rarely gets put to good uses, and those that buy it usually aren’t doing their homework.

Under ordinary circumstances, this would implicate China, but the Chinese government probably has enough resources to cover their next credit crisis. ?That won’t be true forever, though, and China needs to take steps to make their banking system sound, such that it never generates losses that an individual bank can’t handle. ?Personally, I doubt that it will get there, because members of the Party use the banking system for their own benefit.

Points 3, 4, and 6 deal with borrowers compromising on terms in order to borrow. ?They are stretching, and accepting?terms not adjustable in favor of the debtor, or can be adjusted against the debtor. ? If you control your own currency, these problems are modified, because of the option to print currency to pay off debt, and inflate problems away. (Which creates other problems…)

By pseudo-fixed interest rates, I take into account countries that as neo-mercantilists make policy to benefit their exporters at the cost of their importers and consumers. ?These countries fight changes in the exchange rate, even though the exchange rate may technically float.

Point 5 simply says that there is insufficient growth to absorb the increases in debt. ?Economies growing strongly rarely default.

Conclusion?

My view is this: the next major credit crisis will be an international one, and will involve governments that can’t pay on their debts. ?It won’t include the US, the UK, and certainly not Canada. ?It probably won’t involve China. ?Weak parts of the Eurozone and Japan are possibilities, along with a number of emerging markets.

And, as an aside, if?this happens, people will lose faith in central banks as being able to control everything. ?I think the central banks and national treasuries will find themselves hard pressed to find agreement at that time. ?QE and negative interest rates might be controllable in a domestic setting, but in an international framework, other nations might finally say, “Why would I want to get paid back in that weak currency?” ?(And what holds that back now is that virtually all of the world’s currencies except gold are involved in competitive devaluation to some extent.)

My advice is this: be careful with your international holdings. ?The world may be peaceful right now, and everyone may be getting along, but that might not last. ?Diversification is a good idea, but don’t forget that there is no place like home, unless the crisis is in your home.

Our Growing World

Posted on 4 February 2016 by David Merkel

In general, I tend not to go in for macro themes. ?Why? ?I tend to get them wrong, and I think most investors?also get them wrong, or at least, don’t get them right consistently.

I do have one macro theme, and it has served me well for a long time, though not over the past two years. ?I was using the theme as early as 2000, but finally articulated it in 2006.

At that time, I was running my equity strategy for my employer, as well as in my personal account. ?They used it for their profit sharing plan and endowment. ?They liked it because it was different from what the firm did to make money, which was mostly off of financial companies, both public and private. ?They didn’t want employees to worry that their accrued profit sharing bonuses would be in jeopardy if the firm’s ordinary businesses got into trouble. ?In general, a good idea.

At the end of the year, I needed to give a presentation to all of the employees on how I had been managing their money. ?Because my strategies had been working well, it would be an easy presentation to make… but as I looked at the prior year presentation, I felt that I needed to say more. ?It was at that moment that the macro theme that i had been working with became clear to me, and I called it: Our Growing World.

The idea is this: in a post-Cold War world where most economies have accepted the basic idea of Capitalism to varying degrees, there should be growth, and that growth should create a growing middle class globally. ?This middle class would be less well-off than what we presently see in America and Western Europe, at least not initially, but would manifest itself in a lot of demand for food, energy, and a variety of commodities and machinery as the middle class grew.

Now, I never committed everything to this theme, ever. ?Maybe one-third of the portfolio was influenced by it, on averaged. ?Most of what I do was and still is more influenced by my industry models, and by bottom-up stock-picking.

That said, the theme has a cyclical bias, and cyclicals have been kicked lately. ?I still think the theme is valid, but will have to?wait for overinvestment and overproduction in certain industries to get rationalized globally. ?Were this only a US problem, it might be easier to deal with because we’re far more willing to let things fail, and let the bankruptcy process sort these matters out. ?Governments in the rest of the world tend to interfere more, particularly if it is to protect a company that is a “national champion.”

But the rationalization will take place, and so until then in cyclical industries I try to own financially strong companies that are cheap. ?They will survive until the cycle turns, and make good money after that. ?That said, the billion dollar question remains — when will the cycle turn?

More next time, when I write about my industry model.

Direction Matters More Than Position with Monetary Policy

Posted on 19 December 201520 December 2015 by David Merkel

Photo Credit: International Monetary Fund

As I was reading today, I ran across a quotation from Stanley Fischer, Vice-Chairman of the Federal Reserve. ?It was from an interview on CNBC in April 2015. ?I went to get the original source, and here it is:

Still, Fischer emphasized that a tightening would be slight.

“We have to ask what will go wrong,” he said. “I say that if we get this in proportion, we’re going to be changing monetary policy from the most extremely expansionary we’ve been able to do in all of history, to an extremely expansionary monetary policy.”

Fischer added that the expected increase of a quarter of a percent would be the lowest rates had ever been if not for the recent move to zero.

This is the same mistake that Ben Bernanke made when he talked about the “taper” back in 2013, and the same error that Janet Yellen is making now. At any given point in time, there is a schedule of interest rates going out into the future that reflects the future path of rates that the Fed controls.??This isn’t perfect because?almost none of us can borrow at those rates, but if credit spreads don’t vary much, movements in the schedule of rates, driven by expectations of monetary policy, affect business actions.

This implies two things:

Direction matters more than position in monetary policy. ?If expectations have moved from “zero for a long time” to “over 1% by the end of next year,” that is a large shift in expectations, and should slow business down as a result.
As a result, you can look at the Treasury curve as a proxy for the effectiveness of monetary policy.

On that second point, I have collected the Treasury yield curves since the middle of 2015 on the days after monetary policy announcements. ?Here they are, so far:

Maturity	1MO	3MO	6MO	1	2	3	5	7	10	20	30
6/18/2015	0.00	0.01	0.08	0.26	0.66	1.03	1.65	2.08	2.35	2.86	3.14
7/30/2015	0.05	0.07	0.15	0.36	0.72	1.07	1.62	2.02	2.28	2.66	2.96
9/18/2015	0.00	0.00	0.10	0.35	0.69	0.97	1.45	1.83	2.13	2.58	2.93
10/29/2015	0.02	0.07	0.21	0.33	0.75	1.05	1.53	1.90	2.19	2.60	2.96
12/17/2015	0.18	0.23	0.48	0.69	1.00	1.33	1.73	2.05	2.24	2.57	2.94

You can see the impact of the FOMC tightening out to five years, maybe seven. ?After that, there is no effect, so far, except to say that the yield curve is already flattening, and that the Fed my end up stopping much sooner than many expect — including the FOMC and their “dot plot” which expects a 2%+ Fed funds rate in 2017, and 3%+ in 2018. ?Unless the long end of the yield curve reprices up in yield, there is no way those higher Fed funds rates?will happen.

Which brings me back to Stanley Fischer. ?He’s a smart guy, perhaps the smartest on the Fed Board. ?Maybe he meant there was no way rates could rise much for a long time. ?If that’s the case, he may be way ahead of the curve. ?Only time will tell.